"Develop your eccentricities while you are young. That way, when you get old, people won't think you're going ga-ga." - David Ogilvy
Historically, Berkshire Hathaway (BRKa) has often held -- especially when compared to the norm among professional investors -- a rather concentrated equity portfolio.*
To say anything less would be a gross understatement.
In fact, having sixty percent or more of the Berkshire portfolio in just five stocks has been not at all uncommon.**
At times the portfolio has been even more concentrated. In the 1980s and early 1990s Berkshire's top equity positions frequently made up eighty to ninety percent plus of the portfolio.
1987 was one of those years.
Here's how Warren Buffett explained their approach in the 1987 Berkshire letter:
"...our insurance companies own three marketable common stocks that we would not sell even though they became far overpriced in the market. In effect, we view these investments exactly like our successful controlled businesses - a permanent part of Berkshire rather than merchandise to be disposed of once Mr. Market offers us a sufficiently high price."
It's portfolio concentration combined with a very long holding period.***
"A determination to have and to hold, which Charlie [Munger] and I share, obviously involves a mixture of personal and financial considerations. To some, our stand may seem highly eccentric."
In the letter Buffett writes, referring to the quote at the beginning of this post, that they've "long followed" the advice of David Ogilvy and went on to explain their attitude the following way:
"...in the transaction-fixated Wall Street of recent years, our posture must seem odd: To many in that arena, both companies and stocks are seen only as raw material for trades.
Our attitude, however, fits our personalities and the way we want to live our lives. Churchill once said, 'You shape your houses and then they shape you.' We know the manner in which we wish to be shaped. For that reason, we would rather achieve a return of X while associating with people whom we strongly like and admire than realize 110% of X by exchanging these relationships for uninteresting or unpleasant ones."
Similarly, Charlie Munger once said the following:
"...Warren and I do more reading and thinking and less doing than most people in business. We do that because we like that kind of a life. But we've turned that quirk into a positive outcome for ourselves."
It's not always about maximizing returns.
There's nothing wrong with embracing what's a bit unconventional when comfortable with the reasons why. On the other hand, simply being different for different's sake might prove expensive or, at the very least, a distraction.
The kind of portfolio concentration practiced by Berkshire, for example, is certainly not for everyone.
More from the Berkshire letter:
"We really don't see many fundamental differences between the purchase of a controlled business and the purchase of marketable holdings such as these. In each case we try to buy into businesses with favorable long-term economics. Our goal is to find an outstanding business at a sensible price, not a mediocre business at a bargain price."
The need for a huge discount to intrinsic value is more a bonus than a necessity for the highest quality businesses.
In other words, the margin of safety that's required -- while still crucial -- can be at least somewhat reduced when an enterprise has a tough to dislodge competitive position and sound long run core economics.
Adam
Long position in BRKb established at much lower than recent market prices
* The views of Warren Buffett and Charlie Munger on diversification was covered to an extent in the previous post. Berkshire's equity portfolio remains concentrated in its top positions but, due to the company's current size and breadth (including the controlled businesses), it is necessarily rather more diversified overall these days.
** See Table V of a study with the title "Imitation is the Sincerest Form of Flattery: Warren Buffett and Berkshire
Hathaway".
*** One of the three common stocks mentioned is now a Berkshire controlled business (GEICO). As for the other two stocks: Capital Cities/ABC, Inc. was acquired by Disney (DIS) back in the 1990s, while The Washington Post Company has become Graham Holdings (GHC) with Berkshire reducing its stake last year after decades of ownership. Inevitably, no matter how long the intended holding period happens to be, corporate actions, changes to the competitive landscape, and other events will end up having an impact on the actual holding period.
---
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.
Showing posts with label Berkshire Shareholder Letter Highlights: 1987-96. Show all posts
Showing posts with label Berkshire Shareholder Letter Highlights: 1987-96. Show all posts
Tuesday, July 14, 2015
Tuesday, June 23, 2015
Buffett: Arcane Formulae & Foolish Maxims
Warren Buffett wrote the following in his 1987 Berkshire Hathaway (BRKa) shareholder 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.
Adam
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.
"...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.
Adam
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 (BRKa) shareholder 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.
Adam
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.
"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
"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
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.
Adam
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.
Friday, November 21, 2014
Mr. Market
Roughly 15 years ago, Warren Buffett was asked to speak at Sun Valley not long before the tech bubble burst.*
Here's how an article on CNBC described the reaction:
"Many of the people in the room had amassed vast paper profits from stocks shooting ever higher in the Internet boom. Buffett wasn't playing that game, and some of the younger people in the audience thought he was stuck in the past, unable to understand that this time it would be 'different.'"
His message to the audience was rather straightforward:
"There was no new paradigm..."
Despite his long-term investing track record, many chose to discount or ignore what Buffett was saying back in 1999. There was, in a similar way, a fair amount of skepticism toward his favorable views of stocks during the financial crisis and even more recently (in both cases the market overall was substantially lower than it is now).
It's not that Buffett gets the timing right. In fact, Buffett doesn't try to guess where prices are going or to get the timing right.
"...we have no idea - and never have had - whether the market is going to go up, down, or sideways in the near- or intermediate term future." - From the 1986 Berkshire Hathaway (BRKa) Shareholder Letter
Predicting, in a reliable manner, where prices will be going is close to impossible and mostly a waste of energy.
Fortunately, being a successful long-term investor doesn't require brilliant timing.
"I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two.
But I think it is very easy to see what is likely to happen over the long term." - Warren Buffett in Fortune, December 2001
Trying to guess where prices are going in the coming weeks, months, or even over several years ends up best case being a distraction and, more likely, is just a plain foolish thing to do. Investing is (or should be) about how price compares to intrinsic value and how that value is likely to change over a longer time horizon. The emphasis is long-term effects instead of some unusual acuity for jumping in and out at just the right time.
Attempting to time things is a great way to make unnecessary mistakes and incur unnecessary frictional costs. The emphasis on what market prices might do next can end up being a big contributor to unsatisfactory investment outcomes (or worse).
In 1999, it was all about the upside. At the time there was lots of enthusiastic buying of stocks that offered incredibly high risk of permanent capital loss. For too many, those losses indeed became very real and very permanent.
Errors of commission.
In 2008, when the world was a real economic mess -- with compelling and scary headlines everywhere -- buying seemed dangerous and the enthusiasm for stocks all but disappeared. At that time many stocks were unusually undervalued. The risk of permanent capital loss -- especially for those with a long-term investment time horizon -- was rather low. Those missed gains were also very real and very permanent.
Errors of omission.
With the benefit of hindsight, these outcomes may seem obvious, but being correct and decisive in real time while keeping emotions in check just isn't the easiest thing to do.
Errors of commission might be more plain to see but that doesn't mean errors of omission don't matter a whole bunch.
They certainly do.
These days, many stocks have become rather, at the very least, not at all cheap. The risk of permanent loss -- or, at least, subpar returns considering the risks -- is now much higher and getting worse as the rally continues. Margin of safety is, in many cases, way too low for incremental purchases as far as I'm concerned.
Unfortunately, some will make of mistake of getting interested in stocks now after having mostly missed the chance to buy when prices were attractive.
"Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can't buy what is popular and do well." - Warren Buffett
Prices may continue to go up, of course. What's already not cheap goes on to become plainly expensive.
There's no way to know this beforehand.
There's also no need to know it.
"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
For those with a long investing time horizon, if prices do continue to rise in the near-term or intermediate-term, it's not a good thing at all.
To me, while there are naturally always individual exceptions, the chance to buy part of a good business at a really substantial discount is, at least until the next bear market or substantial market correction, mostly in the rear-view mirror.
Investing well inevitably involves lots of waiting for a good opportunity to present itself; it inevitably involves lots of preparation. Ultimately, it requires sound business judgment and price discipline. So energy should be spent trying to better understand existing or potential investments. In combination, this makes it possible to act decisively while others -- those caught up in the emotions of the moment and less prepared -- simply cannot.
In the end, how the business performs is what mostly matters while price action does not.
"...Charlie [Munger] and I let our marketable equities tell us by their operating results - not by their daily, or even yearly, price quotations - whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it." - From the 1987 Berkshire Letter
These days, while most things are far from cheap, it is still nothing like 1999. Back then valuations became completely nonsensical for way too many assets. That doesn't mean right now is a wonderful time to be buying stocks.
Far from it.
Those who think results over the next five years are likely to be as attractive as the past five years are likely to be disappointed. Put another way, the only way for stocks to produce similar results is if prices run far ahead of increases to per share intrinsic value.
That can happen, of course, but I certainly hope it does not. Bubbles do real damage. Some of it subtle; some of it not.
In fact, a good chunk of the returns these past five years have been, in many cases, driven by a closing of the discount to value gap. It's not that per share intrinsic value didn't increase somewhat. For good businesses they did and will continue to do so. It just that the increases were far less than the returns would imply.
In the very long run, as long as the purchase price was reasonable in the first place, what matters is whether a business can increase per share intrinsic value at attractive rate. The bonus returns in recent years resulted from the big discounts to value that existed for a time.
The crisis created those big discounts and, for the most part, they are now gone. So price has caught up -- and in some instances no doubt now has even exceeded -- per share intrinsic value.
So total return expectations -- even for very high quality businesses -- should be more modest going forward (at least until the market goes meaningfully south again).
Otherwise, allow the market to serve.
Adam
Long position in BRKb established at much lower than recent market prices
* The 1999 Sun Valley speech by Buffett that I mentioned above was covered in Chapter 2 of 'The Snowball'. It was also covered in a 1999 Fortune article where he said the following: "Investors in stocks these days are expecting far too much, and I'm going to explain why. That will inevitably set me to talking about the general stock market, a subject I'm usually unwilling to discuss."
---
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.
Here's how an article on CNBC described the reaction:
"Many of the people in the room had amassed vast paper profits from stocks shooting ever higher in the Internet boom. Buffett wasn't playing that game, and some of the younger people in the audience thought he was stuck in the past, unable to understand that this time it would be 'different.'"
His message to the audience was rather straightforward:
"There was no new paradigm..."
Despite his long-term investing track record, many chose to discount or ignore what Buffett was saying back in 1999. There was, in a similar way, a fair amount of skepticism toward his favorable views of stocks during the financial crisis and even more recently (in both cases the market overall was substantially lower than it is now).
It's not that Buffett gets the timing right. In fact, Buffett doesn't try to guess where prices are going or to get the timing right.
"...we have no idea - and never have had - whether the market is going to go up, down, or sideways in the near- or intermediate term future." - From the 1986 Berkshire Hathaway (BRKa) Shareholder Letter
Predicting, in a reliable manner, where prices will be going is close to impossible and mostly a waste of energy.
Fortunately, being a successful long-term investor doesn't require brilliant timing.
"I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two.
But I think it is very easy to see what is likely to happen over the long term." - Warren Buffett in Fortune, December 2001
Trying to guess where prices are going in the coming weeks, months, or even over several years ends up best case being a distraction and, more likely, is just a plain foolish thing to do. Investing is (or should be) about how price compares to intrinsic value and how that value is likely to change over a longer time horizon. The emphasis is long-term effects instead of some unusual acuity for jumping in and out at just the right time.
Attempting to time things is a great way to make unnecessary mistakes and incur unnecessary frictional costs. The emphasis on what market prices might do next can end up being a big contributor to unsatisfactory investment outcomes (or worse).
In 1999, it was all about the upside. At the time there was lots of enthusiastic buying of stocks that offered incredibly high risk of permanent capital loss. For too many, those losses indeed became very real and very permanent.
Errors of commission.
In 2008, when the world was a real economic mess -- with compelling and scary headlines everywhere -- buying seemed dangerous and the enthusiasm for stocks all but disappeared. At that time many stocks were unusually undervalued. The risk of permanent capital loss -- especially for those with a long-term investment time horizon -- was rather low. Those missed gains were also very real and very permanent.
Errors of omission.
With the benefit of hindsight, these outcomes may seem obvious, but being correct and decisive in real time while keeping emotions in check just isn't the easiest thing to do.
Errors of commission might be more plain to see but that doesn't mean errors of omission don't matter a whole bunch.
They certainly do.
These days, many stocks have become rather, at the very least, not at all cheap. The risk of permanent loss -- or, at least, subpar returns considering the risks -- is now much higher and getting worse as the rally continues. Margin of safety is, in many cases, way too low for incremental purchases as far as I'm concerned.
Unfortunately, some will make of mistake of getting interested in stocks now after having mostly missed the chance to buy when prices were attractive.
"Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can't buy what is popular and do well." - Warren Buffett
There's no way to know this beforehand.
There's also no need to know it.
"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
For those with a long investing time horizon, if prices do continue to rise in the near-term or intermediate-term, it's not a good thing at all.
To me, while there are naturally always individual exceptions, the chance to buy part of a good business at a really substantial discount is, at least until the next bear market or substantial market correction, mostly in the rear-view mirror.
Investing well inevitably involves lots of waiting for a good opportunity to present itself; it inevitably involves lots of preparation. Ultimately, it requires sound business judgment and price discipline. So energy should be spent trying to better understand existing or potential investments. In combination, this makes it possible to act decisively while others -- those caught up in the emotions of the moment and less prepared -- simply cannot.
In the end, how the business performs is what mostly matters while price action does not.
"...Charlie [Munger] and I let our marketable equities tell us by their operating results - not by their daily, or even yearly, price quotations - whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it." - From the 1987 Berkshire Letter
These days, while most things are far from cheap, it is still nothing like 1999. Back then valuations became completely nonsensical for way too many assets. That doesn't mean right now is a wonderful time to be buying stocks.
Far from it.
Those who think results over the next five years are likely to be as attractive as the past five years are likely to be disappointed. Put another way, the only way for stocks to produce similar results is if prices run far ahead of increases to per share intrinsic value.
That can happen, of course, but I certainly hope it does not. Bubbles do real damage. Some of it subtle; some of it not.
In fact, a good chunk of the returns these past five years have been, in many cases, driven by a closing of the discount to value gap. It's not that per share intrinsic value didn't increase somewhat. For good businesses they did and will continue to do so. It just that the increases were far less than the returns would imply.
In the very long run, as long as the purchase price was reasonable in the first place, what matters is whether a business can increase per share intrinsic value at attractive rate. The bonus returns in recent years resulted from the big discounts to value that existed for a time.
The crisis created those big discounts and, for the most part, they are now gone. So price has caught up -- and in some instances no doubt now has even exceeded -- per share intrinsic value.
So total return expectations -- even for very high quality businesses -- should be more modest going forward (at least until the market goes meaningfully south again).
Otherwise, allow the market to serve.
Adam
Long position in BRKb established at much lower than recent market prices
* The 1999 Sun Valley speech by Buffett that I mentioned above was covered in Chapter 2 of 'The Snowball'. It was also covered in a 1999 Fortune article where he said the following: "Investors in stocks these days are expecting far too much, and I'm going to explain why. That will inevitably set me to talking about the general stock market, a subject I'm usually unwilling to discuss."
---
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, August 29, 2014
The Benefits of a Declining Stock
I have covered on a number of occasions -- okay, maybe too many occasions -- why the long-term investor should hope that any stock they bought cheap performs poorly over the near and even intermediate term.
Well, at least if long run business prospects remain at least reasonably sound.
Over the very long haul, market prices will roughly track changes to per share intrinsic value.
Over the short haul, prices can do just about anything.
That's an advantage for the long-term investor.
Warren Buffett explained it this way in the 2011 Berkshire Hathaway (BRKa) shareholder letter:
"When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well."
and
"If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day's supply.
Charlie and I don't expect to win many of you over to our way of thinking – we've observed enough human behavior to know the futility of that – but we do want you to be aware of our personal calculus."
Here's another good take on the subject from Vitaliy Katsenelson:
"A stock decline is not necessarily a bad thing, even if it happens right after you buy (assuming fundamentals have not collapsed)."
and
"It may be painful to see your newly minted position show losses right away or remain below your purchase price for a long time. But if a company is taking advantage of its stock's cheap valuation through share repurchases, the intrinsic value of what you own is actually enhanced by the price decline."
Watching recently purchased shares drop in price right after the purchase occurred naturally doesn't exactly feel great. That's loss aversion at work and, of course, perfectly understandable. Yet it's not impossible to develop a more appropriate and sensible response. Even if an underperforming stock does not feel like such a wonderful thing, under the right circumstances and viewed rationally, it actually is.
In contrast, if an investor pays a speculative premium price on what seem like exciting future prospects that don't become reality, a drop in stock price feels pretty bad and, well, is very bad. That's likely to lead to permanent capital loss or, at least, insufficient returns considering risks and alternatives. This approach also depends heavily on being good at reliably picking winners -- usually in a dynamic and unpredictable new space where the core economics are not yet well defined -- and not paying too much for promise.
Now if, instead, the approach is to consistently pay a plain and comfortable discount to current estimated value based upon conservative assumptions, some good things seem likely to happen; big mistakes, including the likelihood of permanent capital loss, become more avoidable.
This, for example, might require judging whether a business with sound core economics and durable advantages that has long dominated an industry will continue to do so. Not exactly easy but, with enough patience and work, at least potentially less likely to produce large misjudgments and the associated losses compared to more speculative approaches.
An undervalued stock can naturally become even more undervalued but attempting to guess whether that will happen or not is folly. When I buy something, I never know what direction the price action is going to be, nor do I even try to figure that out. It's a waste of energy and leads to unnecessary mistakes (incl. errors of omission).
So temporarily lower stock prices only improve the long-term outcome if something was bought at a discount in the first place.
A long-term investor should celebrate if something they bought cheap temporarily gets even cheaper.
That's just the nature of investment even if it might go against intuition and instincts.
The tough part is becoming comfortable with thinking this way about investments. It's knowing when intrinsic value can be estimated within a narrow enough range, always paying a nice discount to that estimate, and having a truly long-term investment time horizon.
That's necessarily measured in at least many years, preferably decades or, ideally, the favorite holding period of Warren Buffett and Charlie Munger.
That'd be forever.
From the 1988 Berkshire Hathaway shareholder letter:
"...when we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever. We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint. Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds."
So this approach doesn't work when a high price is paid and the long-term outcome is dependent on speculative assumptions.
Assumptions that, while possibly not even unreasonable, cannot be known with enough warranted confidence to invest in this manner.
When dependent on lots of difficult to foresee good things happening, it's easy to underestimate how one negative surprise can do huge damage to overall portfolio returns. A big part of investing well long-term is the elimination of large mistakes. That may not be as exciting as trying to judge what the next big thing is going to be then riding the wave, but it can offer a useful way to balance risk and reward.
What matters is whether the business at least has durable free cash flows even if it lacks exciting growth prospects. When, let's say, less than 10x durable free cash flows is paid, future share repurchases can have a big impact if the multiple at least remains roughly at that level or, ideally, goes even lower. At that kind of valuation it is durability that matters more than growth. When a plain discount to conservative per share value is paid upfront, and that discount temporarily gets even bigger, not only should it be of no concern to the long-term owner, it should be viewed as a positive development.
Of course, none of this will be of much interest to those who are primarily focused on making bets on price action.
This approach won't work very well if per share intrinsic value can't be estimated well.
This won't work if the price paid doesn't offer an appropriate margin of safety.
This won't work if time horizon is measured in only a few years or less.
Ignoring these things leads to unnecessary permanent losses and subpar results.
More in a follow-up.
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
The P/E Illusion (follow-up)
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
Buy a Stock...Hope the Price Drops?
---
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.
Well, at least if long run business prospects remain at least reasonably sound.
Over the very long haul, market prices will roughly track changes to per share intrinsic value.
Over the short haul, prices can do just about anything.
That's an advantage for the long-term investor.
Warren Buffett explained it this way in the 2011 Berkshire Hathaway (BRKa) shareholder letter:
"When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well."
and
"If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day's supply.
Charlie and I don't expect to win many of you over to our way of thinking – we've observed enough human behavior to know the futility of that – but we do want you to be aware of our personal calculus."
Here's another good take on the subject from Vitaliy Katsenelson:
"A stock decline is not necessarily a bad thing, even if it happens right after you buy (assuming fundamentals have not collapsed)."
and
"It may be painful to see your newly minted position show losses right away or remain below your purchase price for a long time. But if a company is taking advantage of its stock's cheap valuation through share repurchases, the intrinsic value of what you own is actually enhanced by the price decline."
Watching recently purchased shares drop in price right after the purchase occurred naturally doesn't exactly feel great. That's loss aversion at work and, of course, perfectly understandable. Yet it's not impossible to develop a more appropriate and sensible response. Even if an underperforming stock does not feel like such a wonderful thing, under the right circumstances and viewed rationally, it actually is.
In contrast, if an investor pays a speculative premium price on what seem like exciting future prospects that don't become reality, a drop in stock price feels pretty bad and, well, is very bad. That's likely to lead to permanent capital loss or, at least, insufficient returns considering risks and alternatives. This approach also depends heavily on being good at reliably picking winners -- usually in a dynamic and unpredictable new space where the core economics are not yet well defined -- and not paying too much for promise.
Now if, instead, the approach is to consistently pay a plain and comfortable discount to current estimated value based upon conservative assumptions, some good things seem likely to happen; big mistakes, including the likelihood of permanent capital loss, become more avoidable.
This, for example, might require judging whether a business with sound core economics and durable advantages that has long dominated an industry will continue to do so. Not exactly easy but, with enough patience and work, at least potentially less likely to produce large misjudgments and the associated losses compared to more speculative approaches.
An undervalued stock can naturally become even more undervalued but attempting to guess whether that will happen or not is folly. When I buy something, I never know what direction the price action is going to be, nor do I even try to figure that out. It's a waste of energy and leads to unnecessary mistakes (incl. errors of omission).
So temporarily lower stock prices only improve the long-term outcome if something was bought at a discount in the first place.
A long-term investor should celebrate if something they bought cheap temporarily gets even cheaper.
That's just the nature of investment even if it might go against intuition and instincts.
The tough part is becoming comfortable with thinking this way about investments. It's knowing when intrinsic value can be estimated within a narrow enough range, always paying a nice discount to that estimate, and having a truly long-term investment time horizon.
That's necessarily measured in at least many years, preferably decades or, ideally, the favorite holding period of Warren Buffett and Charlie Munger.
That'd be forever.
From the 1988 Berkshire Hathaway shareholder letter:
"...when we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever. We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint. Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds."
So this approach doesn't work when a high price is paid and the long-term outcome is dependent on speculative assumptions.
Assumptions that, while possibly not even unreasonable, cannot be known with enough warranted confidence to invest in this manner.
When dependent on lots of difficult to foresee good things happening, it's easy to underestimate how one negative surprise can do huge damage to overall portfolio returns. A big part of investing well long-term is the elimination of large mistakes. That may not be as exciting as trying to judge what the next big thing is going to be then riding the wave, but it can offer a useful way to balance risk and reward.
What matters is whether the business at least has durable free cash flows even if it lacks exciting growth prospects. When, let's say, less than 10x durable free cash flows is paid, future share repurchases can have a big impact if the multiple at least remains roughly at that level or, ideally, goes even lower. At that kind of valuation it is durability that matters more than growth. When a plain discount to conservative per share value is paid upfront, and that discount temporarily gets even bigger, not only should it be of no concern to the long-term owner, it should be viewed as a positive development.
Of course, none of this will be of much interest to those who are primarily focused on making bets on price action.
This approach won't work very well if per share intrinsic value can't be estimated well.
This won't work if the price paid doesn't offer an appropriate margin of safety.
This won't work if time horizon is measured in only a few years or less.
Ignoring these things leads to unnecessary permanent losses and subpar results.
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
The P/E Illusion (follow-up)
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
Buy a Stock...Hope the Price Drops?
---
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, July 4, 2014
Buffett & Munger on Compensation - Part II
A follow up to this post. In this CNBC interview, Warren Buffett helps explain why less than optimal compensation systems come to exist in the first place:
"...once a board has delegated to a committee and they've spent hours working on something, and then they report it and there's 20 other items on the agenda and the Chairman calls on the comp committee to give his report and gives it in about 30 seconds, it never gets voted against. And it would be regarded as sort of usurping the power of the committee to all of a sudden say I've got a better idea. I haven't talked to the compensation consultants, I haven't looked at the figures, but I still have a better idea. It doesn't happen."
Becky Quick -- the CNBC interviewer -- brought up the idea that corporate boards might become rather clubby at times. Buffett responded by saying he finds it "always interesting...to read academic discussions of boards." Some have a tendency to overestimate the likelihood that corporate board actions will be primarily about "business maximization" and underestimate the social component.
"...boards are in part business organizations and in part social organizations. People walk into those with their behavior formed by dozens of — usually your people have achieved some standing, perhaps, in the community. So they've learned how to get along with other people. And they don't suddenly change their stripes when they come into a board meeting. So there's a great tendency to behave in a socially acceptable way and not necessarily in a business maximization way. The motives are good; the behavior is formed by decades earlier."
That comment about boards being social organizations -- and the implications for owners -- deserves some attention. In the real world, corporate board behavior isn't, as some might like to imagine, necessarily all about what's best for the business and owners. During the same interview, Andrew Ross Sorkin later asked:
"I hear you saying this is what happens. My question is should it happen this way?"
Buffett's response:
"Well, no, obviously you know everybody would speak freely and all of that sort of thing, and dialogue would be encouraged and the chairman would love to hear reasons why his ideas were no good, but it isn't quite that way."
Buffett later goes on to explains another important dynamic at work:
"There are a number of directors at any company that are making two or three hundred thousand dollars a year, and that money is important to them. And what they really hope is they get invited to go on other boards.
Now if a CEO comes to another CEO and says I hear you've got so-and-so on the board, we need another woman or whatever it may be, oh, she will behave.
If they say she raises hell at every meeting, she's not going to be on the next board. On the other hand, if they say she's constructive, her compensation committee recommendations have been spot on, et cetera, she's got another $300,000 a year job. That's the real world."
These are, at least in some ways, remarkably blunt comments that reveals just how social -- and not surprisingly a bit self-serving -- things end up being on at least some boards. The idea that "business maximization" is what boards are about is an invented version of how humans -- even very capable ones -- are likely to behave in groups. The error of expecting otherwise seems similar to the error of assuming that market participants will mostly act in a cold and rational manner.
There are, of course, some very good boards. That doesn't mean many boards are not susceptible to some of these adverse dynamics.
It's worth noting that, unlike many other companies, non-executive board members at Berkshire Hathaway (BRKa) do not get paid.
Here's Charlie Munger's take:
"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..."
He also said the following when asked about the unconventional view that 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."
Buffett followed with this:
"It's very natural to think if you're a director of the ABC Corp. and the CEO of the XYZ Corp is getting more, well, our guy is at least as good as theirs. And it goes on and on and on.
So publication of the top salaries has cost the American shareholder money. Maybe disclosure is the great disinfectant, all of that, sunshine is the great disinfectant. Sunshine has cost American shareholders money when it comes to paying their managers."
Munger then quipped that it's "a peculiarity of ours, but we're right".
Basically, publishing the information creates envy that leads to higher pay packages. They think people will generally expect to earn more when they see what others are earning.
In the 2006 letter, Buffett offers some thoughts on Berkshire's board (page 18) and compensation practices (starting at the bottom of page 19).
Also, for some additional thoughts on compensation -- including the misalignment of interests that can occur with stock options -- check out the Compensation section of the 1994 letter.
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
Buffett & Munger on Compensation - Part I
The Illusion of Consensus
---
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.
(1, 6)
"...once a board has delegated to a committee and they've spent hours working on something, and then they report it and there's 20 other items on the agenda and the Chairman calls on the comp committee to give his report and gives it in about 30 seconds, it never gets voted against. And it would be regarded as sort of usurping the power of the committee to all of a sudden say I've got a better idea. I haven't talked to the compensation consultants, I haven't looked at the figures, but I still have a better idea. It doesn't happen."
Becky Quick -- the CNBC interviewer -- brought up the idea that corporate boards might become rather clubby at times. Buffett responded by saying he finds it "always interesting...to read academic discussions of boards." Some have a tendency to overestimate the likelihood that corporate board actions will be primarily about "business maximization" and underestimate the social component.
"...boards are in part business organizations and in part social organizations. People walk into those with their behavior formed by dozens of — usually your people have achieved some standing, perhaps, in the community. So they've learned how to get along with other people. And they don't suddenly change their stripes when they come into a board meeting. So there's a great tendency to behave in a socially acceptable way and not necessarily in a business maximization way. The motives are good; the behavior is formed by decades earlier."
That comment about boards being social organizations -- and the implications for owners -- deserves some attention. In the real world, corporate board behavior isn't, as some might like to imagine, necessarily all about what's best for the business and owners. During the same interview, Andrew Ross Sorkin later asked:
"I hear you saying this is what happens. My question is should it happen this way?"
Buffett's response:
"Well, no, obviously you know everybody would speak freely and all of that sort of thing, and dialogue would be encouraged and the chairman would love to hear reasons why his ideas were no good, but it isn't quite that way."
Buffett later goes on to explains another important dynamic at work:
"There are a number of directors at any company that are making two or three hundred thousand dollars a year, and that money is important to them. And what they really hope is they get invited to go on other boards.
Now if a CEO comes to another CEO and says I hear you've got so-and-so on the board, we need another woman or whatever it may be, oh, she will behave.
If they say she raises hell at every meeting, she's not going to be on the next board. On the other hand, if they say she's constructive, her compensation committee recommendations have been spot on, et cetera, she's got another $300,000 a year job. That's the real world."
These are, at least in some ways, remarkably blunt comments that reveals just how social -- and not surprisingly a bit self-serving -- things end up being on at least some boards. The idea that "business maximization" is what boards are about is an invented version of how humans -- even very capable ones -- are likely to behave in groups. The error of expecting otherwise seems similar to the error of assuming that market participants will mostly act in a cold and rational manner.
There are, of course, some very good boards. That doesn't mean many boards are not susceptible to some of these adverse dynamics.
It's worth noting that, unlike many other companies, non-executive board members at Berkshire Hathaway (BRKa) do not get paid.
Here's Charlie Munger's take:
"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..."
He also said the following when asked about the unconventional view that 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."
Buffett followed with this:
"It's very natural to think if you're a director of the ABC Corp. and the CEO of the XYZ Corp is getting more, well, our guy is at least as good as theirs. And it goes on and on and on.
So publication of the top salaries has cost the American shareholder money. Maybe disclosure is the great disinfectant, all of that, sunshine is the great disinfectant. Sunshine has cost American shareholders money when it comes to paying their managers."
Munger then quipped that it's "a peculiarity of ours, but we're right".
Basically, publishing the information creates envy that leads to higher pay packages. They think people will generally expect to earn more when they see what others are earning.
In the 2006 letter, Buffett offers some thoughts on Berkshire's board (page 18) and compensation practices (starting at the bottom of page 19).
Also, for some additional thoughts on compensation -- including the misalignment of interests that can occur with stock options -- check out the Compensation section of the 1994 letter.
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
Buffett & Munger on Compensation - Part I
The Illusion of Consensus
---
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.
(1, 6)
Wednesday, June 26, 2013
Buffett and Munger on See's Candies, Part II
A follow up to this post. Roughly two years ago, Charlie Munger said the following about what he and Warren Buffett learned from buying See's Candies:*
"When we bought See's Candies, we didn't know the power of a good brand. Over time we just discovered that we could raise prices 10% a year and no one cared. Learning that changed Berkshire. It was really important.
You have to be a lifelong learner to appreciate this stuff. We think of it as a moral duty."
As always, the price paid relative to value -- paying a plain discount to conservative per share intrinsic value -- matters a whole lot when it comes to reducing risk while increasing potential reward for the long-term investor.** Otherwise, attractive risk-adjusted returns come from owning a business (or part of a business via marketable common stocks) with characteristics that lead to attractive and durable return on capital.
Well, it's having sustainable pricing power (and a commodity that's in high demand/in short supply doesn't qualify) that is often a key driver of return on capital. Possession of a great brand -- what Buffett calls "share of mind" -- can provide an ongoing source of sustainable pricing power.
(Even if, as in the case of See's, it happens to be primarily regional brand strength developed over many years.)
In the prior post I noted the following:
...if a business can raise price a certain percentage each year and it mostly sticks (i.e. there's no real hit to volume), the increase all falls to the bottom line after taxation. If that same business instead had a similar percentage increase in revenue via greater unit volume, there inevitably has to be an incremental cost -- sometimes significant -- associated with each additional unit. The result being -- at least when there's real pricing power -- not as much of an equivalent increase in revenue actually falls to the bottom line.***
A price increase requires no additional capital and has no incremental cost. What matters is whether price can be increased in a way that doesn't significantly impact volume. Here's what Warren Buffett said at the 2005 Berkshire Hathaway (BRKa) shareholder meeting:
"We like buying businesses with some untapped pricing power. When we bought See's for $25 million, I asked myself, 'If we raised prices by 10 cents per pound, would sales fall off a cliff?' The answer was obviously no. You can determine the strength of a business over time by the amount of agony they go through in raising prices."
In contrast, what it takes to support the added unit volume certainly creates additional operating costs and might even require more capital to be employed.
Either way, that means reduced return on capital for similar incremental growth.
Growth, in itself, can be an overrated. Well, at least it can be when it comes to generating attractive risk adjusted shareholder returns. At a minimum, there's a great tendency to overpay for it.
During this interview with the Financial Crisis Inquiry Commission (FCIC), Warren Buffett had the following to say about the importance of pricing power when evaluating a business:
It also helps if the business requires little in the way of capital to maintain or even strengthen its advantages.
See's may, in the very long run, attempt to expand beyond its mostly regional footprint (in fact, there's for the first time some at least limited indication they may) but that will make sense only if they can develop the "share of mind" where they move to next.
Some might wonder why they didn't expand sooner. That takes patience, time, and it's not inevitable that it will work. Enduring some pain in the near-term or longer, the willingness to forgo returns early on to gain a foothold -- what Tom Russo calls the "capacity to suffer" -- can make a lot of sense. Many of the great global consumer franchises do just that but it depends on the specific circumstances. When it comes to the "capacity to suffer", Russo also emphasizes the importance of first mover advantage. Well, one of the reasons See's may not want to move into a new region is the existence of already entrenched brands. The lack of first mover advantage could mean the returns on the incremental capital invested turn out to be unattractive.
The good news is that there's often nothing wrong with striving for more modest growth prospects while using the excess capital wisely elsewhere. That's essentially what Berkshire has been doing with See's for more than 40 years. It depends not just on first mover advantage but also on the competitive landscape more generally (and many other factors, of course).
Those that push for growth -- too often blindly in the context of the capital requirements -- sometimes underestimate this. Exciting growth prospects need to be fully understood in the context of the incremental capital investment. Will it actually be of the high return variety? Could that capital be put to use elsewhere at higher returns and less risk?
High return growth is not a given. Some treat all forms of growth as a good thing or, at least, assume the growth will be high return in nature.
From the 1992 Berkshire Hathaway shareholder letter:
"Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive."
Remember, for example, that airlines grew for a long time at impressive rates. Saying the returns from all that capital investment have been poor for those who held common stock in airlines is more than an understatement.
(I'm writing strictly from a common shareholder perspective. Airlines and air travel clearly have been quite important and valuable to civilization in other ways.)
More from the 1992 Berkshire letter:
"...business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.
Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value."
Sometimes growth is pursued where lots of capital must be deployed -- with diminishing and even negative returns -- to continue fueling that growth.
In the short run (and sometimes even much longer), exciting growth can provide for equally exciting stock price action. That's fine, I suppose, if one likes to speculate on such things.
In the long run, investors will have quite a difficult time benefiting from behavior that amounts to growth for its own sake or growth for growth's sake.
Well, at least they will have difficulty benefiting on an intrinsic basis.
Some might decide to treat the See's example as nothing more than a merely interesting curiosity and consider its implications no further.
I happen to think that's a mistake.
To me, it's an essential business and investing lesson.
Adam
Long position in BRKb established at much lower than recent prices
Related posts:
Buffett and Munger on See's Candies - Jun 2013
Aesop's Investment Axiom - Feb 2013
Grantham: Investing in a Low-Growth World - Feb 2013
Buffett: Stocks, Bonds, and Coupons - Jan 2013
Maximizing Per-Share Value - Oct 2012
Death of Equities Greatly Exaggerated - Aug 2012
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Buffett: What See's Taught Us - May 2011
Buffett on Coca-Cola, See's & Railroads - May 2011
Buffett on Pricing Power - Feb 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
Pricing Power - Jul 2009
The Growth Myth - Jun 2009
Buffett on Economic Goodwill - Apr 2009
* According to The Motley Fool these notes are "in Munger's own words, lightly edited and condensed for clarity."
** Note that the correlation between risk and reward need not be positively correlated.
*** Even if a modest drop in volume were to occur, the increased price may still make sense as far as total return goes. It all comes down to how much pricing power actually exists. What some might describe as being price inelastic.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.
"When we bought See's Candies, we didn't know the power of a good brand. Over time we just discovered that we could raise prices 10% a year and no one cared. Learning that changed Berkshire. It was really important.
You have to be a lifelong learner to appreciate this stuff. We think of it as a moral duty."
Buffett said something very similar in this more recent article:
"We have made a lot more money out of See's than shows from the earnings of See's, just by the fact that it's educated me, and I'm sure it's educated Charlie too."
"We have made a lot more money out of See's than shows from the earnings of See's, just by the fact that it's educated me, and I'm sure it's educated Charlie too."
As always, the price paid relative to value -- paying a plain discount to conservative per share intrinsic value -- matters a whole lot when it comes to reducing risk while increasing potential reward for the long-term investor.** Otherwise, attractive risk-adjusted returns come from owning a business (or part of a business via marketable common stocks) with characteristics that lead to attractive and durable return on capital.
Well, it's having sustainable pricing power (and a commodity that's in high demand/in short supply doesn't qualify) that is often a key driver of return on capital. Possession of a great brand -- what Buffett calls "share of mind" -- can provide an ongoing source of sustainable pricing power.
(Even if, as in the case of See's, it happens to be primarily regional brand strength developed over many years.)
In the prior post I noted the following:
...if a business can raise price a certain percentage each year and it mostly sticks (i.e. there's no real hit to volume), the increase all falls to the bottom line after taxation. If that same business instead had a similar percentage increase in revenue via greater unit volume, there inevitably has to be an incremental cost -- sometimes significant -- associated with each additional unit. The result being -- at least when there's real pricing power -- not as much of an equivalent increase in revenue actually falls to the bottom line.***
A price increase requires no additional capital and has no incremental cost. What matters is whether price can be increased in a way that doesn't significantly impact volume. Here's what Warren Buffett said at the 2005 Berkshire Hathaway (BRKa) shareholder meeting:
"We like buying businesses with some untapped pricing power. When we bought See's for $25 million, I asked myself, 'If we raised prices by 10 cents per pound, would sales fall off a cliff?' The answer was obviously no. You can determine the strength of a business over time by the amount of agony they go through in raising prices."
In contrast, what it takes to support the added unit volume certainly creates additional operating costs and might even require more capital to be employed.
Either way, that means reduced return on capital for similar incremental growth.
Growth, in itself, can be an overrated. Well, at least it can be when it comes to generating attractive risk adjusted shareholder returns. At a minimum, there's a great tendency to overpay for it.
During this interview with the Financial Crisis Inquiry Commission (FCIC), Warren Buffett had the following to say about the importance of pricing power when evaluating a business:
"...the single most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you've got a terrible business."
It also helps if the business requires little in the way of capital to maintain or even strengthen its advantages.
See's may, in the very long run, attempt to expand beyond its mostly regional footprint (in fact, there's for the first time some at least limited indication they may) but that will make sense only if they can develop the "share of mind" where they move to next.
Some might wonder why they didn't expand sooner. That takes patience, time, and it's not inevitable that it will work. Enduring some pain in the near-term or longer, the willingness to forgo returns early on to gain a foothold -- what Tom Russo calls the "capacity to suffer" -- can make a lot of sense. Many of the great global consumer franchises do just that but it depends on the specific circumstances. When it comes to the "capacity to suffer", Russo also emphasizes the importance of first mover advantage. Well, one of the reasons See's may not want to move into a new region is the existence of already entrenched brands. The lack of first mover advantage could mean the returns on the incremental capital invested turn out to be unattractive.
The good news is that there's often nothing wrong with striving for more modest growth prospects while using the excess capital wisely elsewhere. That's essentially what Berkshire has been doing with See's for more than 40 years. It depends not just on first mover advantage but also on the competitive landscape more generally (and many other factors, of course).
Those that push for growth -- too often blindly in the context of the capital requirements -- sometimes underestimate this. Exciting growth prospects need to be fully understood in the context of the incremental capital investment. Will it actually be of the high return variety? Could that capital be put to use elsewhere at higher returns and less risk?
High return growth is not a given. Some treat all forms of growth as a good thing or, at least, assume the growth will be high return in nature.
From the 1992 Berkshire Hathaway shareholder letter:
"Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive."
Remember, for example, that airlines grew for a long time at impressive rates. Saying the returns from all that capital investment have been poor for those who held common stock in airlines is more than an understatement.
(I'm writing strictly from a common shareholder perspective. Airlines and air travel clearly have been quite important and valuable to civilization in other ways.)
More from the 1992 Berkshire letter:
"...business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.
Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value."
Sometimes growth is pursued where lots of capital must be deployed -- with diminishing and even negative returns -- to continue fueling that growth.
In the short run (and sometimes even much longer), exciting growth can provide for equally exciting stock price action. That's fine, I suppose, if one likes to speculate on such things.
In the long run, investors will have quite a difficult time benefiting from behavior that amounts to growth for its own sake or growth for growth's sake.
Well, at least they will have difficulty benefiting on an intrinsic basis.
Some might decide to treat the See's example as nothing more than a merely interesting curiosity and consider its implications no further.
I happen to think that's a mistake.
To me, it's an essential business and investing lesson.
Adam
Long position in BRKb established at much lower than recent prices
Related posts:
Buffett and Munger on See's Candies - Jun 2013
Aesop's Investment Axiom - Feb 2013
Grantham: Investing in a Low-Growth World - Feb 2013
Buffett: Stocks, Bonds, and Coupons - Jan 2013
Maximizing Per-Share Value - Oct 2012
Death of Equities Greatly Exaggerated - Aug 2012
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Buffett: What See's Taught Us - May 2011
Buffett on Coca-Cola, See's & Railroads - May 2011
Buffett on Pricing Power - Feb 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
Pricing Power - Jul 2009
The Growth Myth - Jun 2009
Buffett on Economic Goodwill - Apr 2009
* According to The Motley Fool these notes are "in Munger's own words, lightly edited and condensed for clarity."
** Note that the correlation between risk and reward need not be positively correlated.
*** Even if a modest drop in volume were to occur, the increased price may still make sense as far as total return goes. It all comes down to how much pricing power actually exists. What some might describe as being price inelastic.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.
Friday, January 25, 2013
Buffett: Cigar Butts & Wonderful Businesses
Warren Buffett wrote the following in the 1989 Berkshire Hathaway (BRKa) shareholder letter:
"If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the 'cigar butt' approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the 'bargain purchase' will make that puff all profit.
Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original 'bargain' price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces - never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost. Time is the friend of the wonderful business, the enemy of the mediocre.
You might think this principle is obvious, but I had to learn it the hard way..."
Buffett provides one example (Hochschild Kohn, a Baltimore department store) of a bargain that turned out not to be one at all, and says he could offer more.
So, with the mediocre businesses, what seems like it's selling at a big discount at the time often proves otherwise. He then later in the letter added this:
"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner. But now, when buying companies or common stocks, we look for first-class businesses accompanied by first-class managements."
Businesses with sustainable advantages that generate high return on capital have the capacity over time to do just fine even if the investor, on occasion, mistakenly pays a price that proves to be somewhat expensive. Margin of safety is always a very important aspect of the investing process -- and an investor can't do very well if they often pay too much -- but errors in judgment about current value inevitably happen.
That wind isn't at your back in a low return business. What seems cheap at first isn't at all.
Adam
Long position n BRKb established at much lower prices
---
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.
"If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the 'cigar butt' approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the 'bargain purchase' will make that puff all profit.
Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original 'bargain' price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces - never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost. Time is the friend of the wonderful business, the enemy of the mediocre.
You might think this principle is obvious, but I had to learn it the hard way..."
Buffett provides one example (Hochschild Kohn, a Baltimore department store) of a bargain that turned out not to be one at all, and says he could offer more.
So, with the mediocre businesses, what seems like it's selling at a big discount at the time often proves otherwise. He then later in the letter added this:
"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner. But now, when buying companies or common stocks, we look for first-class businesses accompanied by first-class managements."
Businesses with sustainable advantages that generate high return on capital have the capacity over time to do just fine even if the investor, on occasion, mistakenly pays a price that proves to be somewhat expensive. Margin of safety is always a very important aspect of the investing process -- and an investor can't do very well if they often pay too much -- but errors in judgment about current value inevitably happen.
That wind isn't at your back in a low return business. What seems cheap at first isn't at all.
Adam
Long position n BRKb established at much lower prices
---
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 18, 2013
Buffett: Stocks, Bonds, and Coupons
In the 1992 Berkshire Hathaway (BRKa) shareholder letter, there's a condensed version of how John Burr Williams described the equation for value in his book The Theory of Investment Value back in the 1938.*
Warren Buffett explained it as follows in the letter:
"In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset."
Notably, as Buffett highlights, the formula is the same for stocks and bonds. The key difference being that bonds generally have future cash flows defined by the coupon and maturity date unless there's a default of some kind. In contrast, the equity 'coupons' have to be estimated by the investor.
"...in the case of equities, the investment analyst must himself estimate the future 'coupons.'"
The size and duration of those 'coupons' have a much wider range of possibilities. More from the letter:
"The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase - irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value. Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought.
Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite..."
It's easy to overly complicate the investment process, but it pretty much comes down to consistently paying comfortably less than the appropriately discounted present value of future cash flows. In other words, paying less than a well-judged conservative estimate of intrinsic value.**
If an investor is highly confident in their future cash flows estimate (and the appropriate interest rate to use), then a smaller discount would be necessary.
Still, requiring that an appropriate discount to value exists (margin of safety) is all-important to protect the investor against the unforeseen and unforeseeable.
Buffett's "irrespective of whether the business grows or doesn't" comment is worth noting.
(A subject I've covered quite a lot, if nothing else, on this blog.)
Some take it as a given that growth is of primary importance in investing. Well, for example, if $ 1 of earnings in perpetuity can be bought for $ 3, should the investor care if it grows? That's an extreme example, but sometimes the blind pursuit of growth leads an investor to take more risk than necessary to achieve a similar or worse result.
In fact, listen to enough commentary on investing and it seems growth dominates the conversation. That all growth is good growth is, at least, implied. I mean, how could growth not be a good thing, right? Growth is fine if it's of the high return variety and can be bought at a fair price. Unfortunately, many forms of growth do not produce attractive returns and can even destroy value. From the 2000 Berkshire Hathaway shareholder letter:
"Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years."
Attractive growth prospects usually sell for a premium. Too often -- even if growth happens to be in a potentially high return form -- the premium price paid means that permanent capital loss is more likely to occur if things do not pan out as expected.
Insufficient margin of safety.
Growth will, of course, often have a favorable impact on value. It just happens to be a mistake to think that it always has a favorable impact.
Many very fine investments have modest to no growth at all while having more predictable outcomes. Lacking excitement, they more often sell cheap. Their relative predictability also means that getting the investment analysis consistently right is more doable. In contrast, where there's high growth often invites in competition and naturally less predictable long range outcomes. With lots more competition there's usually less certainty that the economics will remain attractive during the pursuit of that growth.
So whether the investor can roughly but meaningfully estimate the coupons a business will produce over a very long time frame is far more important than growth. Buffett points out that even for very experienced and able investors, it's still easy to get the estimate of future coupons very wrong.
How does Berkshire deal with that reality? One way is that they stick to what they understand. As Buffett explains, it's easier to get the estimate of future cash flows right with businesses that are "simple and stable" compared to those that are "complex or subject to constant change". It is not about how much an investor knows. It's about an awareness of what they don't know.
Awareness of limitations.
"An investor needs to do very few things right as long as he or she avoids big mistakes."
The other way they deal with the problem is always buying with a margin of safety. To always pay a price that is substantially lower than their own estimated value of future cash flows.
Finally, as Buffett mentions in the quote above, the current price relative to earnings or book value -- whether seemingly very high or low -- often reveals little about business value. Though, it's worth noting, Buffett has said Berkshire's book value is a rough if quite understated way to gauge the company's intrinsic value. Otherwise, sometimes what seems a low price against current earnings or book value won't turn out to be cheap at all. The opposite is, of course, also true. The price has to be considered against the discounted long run stream of cash that will be generated over time. Sometimes those future cash flows are just too difficult to estimate. In those cases, it's best to avoid the investment no matter how compelling the story is or cheap it appears.
Judging value based upon some simple snapshot measurement will often lead to very big and costly mistakes.
Adam
Long position in BRKb established at much lower than recent prices
Related posts:
Maximizing Per-Share Value - Oct 2012
Death of Equities Greatly Exaggerated - Aug 2012
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009
* First written as a Ph.D. thesis at Harvard in 1937.
** The Berkshire Hathaway owner's manual provides a useful explanation of intrinsic value.
---
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.
Warren Buffett explained it as follows in the letter:
"In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset."
Notably, as Buffett highlights, the formula is the same for stocks and bonds. The key difference being that bonds generally have future cash flows defined by the coupon and maturity date unless there's a default of some kind. In contrast, the equity 'coupons' have to be estimated by the investor.
"...in the case of equities, the investment analyst must himself estimate the future 'coupons.'"
The size and duration of those 'coupons' have a much wider range of possibilities. More from the letter:
"The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase - irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value. Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought.
Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite..."
It's easy to overly complicate the investment process, but it pretty much comes down to consistently paying comfortably less than the appropriately discounted present value of future cash flows. In other words, paying less than a well-judged conservative estimate of intrinsic value.**
If an investor is highly confident in their future cash flows estimate (and the appropriate interest rate to use), then a smaller discount would be necessary.
Still, requiring that an appropriate discount to value exists (margin of safety) is all-important to protect the investor against the unforeseen and unforeseeable.
Buffett's "irrespective of whether the business grows or doesn't" comment is worth noting.
(A subject I've covered quite a lot, if nothing else, on this blog.)
Some take it as a given that growth is of primary importance in investing. Well, for example, if $ 1 of earnings in perpetuity can be bought for $ 3, should the investor care if it grows? That's an extreme example, but sometimes the blind pursuit of growth leads an investor to take more risk than necessary to achieve a similar or worse result.
In fact, listen to enough commentary on investing and it seems growth dominates the conversation. That all growth is good growth is, at least, implied. I mean, how could growth not be a good thing, right? Growth is fine if it's of the high return variety and can be bought at a fair price. Unfortunately, many forms of growth do not produce attractive returns and can even destroy value. From the 2000 Berkshire Hathaway shareholder letter:
"Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years."
Attractive growth prospects usually sell for a premium. Too often -- even if growth happens to be in a potentially high return form -- the premium price paid means that permanent capital loss is more likely to occur if things do not pan out as expected.
Insufficient margin of safety.
Growth will, of course, often have a favorable impact on value. It just happens to be a mistake to think that it always has a favorable impact.
Many very fine investments have modest to no growth at all while having more predictable outcomes. Lacking excitement, they more often sell cheap. Their relative predictability also means that getting the investment analysis consistently right is more doable. In contrast, where there's high growth often invites in competition and naturally less predictable long range outcomes. With lots more competition there's usually less certainty that the economics will remain attractive during the pursuit of that growth.
So whether the investor can roughly but meaningfully estimate the coupons a business will produce over a very long time frame is far more important than growth. Buffett points out that even for very experienced and able investors, it's still easy to get the estimate of future coupons very wrong.
How does Berkshire deal with that reality? One way is that they stick to what they understand. As Buffett explains, it's easier to get the estimate of future cash flows right with businesses that are "simple and stable" compared to those that are "complex or subject to constant change". It is not about how much an investor knows. It's about an awareness of what they don't know.
Awareness of limitations.
"An investor needs to do very few things right as long as he or she avoids big mistakes."
The other way they deal with the problem is always buying with a margin of safety. To always pay a price that is substantially lower than their own estimated value of future cash flows.
Finally, as Buffett mentions in the quote above, the current price relative to earnings or book value -- whether seemingly very high or low -- often reveals little about business value. Though, it's worth noting, Buffett has said Berkshire's book value is a rough if quite understated way to gauge the company's intrinsic value. Otherwise, sometimes what seems a low price against current earnings or book value won't turn out to be cheap at all. The opposite is, of course, also true. The price has to be considered against the discounted long run stream of cash that will be generated over time. Sometimes those future cash flows are just too difficult to estimate. In those cases, it's best to avoid the investment no matter how compelling the story is or cheap it appears.
Judging value based upon some simple snapshot measurement will often lead to very big and costly mistakes.
Adam
Long position in BRKb established at much lower than recent prices
Related posts:
Maximizing Per-Share Value - Oct 2012
Death of Equities Greatly Exaggerated - Aug 2012
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009
* First written as a Ph.D. thesis at Harvard in 1937.
** The Berkshire Hathaway owner's manual provides a useful explanation of intrinsic value.
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