The Quality Enterprise, Part II

As a follow up to this previous post, here's another excerpt from this GMO white paper on high quality companies* and their stocks:

Their predictably higher profits are not quite high enough to command the attention of a market in thrall to the possibility of the next big jackpot. This has led to the systematic undervaluation of Quality stocks, which leads to their systematically higher returns over the long term.

The Quality Enterprise

Those that only give this a passing glance, treat it as just some strange but uninteresting anomaly, or worse, dismiss its merits entirely are leaving attractive risk-adjusted returns on the table (with risk defined as the likelihood and size of permanent capital loss, not beta). The approach deserves more respect than it gets but, at least based upon history, I suspect it will not anytime soon.

In any case, it's worth taking some time to more fully appreciate what is on the surface a rather simple insight.

More from the white paper:

Despite the benefits of this approach to low-risk investing, it appears that not many have the willpower to stay true to the concept. Stability is simply not exciting enough for most investors.

The least challenging part of this approach is finding an example of what GMO means by Quality. Look no further than what's inside many refrigerators and cupboards. The companies that make the leading small-ticket branded consumer products on a big scale and with robust distribution capabilities aren't a bad place to start.

What's sometimes more difficult is having enough patience to buy them on the rare occasions they become very cheap.

As I mentioned in the prior post, these days most are, at best, merely not expensive. No matter how good a business might be, what's sensible to buy at a discount to intrinsic value doesn't make sense at some materially higher valuation.

If interested, I've included links to the following related posts.

Some of the older posts provide more specific examples:

The Quality Enterprise - Aug 2012
Consumer Staples: Long-term Performance, Part II - Dec 2011
Consumer Staples: Long-term Performance - Dec 2011
Grantham: What to Buy? - Aug 2011
Defensive Stocks Revisited - Mar 2011
KO and JNJ: Defensive Stocks? - Jan 2011
Altria Outperforms...Again - Oct 2010
Grantham on Quality Stocks Revisited - Jul 2010
Friends & Romans - May 2010
Grantham on Quality Stocks - Nov 2009
Best Performing Mutual Funds - 20 Years - May 2009
Staples vs Cyclicals - Apr 2009
Best and Worst Performing DJIA Stock - Apr 2009
Defensive Stocks? - Apr 2009

With no possibility of making a quick buck in shares of Quality stocks, there's historically been a lack interest in them until a period of market stress emerges. A temporary, even extended, lousy macro environment is, in fact, a good thing in the long run for the persistently profitable high quality enterprise. Their desirability during periods of stress makes sense, but it's not like the share prices of these businesses don't drop, sometimes substantially, during a rough patch. They certainly do (even if by a lesser amount than many others).

The relatively more stable price action isn't really what matters here though that's where most of the focus seems to often be.

More importantly, it's that their profitability is far less impacted by a substantial slowdown in economic activity. Some businesses had their profits crushed during the recent financial crisis. Others did not. (Those that did not aren't a bad place to begin the search for Quality.) If profits remain relatively healthy (even if somewhat diminished) and the balance sheet is strong, a temporarily reduced stock price is a very good thing for long-term investors.**

If anything, the strong get stronger during a tough economic period even if near-term profitability is hurt somewhat. Their relative financial health allows them to make smart moves in a downturn -- a time when the best opportunities are usually available -- that weaker businesses can't do.

Lower quality businesses, especially those with excess leverage, will see their profitability hit massively during times of economic stress. They end up on defense when the chance to make smart long-term moves should be at their greatest.

The weak get weaker.

So the defensive characteristics of Quality is very real, but the persistent profits allow them to often be fundamentally positioned very well once the economic headwinds become tailwinds. In combination, this usually leads to outperformance over a full business cycle.

The term "flight to quality" or "defensive" will often be used to describe these businesses. Calling them "defensive" isn't wrong just incomplete. Over a full business cycle or longer, for sound fundamental reasons, the best of them have tended to produce higher returns at less risk.

Some investors will no doubt continue attempting to lighten up on quality during extremely euphoric periods (trying to catch the wave), with the idea of jumping back into the quality stuff when the tide turns. Well, there's enough evidence to suggest this is one of those ideas that, for most participants, works well only in theory.
(Skilled or lucky folks -- the difference isn't always clear -- may even actually jump in and out this way with consistent success. Otherwise, us mere mortals or those with less luck require a more prudent approach.)

It's easy to forget the following:

Portfolio moves aren't just chances to improve portfolio performance, they're a chance to make a mistake. It's an illusion of control that can be expensive.

So are the added frictional costs.

When shares of a high quality enterprise are bought at a clear discount to value, and held for a very long time, returns relative to the risk can be very attractive indeed. Quality provides both offense and defense especially if bought with discipline. Yet, they're still common stocks and any individual one can get into real difficulties. In other words, there's less risk for the return achieved, not no risk.

Getting a great price usually requires a crisis of some kind. The time to buy for the long-term is usually when it feels awful. That, in some ways, may be the toughest part of investing. A calm temperament when the world seems a bit unstable is not a small asset.***

Now, paying a merely fair price for these durable high return businesses can work out just fine in the long run but likely means: 1) accepting less than spectacular or worse near and intermediate term performance, and 2) a reduced margin of safety to protect against the unknowable and unforeseeable.

Unfortunately, the window that opened (as a result of the financial crisis) to buy shares of higher quality businesses at very attractive valuations has mostly closed. Even with the best businesses, buying their shares with an appropriate margin of safety is still all-important but, as I've mentioned previously, it's worth considering this:

"If the business earns 6% o­n capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% o­n capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result." - Charlie Munger at USC Business School in 1994

Finally, the price action of Quality stocks does have a tendency toward the unexciting. Those who invest for the adrenaline rush probably won't find the above approach to investing of much interest at all. It can be hard mental work at times, but mostly, there's just not much happening.

A substantial reserve of patience certainly doesn't hurt.

Adam

* With Quality defined as those with persistent profits and strong balance sheets. Basically, things like the great global franchises (though certainly others as well) with durable competitive advantages (often the great brands with wide distribution). It's an indication of core business economics and reveals little else. In other words, airlines have had a tremendous impact on civilization, but their business economics have been generally terrible.
** If a stock that's already selling below it's intrinsic value drops, yet profitability remains relatively persistent, that just means shares can be bought back from other owners (using the company's free cash flow over time) at an increasingly large discount. Those that sell their shares effectively surrender their portion of the ongoing profits to the owners who hang in there. Naturally, the less they are willing to sell their share of the profits the better. Intrinsic value doesn't increase but per share intrinsic value very much does. Allow that dynamic to compound over time and the benefits to long-term holders is far from academic.
*** I'm of the view that no one should invest in any stock unless they have a high level of personal conviction that the price paid provides a sufficient discount to their own estimate of intrinsic value. If an investor doesn't have that level of conviction at their disposal, they too often end up shaken out before the full story plays out, in some cases, over many years. So judging intrinsic value consistently well and how it's likely to change over time is all-important.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

Berkshire Hathaway's 2nd Quarter 2012 Earnings: Net Seller of Stocks

Berkshire Hathaway (BRKa) released its latest quarterly earnings this past Friday. Some things that seem worth noting at first glance:

1) Berkshire's cash position continues to grow.

The pile of cash on Berkshire's balance sheet grew to over $ 40 billion. The company is now more than well-positioned for another very substantial acquisition.

2) Berkshire was a net seller of stocks during the quarter.

The Consolidated Statement of Cash Flows in the latest 10-Q (the cash flows from investing activities section) reveals more selling of equity securities than buying. That shouldn't be terribly surprising but is, at least, mildly interesting. More specifically, Berkshire bought ~ $ 1.9 billion in equities while selling $ 3.0 billion worth in the latest quarter.

Quarter-to-quarter changes don't mean a whole lot but, while I wouldn't read too much into it, the moves are still worth keeping an eye on.

Stepping back just a bit from the most recent quarter, Berkshire bought $ 5.3 billion of equities in the first half of 2012 while selling $ 3.8 billion. That's not exactly running away from equities. In any case, we'll get more details on changes to the portfolio when the 13F-HR is released later this month. The specific changes that occurred (buying and selling) should become less of a mystery at that time.

3) Berkshire sold a meaningful portion of one or more of its consumer stocks.

Based upon the latest 10-Q, the cost basis of the consumer products stocks dropped substantially (from $ 12,296 billion to $ 9,843 billion = a drop of $ 2,453) compared to the prior quarter. So that's where the bulk of the selling appears to have been done. To me, it's not all that surprising. Consumer stocks aren't expensive these days but nor are they cheap. Some, like Procter & Gamble (PG) for example, have even had some meaningful (though hardly catastrophic) difficulties in recent years. It's also likely just a matter of there being better places to allocate the capital (and not so much an indication that the consumer products stocks Berkshire owns are not sound long-term investments).

It's worth pointing out that the stock (or stocks) that were sold probably did not have an extremely low cost basis relative to current market value.

Why is that the case?

Basically, the math makes it unlikely that anything more than a token amount of something like Coca-Cola (KO) was sold.  Berkshire's cost basis for their Coca-Cola shares is less than 1/10th of the current market valuation of those shares. In other words, if they sold $ 3 billion of Coca-Cola's stock, there'd be less than a $ 300 million drop in cost basis. So the math just doesn't work (and their are several other reasons to doubt that it is Coca-Cola).

The bottom line is it's the shares Berkshire owns with a cost basis much more near the current market value make more sense as candidates that were sold.

With the limited information available, it's obviously difficult at best to guess why a stock (or stocks) may have been sold.

Some of the reasons that come to mind include:

• A less optimistic (or downright pessimistic) view of the long-term prospects for a particular equity
• An expensive share price relative to per-share intrinsic value
• A relatively attractive alternative investment that requires freed up cash

Among others. Only time will really tell but, once again, the yet to be released 13F-HR should shed some light.

*****
Finally, it's well known that Warren Buffett and Charlie Munger prefer to own businesses "forever", whether outright or via partial ownership of common shares. There are practical differences between the two (owning outright vs partial ownership), of course, but they should mostly be treated as fundamentally the same during analysis.

Here's one of the practical differences that's unique to Berkshire. Once they've bought a business outright they will under almost no circumstances sell it. That's true even for the underperformers and the reasons for this is articulated in the Berkshire Owner's Manual.*

It's a principle Berkshire established a long time ago and they have stuck to it.

Prior post: Buffett on Errant Purchases: Why We Hold On To My Mistakes

In contrast, the threshold required to justify selling some of their common stocks, while still relatively high, is understandably lower. They're just not nearly as rigid about selling shares of a stock if better use for the capital exists elsewhere.

It's still a rather high threshold compared to many other investors. Buying a stock with the intent to sell it soon after at a particular higher price "target" or whatever is certainly not what they do. Berkshire buys with the intention of owning the shares for an extended period.

Now it's true that certain equities they own, at least if history is any guide, seem more likely than others to remain in Berkshire portfolio indefinitely. Those with unique durable competitive advantages aren't likely to be sold just because they've become somewhat expensive or have minor near-term difficulties.
(Once you own shares of an exceptional business at a fair price, hold onto it.)

Berkshire's bias remains long-term by any standard (and especially by today's standards) but even that ethos rightly has its limits.

The preferred holding period for many of the equity holdings in Berkshire Hathaway's portfolio is, if not "forever", an awful long time.

Adam

Long positions in KO and BRKb established at lower prices

* The owner's manual provides a good explanation of why they hold onto their poorly performing businesses, even if they are likely to remain that way for quite a long time. It's worth taking some time to understand their thinking. Check out the Business Principle # 11 in the Owner's Manual. More recently, Buffett also gave a good explanation of this thinking in the Manufacturing, Service, and Retailing Operations section of the 2011 Berkshire Hathaway shareholder letter.

The Quality Enterprise

From this GMO white paper:

...in 2004, we published our findings that investors had historically underpaid for the low-risk attributes of high quality companies. 

Later in the paper they also added the following:

The systematic valuation advantage of Quality companies is an important component of our investment thesis. While it is possible that at some point Quality could become universally overvalued, we currently view that as unlikely because so few market participants adhere to our Quality framework. Meanwhile, academia continues to promulgate Modern Portfolio Theory, ensuring a steady supply of new market participants who follow the logic that risk is necessary for outperformance.

Basically, the paper makes the case that market participants have historically overpaid for high risk and underpaid for low risk and provides solid backup for their view.

Contrary to Modern Portfolio Theory (MPT), historically the lower risk companies outperform the risky ones and the market has systematically undervalued them (the early 70s and late 90s are two time periods I can think of when many became much more than fully priced). It's an insight often not used (by pros and non-pros alike) even though the evidence to support it is not tough to find nor does it require some kind of complex analysis.
(By the way it's not exactly easy to convince someone of this. I've had modest success at best over the years. In my experience the typical response to it has been: "There has to be more to it!" Well, there really isn't.)

Companies with durable profitability, those all too frequently referred to as "defensive", provide more "offense" than market participants seem to think. These businesses just happen to do it at lower risk.

The above may trash MPT, deservedly so, but the paper strongly embraces the best ideas from the microeconomics of oligopolies.

It's that the best companies, among what are essentially oligopolies, can legally create barriers to normal competitive forces. This potentially creates above average long run returns.

Not exactly groundbreaking stuff but it just, for whatever reason, seems to be underestimated or at least underutilized. The reasons why are less important from a practical standpoint. What does matter, practically speaking, is it has historically led to mispricing on the low side.

Some may remain dedicated adherents to the competitive equilibrium model but it's either limited or totally flawed depending on your point of view. Businesses, according to that model, are destined to have their profits revert to the mean. Well, in general, as the GMO paper points out:

Oligopolies Do Not Revert

Flawed ways of thinking can be very costly.

The higher quality enterprises, those with a long track record of above average returns on capital, have a tendency to continue producing above average returns. Their profitability has been persistent with long-term effects and outcomes not as difficult to foresee as some might imagine. Of course one has to take more risk to get more return, right? Nope. There is certainly at least some evidence to support the idea that these kind of companies produce very solid returns, at possibly lower risk, over the long haul. While this may go against conventional wisdom, it has the great benefit of sound reasoning and enough evidence to make it more than mildly interesting.

There's hardly a guarantee the above will remain true going forward but, in the context of the risks one must take when investing in common stocks, it's a very useful insight.

Just about as good as one can ever reasonably expect when it comes to investing in stocks.

In other words, this promises nothing about the future. Yet it would seem to be, at the very least, not a terrible place to focus the investment process.

Unlike many of my earlier posts on this subject, I happen to think shares of the highest quality businesses are not exactly cheap these days (they're merely not very expensive).* Still, with enough patience and discipline, buying pieces of businesses with durable advantages -- especially those that are well understood by the investor and sell at a clear discount to a conservative estimate of value -- can produce long run returns relative to the risk that tend to be very attractive indeed.

I'll follow up on this in another post.

Adam

Related posts:
The Quality Enterprise, Part II - Aug 2012
Consumer Staples: Long-term Performance, Part II - Dec 2011
Consumer Staples: Long-term Performance - Dec 2011
Grantham: What to Buy? - Aug 2011
Defensive Stocks Revisited - Mar 2011
KO and JNJ: Defensive Stocks? - Jan 2011
Altria Outperforms...Again - Oct 2010
Grantham on Quality Stocks Revisited - Jul 2010
Friends & Romans - May 2010
Grantham on Quality Stocks - Nov 2009
Best Performing Mutual Funds - 20 Years - May 2009
Staples vs Cyclicals - Apr 2009
Best and Worst Performing DJIA Stock - Apr 2009
Defensive Stocks? - Apr 2009

* With any investment, no matter how seemingly attractive, margin of safety is all-important. What's sensible to buy at a price that represents a nice discount to intrinsic value doesn't make sense at some materially higher valuation. Margin of safety protects against the unforeseen real, even if fixable, business problems. Still, it's worth considering this: "If the business earns 6% o­n capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% o­n capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result." - Charlie Munger at USC Business School in 1994
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

eBay's Free Cash Flow

Here's the free cash flow of eBay (EBAY) from 2007 through 2011:

2007:  $ 2,187
2008: $ 2,316
2009:  $ 2,341
2010:  $ 2,022
2011:   $ 2,310

We'll see how it looks by year-end, but first half free cash flow is so far a bit lower in 2012 compared to 2011 (it's worth noting the decline but chances are it doesn't mean a whole lot).

For quite some time -- a number of years in fact -- free cash flow has been hovering at or slightly above $ 2 billion per year. Considering the way the stock has moved up in the past two years, some might rightly expect there'd been a more discernible upward trend in what is a fundamental driver of intrinsic value (as long recent cash flow trends are representative of future cash generation capabilities...they often are not, of course).

Unlike not too long ago, there are far fewer negative headlines about eBay's challenges so the story has certainly become a better one to tell:

- Revenues are much higher now and continue to grow nicely (revenue should approach $ 14 billion this year vs just under $ 7.7 billion in 2007. Impressive, but hasn't yet translated to free cash flow...at least not yet).
- PayPal, eBay's fast-growing payments business, seems poised to continue steadily making up an increasingly large slice of the company's total business. Some see it as eBay's jewel.
- The core marketplace business, struggling not long ago, is doing better.

I could add more to the list of improved characteristics. Here's the problem: I understand that good businesses will often invest for the future in a way that may reduce current free cash flow (or limit the increase to free cash flow). In other words, they invest in a way now that ultimately leads to increased intrinsic value. Some investments maintain the business; other investments build incremental business for the future. That's certainly fine, up to a point and in certain circumstances, as long as return on capital ends up being attractive. Otherwise, if it doesn't begin showing up in the free cash flow, how is it possible to judge whether the business is substantially more valuable?

Consider this:

In mid-2010*, the company had shares outstanding of 1,330 billion and its stock price was selling for roughly $ 20/share, giving it a market cap of $ 26.6 billion. Subtract the $ 6.7 billion of net cash and investments and you get an enterprise value of roughly $ 20 billion. So 10x free cash flow or so but actually more like 12x if you back out stock-based compensation.**

These days, the company has shares outstanding of 1,309 billion and its price at yesterday's close was $ 44.3/share, giving it a market cap of nearly $ 58 billion. Subtract the $ 6.3 billion of net cash and you get an enterprise value of just under $ 52 billion. So roughly 23x free cash flow but, once again, more like 28x if you adjust for stock-based compensation.

It seems a huge change in enterprise value and a substantial multiple for what seems a comparably modest change in apparent intrinsic value.

Sometimes investments being made now can mask future free cash flow potential. So more value may exist than the recent free cash flow would otherwise suggest. Amazon (AMZN) is an example that comes to mind.
(Estimating Amazon's valuation seems difficult at best. Without a clear view of its cash producing capacity, it's tough to decide what's an appropriate margin of safety. The range of value is too wide. I'm well aware that Amazon is or is likely to become quite valuable, but that's of little use if you can't figure out an appropriate price to pay now.)

I'm not suggesting eBay hasn't increased its intrinsic value or improved its business. It's more along the lines of this: In 2007 (and before that), eBay had a pretty good business. In 2010, the headlines weren't great -- real challenges had emerged in its marketplace business, for example -- but eBay still had a pretty good business. As far as I can tell it's still a good business now.

Sometimes the tide will be coming in; sometimes not. That's the case with any long-term investment.

Oh, and it's not like the the tide can't reverse again. An investor has to distinguish the difference between what are near-term difficulties (at times rather serious) and real damage to the economic moat of a business.

As PayPal continues to become a bigger percentage of the company, it's possible that intrinsic value growth may even begin to accelerate. Some could argue that justifies the higher intrinsic value and, of course, the higher stock price. Maybe. Others might point to improvements to the marketplace business. I'd just say PayPal has been a great business for years even if some patience for it to become big enough to really matter was required. I'd also add that the marketplace business continued to have sound economics even when it was struggling.

So there's been some increase to eBay's intrinsic value but, unfortunately, the price action lately would seem to more than reflect it (with far less margin of safety being the result).

That doesn't mean the stock won't keep going up near term (or even longer), but I never have had an opinion on that sort of thing. My focus is on finding a durable franchise, paying a plain discount, then allowing the long-term effects of compounding take care of themselves. (Until there's evidence of material moat damage, other emerging threats, and sometimes when opportunity costs are high.)

- eBay 2nd Quarter 2012 Results
- eBay 2nd Quarter 2010 Results
- eBay 4th Quarter and Full Year 2011 Results
- eBay 4th Quarter and Full Year 2010 Results
- eBay 4th Quarter and Full Year 2009 Results
- eBay 4th Quarter and Full Year 2008 Results
- eBay 4th Quarter and Full Year 2007 Results

I won't be surprised at all if the company becomes much more valuable over time. It just isn't selling at a clear discount to value anymore. What if they hit a bump in the road again? It's better to assume they will from time to time and pay a price that reflects the possibility (likelihood?). There's no downside if they do not hit a bump or two.

Best to pay a price that doesn't require good things to continue happening, one that protects against the unforeseeable. An improving story and increasingly rosy headlines just gets in the way of finding shares of attractively valued businesses.

Adam

I maintain a long position in eBay established at much lower than recent prices. No intention to buy or sell shares near the current price.

Related posts:
eBay's Valuation (follow-up post)
Technology Stocks (prior post)

* In 2010 stock prices had rebounded substantially from the financial crisis lows. I didn't think it made sense to use the extremely depressed share prices that had been heavily influenced by macro factors in this example. So I picked a period where things were at least somewhat settled down. eBay's enterprise value actually briefly dropped to under $ 10 billion back in 2009.
** Obviously, not all free cash flow is created equal. I could certainly pick some things apart here, but at least these comparisons are apples-to-apples. For example, stock-based compensation should not be backed out. It is not a quality source of cash, inflates free cash flow, and, as a result, needs to be accounted for when attempting to value the company. So the free cash flow multiple is, of course, higher when adjusted for stock-based compensation. eBay has bought a rather substantial amount of their stock back since 2007 (nearly $ 6 billion worth) yet have hardly put a dent in shares outstanding (roughly a 5 percent decline in the share count over that time). A larger reduction in share count would have occurred if dilution from options did not offset the buyback to such a meaningful extent. In other words, stock options can be rather quietly expensive for shareholders. It may make sense from an accounting point of view to include stock-based compensation in the cash flow from operating activities but it does not represent quality free cash flow in my book. Even though stock-based compensation is far from a perfect measure of the true cost it is, at the very least, a decent approximation and reasonable starting point.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Bogle: "The Tyranny of Compounding Costs" - Part II

A follow up to this post. 

Bogle: "Tyranny of Compounding Costs"

In the 1983 Berkshire Hathaway Annual (BRKa) Shareholder Letter, Warren Buffett wrote the following about frictional costs and their impact on returns:

"...consider a typical company earning, say, 12% on equity. Assume a very high turnover rate in its shares of 100% per year. If a purchase and sale of the stock each extract commissions of 1% (the rate may be much higher on low-priced stocks) and if the stock trades at book value, the owners of our hypothetical company will pay, in aggregate, 2% of the company's net worth annually for the privilege of transferring ownership. This activity does nothing for the earnings of the business, and means that 1/6 of them are lost to the owners through the 'frictional' cost of transfer. (And this calculation does not count option trading, which would increase frictional costs still further.)

All that makes for a rather expensive game of musical chairs."

The costs of this expensive game ends up in the pocket of the croupier as participants trade stocks back and forth frenetically. Buffett also later added:

"These expensive activities may decide who eats the pie, but they don't enlarge it."

The source of the "frictional costs" in the specific example provided in that letter. Yet no matter what the source happens to be, Buffett's broader point is no less relevant. These days commissions are far lower so the possibility of reduced frictional costs for participants is theoretically easier than ever*.

The problem is the many new potential sources of frictional cost in the system. A bunch of comes from just the general trend toward trading hyperactivity or "short-termism" by market participants.
(A substantially reduced average holding period compared to historic norms whether the trading is done directly via stocks or indirectly via ETFs.)

In the same letter, Buffett parenthetically also added:

"...hyperactive equity markets subvert rational capital allocation and act as pie shrinkers. Adam Smith felt that all noncollusive acts in a free market were guided by an invisible hand that led an economy to maximum progress; our view is that casino-type markets and hair-trigger investment management act as an invisible foot that trips up and slows down a forward-moving economy."

All this additional trading hyperactivity has more than picked up the slack and kept frictional costs for the system as a whole very high. So the current way of doing business remains very costly for the average market participant, but those that avoid all this hyperactivity don't bear these costs.

In the prior post, I mentioned what John Bogle calls "the tyranny of compounding costs". Well, during a SmartMoney interview back in 2005, Bogle noted that in a ~13 percent market the average mutual fund earns something like 10 percent, while the average mutual fund investor earns just 6.5 percent.**

"People understand the magic of compounding returns. But few investors know about what I call the tyranny of compounding costs.... You put up 100% of the capital and take on all the risk, but you get only 20-something percent of the return. That's a system that is destined to fail. People will not be that dumb forever." - John Bogle in SmartMoney back in 2005

"The magic of compounding returns, it turns out, is simply overwhelmed by the tyranny of compounding costs at today's exorbitant levels." - John Bogle in The Wall Street Journal (unedited version of remarks)

Oh, and taxes only make it worse. In the above example, it seems like the average mutual fund investor will earn half as much as the overall market (13 percent versus 6.5 percent) but it's actually worse than that. When you take into account compounding effects, the average mutual fund investor actually ends up with more like a bit more than one fifth as much money over 25 years (and it, of course, just gets worse as the "tyranny" compounds in reverse). This huge gap is the result of all these frictional costs plus the tendency of investors to buy during the good times and sell during the not-so-good times.**

Pretty much the opposite of what successful investors need to do.

Also, consider that both Buffett, Bogle, and Grantham (in the prior post) are referring to frictional costs in their examples that are generally much less than what many hedge funds are known to charge.

Knowing all this, does it make sense to have a system where participants work feverishly to outsmart the other participants (to be on the "right side" of trades) with the net result being nothing of value in the aggregate being created?

Why wouldn't one instead designed to encourage the minimization of frictional costs at every level (and a longer holding period by the average participant) be the better way to go?

The productive assets themselves would still compound in value at the same rate with more of the gains remaining in the pockets of those who actually put capital at risk.

I know this won't happen anytime soon (and we all have to invest in the world as it is) but to me it seems a more than fair question. The good news is (and I mentioned this in the prior post) the individual investor can still choose to not participate in the folly even if the system remains the way it is, give or take, for a very long time.
(Yet, unfortunately, society still bears the cost of this mostly unproductive activity. Jeremy Grantham once made the point that frictional costs like this actually "raid the balance sheet" of investors.)

Those that work to minimize frictional costs, stay within their limits, buy with discipline (a plain discount to value), and generally own assets long-term that compound intrinsically at a high rate increase the probability of ending up well ahead of most investors. Other than that, it's often one's own temperament and various cognitive biases that get in the way of above average long-term returns.

Adam

* Even if someone is not buying stocks directly, quite a few low cost ETFs and traditional mutual funds exist now that could be bought and held long-term to keep expenses low. The problem is that the evidence suggests ETFs are traded rather excessively.
** The difference between the fund returns and what the investors get for returns comes down to investors attempting to buy and sell in order to increase returns and reduce risk. The intent is, of course, to improve results but the opposite is achieved. (i.e. Buying when stocks are expensive during what seems like clear economic skies; selling when stocks are cheap as dark economic clouds emerge.) Bogle provided another example that suggests the gap is even worse back in 2003. The problem stems more from how price compares to per share intrinsic value -- whether or not there is a sufficient margin of safety -- and less from timing. (Even if, at specific times, stock prices can be generally expensive or cheap. In 2000 many stocks sold at big premiums to value; in 2009 many were at big discounts to value. It's just that a focus on timing distracts from what really matters: price vs value.) 
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Philip Morris International

Philip Morris International (PM) is facing plenty of currency headwinds these days. From Philip Morris International's 2012 Second-Quarter Results:

Reported diluted earnings per share of $1.36, up by 0.7%, or by 8.1% excluding currency, versus $1.35 in 2011...

Let's take a step back. In 2008 Altria (MO) spun off Philip Morris International.

The stock has done just fine since then but, more importantly, so has the business itself.

In 2007, the last full year prior to the spin-off, Philip Morris International earned $ 6 billion. 

Five year later in 2011, the company earned roughly $ 8.6 billion.

That's 43 percent earnings growth. Not too bad.

Yet, because they've been doing some consistently smart buying back of their stock, it looks even better on a per share basis.

They've shrunk share count nearly 20% while mostly doing the buying when the shares were comfortably below intrinsic value. They've also been paying a very nice growing dividend and, of course, will likely continue to do so for a very long time.

As a result of this smart capital allocation, earnings should be more than $ 5.00 per share this year compared to the $ 2.86 per share they earned in 2007. 

So more like 75 percent growth on a per share basis.

Unfortunately, at its current price the prospects are far less attractive near-term and, as long as the stock price remains somewhat elevated, the buybacks will have a more modest impact on long-term per share value.

Adam

Long position in MO and PM. Nearly all of my shares of MO were purchased many years ago (at, of course, much lower than recent prices) and my PM shares are mostly the result of the spin-off. No intention to buy any additional shares near the current market price of either stock (nor sell any of the shares I own). Basically, for me at least, PM and MO are shares I intend to own for a very very long time and ideally "forever". One can only hope that these stocks will eventually go lower so more shares could be accumulated at a plain discount to value and so the buybacks will work more effectively.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Stock Returns & GDP Growth: Why There's Little Correlation

A follow up to this post:

Why Growth Matters Less Than Investors Think

Below is a specific example of higher GDP growth not leading to higher stock returns. This article by Brett Arends that I mentioned in the prior post points out the following:

Real GDP growth from 1958 to 2008
- Japan 4.5%
- Sweden 3%

There was much more growth in Japan over that time horizon, but it was the Swedish investors that enjoyed the better returns. In fact, returns were three percentage points higher on average each year over those fifty years. Naturally, with compounding effects, three percent ends up being quite a lot more money over fifty years. It also makes quite an impact over a somewhat shorter time horizon. Let's say over the next quarter century what you've saved as of today ends up growing to $ 1 million by achieving the Japan-like returns. With the same amount of money at risk, the Sweden-like returns would instead grow to more like ~ $ 2 million as a result of the extra three percent per year. So the real cost of that 3% gap left to compound would be $ 1 million in gains.

So in the case of Japan and Sweden, growth in GDP told you little about potential equity returns. The article by Arends points out that research firm MSCI Barra looked at many major markets over the same period of time. The firm found no major correlation between GDP growth and stock market performance among them.

Professor Jay Ritter at the University of Florida also found that the correlation between the GDP growth and stock returns was actually negative for the twentieth century.

So what's at least some of the reasons?

- Investors often overpay for the fast-growers. A good investment at one price becomes a lousy one at another. Where there's excitement, stocks that sell for high multiples of earnings (paying too much for promise) usually follow. It's tough to do well long-term paying more per share than something is intrinsically worth. Also, depending on just how pricey the shares are, buybacks are anywhere from less effective to downright dumb as far as continuing shareholder returns are concerned. Shares that sell consistently below intrinsic value, if bought back when cheap, can juice long-term returns substantially even in a modest economic growth environment.
- Booming economies and industries attract lots of capital that leads to more competition. This usually lowers return on capital at least until a clear leader emerges. Return on capital is all-important and, in the case of Japan, their great companies have not exactly been known for being focused upon achieving high returns for shareholders. Also, high growth sometimes requires more capital than a business might have at its disposal leading to capital raising and share dilution. Well, it's per share increases to earnings that matter for an investor...not just absolute increases.
- Many enterprises are global and derive much of their value creation from outside their home country. So high GDP growth inside their home country, even for a sustained period of time, means little to these companies.

When you buy shares of anything, it's ultimately a proportional claim on its future cash flows. It may or may not be an exciting growth story. That's of little relevance. I opened the prior post with this Buffett quote that's relevant here:

"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." - Warren Buffett in the 1992 Berkshire Hathaway (BRKa) Shareholder Letter

The primary drivers of long-term returns is the price that's paid relative to intrinsic value, return on capital (having the highest possible truly free cash flows relative to the ongoing capital requirements of an enterprise), and whether real durable advantages exist. 

A good business needs little capital, can return excess capital to shareholders or use it to finance opportunities at an attractive long-term return, yet can maintain (better yet...grow) the size and strength of its economic moat. It also requires business leaders who do not choose growth for its own sake over returns for its shareholders. 

To be fair, sometimes the pursuit of market share and a willingness to endure pain in the early stages is quite necessary and smart. It helps if one already has a truly unassailable and profitable franchise well-established in a different market. Many of the great global brands have such a situation. They can afford to invest long-term. The key difference is they are usually operating with huge advantages and predicting that they will have a successful future outcome is less difficult to do. It's more about patience. In these cases deferring profitability in order to build a durable leadership position in a new market is wise.

Otherwise, lots of competing capital tends to show up (financial and human) in a high growth country or industry with difficult to predict outcomes. In this kind of environment there will no shortage excitement, innovation, and rapid change. All that capital formation tends to fund and create capable competition. There will be big winners, big losers and, at least before the fact, it won't always be easy to distinguish between them.* Enough capital for a sustained period of time ends up producing lots of new competitors with unpredictable long-term economics. A business can go from having what seemed to be an unassailable moat to having none at all in a relatively short amount of time. 

Once favorable economics for owners are no more. 

Just keep in mind that certain companies, often the great global brands with difficult to replicate distribution**, earn consistently above average return on capital. These great franchises can remain persistently profitable without engaging in anti-competitive behavior. The simplistic idea that high profitability will attract capital (and vice versa) that leads to less profitability (the supposed inevitable closing of the profits gap) doesn't always work in the real world. That model of how competitive forces will generally play out among competitors over time is flawed or, at least, limited in scope. It is not difficult to provide real world examples.

The formation of new innovative companies is good for civilization but may or may not be good for shareholders. Sometimes it will be. Sometimes not. One has little to do with the other. Airlines are incredibly important but rarely have been good for shareholders. When high returns are expected it often invites capital that creates lots of tough competitors. Pricing power and/or cost advantages are either non-existent or transitory. They do not prove durable. Sometimes, growth is pursued in lieu of returns. With the best intentions market share is pursued with the idea that profits will comes later. Sometimes it even works out. Still, more often than not, you get lots of growth but a low return on capital affair for owners. Not good if the best possible risk-adjusted returns is what you are after.

Those able to consistently pick the big winners (some are very good at that sort of thing) in these kind of dynamic situations may even do very well. To be successful, that style of investor also had better be very good at not allowing the big losses to occur. Big winners and big losers often reside in the same neighborhood and the houses aren't easy to tell apart. It's amazing how much getting above average returns comes down to just avoiding losses. Well, the big losses are often the flip side of going after home runs.

Otherwise, that's why the boring stable modest growth industries can be a more attractive investment approach. They attract little in the way of new capital formation, offer less excitement, but future outcomes are easier to predict. 
(Again, returns can turn out rather well in the long run if you just mitigate the possibility of big losses.)

Finally, as I mentioned above, just because a stock happens to be listed on a particular exchange, doesn't mean its future cash flows are tied to that country. There is no shortage of great franchises that derive a large proportion of their economics a great distance from the country of origin or listing.

Adam

Related posts:
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

* Think search engines in the late 1990s. Anyone that truly could see Google (GOOG) was going to be the winner before it all played out the way it did deserves huge rewards. I say "truly" because I'm guessing at least some early investors in Google thought the young company had a great chance to succeed but did not really know it would work out so well. 
** Though there are certainly other ways to create an enduring moat.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Driven to Trade

Here's a recent Wall Street Journal article by Jason Zweig. 

Zweig explores how much short-term thinking is part of our brain's fundamental wiring and the impact this can have on trading/investing behavior.

Why We're Driven to Trade

From the article:

...in order to avoid trading your accounts to death, you must counteract some of the very tendencies that make Homo sapiens the most intelligent of all species.

It turns out, the frontopolar cortex, an advanced reasoning center of the brain (located directly behind the forehead), is well-suited for finding patterns (and relentlessly attempts to do so) even when there is none. It will attempt to find patterns within randomness and see patterns that don't exist. So, at least somewhat oddly, it is literally the more advanced aspects of human intelligence that can get investors and traders into trouble. A new study (published in the Journal of Neuroscience) actually shows that those with a healthy frontopolar cortex often tried to outsmart a system that is essentially random while those with a damaged frontopolar cortex did not!

Unlike the other control groups (those that had a healthy frontopolar cortex), those with damage to this crucial reasoning center didn't tend to overweight recent random outcomes* and also didn't attempt to find non-existent patterns. If decision-making is heavily influenced by randomness interpreted as something with meaning, it's hard to imagine big misjudgments not being made. The article provides a good overview of the new study and reveals the way this tendency can adversely impact decision-making. More from the article:

...the frontopolar cortex refuses to admit defeat. It draws on all your computational abilities to search for patterns in random data.

In the absence of real patterns, it will detect illusory ones. And it will prompt you to act on them.

No wonder so many investors find it hard to muster the willpower to buy and hold a handful of investments for years at a time.

Naturally, any trained response to this tendency necessarily starts with awareness, followed by procedures and routines that counteract the more adverse consequences, and plenty of ongoing discipline.

Check out the full article. It goes on to suggest some ways to deal with this potential costly weakness. (Zweig's suggestions explicitly do not include the use of a hammer to the forehead. Thankfully, there are many solutions available more practical than that.)

Mostly, I think this gets back to simply knowing and staying within one's own limits while not confusing the illusion of control with actual control.

Adam

* What did healthy participants do? According to the article, they seemed to extrapolate "...their most recent experience into the future and choosing predominantly on that basis," - Nathaniel Daw, neuroscience professor at NYU
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Negative Working-Capital Cycle

The excerpt below is from an interview in Barron's with Paul Isaac.

In the interview, Isaac says he wouldn't buy Amazon (AMZN) at even $ 100 per share. He also says the company's free cash flow is not well understood.

Some of his thoughts on Amazon from the interview:

Amazon generates a lot of cash from its negative working-capital cycle, which funds the build-out of physical facilities to support logistics and fulfillment. In a sense, it borrows short from customers and uses that money to fund long-lived capital assets.

Rapid sales growth masks this process. Broad-based stock-option compensation requires an appreciating stock...It dismounts from that treadmill at great risk to its model.

The stock currently sells at $ 226/share. Many fans of Amazon's business emphasize free cash flow over its relatively weak earnings. A focus on free cash flow usually makes sense if there's a large non-cash charge flowing through the income statement. Unfortunately, in this case, the main driver is their negative working-capital cycle.*

These are very useful sources of cheap funding (actually, zero cost funding if sufficient growth is sustained) but should not be viewed as higher quality operating free cash flow.

Check out the whole interview. In it, Isaac also explains why he likes Devon Energy (DVN)) and Greif Brothers (GEF.B) among others. I have no opinion on either stock.

As far as Amazon goes, my main problem has always been stock valuation and the amount of share dilution that has occurred over the years, not the potential long-term prospects of the business itself. To me, figuring out whether the company's per-share intrinsic value will increase over time in a way that -- relative to the current market price -- the investor will be compensated well is the tough part when it comes to Amazon.

Unlike many other businesses, estimating Amazon's current per-share value and, within a narrow enough range, how much that value is likely to increase over time is just a very difficult thing to do. The company will probably turn out to be worth quite a lot, but the range of valuations is too wide to figure out what price today represents an acceptable margin of safety. Well, at least I can't figure this out. 

I'm just more comfortable with a business that has good long-term prospects and already makes a lot of money now; more comfortable with one that sells at a sensible multiple of what it has already plainly demonstrated it can earn. There are plenty that fit that description and quite a few of them have been available at more than reasonable valuations in recent years.

I have much respect for the way CEO Jeff Bezos seems to always be building Amazon's business with an eye toward the longer term.

I'm just not convinced that translates into great risk-adjusted returns.

With that said, I do pay attention to Amazon for at least the following reason:

They're one of a handful of companies with the potential to disrupt other good businesses if they decide to do so.

As an investor, you have to keep an eye on the company as one that can potentially damage or maybe even destroy the economic moat of another business.

Adam

No position in Amazon, Devon, or Greif Brothers

Related posts:
Amazon, Apple, and Margin of Safety
Amazing Amazon
Barron's on Bezos: Time to Reign in Amazon's CEO?
Amazon's Jeff Bezos On Inventing & Disrupting
Amazon Sells Kindle Fire Below Cost
Technology Stocks

* Amazon gets a nice boost of cheap funding each year from unearned revenue, accounts payable that's in excess of account receivable, etc. 

Also, like many tech stocks, it's worth noting that adding back stock-based compensation (as is done in the Operating Activities section of the cash flow statement) boosts free cash flow but is potentially a material source of future dilution (much as it has been in the past) and likely quite expensive for continuing shareholders over the long haul. Yes, it's a non-cash expense but, unlike some other non-cash expenses, it shouldn't be ignored. One way to think of this is to calculate how much net cash would be needed to keep share count stable over time. Well, that incremental cash expended is a very real cost to shareholders and should be subtracted from free cash flow for a better understanding of the business economics. It's, at the very least, a rather big stretch to consider economically meaningful any free cash flow calculation that doesn't attempt to account for the cost of stock-based compensation. For certain companies -- those that make heavy use of stock for compensation -- the cost is very real even if difficult to estimate. The reality is that these potentially material costs are generally rather difficult to pin down with any precision. Unfortunately, with stock-based compensation, the best case that can usually be expected is an estimated range of costs (the economic costs...not the accounting costs). A bit messy? No doubt, but that messiness doesn't mean the costs can be ignored to make it seem more neat than it is. Not everything that matters economically can be precisely quantified. In fact, some of the most important things can't be quantified at all.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

Bogle: "The Tyranny of Compounding Costs"

Apparently, hedge funds aren't doing so well this year. From this CNBC article on hedge fund performance:

They are supposed to be the smart money—the best of the best....

The article later adds...

Hedge funds as a group are badly underperforming this year, which could lead to a series of redemptions, closings and rethinking of the lofty fee structures the managers of these alternative vehicles enjoy.

Many know the magic of compound returns, but fewer seem to fully appreciate what John Bogle calls "the tyranny of compounding costs". In the aggregate fees, commissions, and other "frictional" costs can only subtract, too often substantially over the long haul, from total returns. There's no way around it. 

Little or, well, nothing of real use is created and the costs aren't exactly immaterial.

An individual investor or professional manager may be outperform but the industry as a whole, after frictional costs are subtracted, can't be anything but a net drag on returns. Productive assets will produce a certain amount of value over time with or without some money manager acting as the middle man. So the fees charged by professional investment management simply subtract (and certainly cannot add). I know some may challenge this premise but, at a minimum, lots of talent wakes up every day engaged in activities that seem mostly non-productive or of little utility.

There are those that rationalize the benefits of all these frictional costs (improved capital allocation being one of them) but I'm mostly skeptical of the arguments that I've heard.
(My mind remains open to the possibility that there are other benefits I do not fully appreciate.)

I do think that investment professionals who stay with their investments for a long time and try to engage constructively in corporate governance issues can add some real value. 

Higher quality management, better business strategies, improved capital and resource allocation among things can be the result. 

Otherwise, these costs meaningfully subtracts from the long-term returns for investors overall. The fees paid may benefit an individual investor who happens to be investing with someone, through luck or skill (or maybe a little of both), produces above average results. So, for that individual investor, it works at a micro-level. The best professionals can outperform by enough on a consistent basis to even justify their fees. I'm not arguing otherwise. This doesn't alter the arithmetic reality that all the salaries, fees, bonuses paid to money managers subtracts from returns of investors as a whole.

"If we [the investment industry] raise our fees from 0.5 percent to 1 percent, we actually raid the balance sheet. We take 0.5 per cent from what would have been savings and investment and turn it into income and GDP. In other words, you're taking money that would have become capital and chewing it up as bankers' bonuses." - Jeremy Grantham

Jeremy Grantham: 'We Add Nothing But Costs'

So it's the conversion of capital to income. Think of the compensation that's paid to investment management professionals (sometimes what seems an endless parade of these professional managers appear on business news each day). Some (maybe even many) are very capable and work very hard for their clients no doubt, but there's no getting around that their rather substantial compensation is literally savings and investment being converted to income. 

It's simple arithmetic. Allow the "tyranny of compounding costs" to play out for many years and we're talking some real money when it is all said and done.

These flaws are costly even if all the costs aren't necessarily measurable. To improve the system overall, reducing frictional costs and increasing the average holding period ought to be among the top priorities. Of course, if and when that might happen isn't knowable. So, until then, the individual investor can still choose to not participate in the folly (even if society still bears the costs, unfortunately).

More in a follow up post.

Adam

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.