Tuesday, June 30, 2015

Earnings Inflation: Why Some Tech Companies Earn Less Than You Think

This Barron's article covers what it calls the "weird world where a wide range of technology companies...encourage investors to ignore the large and very real cost of stock compensation when calculating expenses and earnings."

Remarkably, this kind of "inflated and distorted earnings figure...is widely embraced by analysts and investors in valuing tech companies."

This, in part, reminds me of what Jeremy Grantham once said:

"Career risk drives the institutional world. Basically,everyone behaves as if their job description is 'keep it.' [John Maynard] Keynes explains perfectly how to keep your job: never, ever be wrong on your own. You can be wrong in company; that's okay."

Well, if that's the case, then maybe this bodes well for those less influenced by "the institutional world."

Barron's estimates that a dozen large tech companies are not including roughly $ 16 billion of stock compensation expense in their non-GAAP earnings. A table in the article provides a detailed look at the relevant numbers for the twelve companies.

Some things to consider:

- Stock compensation is usually the major difference between reported GAAP earnings and non-GAAP earnings.

- Profit projections from analysts often ignore stock compensation.

- The likes of Microsoft (MSFT), Intel (INTC), Apple (AAPL), and IBM (IBM) are tech companies that report GAAP numbers only with stock compensation included.

- Some companies prefer non-GAAP earnings because they're highly dependent on stock-based compensation and, well, it makes their numbers look better. Analysts, in enough cases for it to matter, tend to use whatever approach the company thinks makes more sense. So, basically, those that don't offer much in the way of stock compensation don't mind reflecting the cost; those that do rely extensively on stock compensation, not surprisingly, choose the non-GAAP approach.

Here's three examples of how much of a difference it can make:

Google (GOOG)
2015 GAAP Estimated EPS: 22.70
2015 non-GAAP Estimated EPS: $ 28.35

2015 GAAP P/E: 24.7
2015 non-GAAP P/E: 19.8

Amazon.com (AMZN)
2015 GAAP Estimated EPS: 0.37
2015 non-GAAP Estimated EPS: 4.14

2015 GAAP P/E: 1,193
2015 non-GAAP P/E: 106

Salesforce.com (CRM)
2015 GAAP Estimated EPS: -0.05
2015 non-GAAP Estimated EPS: 0.71

2015 GAAP P/E: Not Meaningful
2015 non-GAAP P/E: 104

More from Barron's:

"Various justifications are offered for excluding equity compensation from expenses, but none hold up to scrutiny."

The argument that stock compensation isn't a real expense is a weak one at best.

If stock-based compensation expense is generally ignored by analysts and investors guess what's going to happen?

It seems rather probable it will encourage the use of stock-based compensation.

Some will no doubt continue to argue that stock compensation expense can be ignored. Arguments include that it's a non-cash expense and the additional share count captures the cost.

Well, in this case, it's a real expense even if it happens to be a non-cash expense: unless the strike price of an employee stock option fully reflects per share intrinsic value, the company is, when options are exercised, effectively selling shares at a discount (with tax implications fully considered). That discount is a real cost to continuing owners. So, in such a case, the additional share count only partially reflects that expense.*

Another argument essentially is that, since many industry peers ignore stock-based compensation, it makes sense to also ignore it for comparison purposes. Well, it's a real expense no matter how another company decides to logically present their own numbers.

When a company chooses to repurchase shares to just keep the share count from increasing, those funds could have instead been used for the direct benefit of shareholders in other ways. If the strike price is less than the repurchase price then, effectively, the company is buying high and selling low.

The difference can prove a meaningful cost especially for shareholders who intend to stick around.**

Those funds could be used for reducing share count instead of merely offsetting the dilution that occurs from stock compensation.

Those funds could be used for paying dividends.

Those funds could also be put to many other potential high return uses.

Now, if a company needs to use stock compensation to get the best employees, or to help manage cash flows, it may be very wise to do so.

Just count it as the real expense that it is.***

It simply makes little sense to ignore stock compensation for certain companies but include it for others.

When stock-based compensation is deliberately ignored -- especially for the companies who heavily rely on it -- per share intrinsic value and how it's likely to change over time is likely to be overestimated.

Stock compensation is also a real cost for shareholders even if a company chooses to NOT repurchase shares. In many ways employee stock options -- depending on how the strike/exercise price compares to per share intrinsic value -- partially function like a reverse buyback that quietly (and, sometimes, not so quietly) dilutes continuing shareholders. Keep in mind that, upon the exercise of stock options, a company will receive funds equal to the strike price for each option that's exercised plus, depending on how much the options are in the money, a tax benefit. So, effectively some capital is "raised" in the process but what matters for continuing owners is how reasonable that strike price happens to be.
(If these funds are used to buyback stock then the net dilution is reduced.)

It's hard to completely fault the companies when not enough analysts and investors seem to be forcing the issue.

It's easy to choose to not follow suit and always include stock-based compensation when attempting to estimate, within a range on a conservative basis, per share intrinsic value.

None of this necessarily means some of these tech stocks aren't fine businesses. In fact, some are already extremely valuable and will no doubt prove to be even more so. It comes down to:

Will the value per share increase sufficiently?

Does the price paid offers an acceptable or better risk versus reward against alternatives?

Is there sufficient margin of safety to protection against what might go wrong and/or misjudged prospects?

If nothing else, a willingness to ignore stock-based compensation is fundamentally at odds with the margin of safety principle.

It's worth noting that I'm not referring to the speculative buying at one premium price (premium to per intrinsic value) with the hope of later sell at an even higher price. I'm referring to whether the price paid today offers an attractive outcome compared to what these businesses will be intrinsically worth on a per share basis in 10 or 20 years.

Those who successfully buy shares at a premium to value and exit successfully are likely taking on far more risk of permanent capital loss than they realize.

Risk that's not usually obvious until it is.


Long positions in MSFT and AAPL established at much lower than recent prices; long position in IBM established at somewhat higher than current prices; very small long position in GOOG also established at much lower than recent prices. No position in the other stocks mentioned.

Related posts:

Stock-based Compensation: Impact On Tech Stock P/E Ratios
Big Cap Tech: 10-Year Changes to Share Count
Technology Stocks
Time for Dividends in Techland

* There are exceptions. When, for example, the strike price of employee stock options is well above per share intrinsic business value, then stock-based compensation can actually become beneficial to long-term owners. Of course, for these to be of any value to an employee the stock must necessarily be more than fully valued upon exercise. In this narrow (and somewhat unlikely) scenario, the company would be getting more than full value. The situation functions like capital being raised at an attractive price with a tax benefit as a bonus. This doesn't apply to stock-based compensation that's in the form of restricted stock (which is increasingly favored over stock options).
** The actual cost for shareholders is the difference between the lower strike price and the higher repurchase price. For companies where this kind of buy high/sell low behavior is the norm, this can become rather expensive (depending on the specifics of the stock-based compensation plan) for long-term owners when compounding effects are fully considered. In contrast, these still very real costs might be viewed as mere noise for those with shorter holding periods.
*** It's worth mentioning, as I noted in a previous post, it's not as if the GAAP numbers are always a terrific indication of actual business economics. Accounting can be a very useful tool but has its own real limitations.
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.

Tuesday, June 23, 2015

Buffett: Arcane Formulae & Foolish Maxims

Warren Buffett wrote the following in his 1987 Berkshire Hathaway (BRKashareholder letter:

"...investment success will not be produced by arcane formulae, computer programs or signals flashed by the price behavior of stocks and markets. Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace."

So, as far as Buffett's concerned, it's ignoring the noise (i.e. things like macro data, what most market participants and commentators are doing/saying, etc.), controlling one's own emotional reactions, along with sound business decisions and judgments made over many years -- and, ideally, over many decades -- that has the greatest influence over investment outcomes.

It's not about attempting to correctly guess near-term price movements.

It's about increases to intrinsic business value. More from the letter:

"As Ben [Graham] said: 'In the short run, the market is a voting machine but in the long run it is a weighing machine.' The speed at which a business's success is recognized, furthermore, is not that important as long as the company's intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price.*

Sometimes, of course, the market may judge a business to be more valuable than the underlying facts would indicate it is. In such a case, we will sell our holdings. Sometimes, also, we will sell a security that is fairly valued or even undervalued because we require funds for a still more undervalued investment or one we believe we understand better.

We need to emphasize, however, that we do not sell holdings just because they have appreciated or because we have held them for a long time. (Of Wall Street maxims the most foolish may be 'You can't go broke taking a profit.') We are quite content to hold any security indefinitely, so long as the prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business."

Back in the late 1990s, the market prices of many stocks -- and it wasn't just tech stocks -- became completely nonsensical. While prevailing prices these days aren't nearly as silly as they were back then, that doesn't mean right now is, in general, a wonderful investing environment. Far from it.**

Effective investing, best case, generally involves lots of waiting.

As stocks have rallied in recent years the risk-reward has, in fact, become much less attractive.

Time and energy is best spent understanding how to value a favored investment. Patience, discipline, and the right temperament essential. Focusing on an increased depth and breadth of understanding -- instead of the next trade -- makes it possible to act decisively with some scale when the opportunity presents itself.
(When, for example, market prices might become extreme whether on the high side or the low side.)

Meaningful discounts can arise when macro events and the headlines are most daunting and fear is running rather high. Well, at least for those businesses challenged by the immediate circumstances but otherwise with sound long-term prospects. Premium prices, possibly substantial, can arise when everything appears to be going right and it seems inevitable that such an environment will persist for some time.
(Which, of course, it won't.)

For a business with durable advantages that's comfortably financed, the risk-reward is generally most favorable when it feels like the worst time to buy. That's where being able to "insulate... thoughts and behavior" comes into play. The market price fluctuations of a quality business, over the short run, can far exceed changes to per share intrinsic value when "emotions... swirl about the marketplace."

A good business that's well understood and bought at a clear discount (to conservatively estimated per share intrinsic value) beats the best business that's not well understood bought at a healthy premium.

When an investment is truly understood ignoring the noise around you becomes, if not exactly easy, more doable. So the importance of understanding what one owns isn't just about avoiding analytical errors; it's about managing psychological factors.

During extremely adverse economic/market/financial environments, equity prices can get low enough that, even under a very bad scenario, permanent capital loss becomes extremely unlikely. Such a price may not become available often, but that's where patience comes into play.

Here's just one good example of this.

Generally, when shares of a good business are bought well in the first place, it's not a bad idea to be a reluctant seller.

Still, there inevitably will be times when it makes sense to sell.

The key thing being that it's, in fact, a good business. If future prospects change materially and permanently (and I'm not referring to the normal challenges that even the best businesses face from time to time) for the worse, or were misjudged in the first place, then patience is no longer a virtue.

Otherwise, it's when market prices represent a large premium to conservatively estimated value (within a range), or when opportunity costs are high, where selling will start to make sense.

Buying with a clear margin of safety isn't just protection against things going less well than expected; it's protection against inevitable misjudgments along with behavioral biases.

Some market participants will get caught up in the price action.

The potential for quick returns will cloud their judgment.

They start to believe it'll be possible to jump in and ride a wave until it makes sense to get out.

Well, that's not good in theory nor is it a wise strategy. Participants can mistakenly extrapolate what's been happening in recent years for far too long going into an unpredictable future. The "good times" may feel like a safer and more certain time to invest but, too often, they're just not. Existing trends that seem persistent eventually, and sometimes suddenly, prove otherwise. It's when it seems like a favorable economic environment will continue indefinitely that the risk of permanent loss is increased while return prospects are reduced.
(Due, in no small part, to the prevailing premium market prices.)

At the other end of the spectrum, some will also become less inclined to buy when market prices are most depressed. Well, it's at those times -- if one learns to ignore temporary losses and is actually good at judging value -- that the risk of permanent loss is much reduced and potential reward is greatly enhanced.***

Buying, in a disciplined way, at a discount offers real protection against uncertainty and mistakes. The price paid, unlike macro factors, is one of the few levers an investor has direct control over.

So participants may feel better during a bull market but, for those with a long time horizon, it's not an entirely sensible reaction.

The market is a servant; it's not a guide.

Risk and return can be, but need not be, positively correlated.

This, in my view, is often underappreciated and underutilized.

"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 in his 'Risk Revisited' Memo

In other words, the fact that many incorrectly assume more risk must be taken to achieve greater returns doesn't make it true.

On page 6 of the memo, Marks provides two very useful graphics to better explain the relationship between risk and return.

Worth checking out.


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

Related post:

Mr. Market Revisited
Mr. Market

* Also, buybacks and dividend reinvestments are more effective when shares remain at bargain prices.
** Naturally, certain individual securities can be mispriced.
*** Unfortunately, what proves to be a temporary loss of capital versus a permanent loss is often only clear after the fact.

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.

Tuesday, June 16, 2015

Mr. Market Revisited

From the 1987 Berkshire Hathaway (BRKashareholder letter:

"Ben Graham...said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but."

Mr. Market, as Warren Buffett explains in the same letter, is a "poor fellow" with "incurable emotional problems" who tends to swing from euphoria to depression and, best of all, allows his emotional state to influence the price he's willing to buy or sell at. Here's how he once explained it:*

"The market is a psychotic, drunk, manic-depressive selling 4,000 companies every day. In one year, the high will double the low. These businesses are no more volatile than a farm or an apartment block [whose values do not swing so wildly]." - Warren Buffett at Wharton

The second by second quotations offered by Mr. Market may, at times, be nonsensical in a way that can directly benefit those with a relatively more even temperament who know how to judge the economics of a business reasonably well.

"Mr. Market has another endearing characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you." - From the 1987 Berkshire Letter

Thinking about the capital markets in this way remains as relevant today as ever though it's at odds with those who, instead, behave as if the equity markets are a casino or, on the other hand, maybe still believe prices are set more or less efficiently.

"Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game." - From the 1987 Berkshire Letter

If nothing else this should logically lead to a very different reaction to bear and bull market environments.

Bear markets are usually viewed as being an unfavorable environment while bull markets are supposed to be a favorable environment. That makes little sense for the long-term investor.

Obviously, sometimes a bull market offers the chance to sell something originally bought at attractive valuations at full price (or maybe even at a premium).

Yet, for those investing with the long haul in mind, it is a bear market that can reduce risk -- which is certainly not captured by something like beta -- by offering the chance to buy part of a business that's "no more volatile than a farm or an apartment block" at a big discount to value.

"You make most of your money in a bear market. You just don't realize it at the time." - Shelby Davis

There's no reason to dread a bear market when shares are bought that can be valued -- within a narrow enough range -- with justifiable confidence.

It simply means getting used to shares of something bought cheap to possibly temporarily get cheaper. Some won't be able to tolerate seeing the quoted values below what was paid.

Well, if what was paid truly is less than per share intrinsic value, and the time horizon is long enough, those quotations shouldn't really be a problem.

Those that can't stomach when quoted prices remain below what they paid (sometimes for an extended period) really shouldn't be buying common stocks.


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

Related post:

Mr. Market

* Based upon notes that were taken at a 2006 Wharton meeting.

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.

Tuesday, June 9, 2015

Howard Marks: The Value of 'I Don't Know'

Back in April on CNBC, Howard Marks complimented what a previous CNBC guest had said that day:

"I listened to your previous guest and he said 'I don't know'. I love when people say that because so few people do."

Then, later in the interview, he added "that's why I like that fellow who said I don't know. I also don't know. He and I should have a drink."

He went on to explain that "I don't like it when people claim to know" what will happen and then went on to paraphrase the following John Kenneth Galbraith quote:

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

Marks added that "I have much more respect for the first group."

To me, for similar reasons, another phrase worth remembering is "I have no idea".

The good news is that it's not necessary to make accurate predictions to invest well though some seem to think it's important and, as a result, behave accordingly. What is required -- among other things -- is an ability to estimate value, sticking to what you know, some real price discipline, and patience. Yet no less important is an appreciation for what simply can't be reliably predicted or known.

Charlie Munger once said:

"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 confident prognostications should mostly be ignored.

The future has always been uncertain. That will continue to be true even if the perception of uncertainty necessarily fluctuates. In other words, just because the future is perceived to be more or less certain -- at any particular point in time -- doesn't mean that it actually is.

For investors, the emphasis needs to be on compounded effects over decades, while being aware many unexpected events will occur -- both the negative and the positive variety -- and there's little point in trying to predict them. In fact, attempts to do so is usually a distraction. Investing is already tough enough to do well without such expensive diversions.

Margin of safety, flexibility, price discipline, and patience can, at least to an extent, protect against uncertainties and the inevitable misjudgments.

A sound investment approach is inherently flexible and open-minded and relies, in principle, on a substantial margin of safety. Some unusual ability to foresee what's going to happen, staring into an always uncertain future, is not required (and may even do harm by diverting time and energy away from what really matters).

Remaining focused on what you know is not a small advantage.

Knowing what you don't know is an even bigger one.


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.

Tuesday, June 2, 2015

Altria: Price Matters

This article, written by Morgan Housel earlier this year, notes that $ 1 invested in Altria (MO) back in 1968 would be, with dividends, worth $ 6,638 (Source: S&P Capital IQ).

That's a 20.6% annualized return.

That same dollar in the S&P 500 would be worth more like $ 87.

Now, consider Altria's stock performance over a somewhat different nearly fifty year time horizon; it's, in a similar way, not exactly unimpressive.

In fact, here's what one dollar invested from 1900-2010 became worth for American industry overall compared to tobacco companies (Source: Credit Suisse):

Average American Industry: $ 38k
Tobacco Companies: $ 6.3 million

Food companies also did rather well compared to the average stock but certainly couldn't match tobacco's performance.

Housel's article points out that "what's extraordinary about this story is that the cigarette industry has been in decline for decades."

U.S. cigarette volumes have, in fact, been in decline since the early 1980s. Those who assume that only through the ownership of businesses with exceptional growth prospects can exceptional returns be produced might want to take a closer look at this.

Housel points out that cigarette volumes hit their peak at 640 billion in 1981 and fell to 360 billion in 2007. Smoking rates have been falling for a very long time and seem likely to continue.

In 2014, 264 billion cigarettes were sold. So the volumes continue to drop.

That's the industry as a whole. What about Altria?

Well, Altria's smokeable products volumes continue to shrink as they have for a very long time.

Last summer, I pointed out that even someone who bought Altria when the S&P 500 reached its pre-crisis peak on October 11th, 2007 -- hardly the ideal time -- actually experienced a very nice result. In fact, Altria's annualized total return was roughly 17% for those who bought at the pre-crisis peak through July 2014.*

Yet, since back in 2007, Altria's smokeable products volume declines have been anything but small.

Volume was 175.1 billion in 2007.

Last year volume was 126.7 billion.

The number was more like 230 billion during the mid-1990s.

Over the years, I've covered Altria quite a bit, mostly because my view is there's much to be learned from it, even if someone has no interest in owning shares of the company.**

One of the reasons for the high returns relates to the company's historic competitive position and advantages. It's partly about established brands, strong distribution, and the lack of new competitors. It's the fact that small amounts of incremental capital is required to maintain what remains a wide moat. New competition (and fresh capital) doesn't usually chase markets that are getting smaller especially when established competitors exist. The existing rules are such that building a new tobacco brand is, if not impossible, a hugely difficult task.

Tobacco marketing restrictions make it tough for a new industry entrant to build an alternative brand. These restrictions tend to hurt the established brands less (or may even be a net benefit since, I think it's fair to say, it's much tougher to build a new brand than it is to fortify/enhance an existing one).

These built in advantages contribute to pricing power -- and high returns on capital -- even if litigation, regulation, and taxation remain, as they have for a very long time, unpredictable risks.

Pricing power, at least up to now, has generally made up for long-standing volume declines in Altria's core smokeable products business.

Will that continue? It has been and remains a key question.

Another one of the reasons Altria has worked so well over the long haul comes down to that the shares have been frequently cheap (i.e. selling at a nice discount to per share intrinsic value). The benefits of a stock remaining cheap over an extended time shouldn't be underestimated in the context of managing risk and reward. What happens when a stock remains persistently cheap is, in effect, that an intrinsic value transfer occurs from short-term oriented owners to the longer term continuing owners through buybacks and dividend reinvestments.
(Buybacks can make sense when both more than sufficient funds are available to meet all operational/liquidity needs of a business AND the stock is cheap. The decision to pay a dividend -- by the board/management -- should come down to whether the business needs are covered while the decision to reinvest that dividend -- by the investor -- should be based on whether shares sell at a discount to value.)

Of course, incremental purchases would also be beneficial. In all cases, whether buybacks, dividend reinvestments, or incremental purchases, these actions only make sense when shares sell for less than intrinsic worth. (Naturally, paying a premium to value benefits the seller.) The transfer of intrinsic value comes from the gap between price paid and per share value. The compounded effect over many years can end up being not at all small.

Yet the key is there's no need for the shareholder to purchase incremental shares to benefit. The buybacks and dividend reinvestments alone -- as long as shares are only bought at a plain discount -- can make a big difference in terms of total return.

Well, these days, Altria's stock is no longer selling at a meaningful discount to intrinsic value (especially compared to some of my earlier posts). It's gone from a single digit multiple of earnings to a high teens multiple of earnings. Return expectations, as a result, must necessarily become much reduced. That doesn't necessarily make it an awful investment, but does meaningfully alter the risks versus potential rewards.

As always, history isn't what matters; what happens going forward does. Altria now sells at a rather more full valuation. Other tobacco stocks seem, at least to me, also fully valued if not expensive. So one of the key factors behind the long-term stock performance -- frequently selling at a nice discount to value -- has been, at least for now, mostly eliminated.

Those expecting Altria's stock to produce the kind of results it has in the past -- at least from current valuation levels and especially if the future earnings multiple remains persistently high -- seem likely to be very disappointed. Now, even more speculative prices could temporarily emerge. Such a situation would benefit those who are selling in the short run but would only end up hurting the long-term owner (at least those, despite the price increases, who'd still prefer not to be selling). It also might create pressure to sell what's well understood with solid long-term prospects in order to buy something else (that might be less well understood but now appears more reasonably valued).

While selling an asset at a full (or more than full) price may not exactly be an unsatisfactory outcome (it certainly beats selling at a loss), it does potentially lead to unnecessary mistakes and added frictional costs. The risk-reward of the less well understood investment alternatives may be misjudged. That's more likely to happen when trading what you've developed a good understanding of for something where that's less the case. With reduced conviction levels, it might be tougher to hang in there when the inevitable business difficulties emerge. Even the best businesses eventually end up facing some real challenges. Also, viable alternatives offering plainly superior forward returns, all costs and risks considered, may not be available when needed.

Patience required. Otherwise, avoidable errors get made.

It's easy to end up owning what's outside one's own circle of competence -- something that's necessarily unique for each investor -- when there's pressure to find an investment that's more attractive than the (well understood) investment just sold.

Each portfolio move isn't just a chance to improve results; it's also a chance to subtract from results. It's easy to overemphasize the former while not sufficiently considering the latter.

There's usually few complaint when shares of a long-term investment heads higher but, in fact, that rally can make the job of the investor more difficult (i.e. inherently more susceptible to error) over the longer haul.

In other words, those who like Altria -- or maybe some other favored business -- for the long-term would benefit greatly if its stock price did poorly over the next several years or, better yet, dropped substantially from current levels to well below intrinsic value.

I realize that's a tough sell for traders; it shouldn't be for long-term owners.

This, at times, requires the kind of temperament that can ignore temporary paper losses. Easier to do if the confidence in estimated intrinsic value -- and how that value will change over time -- is warranted.

Buying favored shares consistently at a discount -- whether via buybacks, dividend reinvestments, and incremental purchases -- has the potential to reduce errors. Sometimes, being forced outside of one's comfort zone leads to unnecessary and costly mistakes. Those who stick to owning only what they know (i.e. what's likely to be valued correctly and where confidence is warranted) make misjudgments, at the very least, somewhat less likely.

For obvious reasons, considering the products they sell, tobacco businesses will not be seen by some as a viable investment. I certainly don't blame anyone who will not invest for that reason alone.

Still, there are plenty of lessons to be learned from Altria that can be applied elsewhere.

A sound long-term investment, that's understandable (to the owner), and bought at a nice discount to value in the first place, shouldn't necessarily be sold just because it has become more fully valued.***

To me, that's a recipe for making unnecessary mistakes.

It simply means the risk versus reward has changed substantially and, especially if the price appreciation were to persist well in excess of increases to per share intrinsic value, the capital might reluctantly even become a candidate for something else more attractive.

Opportunity costs.

At a minimum, it's understandable if a business that's serving a market in decline doesn't feel like a great investment (and, going forward, that may ultimately prove to be the case).

It's just important to remember that -- for investors -- what intuitively feels correct can be very different from what is, if not a perfect solution, more correct than not and far more useful.
(Or, at least, what's the best answer is very different from what intuitively feels like the best answer.)

Sometimes, what doesn't quite fit expectations deserves the most attention.

"The thing that doesn't fit is the thing that's the most interesting, the part that doesn't go according to what you expected." - From The Pleasure of Finding Things Out by Nobel Prize winning physicist Richard Feynman

Counterintuitive. Paradoxical. Contradictory. Inconsistent.

At times, that's where the best insights reside.

As always, I have no opinion on what the price of any stock might do in the near-term or even much longer. I just try to appreciate how much that lower prices can, under the right circumstances, be a very good thing for the long-term owner, knowing it can also be less than intuitive especially when viewed over the shorter run.

None of the above begins to deal with the difficult question of the right amount of diversification. Naturally, sufficient diversification needs to be considered carefully with the right answer being very much specific to the investor.

Some investors need a bunch of it; others might not.

Yet, under the guise of diversification, sometimes an investor will end up investing in areas rather far removed from their core knowledge and capabilities. The situation noted above -- where a high valuation pushes the investor out of a sound investment into something else they don't understand -- is just one example of why this might happen. Well, whatever might be the appropriate diversification for a particular investor, it's hard to imagine why going from what truly is within someone's comfort zone into uncharted territory could be viewed as beneficial diversification. Their are limits to what any one investor can get their arms around.

There are many fine businesses I should never consider owning (even if they appear inexpensive) for the simple reason that the requisite knowledge, experience, and ability to analyze is lacking on my part.

Not all diversification is wonderful.

Invest in what you know.

It'd be different if the investment process offered a nearly endless supply of sound and sufficiently understood alternatives.

It generally does not.


Long position in MO established at much lower than recent prices. No intent to buy or sell near current prices.

Related posts:
Multiple Expansion, Buybacks, & The P/E Illusion
The P/E Illusion
The Benefits of a Declining Stock
Altria: Timing Isn't Everything, Part II
Altria: Timing Isn't Everything
Buffett's Purchase of IBM Revisited
Buffett on Buybacks, Book Value, and Intrinsic Value
Buffett on Teledyne's Henry Singleton
Why Buffett Wants IBM's Shares "To Languish"
Buffett: When it's Advisable for a Company to Repurchase Shares
The Best Use of Corporate Cash
Buffett on Stock Buybacks - Part II
Buffett on Stock Buybacks
Altria Outperforms...Again
Altria vs Coca-Cola
Buy a Stock...Hope the Price Drops?
GM vs Philip Morris (Altria)

* The stock is up an additional ~ 20% (incl. dividends) since that was written. That's unfortunate because buybacks and dividend reinvestments combined with a stock often selling well below intrinsic value has historically provided an incredible tailwind for long-term owners. Well, such a tailwind really isn't there near current prices. A drop in price would be welcome at this point. Speculators want price action to go in a particular direction as soon, and as much, as possible. Certainly nothing wrong with that. Investors focus on - or, at least, generally focus on -- whether the excess cash produced on a per share basis is increasing at a satisfactory long-term rate with consideration for the specific risks and the price paid. The former emphasizes price action; the latter emphasizes what's being produced by the business over time. There's naturally some overlap (or a grey area) between speculation and investment -- and others might have different definitions -- but the differences in emphasis still matter.
** Some excerpts from a few of my previous Altria posts.
In 2009 I wrote:
A big part of the returns produced by Philip Morris/Altria came from dividends that were reinvested in a stock that was consistently inexpensive (this works in a similar way to share buybacks other than tax considerations). The fact that some investors won't touch a tobacco stock along with the risk of litigation, regulation, taxation, and declining volumes kept shares of Philip Morris/Altria mostly cheap for many years.

In 2010 I wrote:
A big part of Altria's long-term performance is, in fact, the combination of a low valuation -- in part due to the fact that there have been no shortage of reasons to NOT own a tobacco stock during the past several decades -- and a substantial dividend. Well, those dividends could be reinvested when the stock was frequently cheap -- enhancing returns. Buybacks would offer a similar effect (though, depending on the circumstances, this is generally more tax efficient). That a consistently cheap stock would enhance long-term returns may at first seem a bit odd but, well, it's straightforward arithmetic. When the shares of a stable business with sound economics remain cheap for an extended time, the fact that incremental shares can be bought -- via dividends and/or buybacks -- at a discount to intrinsic value improves results for continuing shareholders.

In 2014 I wrote:
Altria's stock wasn't going to be immune to the nasty market price action that arose during the financial crisis, but the increasingly cheap shares were an ally to the long-term oriented owner. In fact, it was beneficial to continuing shareholders even if -- other than dividend reinvestments and buybacks -- no incremental purchases were made as the shares became cheaper.

Additional purchases by a continuing shareholder, at the temporarily reduced prices, would naturally also have been beneficial.

The point is that the lower prices can be a benefit, through the wise use of a company's excess capital, even if the shareholder decides to NOT purchase incremental shares. 
(A dividend, of course, is excess capital produced by the company that's distributed to the owners but, unlike excess capital used for buybacks, the decision to invest in more shares must be made by each individual shareholder.)

The key is that market prices became reduced but per share intrinsic value did not. That's a very good combination for long-term owners. It is a permanent and substantial drop in per share intrinsic value that creates a real problem for investors.


Unfortunately, Altria's shares are much more fully priced these days. If this situation were to persist going forward -- or worse, become priced even more highly relative to per share intrinsic business value -- it would lead to, all else equal, reduced future returns.
*** Still, inevitably, some selling ends up being warranted:
- when the stock price represents a significant premium to conservatively estimated per share value
- when prospects and core economics materially deteriorate (i.e. not just temporary but fixable difficulties)
- when prospects and core economics, in the context of the price initially paid, turn out to have been poorly judged
- when opportunity costs are high
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.