Back in July, when this article with some favorable things to say about Mohawk Industries (MHK) was first published, the company's stock was selling at a price (near $ 60/share) I considered not a large enough discount to value.
Barron's: A Housing Stock Not Reliant on a Big Recovery
The recent market sell off has made the price at least somewhat more attractive in my view.
More recently, Mark Massey of AltaRock put together some thoughts on Mohawk Industries in his letter to investors:
Massey on Mohawk Industries
I like Mohawk's business for a variety of reasons as a long-term investment if shares can be had at the right price. I have covered Mohawk in previous posts and it has been one of my Stocks to Watch since the inception of that list.
Having said that, beyond a rather entertainingly wide and volatile trading range, I don't expect much from this stock near term.
Housing is in bad shape and will likely remain so for quite a while. To me, this means the chance to accumulate shares at a nice discount to value will likely continue for an extended period.
What seems impressive is that a relatively cyclical business like Mohawk has continued to be comfortably profitable in what is just an awful housing market. If they can make money in this environment I'm guessing they will do very well upon recovery.
In the last decade, after taking on an uncomfortable amount of debt (at least for my taste) and paying too much for some solid businesses (ie. Unilin and Dal-Tile...these are good businesses bought at high valuations that were financed too aggressively) they have increasingly cleaned up the balance sheet. Today, debt levels are far more manageable.
Management has done an impressive job using free cash flow to pay down the debt they needed to finance those expensive acquisitions.
Massey provides some useful background and thoughts on Mohawk that begins on page 6 of his letter to investors. Some excerpts:
"The company was largely built via acquisition during the 1980's and 1990's. With increased size from each acquisition came increased scale and additional opportunities for savings via vertical integration. However, the most important advantage was the reaching of a critical tipping point that enabled the company to forgo third parties and bring its distribution in-house. We believe that economies of scale and scope in distribution remain the most important and durable advantages of this franchise today."
"Mohawk's distribution platform allows it to service a diversified base of 25,000 retailers, most of whom are small mom and pop flooring dealers. Its largest customer, Home Depot, is less than 5% of sales - a level that has remained largely unchanged for a long time. Flooring is one of the few home improvement categories that the large home center chains have been unable to consolidate. Understanding why is the key to understanding Mohawk's competitive advantage."
Read Massey's full explanation of why flooring is tough for home center chains to consolidate here.
#1 Mohawk controls roughly 22% of the U.S. flooring market. #2 Shaw Industries (a unit of Berkshire Hathaway: BRKa) has 21%.
"These two companies effectively operate a flooring duopoly; the next largest competitor is only one fourth the size of Mohawk. Due to the economics of flooring distribution, we don't see this basic industry structure changing much over time. This makes Mohawk a particularly appealing long-term investment if it can be purchased at a cheap price."
Massey mentions that given some of the truly awful near-term trends in housing, investors are "understandably less than enthused about the sector" yet...
"...Mohawk, even in this extremely depressed environment is generating operating margins in the 6% to 7.5% range and we estimate it will earn around $3.70 in free cash flow this year. That you can acquire this very high quality company, which requires little additional capital to grow, for less than 7x very depressed EBITDA, is quite remarkable. We are confident that Mohawk will be doing a lot better in the future than it is today, a view that we are paying nothing for since everyone else seems to think things will never get better. Perhaps these are the same people that thought house prices would never go down, or that Mohawk at $103 in June 2007 was a sound investment."
"Jeff Lorberbaum, whose family owns 16% ($600 million) of the equity, ably leads Mohawk. We love it when management has a big stake in the future of the business, especially if we think they are smart, ethical, and focused on protecting and growing the competitive moat surrounding the enterprise. We believe that is definitely true when it comes to Jeff and his team."
Massey conceded that management overpaid for the acquisitions but as the largest shareholder they "experienced the psychological and financial pain from these past decisions". He also said that "we like the businesses they bought, it was the prices they paid, with which we had a problem".
"We like this investment a great deal. We own a super business with a durable competitive position."
Finally Massey added....
"Lastly, we reiterate that Mohawk is run by owner-operators who are passionately focused on its long-term success and who have enormous skin in the game. Based on very reasonable assumptions, we believe we will earn between 16-18% compounded annually through 2021. Our cost basis is just under $58."
The stock as of last friday was selling just under $ 47. Mohawk remains of interest to me whenever the price drops below $45/share (preferably well below) as I've noted in Stocks to Watch. So it is close to where I get interested in buying more shares again (the stock did briefly dropped into the high 30s recently).
It, along with Lowe's (LOW), remain my preferred housing related long-term investments.
Whenever Mohawk has been cheap enough, I've accumulated enough of a position to avoid a classic error of omission but leave room to grab more if the discount to value gets even bigger. In this case, I have little expectation of great near term performance yet expect very nice long run performance once housing recovers.
Sometimes ignoring the risk of short-term paper losses is necessary to make sure a meaningful stake is acquired.
This will probably make it so-called "dead money" and some will want to time it. My premise is that if you try to time it the risk of owning "an eyedropper" (or none) of something when a substantial amount was wanted becomes more probable.
When an investor understands and likes a business that's available at a fair price, it makes no sense to try and time it because of fear that it will be so-called "dead money". It's tough enough to find a business that you understand that selling at a large discount to intrinsic value.
I realize this might not quite fit the ethos of the fast money world we live in.
Adam
Long MHK, BRKb, and LOW
---
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.
Monday, October 10, 2011
Friday, October 7, 2011
Buy Stocks, Not Economic Data
With all the focus by investors on macroeconomic data these days, I think the title of this Barron's article from last month sums things up pretty well:
Buy Stocks, Not Economic Data
That's sound long-term advice but I suspect the disproportionate role in the market of ETFs and high speed trading combined with such a macro-oriented focus likely means that mispriced individual stocks can get a whole lot more mispriced* in the short run.
In the long run, paying a substantial discount to value is what matters for an investor. That doesn't mean, for a period of time, things can't get ugly as far as near term stock price action goes.
The durability of core economics for each individual business is what matters to equity investors focused on long-term effects. The article makes the point that macroeconomic data and policies don't impact corporate performance but rarely has it gotten more attention than now.
The article also makes the point, using a study by David P. Goldman, that investors are unwilling to buy the 8% earnings yield of large cap U.S. corporations (what Goldman describes as being in the "sweet spot on the investment spectrum") when the 10-year Treasury is yielding near 2%.
Pretty much the mirror image of a decade or so ago.
The article goes on to use Intel (INTC), Microsoft (MSFT), and Abbott Laboratories (ABT) as examples of profitable businesses with strong balance sheets that "gush free cash flows".
Cash flow that can be returned via buybacks and dividends.
The current list of low price to earnings/ high earnings yield large capitalization stocks selling at a nice discount to value is a very long one.
Here's another article from back in August that makes a similar point about blue-chips selling at 10x earnings with dividend yields greater than 10-year Treasury note:
Bargain Days
It provides a bunch more examples of low multiple stocks.
Just keep in mind that, while lots of stocks seem cheap, the number of investments that most can reasonably expect to understand is not that high.
"The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it." - Warren Buffett in the 1993 Berkshire Hathaway Shareholder Letter
At this point, there are many large capitalization stocks that, at least on the surface, look inexpensive. It would be easy to make the mistake of trying to own too many of them.
It's generally just not possible to get a good understanding of what you own if the number gets too large. When buying a little bit of lots of different stocks in order to diversify it will often make more sense to consider something like an broad-based index fund (or at least maybe use a fund as a supplement to individual stock holdings).
It comes down to how much confidence each investor has in their own ability to pick individual stocks.
Adam
* Mispricing cuts both ways. What seems cheap can become a lot cheaper given the market's current structure and, even if hard to imagine now, in some future euphoric market episode the overvalued can once again become even more overvalued. Yet another bubble. Market participants increasingly focus on the macro, utilize ETFs (including some of the leveraged garbage now available), and employ high frequency trading strategies in lieu of evaluating how market price compares to an individual stock's intrinsic value. If price relative to value of an individual security takes a back seat for a disproportionate number of participants it seems almost certain mispricing will become more the norm. High speed algorithmic trading now accounts for something like 70% of volume and goes a long way toward explaining the 2.8 month average holding period of stocks...down from a holding period more like 2-4 years, historically.
---
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.
Buy Stocks, Not Economic Data
That's sound long-term advice but I suspect the disproportionate role in the market of ETFs and high speed trading combined with such a macro-oriented focus likely means that mispriced individual stocks can get a whole lot more mispriced* in the short run.
In the long run, paying a substantial discount to value is what matters for an investor. That doesn't mean, for a period of time, things can't get ugly as far as near term stock price action goes.
The durability of core economics for each individual business is what matters to equity investors focused on long-term effects. The article makes the point that macroeconomic data and policies don't impact corporate performance but rarely has it gotten more attention than now.
The article also makes the point, using a study by David P. Goldman, that investors are unwilling to buy the 8% earnings yield of large cap U.S. corporations (what Goldman describes as being in the "sweet spot on the investment spectrum") when the 10-year Treasury is yielding near 2%.
Pretty much the mirror image of a decade or so ago.
The article goes on to use Intel (INTC), Microsoft (MSFT), and Abbott Laboratories (ABT) as examples of profitable businesses with strong balance sheets that "gush free cash flows".
Cash flow that can be returned via buybacks and dividends.
The current list of low price to earnings/ high earnings yield large capitalization stocks selling at a nice discount to value is a very long one.
Here's another article from back in August that makes a similar point about blue-chips selling at 10x earnings with dividend yields greater than 10-year Treasury note:
Bargain Days
It provides a bunch more examples of low multiple stocks.
Just keep in mind that, while lots of stocks seem cheap, the number of investments that most can reasonably expect to understand is not that high.
"The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it." - Warren Buffett in the 1993 Berkshire Hathaway Shareholder Letter
At this point, there are many large capitalization stocks that, at least on the surface, look inexpensive. It would be easy to make the mistake of trying to own too many of them.
It's generally just not possible to get a good understanding of what you own if the number gets too large. When buying a little bit of lots of different stocks in order to diversify it will often make more sense to consider something like an broad-based index fund (or at least maybe use a fund as a supplement to individual stock holdings).
It comes down to how much confidence each investor has in their own ability to pick individual stocks.
Adam
* Mispricing cuts both ways. What seems cheap can become a lot cheaper given the market's current structure and, even if hard to imagine now, in some future euphoric market episode the overvalued can once again become even more overvalued. Yet another bubble. Market participants increasingly focus on the macro, utilize ETFs (including some of the leveraged garbage now available), and employ high frequency trading strategies in lieu of evaluating how market price compares to an individual stock's intrinsic value. If price relative to value of an individual security takes a back seat for a disproportionate number of participants it seems almost certain mispricing will become more the norm. High speed algorithmic trading now accounts for something like 70% of volume and goes a long way toward explaining the 2.8 month average holding period of stocks...down from a holding period more like 2-4 years, historically.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Thursday, October 6, 2011
Steve Jobs
Some excerpts of reactions to the passing of Steve Jobs along with a few memorable quotes:
Barron's - Apple: Steve Jobs, 56, Visionary, Passes Away
Intersection of Technology & Art
He thought in broad sweeping terms about where we were going with technology and what happened at what he liked to call the intersection of technology and art, liberal arts. But it's also true that he thought about the smallest details in these products. And that's why he not only saved the company but also put it in a position where it consistently wins the hearts of people, because he believed very much in delighting customers. He did not manage for the quarter, he did not manage for the stock price, as high as the stock price was. He really believed that the only thing worth doing with your life was trying to change the world. - Walt Mossberg in a podcast interview last night
AllThingsD - The Steve Jobs I Knew
by Walt Mossberg
The Optimist
He certainly had a nasty, mercurial side to him, and I expect that, then and later, it emerged inside the company and in dealings with partners and vendors, who tell believable stories about how hard he was to deal with.
But I can honestly say that, in my many conversations with him, the dominant tone he struck was optimism and certainty, both for Apple and for the digital revolution as a whole.
and later in the article...
This quality was on display when Apple opened its first retail store. It happened to be in the Washington, D.C., suburbs, near my home. He conducted a press tour for journalists, as proud of the store as a father is of his first child. I commented that, surely, there'd only be a few stores, and asked what Apple knew about retailing.
He looked at me like I was crazy, said there'd be many, many stores, and that the company had spent a year tweaking the layout of the stores, using a mockup at a secret location. I teased him by asking if he, personally, despite his hard duties as CEO, had approved tiny details like the translucency of the glass and the color of the wood.
He said he had, of course.
New York Times - Apple's Visionary Re-defined Digital Age
Market Research
...Mr. Jobs's genius lay in his ability to simplify complex, highly engineered products, "to strip away the excess layers of business, design and innovation until only the simple, elegant reality remained."
Mr. Jobs's own research and intuition, not focus groups, were his guide. When asked what market research went into the iPad, Mr. Jobs replied: "None. It's not the consumers' job to know what they want."
AllThingsD - Steve Jobs, in His Own Words
Memorable Quotes by Steve Jobs
"My position coming back to Apple was that our industry was in a coma. It reminded me of Detroit in the '70s, when American cars were boats on wheels."
"Being the richest man in the cemetery doesn't matter to me. Going to bed at night saying we’ve done something wonderful, that’s what matters to me."
"Remembering that I'll be dead soon is the most important tool I've ever encountered to help me make the big choices in life. Because almost everything — all external expectations, all pride, all fear of embarrassment or failure — these things just fall away in the face of death, leaving only what is truly important. Remembering that you are going to die is the best way I know to avoid the trap of thinking you have something to lose. You are already naked. There is no reason not to follow your heart."
I won't be surprised if the significance of what Steve Jobs helped set in motion this past decade or so turns out to be in the very early stages. Maybe the bulk of the full impact is yet to be felt.
Of course, it's also possible the industry will end up going off the rails to some extent. Could it become a little like the industry "in a coma" or "Detroit in the '70s" that Jobs saw upon returning to Apple again?
We'll see.
Adam
Barron's - Apple: Steve Jobs, 56, Visionary, Passes Away
Intersection of Technology & Art
He thought in broad sweeping terms about where we were going with technology and what happened at what he liked to call the intersection of technology and art, liberal arts. But it's also true that he thought about the smallest details in these products. And that's why he not only saved the company but also put it in a position where it consistently wins the hearts of people, because he believed very much in delighting customers. He did not manage for the quarter, he did not manage for the stock price, as high as the stock price was. He really believed that the only thing worth doing with your life was trying to change the world. - Walt Mossberg in a podcast interview last night
AllThingsD - The Steve Jobs I Knew
by Walt Mossberg
The Optimist
He certainly had a nasty, mercurial side to him, and I expect that, then and later, it emerged inside the company and in dealings with partners and vendors, who tell believable stories about how hard he was to deal with.
But I can honestly say that, in my many conversations with him, the dominant tone he struck was optimism and certainty, both for Apple and for the digital revolution as a whole.
and later in the article...
This quality was on display when Apple opened its first retail store. It happened to be in the Washington, D.C., suburbs, near my home. He conducted a press tour for journalists, as proud of the store as a father is of his first child. I commented that, surely, there'd only be a few stores, and asked what Apple knew about retailing.
He looked at me like I was crazy, said there'd be many, many stores, and that the company had spent a year tweaking the layout of the stores, using a mockup at a secret location. I teased him by asking if he, personally, despite his hard duties as CEO, had approved tiny details like the translucency of the glass and the color of the wood.
He said he had, of course.
New York Times - Apple's Visionary Re-defined Digital Age
Market Research
...Mr. Jobs's genius lay in his ability to simplify complex, highly engineered products, "to strip away the excess layers of business, design and innovation until only the simple, elegant reality remained."
Mr. Jobs's own research and intuition, not focus groups, were his guide. When asked what market research went into the iPad, Mr. Jobs replied: "None. It's not the consumers' job to know what they want."
AllThingsD - Steve Jobs, in His Own Words
Memorable Quotes by Steve Jobs
"My position coming back to Apple was that our industry was in a coma. It reminded me of Detroit in the '70s, when American cars were boats on wheels."
"Being the richest man in the cemetery doesn't matter to me. Going to bed at night saying we’ve done something wonderful, that’s what matters to me."
"Remembering that I'll be dead soon is the most important tool I've ever encountered to help me make the big choices in life. Because almost everything — all external expectations, all pride, all fear of embarrassment or failure — these things just fall away in the face of death, leaving only what is truly important. Remembering that you are going to die is the best way I know to avoid the trap of thinking you have something to lose. You are already naked. There is no reason not to follow your heart."
I won't be surprised if the significance of what Steve Jobs helped set in motion this past decade or so turns out to be in the very early stages. Maybe the bulk of the full impact is yet to be felt.
Of course, it's also possible the industry will end up going off the rails to some extent. Could it become a little like the industry "in a coma" or "Detroit in the '70s" that Jobs saw upon returning to Apple again?
We'll see.
Adam
Wednesday, October 5, 2011
Buffett: Why Growth Is Not Necessarily A Good Thing - Berkshire Shareholder Letter Highlights
Warren Buffett wrote the following in the 1992 Berkshire Hathaway (BRKa) 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."
Some may find the idea that growth could ever be a negative thing for an investor a bit odd.*
If nothing else it's not necessarily intuitive.
In fact, listen or read carefully someone touting an investment and you'll hear growth potential mentioned in a way that implicitly suggests all growth is good growth.
Buffett later in the same letter added the following:
"...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. In the case of a low-return business requiring incremental funds, growth hurts the investor."
So why would anyone running a business pursue growth strategies that do not produce high returns for shareholders besides poor judgment or incompetence? Well, as Buffett points out above, some industries just don't have favorable economics. So even solid execution results in not great investment outcomes. There are other reasons. The desire of a CEO to expand the business empire, so to speak, even if, in pursuit of that growth, it happens to not produce much in the way of long-term returns (though short-term it may look okay especially with clever use of accounting) is one example.
Growth for growth's sake, the financing of low return (or worse) growth, happens plenty in the world of business and investors end up getting hurt by it.
I've covered variations of the "growth myth" in other posts. If interested, I've included some links to examples below.
Think about this the next time you hear growth prospects at the center of some investment thesis. Growth prospects do tend to be, at least often enough, an overrated component of long run value creation for shareholders.
So, even if not deliberate, growth is at times pursued at shareholder expense and, as part owner of the business, healthy skepticism when it comes to aggressive growth strategies involving the use of shareholder funds is often more than justified.
Now there's obviously nothing wrong with high return growth when you can find it at a fair price. Just keep in mind that dynamic high growth frequently invites competition. It is the potential for intense competition that makes the crucial question of whether a business can sustain its high return on capital characteristics (or generally favorable long run economics) tougher to answer.
Growth for growth's sake often ends up producing lousy rates of return for shareholders. The question becomes this. Will a particular growth opportunity involving incremental capital make shareholders wallets fatter or just make the domain the business happens to occupy larger with returns an afterthought?
(I say only somewhat sarcastically that words like "strategic" or "synergistic" -- when used to justify a large but ill-conceived capital allocation decision -- are, at times, just code for something like: "we're investing to get bigger fast though possibly at the expense of long run shareholder returns".)
The expensive pursuit of market share at subpar or negative returns is another variation of this.
Some businesses, over an extended period, can put large quantities of incremental capital at high rates of return to work. Unfortunately, that is a rare business. Since most cannot do this, it's preferable for the excess funds to be used for buybacks (when the stock sells below -- ideally nicely below -- intrinsic value) or dividends.
Also, for a business structured like Berkshire Hathaway, the businesses that produce excess capital can send it to Warren Buffett for deployment into some other high return investment (that's precisely the role that See's Candies has played for decades).
The reality is most high return businesses like See's need little capital and generate lots of it (relative to its size, of course). Keeping those funds inside a business like See's is an invitation for poor use of capital.
Finding businesses with durable high returns on capital, with management that knows how to wisely deploy funds, then paying a nice discount to a conservative estimate of intrinsic value determines long-term returns for investors...not growth.
Adam
Long BRKb
Related posts:
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
* Growth, of course, will often have a favorable impact on value. It just happens to be a mistake to think that it always has a favorable impact. In fact, growth can actually reduce value if it requires capital inputs in excess of the discounted value of the cash that will be generated over time. Sometimes, the highest growth opportunities attract lots of capable competition (and fresh capital) that, over time, converts what looked like attractive economics into something much less so. Other times, high growth ends up requiring expensive but needed capital raising that dilutes existing shareholders and reduces per share returns.
Finally, even if growth that materializes does have favorable economics, some investors tend to pay a large premium upfront for those growth prospects. That hefty price paid may turn attractive long-term business results into not so attractive investment results.
---
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.
"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."
Some may find the idea that growth could ever be a negative thing for an investor a bit odd.*
If nothing else it's not necessarily intuitive.
In fact, listen or read carefully someone touting an investment and you'll hear growth potential mentioned in a way that implicitly suggests all growth is good growth.
Buffett later in the same letter added the following:
"...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. In the case of a low-return business requiring incremental funds, growth hurts the investor."
So why would anyone running a business pursue growth strategies that do not produce high returns for shareholders besides poor judgment or incompetence? Well, as Buffett points out above, some industries just don't have favorable economics. So even solid execution results in not great investment outcomes. There are other reasons. The desire of a CEO to expand the business empire, so to speak, even if, in pursuit of that growth, it happens to not produce much in the way of long-term returns (though short-term it may look okay especially with clever use of accounting) is one example.
Growth for growth's sake, the financing of low return (or worse) growth, happens plenty in the world of business and investors end up getting hurt by it.
I've covered variations of the "growth myth" in other posts. If interested, I've included some links to examples below.
Think about this the next time you hear growth prospects at the center of some investment thesis. Growth prospects do tend to be, at least often enough, an overrated component of long run value creation for shareholders.
So, even if not deliberate, growth is at times pursued at shareholder expense and, as part owner of the business, healthy skepticism when it comes to aggressive growth strategies involving the use of shareholder funds is often more than justified.
Now there's obviously nothing wrong with high return growth when you can find it at a fair price. Just keep in mind that dynamic high growth frequently invites competition. It is the potential for intense competition that makes the crucial question of whether a business can sustain its high return on capital characteristics (or generally favorable long run economics) tougher to answer.
Growth for growth's sake often ends up producing lousy rates of return for shareholders. The question becomes this. Will a particular growth opportunity involving incremental capital make shareholders wallets fatter or just make the domain the business happens to occupy larger with returns an afterthought?
(I say only somewhat sarcastically that words like "strategic" or "synergistic" -- when used to justify a large but ill-conceived capital allocation decision -- are, at times, just code for something like: "we're investing to get bigger fast though possibly at the expense of long run shareholder returns".)
The expensive pursuit of market share at subpar or negative returns is another variation of this.
Some businesses, over an extended period, can put large quantities of incremental capital at high rates of return to work. Unfortunately, that is a rare business. Since most cannot do this, it's preferable for the excess funds to be used for buybacks (when the stock sells below -- ideally nicely below -- intrinsic value) or dividends.
Also, for a business structured like Berkshire Hathaway, the businesses that produce excess capital can send it to Warren Buffett for deployment into some other high return investment (that's precisely the role that See's Candies has played for decades).
The reality is most high return businesses like See's need little capital and generate lots of it (relative to its size, of course). Keeping those funds inside a business like See's is an invitation for poor use of capital.
Finding businesses with durable high returns on capital, with management that knows how to wisely deploy funds, then paying a nice discount to a conservative estimate of intrinsic value determines long-term returns for investors...not growth.
Adam
Long BRKb
Related posts:
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
* Growth, of course, will often have a favorable impact on value. It just happens to be a mistake to think that it always has a favorable impact. In fact, growth can actually reduce value if it requires capital inputs in excess of the discounted value of the cash that will be generated over time. Sometimes, the highest growth opportunities attract lots of capable competition (and fresh capital) that, over time, converts what looked like attractive economics into something much less so. Other times, high growth ends up requiring expensive but needed capital raising that dilutes existing shareholders and reduces per share returns.
Finally, even if growth that materializes does have favorable economics, some investors tend to pay a large premium upfront for those growth prospects. That hefty price paid may turn attractive long-term business results into not so attractive investment results.
---
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, October 4, 2011
Buffett on Opportunities, Uncertainty, and the Likelihood of a Recession
There are plenty of scary headlines out there. Consumer, investor, and business confidence is low. At a time when the global markets are selling off in a major way over fears of all kinds, below are some things of note said by Buffett...
CNBC: Warren Buffett Buying Stock Bargains
From this interview with Andrew Ross Sorkin:
On Buying Stock Other Than Berkshire's (BRKa)
"...in the current quarter, we bought net $ 4 billion of common equities, which was similar to the total amount we bought in the first half. The cheaper stocks get, the better I like to buy them, whether it's our stock or somebody else's."
On Uncertainty
"I don't have any uncertainty. We are investing at Berkshire a record $7 billion in plant and equipment this year. Never before that much; 90-plus percent is in the United States.
On Bank of America (BAC)
"It's a fabulous underlying business, but it's got a lot of problems from the past..."
From this New York Times article:
"We are coming out of this one, I am virtually certain," Mr. Buffett said. "I see figures on 70-some companies daily. I have a lot of information coming in and basically everything to do with home construction is as bad as it has ever been, and everything else is getting better."
This contrasts starkly with some of the recent headlines and how the markets are behaving. Some samples that I've seen since just since last Friday:
"It's Going to Get a Lot Worse": ECRI's Achuthan Says New Recession Unavoidable
An Unsettling Trifecta for Market Contagion
80% Chance of Bear Market in 2012
Think the Economy's Bad? 'You Haven't Seen Anything'
Europe's 'Lehman Moment' is here
So plenty to scare an investor yet some of the views expressed in those articles can coexist with Buffett's near term and longer term optimism.
Some of the worst outcomes imagined for the capital markets, the financial system, or the global economy may, in fact, happen. Who knows. That does not mean the shares of a good business bought at a nice discount to value now won't be worth a whole lot more in ten years or so. You get the best prices on securities when things look just plain awful.
The question is how much short-term pain can one handle.
It's pretty tough to pick the bottom. In my experience at least, if I try to wait until a stock or the markets overall bottom I'll end up with relatively small positions in the businesses I happen to understand the best. A classic error of omission.
It's the overwhelming influence of loss aversion that often puts errors of omission in the background. That doesn't make errors of omission any less costly.
What's cheap now may get a lot cheaper. I don't doubt that things could get ugly in a macroeconomic sense for a while...making what seems cheap even more so.
Thanks to ETFs and other factors stocks trade in tandem more than ever. Participants in the markets are seemingly as macro focused and short-term oriented as ever.
Also, seemingly in some ways by design, capital markets now operate in a manner that is less stable than what is otherwise possible*.
The players who profit from the current structure sure like the status quo but that doesn't make it wise.
It is the nature of markets to go to emotional extremes. In the current form that nature is amplified. This would seem to almost guarantees a greater than otherwise mispricing of individual securities.
For the long-term investor with a horizon beyond the next headline, there is no better situation, even if some of the stock price action gets ugly for quite a while. What long-term investor would not want quality shares of businesses selling at a discount to intrinsic value that end up getting an even bigger discount?
This only works, of course, if the buyer has the stomach and temperament to hold onto shares and an appropriate discount to value was paid for the right shares.
I've said on more than a few occasions that capital markets are operating far from optimally. It is too much of a casino with mispricing the norm. These weaknesses, even if not great for civilization, provide great opportunities to the informed and disciplined investor.
Adam
* A big assist goes to things like the advent of widespread derivatives usage, various other forms of not-so-transparent leverage, short-termism, and more generally allowing the capital markets to morph into a casino.
---
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.
CNBC: Warren Buffett Buying Stock Bargains
From this interview with Andrew Ross Sorkin:
On Buying Stock Other Than Berkshire's (BRKa)
"...in the current quarter, we bought net $ 4 billion of common equities, which was similar to the total amount we bought in the first half. The cheaper stocks get, the better I like to buy them, whether it's our stock or somebody else's."
On Uncertainty
"I don't have any uncertainty. We are investing at Berkshire a record $7 billion in plant and equipment this year. Never before that much; 90-plus percent is in the United States.
On Bank of America (BAC)
"It's a fabulous underlying business, but it's got a lot of problems from the past..."
From this New York Times article:
"We are coming out of this one, I am virtually certain," Mr. Buffett said. "I see figures on 70-some companies daily. I have a lot of information coming in and basically everything to do with home construction is as bad as it has ever been, and everything else is getting better."
This contrasts starkly with some of the recent headlines and how the markets are behaving. Some samples that I've seen since just since last Friday:
"It's Going to Get a Lot Worse": ECRI's Achuthan Says New Recession Unavoidable
An Unsettling Trifecta for Market Contagion
80% Chance of Bear Market in 2012
Think the Economy's Bad? 'You Haven't Seen Anything'
Europe's 'Lehman Moment' is here
So plenty to scare an investor yet some of the views expressed in those articles can coexist with Buffett's near term and longer term optimism.
Some of the worst outcomes imagined for the capital markets, the financial system, or the global economy may, in fact, happen. Who knows. That does not mean the shares of a good business bought at a nice discount to value now won't be worth a whole lot more in ten years or so. You get the best prices on securities when things look just plain awful.
The question is how much short-term pain can one handle.
It's pretty tough to pick the bottom. In my experience at least, if I try to wait until a stock or the markets overall bottom I'll end up with relatively small positions in the businesses I happen to understand the best. A classic error of omission.
It's the overwhelming influence of loss aversion that often puts errors of omission in the background. That doesn't make errors of omission any less costly.
What's cheap now may get a lot cheaper. I don't doubt that things could get ugly in a macroeconomic sense for a while...making what seems cheap even more so.
Thanks to ETFs and other factors stocks trade in tandem more than ever. Participants in the markets are seemingly as macro focused and short-term oriented as ever.
Also, seemingly in some ways by design, capital markets now operate in a manner that is less stable than what is otherwise possible*.
The players who profit from the current structure sure like the status quo but that doesn't make it wise.
It is the nature of markets to go to emotional extremes. In the current form that nature is amplified. This would seem to almost guarantees a greater than otherwise mispricing of individual securities.
For the long-term investor with a horizon beyond the next headline, there is no better situation, even if some of the stock price action gets ugly for quite a while. What long-term investor would not want quality shares of businesses selling at a discount to intrinsic value that end up getting an even bigger discount?
This only works, of course, if the buyer has the stomach and temperament to hold onto shares and an appropriate discount to value was paid for the right shares.
I've said on more than a few occasions that capital markets are operating far from optimally. It is too much of a casino with mispricing the norm. These weaknesses, even if not great for civilization, provide great opportunities to the informed and disciplined investor.
Adam
* A big assist goes to things like the advent of widespread derivatives usage, various other forms of not-so-transparent leverage, short-termism, and more generally allowing the capital markets to morph into a casino.
---
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.
Monday, October 3, 2011
Amazon Sells Kindle Fire Below Cost
Well, can't say I'm exactly surprised. This Barron's article on Amazon's (AMZN) new $ 199 Kindle Fire tablet points out the cost per unit is higher than what they sell it for at $ 209.
In contrast, Apple's (AAPL) iPad (the original) sells for an entry level price of $ 499 and has a 46% gross profit.
I think Amazon has a pretty good chance of having a superb business down the road (it's not too bad now, of course).
The company has many strengths but its business success up to now is assisted by 1) the willingness of shareholders to put up temporarily with its rather modest profitability ("investing for growth") along with 2) a stock "currency" that has consistently had an extreme valuation.
Amazon's stock success has been, up to now at least, assisted by shareholder willingness to pay for promise yet to be realized.
Shareholders that bought Amazon while it was more reasonably valued (i.e. some of the smart long-term holders who bought it before roughly 2007) have already done just fine. There is also more than a reasonable chance that those shareholders end up making very nice risk-adjusted returns relative to what Amazon's intrinsic value will be in five or ten years.
In contrast, those that have bought or are buying the stock at a more inflated multiple will, at least on a risk-adjusted basis, likely get somewhat less than satisfactory returns in the long run (even if the stock happens to go up much higher near-term).
The share count of Amazon has grown from 364 to 460 million in ten years (a 26% increase). Allowing the share count to grow when the stock is generally expensive is not necessarily at all unwise. Shares could even be sold to raise capital while it trades above intrinsic value.
A good thing for shareholders who paid a reasonable price?
Possibly.
A good for the shareholders "paying for promise" and, as a result, buying well above intrinsic value?
Less likely.
When it comes to Amazon, I've never been able to come to estimating intrinsic value in a meaningful way. That's why I've never considered owning it. Others, no doubt, have a better idea what it's worth now and what it might be worth down the road.
Shareholders in Amazon today own a stock with a market value of roughly $ 100 billion that is expected to earn less than $ 1 billion in 2011.
That 2011 earnings number has actually shrunk year over year.
As a comparison, Apple will actually earn more like $ 26 billion this year, up from $ 14 billion the year before, and has ~22% of its market value in cash and investments with no debt.
In fact, it won't surprise me if Amazon continues the process of going from very overvalued to even more overvalued. (Though, as always, I have no specific view on near-term or even intermediate-term price action.) That process often continues, for many years sometimes, up until the point when the business materially fails to deliver on its promise or, somewhat counterintuitively, does deliver on its promise but it's clear that growth is slowing. At that point, the earnings multiple contraction process (what investors are willing to pay per dollar of current earnings) usually seriously hurts whoever got in late.
(Of course, Amazon's growth rate will eventually inevitably slow but the question is when. Another important question is: When and how long will it be before Amazon starts making some real money?)
Once that happens, there is the inevitable shift from the extreme growth-oriented investors and momentum traders to those more long-term value-oriented. It's during that kind of transition where bargain valuations sometimes arrive.
To some extent, that is what happened to eBay (EBAY) when investors began seeing growth of its marketplace business wane (interestingly, eBay never got the "investing for growth" pass from shareholders because the top line revenue wasn't growing enough even though earnings and free cash flow was superior to Amazon's).
High Growth eBay in 2004
Enterprise Value (EV) = $ 78 billion
Earnings = $ 778 million
EV/Earnings = 100x
Slow Growth eBay in 2010
Enterprise Value (EV) = $ 19 billion
Earnings = $ 1.8 billion
EV/Earning = 10.5x
More than 2x earnings power yet valuation dropped by more than 75%.
So the promise of growing $ 778 million rapidly was 4 times more valuable than the reality of earning $ 1.8 billion at a slower rate of growth.
Back to Amazon. So while Amazon is not of much interest now to most value-oriented investors, if it did become a bargain during the transition, that's precisely who could become interested as long as it was clear a sustainable economic moat had been built.
The high-powered return potential would be gone along with the possibility for high-powered losses. Missing a potential big winner is not a big deal. Exposure to a potential big permanent loss of capital is unacceptable.
If Amazon does get cheap someday and builds a durable moat around its business, value investors should be sure to thank all of those investors/traders who paid "too much", made very little on a risk-adjusted basis in the aggregate*, but at least ended up creating an environment (intentionally or by accident) over the years that allowed Amazon's business to be built into something worthwhile and durable.
Too often, management at a company is forced into managing the business to meet quarterly expectations.
Still, paying an extreme multiple is only admirable if, as an investor, one views the high probability of making modest or worse returns at great risk in order to support a company's cause to be a good thing.
Well done to those that bought Amazon reasonably cheap many years and stuck with it.
Again, at least for me, Amazon has been and remains a very tough to value company.
So, in some ways, I think a better description may be difficult-to-value instead of overvalued. If I can't value something within a narrow enough range, it's pretty tough to decide how much of a discount to that value is needed to protect against future uncertainties. Amazon may, in fact, justify its valuation someday. I certainly have no idea. It's just that investment is not about valuation ultimately proving to be justified; it's about getting a satisfactory or better return considering risks and alternatives.
Others may, of course, find estimating Amazon's intrinsic value to be more doable. Those who think they can estimate the company's value (with a confidence that's warranted) will be better suited to invest in the shares than myself.
Adam
Long position AAPL and EBAY; No position in AMZN
Related post:
Technology Stocks
* There will be plenty who traded it right, of course, but we likely won't hear much from those who did not. The point is that, in the aggregate, long-term risk-adjusted returns aren't likely to be great from near current prices. Near its current price, the risk of negative returns seems uncomfortably high if things go a bit less well than expected. Having said that, sustained high return on capital over 2 or 3 decades eventually does make an initially expensive looking investment make sense. In the very long run, results tend to be drawn like a magnet toward the return on capital earned by the business. I don't think I have any capacity to even roughly estimate Amazon's return on capital or its sustainability over such a long time horizon.
---
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.
In contrast, Apple's (AAPL) iPad (the original) sells for an entry level price of $ 499 and has a 46% gross profit.
I think Amazon has a pretty good chance of having a superb business down the road (it's not too bad now, of course).
The company has many strengths but its business success up to now is assisted by 1) the willingness of shareholders to put up temporarily with its rather modest profitability ("investing for growth") along with 2) a stock "currency" that has consistently had an extreme valuation.
Amazon's stock success has been, up to now at least, assisted by shareholder willingness to pay for promise yet to be realized.
Shareholders that bought Amazon while it was more reasonably valued (i.e. some of the smart long-term holders who bought it before roughly 2007) have already done just fine. There is also more than a reasonable chance that those shareholders end up making very nice risk-adjusted returns relative to what Amazon's intrinsic value will be in five or ten years.
In contrast, those that have bought or are buying the stock at a more inflated multiple will, at least on a risk-adjusted basis, likely get somewhat less than satisfactory returns in the long run (even if the stock happens to go up much higher near-term).
The share count of Amazon has grown from 364 to 460 million in ten years (a 26% increase). Allowing the share count to grow when the stock is generally expensive is not necessarily at all unwise. Shares could even be sold to raise capital while it trades above intrinsic value.
A good thing for shareholders who paid a reasonable price?
Possibly.
A good for the shareholders "paying for promise" and, as a result, buying well above intrinsic value?
Less likely.
When it comes to Amazon, I've never been able to come to estimating intrinsic value in a meaningful way. That's why I've never considered owning it. Others, no doubt, have a better idea what it's worth now and what it might be worth down the road.
Shareholders in Amazon today own a stock with a market value of roughly $ 100 billion that is expected to earn less than $ 1 billion in 2011.
That 2011 earnings number has actually shrunk year over year.
As a comparison, Apple will actually earn more like $ 26 billion this year, up from $ 14 billion the year before, and has ~22% of its market value in cash and investments with no debt.
In fact, it won't surprise me if Amazon continues the process of going from very overvalued to even more overvalued. (Though, as always, I have no specific view on near-term or even intermediate-term price action.) That process often continues, for many years sometimes, up until the point when the business materially fails to deliver on its promise or, somewhat counterintuitively, does deliver on its promise but it's clear that growth is slowing. At that point, the earnings multiple contraction process (what investors are willing to pay per dollar of current earnings) usually seriously hurts whoever got in late.
(Of course, Amazon's growth rate will eventually inevitably slow but the question is when. Another important question is: When and how long will it be before Amazon starts making some real money?)
Once that happens, there is the inevitable shift from the extreme growth-oriented investors and momentum traders to those more long-term value-oriented. It's during that kind of transition where bargain valuations sometimes arrive.
To some extent, that is what happened to eBay (EBAY) when investors began seeing growth of its marketplace business wane (interestingly, eBay never got the "investing for growth" pass from shareholders because the top line revenue wasn't growing enough even though earnings and free cash flow was superior to Amazon's).
High Growth eBay in 2004
Enterprise Value (EV) = $ 78 billion
Earnings = $ 778 million
EV/Earnings = 100x
Slow Growth eBay in 2010
Enterprise Value (EV) = $ 19 billion
Earnings = $ 1.8 billion
EV/Earning = 10.5x
More than 2x earnings power yet valuation dropped by more than 75%.
So the promise of growing $ 778 million rapidly was 4 times more valuable than the reality of earning $ 1.8 billion at a slower rate of growth.
Back to Amazon. So while Amazon is not of much interest now to most value-oriented investors, if it did become a bargain during the transition, that's precisely who could become interested as long as it was clear a sustainable economic moat had been built.
The high-powered return potential would be gone along with the possibility for high-powered losses. Missing a potential big winner is not a big deal. Exposure to a potential big permanent loss of capital is unacceptable.
If Amazon does get cheap someday and builds a durable moat around its business, value investors should be sure to thank all of those investors/traders who paid "too much", made very little on a risk-adjusted basis in the aggregate*, but at least ended up creating an environment (intentionally or by accident) over the years that allowed Amazon's business to be built into something worthwhile and durable.
Too often, management at a company is forced into managing the business to meet quarterly expectations.
Still, paying an extreme multiple is only admirable if, as an investor, one views the high probability of making modest or worse returns at great risk in order to support a company's cause to be a good thing.
Well done to those that bought Amazon reasonably cheap many years and stuck with it.
Again, at least for me, Amazon has been and remains a very tough to value company.
So, in some ways, I think a better description may be difficult-to-value instead of overvalued. If I can't value something within a narrow enough range, it's pretty tough to decide how much of a discount to that value is needed to protect against future uncertainties. Amazon may, in fact, justify its valuation someday. I certainly have no idea. It's just that investment is not about valuation ultimately proving to be justified; it's about getting a satisfactory or better return considering risks and alternatives.
Others may, of course, find estimating Amazon's intrinsic value to be more doable. Those who think they can estimate the company's value (with a confidence that's warranted) will be better suited to invest in the shares than myself.
Long position AAPL and EBAY; No position in AMZN
Related post:
Technology Stocks
* There will be plenty who traded it right, of course, but we likely won't hear much from those who did not. The point is that, in the aggregate, long-term risk-adjusted returns aren't likely to be great from near current prices. Near its current price, the risk of negative returns seems uncomfortably high if things go a bit less well than expected. Having said that, sustained high return on capital over 2 or 3 decades eventually does make an initially expensive looking investment make sense. In the very long run, results tend to be drawn like a magnet toward the return on capital earned by the business. I don't think I have any capacity to even roughly estimate Amazon's return on capital or its sustainability over such a long time horizon.
---
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, September 30, 2011
Buffett: The Berkshire Hathaway Buybacks Have Begun
In a live interview with CNBC on the New York Stock Exchange, Warren Buffett told CNBC that the buying back of Berkshire Hathaway's (BRKa) stock has now started.
He also added that they have been buying net $ 4 billion of some other common stocks in the 3rd quarter.
CNBC article: Warren Buffett Buying Stock Bargains
Buffett says he still hopes to make some big acquisitions. Not exactly bearish.
Adam
He also added that they have been buying net $ 4 billion of some other common stocks in the 3rd quarter.
CNBC article: Warren Buffett Buying Stock Bargains
Buffett says he still hopes to make some big acquisitions. Not exactly bearish.
Adam
Buffett on Wells Fargo - Part II: Berkskhire Shareholder Letter Highlights
A follow up to this post.
Warren Buffett, in the 1990 Berkshire Hathaway (BRKa) shareholder letter, wrote the following about Wells Fargo (WFC):
Of course, ownership of a bank - or about any other business - is far from riskless. California banks face the specific risk of a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them. A second risk is systemic - the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run. Finally, the market's major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable.
None of these eventualities can be ruled out. The probability of the first two occurring, however, is low and even a meaningful drop in real estate values is unlikely to cause major problems for well-managed institutions. Consider some mathematics: Wells Fargo currently earns well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank's loans - not just its real estate loans - were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even.
A year like that - which we consider only a low-level possibility, not a likelihood - would not distress us. In fact, at Berkshire we would love to acquire businesses or invest in capital projects that produced no return for a year, but that could then be expected to earn 20% on growing equity. Nevertheless, fears of a California real estate disaster similar to that experienced in New England caused the price of Wells Fargo stock to fall almost 50% within a few months during 1990. Even though we had bought some shares at the prices prevailing before the fall, we welcomed the decline because it allowed us to pick up many more shares at the new, panic prices.
When the above was written the extensive use of derivatives was not in vogue yet. Their current prevalent use create systemic risks and risks unique to each institution that is difficult to gauge.
From the 2002 Berkshire Hathaway shareholder letter:
...derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don't understand how much risk the institution is running.
The shares of Wells Fargo have increased in value well over 1,800% including dividends since Buffett wrote about the bank in the 1990 letter (though Buffett has bought many shares since with lesser gains). I doubt many banks will produce those kind of returns over the next twenty years or so but some of the better ones will certainly do quite well.
It's an example of what high return on equity (or preferably high return on capital for a non-financial) bought at 5x earnings, what Buffett paid for Wells back then, can produce in value when compounded over 20 years.
Yesterday's post covered this. Pay a lot less than what a business is worth now and make sure it is capable of producing a high return on tangible capital in the future. The cheap price provides a margin of safety in the near term. The high return on capital drives value long-term.
Joel Greenblatt on Stocks
Still, as I said in the earlier post, with so many inexpensive non-financial businesses available I'm not certain any bank is worth the trouble (considering the unique risks involved with owning shares of a bank) for most investors.
Adam
Long BRKb and WFC
---
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, in the 1990 Berkshire Hathaway (BRKa) shareholder letter, wrote the following about Wells Fargo (WFC):
Of course, ownership of a bank - or about any other business - is far from riskless. California banks face the specific risk of a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them. A second risk is systemic - the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run. Finally, the market's major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable.
None of these eventualities can be ruled out. The probability of the first two occurring, however, is low and even a meaningful drop in real estate values is unlikely to cause major problems for well-managed institutions. Consider some mathematics: Wells Fargo currently earns well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank's loans - not just its real estate loans - were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even.
A year like that - which we consider only a low-level possibility, not a likelihood - would not distress us. In fact, at Berkshire we would love to acquire businesses or invest in capital projects that produced no return for a year, but that could then be expected to earn 20% on growing equity. Nevertheless, fears of a California real estate disaster similar to that experienced in New England caused the price of Wells Fargo stock to fall almost 50% within a few months during 1990. Even though we had bought some shares at the prices prevailing before the fall, we welcomed the decline because it allowed us to pick up many more shares at the new, panic prices.
When the above was written the extensive use of derivatives was not in vogue yet. Their current prevalent use create systemic risks and risks unique to each institution that is difficult to gauge.
From the 2002 Berkshire Hathaway shareholder letter:
...derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don't understand how much risk the institution is running.
The shares of Wells Fargo have increased in value well over 1,800% including dividends since Buffett wrote about the bank in the 1990 letter (though Buffett has bought many shares since with lesser gains). I doubt many banks will produce those kind of returns over the next twenty years or so but some of the better ones will certainly do quite well.
It's an example of what high return on equity (or preferably high return on capital for a non-financial) bought at 5x earnings, what Buffett paid for Wells back then, can produce in value when compounded over 20 years.
Yesterday's post covered this. Pay a lot less than what a business is worth now and make sure it is capable of producing a high return on tangible capital in the future. The cheap price provides a margin of safety in the near term. The high return on capital drives value long-term.
Joel Greenblatt on Stocks
Still, as I said in the earlier post, with so many inexpensive non-financial businesses available I'm not certain any bank is worth the trouble (considering the unique risks involved with owning shares of a bank) for most investors.
Adam
Long BRKb and WFC
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Thursday, September 29, 2011
Joel Greenblatt on Stocks
From this CNBC interview with Joel Greenblatt:
"It's a very scary time to invest, and that's when you get your best bargains," he told CNBC Tuesday.
Greenblatt, known for his "magic formula" investing approach, places emphasis on buying companies with a high free cash flow yield and high return on tangible capital.
Basically, a decent quality business that is cheap.
Greenblatt uses free cash flow yield* to measure whether a company is cheap and uses return on tangible capital as the measure of choice to indicate higher quality.
In the interview, Greenblatt acknowledged his formula isn't perfect and doesn't always work (nothing always works, of course). So it's far from comprehensive. Clearly, other factors must also be considered (threats to the sustainability of the company's economic moat among other things), some of them intangible, but high free cash flow yield in combination with high return on tangible capital is not a bad place to start.
I think it is a very useful way of looking at things.
Using this approach Greenblatt says the stocks he now likes include:
Gamestop (GME)
American Eagle (AEO)
Best Buy (BBY)
Microsoft (MSFT)
Wells Fargo (WFC)
Hewlett-Packard (HPQ)
More from Greenblatt on CNBC:
What they have in common is "each one of those companies is hated brutally by most people."
In the interview he added that at HP's current multiple "you're going to get your money back in the next 4-5 years and own the company for free at these kind of prices."
I happen to think HP's earnings and free cash flow will probably be less than $ 5/share but what he is saying is still chiefly valid.
Once something sells at or near 5x free cash flow (a 20% free cash flow yield) very little has to go right. Well, that is true as long as management doesn't do the equivalent of throwing the cash into a furnace (consistently overpaying for acquisitions, buying back the stock when expensive etc.) and there is not a serious threat to the economic moat.
In other words, just believing that a business is stagnating or even shrinking a bit isn't compatible with a 5x multiple. The economic situation of a business has to be much worse to justify a multiple that low.
Consider a durable high return on capital business bought at a 20% free cash flow yield that happens to shrink a bit over the next five years. I know I can still live with those kinds of returns as a co-owner. I mean, a 20% return getting reduced to something like 15% is not exactly a disaster as long as it stabilizes at a somewhat lower level of profitability**.
There is often an obsession with growth that can be misplaced. A low price combined with durability trumps growth.
At very low prices a little growth is not a necessity but a bonus if it happens.
(It's worth noting that extremely high growth sometimes attracts fresh capital and competition that can adversely change the economics of a business down the road.)
The story of a very low multiple stock will rarely sound like a great one (so usually not a great subject at a cocktail party) but that doesn't matter. You can't spend a story. What does matter is whether the future stream of cash flows provides satisfactory returns considering the risks.
The key thing will always be that the stream of cash flows remains durable, even if a bit variable, and is either returned to shareholders or put to high return use by management.
Adam
Long position in WFC established at lower than recent prices in addition to much smaller long positions in MSFT and HPQ.
* Use earnings yield (inverse price to earnings) as a measure instead is often sufficient but free cash flow is more economically reliable and helps in avoiding lower quality earnings via accounting gimmickry. It's easier to dress up the income statement than the statement of cash flows.
** At an extremely low valuation the business doesn't even need to stabilize. Berkshire's Blue Chip Stamps is an example that comes to mind.
---
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.
"It's a very scary time to invest, and that's when you get your best bargains," he told CNBC Tuesday.
Greenblatt, known for his "magic formula" investing approach, places emphasis on buying companies with a high free cash flow yield and high return on tangible capital.
Basically, a decent quality business that is cheap.
Greenblatt uses free cash flow yield* to measure whether a company is cheap and uses return on tangible capital as the measure of choice to indicate higher quality.
In the interview, Greenblatt acknowledged his formula isn't perfect and doesn't always work (nothing always works, of course). So it's far from comprehensive. Clearly, other factors must also be considered (threats to the sustainability of the company's economic moat among other things), some of them intangible, but high free cash flow yield in combination with high return on tangible capital is not a bad place to start.
I think it is a very useful way of looking at things.
Using this approach Greenblatt says the stocks he now likes include:
Gamestop (GME)
American Eagle (AEO)
Best Buy (BBY)
Microsoft (MSFT)
Wells Fargo (WFC)
Hewlett-Packard (HPQ)
More from Greenblatt on CNBC:
What they have in common is "each one of those companies is hated brutally by most people."
In the interview he added that at HP's current multiple "you're going to get your money back in the next 4-5 years and own the company for free at these kind of prices."
I happen to think HP's earnings and free cash flow will probably be less than $ 5/share but what he is saying is still chiefly valid.
Once something sells at or near 5x free cash flow (a 20% free cash flow yield) very little has to go right. Well, that is true as long as management doesn't do the equivalent of throwing the cash into a furnace (consistently overpaying for acquisitions, buying back the stock when expensive etc.) and there is not a serious threat to the economic moat.
In other words, just believing that a business is stagnating or even shrinking a bit isn't compatible with a 5x multiple. The economic situation of a business has to be much worse to justify a multiple that low.
Consider a durable high return on capital business bought at a 20% free cash flow yield that happens to shrink a bit over the next five years. I know I can still live with those kinds of returns as a co-owner. I mean, a 20% return getting reduced to something like 15% is not exactly a disaster as long as it stabilizes at a somewhat lower level of profitability**.
There is often an obsession with growth that can be misplaced. A low price combined with durability trumps growth.
At very low prices a little growth is not a necessity but a bonus if it happens.
(It's worth noting that extremely high growth sometimes attracts fresh capital and competition that can adversely change the economics of a business down the road.)
The story of a very low multiple stock will rarely sound like a great one (so usually not a great subject at a cocktail party) but that doesn't matter. You can't spend a story. What does matter is whether the future stream of cash flows provides satisfactory returns considering the risks.
The key thing will always be that the stream of cash flows remains durable, even if a bit variable, and is either returned to shareholders or put to high return use by management.
Adam
Long position in WFC established at lower than recent prices in addition to much smaller long positions in MSFT and HPQ.
* Use earnings yield (inverse price to earnings) as a measure instead is often sufficient but free cash flow is more economically reliable and helps in avoiding lower quality earnings via accounting gimmickry. It's easier to dress up the income statement than the statement of cash flows.
** At an extremely low valuation the business doesn't even need to stabilize. Berkshire's Blue Chip Stamps is an example that comes to mind.
---
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.
Wednesday, September 28, 2011
Coca-Cola's Muhtar Kent on China, Brazil, and the U.S.
Muhtar Kent, the CEO of Coca-Cola (KO), said some things of note about doing business in the U.S. compared to China and Brazil in this article:
..."in many respects" it was easier doing business in China, comparing the country with a well-managed company. "You have a one-stop shop in terms of the Chinese foreign investment agency and local governments are fighting for investment with each other," he told the Financial Times.
He later added...
"They're learning very fast, these countries," he said. "In the west, we're forgetting what really worked 20 years ago. In China and other markets around the world, you see the kind of attention to detail about how business works and how business creates employment."
The above comments remind me of what Professor Michael Porter said in an interview earlier this year on U.S. competitiveness. In the interview, he offers up some thoughts on how to make doing business in the United States more competitive with other countries.
How the U.S. Can Compete Better
Separately, in this 2010 interview, Professor Porter said that the U.S. needs to do more to encourage domestic investment.
According to Porter, data shows U.S. domestic investment is, somewhat amazingly, the lowest among OECD countries. He says that individual U.S. companies are competitive globally but they hold back investment on home soil because the cost and complexity (healthcare, litigation, taxes, other regulations etc.) of doing business in the U.S. has piled up over the years.
Michael Porter: U.S. Needs Increased Domestic Investment
In the interview, Professor Porter also said that according to the Global Competitiveness Report, the US now ranks like a developing country in terms of cost and complexity of doing business.
Finally, in this The Globe and Mail article from a couple years back, he added the following thoughts:
Michael Porter on Business and Investing
With so much focus on the immediate value of stocks, and the resulting costs from short-term trading in and out of individual company shares, "the stock market now is a tax on the real economy."
"The financial sector is extracting value from the rest of the economy [through] fees, costs and expenses."
Mr. Porter, considered one of the world's foremost experts on business strategy, noted that 30 years ago many people owned stocks for the long term – 20 years or more. In that environment, corporate executives could focus on long-term growth rather than quarterly results, and investors' interests were aligned with those goals.
We can't address some of these weaknesses soon enough as far as I'm concerned.
Adam
Long KO
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.
..."in many respects" it was easier doing business in China, comparing the country with a well-managed company. "You have a one-stop shop in terms of the Chinese foreign investment agency and local governments are fighting for investment with each other," he told the Financial Times.
He later added...
"They're learning very fast, these countries," he said. "In the west, we're forgetting what really worked 20 years ago. In China and other markets around the world, you see the kind of attention to detail about how business works and how business creates employment."
The above comments remind me of what Professor Michael Porter said in an interview earlier this year on U.S. competitiveness. In the interview, he offers up some thoughts on how to make doing business in the United States more competitive with other countries.
How the U.S. Can Compete Better
Separately, in this 2010 interview, Professor Porter said that the U.S. needs to do more to encourage domestic investment.
According to Porter, data shows U.S. domestic investment is, somewhat amazingly, the lowest among OECD countries. He says that individual U.S. companies are competitive globally but they hold back investment on home soil because the cost and complexity (healthcare, litigation, taxes, other regulations etc.) of doing business in the U.S. has piled up over the years.
Michael Porter: U.S. Needs Increased Domestic Investment
In the interview, Professor Porter also said that according to the Global Competitiveness Report, the US now ranks like a developing country in terms of cost and complexity of doing business.
Finally, in this The Globe and Mail article from a couple years back, he added the following thoughts:
Michael Porter on Business and Investing
With so much focus on the immediate value of stocks, and the resulting costs from short-term trading in and out of individual company shares, "the stock market now is a tax on the real economy."
"The financial sector is extracting value from the rest of the economy [through] fees, costs and expenses."
Mr. Porter, considered one of the world's foremost experts on business strategy, noted that 30 years ago many people owned stocks for the long term – 20 years or more. In that environment, corporate executives could focus on long-term growth rather than quarterly results, and investors' interests were aligned with those goals.
We can't address some of these weaknesses soon enough as far as I'm concerned.
Adam
Long KO
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.
Subscribe to:
Posts (Atom)
