The P/E Illusion

"...alternative frames evoke different mathematical intuitions, and one is much superior to the other." - Daniel Kahneman in Thinking, Fast and Slow

This recent post covered why the long-term investor should actually prefer that the stocks they own for the long-term will underperform in the near-term and even intermediate term. In fact, maybe somewhat oddly, that investor shouldn't mind this even if (annoyingly) the stock drops meaningfully right after it has been bought.

Now, when a high price is paid, and the long-term outcome is dependent on speculative assumptions, this won't work. Assumptions that, while possibly even not unreasonable, cannot be known with enough certainty to narrow the range of outcomes.

Yet the real problem might be more about mathematical intuition and framing effects.

Think of it this way. Consider a stock with a price-to-earnings (P/E) of 100. Naturally, a stock like that must have significant growth prospects if it's going to work out well for owners. There's just not enough current earnings relative to price to provide a meaningful tailwind or sufficient return for the capital at risk. If earnings, for example, were to unexpectedly flatline, it'll be 100 years before the cumulative earnings will equal the price paid. Let's say, as a result of this disappointment, the stock were to fall by 50%. Well, it would still require, without growth resuming, 50 years of earnings to equal price. So, even after a quite large decline, without some real future growth, the price paid will still lead to a very unattractive outcome. The continuing shareholders who decide to hang on and wait for growth to resume, unfortunately, can't rely on buybacks to help the situation very much either. Here the investor is dependent on things not controllable: whether growth will return and will be sustained for a rather long time into the future.

Figuring this out may not be impossible but, to me, sure seems like a recipe for making some big mistakes.

Here's where the framing effects and their critical impact on decision-making becomes more apparent:

A 50% drop from 100 times earnings only increases the earnings yield from 1% to 2%.

In contrast, pay 10 times earnings for something with modest or even no growth prospects and every ten years or so it produces in earnings what was paid. If the stock price were to drop 50% for some reason, each incremental purchase makes a big difference whether via buybacks or through incremental purchases by the owner.

A 50% drop from 10 times earning increases the earnings yield increases from 10% to 20%.

In both cases, it was a 50% drop in price but the improvement in earnings yield is vastly different.

Framing in terms of earnings yield instead of price-to-earnings makes this more intuitive.

This is a big part of the reason why paying speculative premiums on stocks can be so dangerous. It's why I prefer to think in terms of earnings yield instead of price to earnings.  Some will choose to discount the importance of framing effects, but I think some familiarity with what's known as "The MPG Illusion" just might change that.

Below is a quick explanation of "The MPG Illusion" but it's well worth reading up further on the subject:

Let's say you and a friend each have a car.

The one you own is a gas guzzler that gets 6 MPG. Your friend's current car gets 20 MPG.

Both of you are about to purchase new ones.

Both of you happen to drive the same number of miles each year.

The car you end up buying gets a still rather paltry 8 MPG.

Your friends new car gets 40 MPG.

Which decision results in more fuel savings?

Seems straightforward enough.

Your car only improves MPG by 2 or 33%.

The other car improves MPG by 20 or 100%.

This seems like a no-brainer: trading in your car improves gas mileage by only 2 mpg (33%), while your friends car improves gas mileage by 20 mpg (100%).

So the intuition points us to what seems an obvious answer. Well, it's not so obvious.

Here's the math. If each car drives 12,000 miles a year...

Then you used to use 2000 gallons per year (12000 miles/6 MPG).

Doing the same math, the new car will use up 1500 gallons per year.

So the saving is 500 gallons per year.

Your friend, on the other hand, used to use 600 gallons per year (12000 miles/20 MPG) but, doing the same math, now uses 300 gallons.

So the saving that comes out of this decision is only 300 gallons.

It turns out that gallons per mile (GPM) is more intuitive. The inverse framing make this dynamic more plain and less likely to lead to misjudgments.

The 40 MPG car obviously still burns less gas overall, but the decision to go from 20 MPG to 40 MPG versus from 6 to 8, counterintuitively, does not save as much fuel.

So how something is framed matters a lot.

Price to earnings functions much like MPG.

Earnings yield functions much like GPM.

So the high P/E stock is like the fuel efficient car. It's the better story to tell but much more is needed than intuition would suggest.

The low P/E stock is like the gas guzzler. It's still a lousy story but not much is needed for good things to happen.

Incremental earnings yield (as price drops) is a big advantage for the low P/E stock.

Incremental reduction in GPM (as efficiency increases) is a big advantage for the gas guzzler.

The more intuitive way to guide fuel economy decision-making is GPM.

The more intuitive way to guide investment decision-making is earnings yield.

This doesn't mean no high P/E stock deserves to sell at such a premium.

This does mean investors might decide to take more risk than they need to, in part, because of the way the information is framed.

So MPG is not the best way to frame fuel efficiency, and P/E is not the best way to frame business valuation.

For investors to consider the risk and reward appropriately, they need to be careful that how something is framed isn't getting in the way of sound judgments.

I suspect that one of the reasons market participants tend to overpay for growth is at least partially caused but this. I also think sometimes those who learn the higher and more complex maths forget the power of good old-fashioned arithmetic.

There's certainly nothing at all wrong with attempting to get attractive investment results through something that has exciting growth prospects.

The problems begin when a premium to current value is paid -- even one that seems warranted because of the excellent prospects -- in an always uncertain world. When the range of future outcomes is very wide (i.e. when judging what the future cash flows will be is difficult at best) it's tough to determine what's an appropriate margin of safety to reduce the likelihood of permanent capital loss.

Those that can avoid the big losses meaningfully improve their chances of doing well. This requires, at the very least, that a reasonable price is paid in the first place. This depends on owning long-term only what's truly well understood.

When the multiple of earnings paid is low, all that has to be judged is whether those earnings are mostly sustainable* to get a good or better investment outcome. That's not necessarily easy but, compared to judging which high flyer will live up their long-term potential, it sure seems more reliably doable.

With lower multiple stocks -- those, for example, with maybe modest or no growth but at least some sustainable advantages -- the end result can be an attractive one as long as capital allocation is done reasonably well.

Of course, that's hardly a given.

Some might argue that P/E is very different than MPG because the E can change significantly.

While that's clearly not wrong, it is a distraction from how the illusion contributes to misjudgments.

Adam

Related posts:
Multiple Expansion, Buybacks, & The P/E Illusion (Follow-up)
The Benefits of a Declining Stock
Buffett's Purchase of IBM Revisited
Buffett on Buybacks, Book Value, and Intrinsic Value
Buffett on Teledyne's Henry Singleton
Why Buffett Wants IBM's Shares "To Languish"
Buffett: When it's Advisable for a Company to Repurchase Shares
The Best Use of Corporate Cash
Buffett on Stock Buybacks - Part II
Buffett on Stock Buybacks
Buy a Stock...Hope the Price Drops?

* At extremely low earnings multiples, a decline in earnings may not even be a problem if the capital is well allocated and the business is otherwise sustainable. Of course, it's important that the business not be collapsing and will be around for a long time with, at least, similar core economics. Growth is either irrelevant or a bonus.
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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.

Howard Marks on Risk

From the latest memo by Howard Marks of Oaktree Capital:

"Volatility is the academic's choice for defining and measuring risk. I think this is the case largely because volatility is quantifiable and thus usable in calculations and models of modern finance theory."

He then adds, not surprisingly, that volatility can "be an indicator or symptom of riskiness and even a specific form of risk" but "it falls far short as 'the' definition of investment risk."

The primary investment risk is the permanent loss of capital. Investors must be compensated sufficiently for that possibility. Well, volatility reveals nothing of real utility when it comes to making that assessment.

The problem is that, unlike volatility, actual risks can't really be quantified. Now, some will contend that risks can in fact be quantified but Marks argues, I think convincingly, that they cannot be. My view is that risk can be, best case, estimated in a meaningful but, more or less, qualitative way and cannot be known with any precision.

Marks writes that not only are risks not quantifiable a priori, they can't even really be known afterwards. This might seem odd but think of it this way: When an investment is sold, the investor knows specifically what the return ended up being. That doesn't mean that investor really understands the actual risk that was taken in order to get the now known result. The actual outcome was just one possible outcome among many. The risk and likelihood of a loss remains not quantifiable even after the sale is complete.

There's just no easy way to quantify the risks beforehand. Worse yet, it's not even really possible to quantify the risks after something has happened. Marks mentions that John Kenneth Galbraith believed that forecasters could not reliably predict the future and, as a result, necessarily fell into one of two categories:

"Those who don't know -- and those who don't know they don't know."

The same could be said about those who think most risks can actually be meaningfully measured.

This might at first all seem a bit unworkable, but I believe investing well requires getting comfortable with the subjective and qualitative nature of risk assessment. Time and energy should be directed at what an investor can actually control. Evaluating risk effectively is terribly important but the limits on what can be known and predicted are significant. Recognition of this should logically lead to less attention being paid to the many prognosticators and, instead, more focus on improving the investment process. Every aspect of investment decision-making needs to be continuously developed. Forecasts are mostly distraction.

It is possible to effectively deal with an uncertain future even if there's no reliable way to predict what's specifically going to happen. The many uncertainties can be dealt with by learning to roughly, but meaningfully, estimate the range of possible future outcomes and approximate probabilities.

Marks says that the estimation of risk "will by necessity be subjective, imprecise and more qualitative than quantitative (even if it's expressed in numbers)."

Volatility is totally insufficient as a measure of investment risk but has the advantage of being easily quantifiable. It's widespread use comes mostly down to that and not validity. Here's how Charlie Munger explained it once in a speech at UC Santa Barbara:

"...practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that." 

Later in the memo Marks mentions a quote by Elrod Dimson:*

"Risk means more things can happen than will happen."

Marks then refers to something he wrote back in 2007:**

"...the history that took place is only one version of what it could have been."

So that means "the relevance of history to the future is much more limited than may appear to be the case."

With so much necessarily unknown and unknowable it quickly becomes clear -- or should become clear -- why, for investors, margin of safety is such a crucial principle. Buying an asset far below a conservative estimate of value offers some protection, up to a point at least, against uncertainties. This usually means lots of waiting since, under normal economic conditions, assets don't generally become extremely mispriced on the low side. Some real economic difficulties is usually required. This also means that it's crucial to be able to act decisively when something finally sells at a big discount. You can bet that there'll either be broad-based economic turmoil or troubles that are specific to the asset itself. So the analytical work has to be done well in advance. Temperamental factors will also play a big role. Those who can't resist being influenced by things like the media echo chamber -- whether cognitively, emotionally, or both -- aren't likely to make great investment decisions when it counts.

Sometimes the worst case scenario is so intolerable that it's necessary to avoid an investment with otherwise lots of potential upside. In other words, even a very large margin of safety would prove insufficient. The example of a skydiver who's successful 95% of the time is mentioned in the memo. That's a useful way to think about it. The outcome 5% of the time is just unacceptable no matter how good things go the other 95% of the time. There will be times where there's just no way to know the range of possible outcomes (sometimes due to investor limitations, sometimes due to external factors). The risk versus reward may in fact be very favorable, but it's just not clear so decisive action cannot be taken.

A more or less traditional view is that taking more risk is the path to outsized returns. Well, that's just not correct. Those that continue to think along these lines are likely to end up with rather disappointing results. More from Marks:

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

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

On page 6 of the memo, Marks provides two very useful graphics to better explain the relationship between risk and return. The first graphic shows the rather conventional -- if not necessarily correct -- positive correlation between risk and return.

Well, the correlation between risk and return is sometimes positive, it's just not inevitably positive. I've covered this in prior posts but, as far as I'm concerned, it can't be repeated or emphasized enough.

The second graphic portrays the risk-return relationship in a much more useful fashion. It shows that increased risk increases the range of outcomes...not necessarily returns.

So volatility happens to be totally deficient as a measure of investment risk but that doesn't mean it's inconsequential:

"When you're under pressure, the distinction between 'volatility' and 'loss' can seem only semantic."

Price plays the key role in managing the many mostly not quantifiable risks that are an inevitable part of the investment process:

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

The following from Warren Buffett's The Superinvestors of Graham-and-Doddsville comes to mind:

"I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, 'I have here a six-shooter and I have slipped one cartridge into it. Why don't you just spin it and pull it once? If you survive, I will give you $1 million.' I would decline -- perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice -- now that would be a positive correlation between risk and reward!

The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it's riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.

One quick example: The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy. 

Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people that think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it's riskier to buy $400 million worth of properties for $40 million than $80 million. And, as a matter of fact, if you buy a group of such securities and you know anything at all about business valuation, there is essentially no risk in buying $400 million for $80 million..."

I think Howard Marks writes about risk just about as good as, if not better, than anyone else. In the memo, he walks through no less than 24 different forms of risk. Many of these are related to the "main risk" -- that being the possibility capital will be permanently lost. Sometimes, trying to minimize one type of risk increases another type of risk. That's part of what makes the investment process so challenging and, well, so enjoyable.

Overall, Marks has produced an impressively comprehensive memo.

Reading it is time well spent.

Some will want to focus on how to generate the biggest possible returns.

That will usually be a mistake.

The focus should be on, first and foremost, investment risk and how to deal with it.

Adam

Related posts:
-Grantham on Efficient Markets, Bubbles, and Ignoble Prizes
-Efficient Markets - Part II
-Risk and Reward Revisited
-Efficient Markets
-Modern Portfolio Theory, Efficient Markets, and the Flat Earth Revisited
-Buffett on Risk and Reward
-Buffett: Why Stocks Beat Bonds
-Beta, Risk, & the Inconvenient Real World Special Case
-Howard Marks: The Two Main Risks in the Investment World
-Black-Scholes and the Flat Earth Society
-Buffett: Indebted to Academics
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind

* Dimson is a professor at London Business School.
** From No Different This Time -- The Lessons of '07 (December 2007).
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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.

Munger on Airlines, Cereal Makers, and Bottlers

From this 1994 USC speech by Charlie Munger:

"Here's a model that we've had trouble with. Maybe you'll be able to figure it out better. Many markets get down to two or three big competitors—or five or six. And in some of those markets, nobody makes any money to speak of. But in others, everybody does very well.

Over the years, we've tried to figure out why the competition in some markets gets sort of rational from the investor's point of view so that the shareholders do well, and in other markets, there's destructive competition that destroys shareholder wealth.

If it's a pure commodity like airline seats, you can understand why no one makes any money. As we sit here, just think of what airlines have given to the world—safe travel, greater experience, time with your loved ones, you name it. Yet, the net amount of money that's been made by the shareholders of airlines since Kitty Hawk, is now a negative figure—a substantial negative figure. Competition was so intense that, once it was unleashed by deregulation, it ravaged shareholder wealth in the airline business.

Yet, in other fields—like cereals, for example—almost all the big boys make out. If you're some kind of a medium grade cereal maker, you might make 15% on your capital. And if you're really good, you might make 40%. But why are cereals so profitable—despite the fact that it looks to me like they're competing like crazy with promotions, coupons and everything else? I don't fully understand it.

Obviously, there's a brand identity factor in cereals that doesn't exist in airlines. That must be the main factor that accounts for it.

And maybe the cereal makers by and large have learned to be less crazy about fighting for market share—because if you get even one person who's hell-bent on gaining market share.... For example, if I were Kellogg and I decided that I had to have 60% of the market, I think I could take most of the profit out of cereals. I'd ruin Kellogg in the process. But I think I could do it.

In some businesses, the participants behave like a demented Kellogg. In other businesses, they don't. Unfortunately, I do not have a perfect model for predicting how that's going to happen.

For example, if you look around at bottler markets, you'll find many markets where bottlers of Pepsi and Coke both make a lot of money and many others where they destroy most of the profitability of the two franchises. That must get down to the peculiarities of individual adjustment to market capitalism. I think you'd have to know the people involved to fully understand what was happening."

The above is just one good example among many that investment inevitably requires lots of qualitative judgments. The math matters, of course, but completely insufficient when it comes to sound investment decision-making.

Munger explained it this way in a 2003 speech at UC Santa Barbara:

"...practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that."

At the 2002 Wesco annual meeting, Munger had this to say about the tendency to focus too much on the calculations:

"Organized common (or uncommon) sense -- very basic knowledge -- is an enormously powerful tool. There are huge dangers with computers. People calculate too much and think too little."

Also, here's a revealing exchange between Warren Buffett and Charlie Munger: 

Munger: "You really have to understand the company and its competitive positions. ...That's not disclosed by the math.

Buffett: "I don't know how I would manage money if I had to do it just on the numbers."

Munger, interupting, "You'd do it badly."

Big mistakes are likely to get made by the investor who looks only at, -- or, at least, mostly at -- the numbers while ignoring the more qualitative things like, for example, industry dynamics. An industry with a particular set of characteristics -- even if for a very long time -- may change.

The investment process is necessarily subjective and imprecise. Both qualitative and quantitative factors have to be fully integrated with the former often being more significant than the latter.

Margin of safety can, up to a point, account for the some of unknowns and uncertainties. Yet even something as important as always buying with a sufficient margin of safety has its limits. Sometimes the worst case scenario, even if not very probable, is simply intolerable. Howard Marks mentions in his latest memo the skydiver who's successful 95% of the time. That's a good example of this.

In other words, for some potential investments with lots of upside but also the possibility of a very bad outcome, no price will be low enough.

So, in the context of an investment portfolio, it becomes necessary to forgo a big possible gain to keep something really bad from happening.

Unfortunately, the probabilities will almost never be as precise as something like 95%.

Mostly, a qualitative judgment will have to be made.

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.

Risk and Reward: Wells Fargo, U.S. Bancorp, and BofA

From this CNBC Interview with Warren Buffett back in 2012:

"The profitability of banking is a function of two items. Return on assets and assets to equity.

And return on assets is not going to go up particularly. USB has done the very best on that. They're at about 1.7 percent. Wells is between 1.4 and 1.5 percent. But most banks are lower. Now, if you have 20 times leverage and you're getting 1.5 percent on assets, you're making 30 percent on equity.

And that was not lost on people a few years back. And they pushed balance sheets..."

He also added this:

"Banks were —banks were earning 25 percent on tangible equity not so many years ago. And really, that's kind of a crazy number. You know, for a basic semi-commodity business, you really don't want to allow that." 

and

"...people got to push and push it and push it, and then the government says, 'Listen, we got a vested interest in this. You're using our credit, in effect, and if you want to play, you're only going to have 10-to-1, or some number like that.' So the returns on banks have come down. It's still a good business."

Buffett on Banks: CNBC Interview

One limited way , but I think meaningful, compare the relative strength of banks is to look at what happened to these businesses (and, ultimately, their stocks) as a result of the financial crisis.

Let's say Wells Fargo's (WFC) stock was purchased at its pre-crisis peak price. As the crisis unfolded, that no doubt didn't feel like a brilliant move.

Those who did buy at that worst possible time pre-crisis would actually still have a rather solid (~ 60%) if not spectacular gain at this point (though some rather wild price action, to say the least, had to be tolerated). Stock performance has not been dependent on the shares trading at some speculative (high) price. Normalized per share earning power has increased substantially and the stock, give or take, reflects it.

So it's been mostly about business performance over that time. The acquisition of Wachovia resulted in additional shares outstanding but seems to have worked out just fine. The dilution that did occur as a result of capital that was raised wasn't without a real cost to continuing shareholders. Not all dilution is created equal. How market price compares to intrinsic value, as always, matters a bunch. The shares, like many banks at the time, were selling at a meaningful discount to value. So that was less than ideal but, overall, the bank's business and stock have performed rather well. Not phenomenal investment results if bought at the pre-crisis high but, then again, value conscious long-term oriented investors should have been able to buy at more attractive valuations.

At the other extreme, not surprisingly, those who bought at the lowest price during the crisis would have huge gains -- several hundred percent, in fact.

The results were mostly similar for U.S. Bancorp (USB).

In other words, the range of outcomes was from reasonably good to very good; from gains to even greater gains. A decent result even if the stock wasn't bought brilliantly. Realistically, what would happen in the real world to someone investing long-term in these banks is they'd have made purchases somewhere between these two extremes. That would have produced a very good result indeed. The focus should be on the strength of a banking franchise, price versus value, and long-term effects instead of near-term price action. The point being that there's no need to get the timing right nor is it possible to reliably do so.

Attempts to time things perfectly leads to missed opportunities.

What these banks have in common is the robustness of their core economics. They're better able to absorb losses during the tough times and produce above average normalized returns.

The same cannot be said for Bank of America (BAC).

Lets say someone similarly bought Bank of America's stock at its pre-crisis peak. Those who took that action would still now need the stock to more than triple to get back to even.

At the other extreme, those who bought at the lowest possible price would be up several hundred percent. So the best case was much like Wells and U.S. Bancorp.

In this case, the range of outcomes went from very bad to very good; from big losses to big gains. Those who had the misfortune of buying at the peak will likely have to wait until something like 2025 (and maybe much later) for per share intrinsic value to equal what was paid pre-crisis.*

By the time BofA's stock finally reaches those pre-crisis levels, the buyers of Wells at the somewhat expensive pre-crisis peak should still end up with a more than respectable annualized total return. That's under the scenario of having bought at the worst possible pre-crisis price! Obviously, it wasn't difficult to buy at much more attractive prices if the focus was on long-term effects instead of scary headlines and awful near-term stock price action.

Getting a good result investing in BofA was highly dependent on buying brilliantly; not so for Wells and U.S. Bancorp.

I'm certainly not downplaying how serious the crisis was. Without certain policies, and decisive actions, even the very high quality banks would not produced these investment outcomes. This is why investing in the common stocks of banks can be far more tricky than many other common stocks. Even when run competently these are inherently leveraged institutions that depend on system stability and the inevitable associated risks. These businesses are incredibly complex.

There are a number of more straightforward ways to get investment results. Sometimes I wonder whether it's worth all the additional work that's required.

Keep in mind that Wells and U.S. Bancorp were the "expensive" stocks pre-crisis. They were selling for roughly 14-15x earnings at the time.

BofA is the one that looked cheap at more like 11-12x earnings before the financial crisis.

The real emphasis here is on per share earnings since, there's no way to know when stock prices will reflect something close to per share intrnsic value. Wells has increased its per share earnings power meaningfully compared to pre-crisis peak earnings; U.S. Bancorp earnings has increased more modestly.

The key thing here is that, at least with these two banks, we are at least talking about increases to per share earnings.

In contrast, BofA is struggling to earn even one third as much as it did pre-crisis. Much of this comes down to the dilution that occurred as a result of necessary capital raising. The fact that they were forced to raise capital when their stock price was very low didn't help at all, of course. It did great damage to their per share earning power. Also, the acquisition of Countrywide has been incredibly expensive. There are other factors including reduced leverage and the regulatory environment more generally.

In any case, Wells Fargo and U.S. Bancorp are, for many reasons, just vastly more capable of generating an attractive return on assets and equity. As Buffett points out above that's what matters in the long run if at least a reasonable price is paid in the first place.

A bank with a 1.5 percent return on assets compared to one with, let's say, 1 percent return on assets may not seem like a big deal but it is. At 10x leverage that'd be 15% return on equity (ROE) versus 10%.

- ROE for Wells currently sits at 13.4%

- ROE for U.S. Bancorp is 15.1%

- ROE for BofA is in the single digits, though it should improve somewhat as earning power normalizes

So Wells and U.S. Bancorp continue to have big economic advantages over BofA. Compounded over longer time frames, if persistent, these superior economics will matter a great deal in terms of investment results.

It's not just about offense.

There's a defensive element to consider.

Wells Fargo, for example, should be able to roughly absorb an extra $ 10 billion or so of losses per year on its current asset base because of its ROE advantage. The not so good times will inevitably return -- likely under very different circumstances -- and a quality bank should be built to comfortably handle significant economic and financial stress.

So, for the better banks, not only are overall returns higher on a normalized basis, the risk of permanent capital loss is reduced because of a greater ability to absorb losses with earnings over time instead of cutting into capital. Most of the damage that was done during the crisis, for common shareholders, was due to costly capital raising (i.e. when the capital is raised at a price that is well below per share intrinsic value based on normalized earning).

Wells and U.S. Bancorp have been and mostly remain vastly superior in terms of the capacity to protect against downside.** 

In the end this makes for a very different risk versus reward profile.

So watch out for the "cheap" banks or, at least, those that appear to be cheap on the surface.

For now, my view is that the risk-reward profile still appears more challenging -- more risk for less reward. To me, BofA's risk-reward profile at the very least calls for a bigger margin of safety.
(There are many investment situations where no margin of safety is sufficient considering the investment specific risks; when the expected worst case outcome is intolerable.) 

BofA may yet develop more favorable core economics over time and the risk-reward profile may change. It will be interesting to watch as things evolve over time.

Much of modern finance theory still assumes that more risk must be taken to achieve greater reward. In fact, the formulas found in prevailing theory really only allow for a positive correlation to exist between risk and reward. So it's not just words. Of course, many times risk and reward must necessarily be correlated in a positive manner.

Other times, they're not correlated in such a manner.

The significance of this is sometimes underappreciated.

Risk and reward can be positively correlated; it's just not necessarily so.

As noted above, a bank can be both less risky and offer more potential reward. The same can be true for other businesses. Also, consider the impact of paying a lower price for a particular asset. Well, the lower price will simultaneously reduce the risk of permanent capital loss while increasing the potential reward.***

At least some of the prevailing modern finance theory seems deeply flawed.

Adam

Long positions in WFC, USB, and BAC established at much lower than recent prices. WFC and USB are long-term investments; BAC is likely much less so.

* That's if there's not another costly financial crisis. No bank -- not even the very best -- is immune to the financial system completely collapsing. Of course, if that were to happen, I'm guessing many of us will be focused on more pressing things than stock prices.
** Pre-tax pre-provision profit is a key consideration. It indicates how much in terms of losses a bank can absorb through earnings over time before cutting into capital. Asset quality, capital levels, stable funding and liquidity also naturally matters a bunch. 
*** Here's how Warren Buffett explained the correlation between risk and reward in The Superinvestors of Graham-and-Doddsville:

"I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, 'I have here a six-shooter and I have slipped one cartridge into it. Why don't you just spin it and pull it once? If you survive, I will give you $1 million.' I would decline -- perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice -- now that would be a positive correlation between risk and reward!

The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it's riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.

One quick example: The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy. 

Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people that think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it's riskier to buy $400 million worth of properties for $40 million than $80 million. And, as a matter of fact, if you buy a group of such securities and you know anything at all about business valuation, there is essentially no risk in buying $400 million for $80 million..."
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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.

The Benefits of a Declining Stock

I have covered on a number of occasions -- okay, maybe too many occasions -- why the long-term investor should hope that any stock they bought cheap performs poorly over the near and even intermediate term.

Well, at least if long run business prospects remain at least reasonably sound.

Over the very long haul, market prices will roughly track changes to per share intrinsic value.

Over the short haul, prices can do just about anything.

That's an advantage for the long-term investor.

Warren Buffett explained it this way in the 2011 Berkshire Hathaway (BRKa) shareholder letter:

"When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well."

and

"If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day's supply.

Charlie and I don't expect to win many of you over to our way of thinking – we've observed enough human behavior to know the futility of that – but we do want you to be aware of our personal calculus."

Here's another good take on the subject from Vitaliy Katsenelson:

"A stock decline is not necessarily a bad thing, even if it happens right after you buy (assuming fundamentals have not collapsed)."

and

"It may be painful to see your newly minted position show losses right away or remain below your purchase price for a long time. But if a company is taking advantage of its stock's cheap valuation through share repurchases, the intrinsic value of what you own is actually enhanced by the price decline."

Watching recently purchased shares drop in price right after the purchase occurred naturally doesn't exactly feel great. That's loss aversion at work and, of course, perfectly understandable. Yet it's not impossible to develop a more appropriate and sensible response. Even if an underperforming stock does not feel like such a wonderful thing, under the right circumstances and viewed rationally, it actually is.

In contrast, if an investor pays a speculative premium price on what seem like exciting future prospects that don't become reality, a drop in stock price feels pretty bad and, well, is very bad. That's likely to lead to permanent capital loss or, at least, insufficient returns considering risks and alternatives. This approach also depends heavily on being good at reliably picking winners -- usually in a dynamic and unpredictable new space where the core economics are not yet well defined -- and not paying too much for promise.

Now if, instead, the approach is to consistently pay a plain and comfortable discount to current estimated value based upon conservative assumptions, some good things seem likely to happen; big mistakes, including the likelihood of permanent capital loss, become more avoidable.

This, for example, might require judging whether a business with sound core economics and durable advantages that has long dominated an industry will continue to do so. Not exactly easy but, with enough patience and work, at least potentially less likely to produce large misjudgments and the associated losses compared to more speculative approaches.

An undervalued stock can naturally become even more undervalued but attempting to guess whether that will happen or not is folly. When I buy something, I never know what direction the price action is going to be, nor do I even try to figure that out. It's a waste of energy and leads to unnecessary mistakes (incl. errors of omission).

So temporarily lower stock prices only improve the long-term outcome if something was bought at a discount in the first place.

A long-term investor should celebrate if something they bought cheap temporarily gets even cheaper.

That's just the nature of investment even if it might go against intuition and instincts.

The tough part is becoming comfortable with thinking this way about investments. It's knowing when intrinsic value can be estimated within a narrow enough range, always paying a nice discount to that estimate, and having a truly long-term investment time horizon.

That's necessarily measured in at least many years, preferably decades or, ideally, the favorite holding period of Warren Buffett and Charlie Munger.

That'd be forever.

From the 1988 Berkshire Hathaway shareholder letter:

"...when we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever. We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint. Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds."

So this approach doesn't work when a high price is paid and the long-term outcome is dependent on speculative assumptions.

Assumptions that, while possibly not even unreasonable, cannot be known with enough warranted confidence to invest in this manner.

When dependent on lots of difficult to foresee good things happening, it's easy to underestimate how one negative surprise can do huge damage to overall portfolio returns. A big part of investing well long-term is the elimination of large mistakes. That may not be as exciting as trying to judge what the next big thing is going to be then riding the wave, but it can offer a useful way to balance risk and reward.

What matters is whether the business at least has durable free cash flows even if it lacks exciting growth prospects. When, let's say, less than 10x durable free cash flows is paid, future share repurchases can have a big impact if the multiple at least remains roughly at that level or, ideally, goes even lower. At that kind of valuation it is durability that matters more than growth. When a plain discount to conservative per share value is paid upfront, and that discount temporarily gets even bigger, not only should it be of no concern to the long-term owner, it should be viewed as a positive development.

Of course, none of this will be of much interest to those who are primarily focused on making bets on price action.

This approach won't work very well if per share intrinsic value can't be estimated well.

This won't work if the price paid doesn't offer an appropriate margin of safety.

This won't work if time horizon is measured in only a few years or less.

Ignoring these things leads to unnecessary permanent losses and subpar results.

More in a follow-up.

Adam

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

Related posts:
The P/E Illusion (follow-up)
Buffett's Purchase of IBM Revisited
Buffett on Buybacks, Book Value, and Intrinsic Value
Buffett on Teledyne's Henry Singleton
Why Buffett Wants IBM's Shares "To Languish"
Buffett: When it's Advisable for a Company to Repurchase Shares
The Best Use of Corporate Cash
Buffett on Stock Buybacks - Part II
Buffett on Stock Buybacks
Buy a Stock...Hope the Price Drops?
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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.

John Kay: Decline in Equity Issuance

In 2012, John Kay produced a report on UK equity markets that was focused on, among other things, the reduction in long-term oriented behavior among UK equity market participants and corporate decision-makers.

This post from last year focused on the first section of that report.

John Kay on Equity Markets: Exit, Voice, and Short-termism

In the second section of the report, the emphasis is on new equity issuance or, more specifically, the lack of it:

"Equity markets have not been an important source of capital for new investment in British business for many years. Large UK companies are self-financing – the cash flow they obtain from operations through profits and depreciation is more than sufficient for their investment needs. This is true of the quoted company sector as a whole and of a large majority of companies within it."

and

"Finance raised through placings and rights issues by established companies, and initial public offerings (IPOs) by new companies, have generally been more than offset by the acquisition of shares for cash in takeovers and through share buyback..."

As a result, the issuance of equities has been negative over the last decade even if the situation has recently improved somewhat.

Why has there been a decline?

"There are many reasons for the decline in the role of equity issues in investment. In a modern economy, investment in physical capital is much less important than it was."

Yet...

"Even companies in sectors that have large capital requirements – such as oil and utilities – make little or no use of primary equity markets, relying instead on debt and internal funding."

There are many explanations for why equity issuance has declined -- and some of them are valid to an extent -- but the report states "we do not find them adequate" while adding "we believe the fundamental reasons go deeper, and reflect the nature of financial intermediation itself."

The combined impact of regulatory and cultural changes over the years led to "the rise of an ethos which emphasised transactions and trading over relationships. This ethos permeated all areas" of financial services and "the shift from relationship to trading, from voice to exit, came to affect not only the interaction between shareholders and companies but between corporate executives and their companies: some managers came to see themselves as traders, engaged in the management of a portfolio of businesses to which they owed no particular attachment."

The United States has had more than its fair share of influence on the changes that have occurred in recent decades. Equity markets, of course, need to facilitate the funding of new and existing businesses. If working well, equity capital efficiently gets where it's needed while misallocation and mispricing is minimized.

Increasingly, that's not their primary function.

Equity markets are also "one of the means by which investors who support fledgling companies can hope to realise value. Equity markets provide a means of oversight of the principal mechanism of capital allocation, which takes place within companies. Promoting stewardship and good corporate governance is not an incidental function of equity markets."

Not only is it important "that equity markets remain an attractive means of obtaining funding", policies should "ensure there are no unnecessary disincentives to using equity markets, either for companies or for their investors. And we believe that our recommendations to encourage asset managers to act as long-term stewards of more concentrated, less liquid equity portfolios will mean a greater willingness to invest funds across a broader range of companies, including smaller businesses who wish to raise equity finance, but are currently unable to do so."

Warren Buffett's long-term oriented investing behavior -- whether in equity markets or how Berkshire Hathaway's (BRKa) many businesses are operated -- would be a prime example of what would become more commonplace.

This requires no less than a fundamental culture change.

For an example closer to home in the UK, as this article points out, look no further than the way that Neil Woodford operates:

"To many, he [Woodford] is an example of what John Kay, commissioned by the government to encourage long-term investment, should look for in a fund manager, holding shares for 15 years rather than switching in and out in search of a quick buck."

Woodford recently left Invesco after more than 25 years at the firm to start a fund management company and launched a new fund, Woodford Equity Income.

There are certainly a number of other good examples.

The focus of John Kay's work is the UK but many of the same problems, as well as potential solutions, are more than a little bit similar to the US.

IPOs have come back somewhat recently in the US, though still are well below what we saw in the 1990s.

Progress on this front starts with recognizing the costly long-term implications of not making some sensible adjustments.

Adam

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

* Excerpts in this post are from sections 2.6, 2.7, 2.12, 2.13, 2.18, 2.28, 2.32, and 2.33 of the report.
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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.

Berkshire Hathaway 2nd Quarter 2014 13F-HR

The Berkshire Hathaway (BRKa) 2nd Quarter 13F-HR was released yesterday. Below is a summary of the changes that were made to the Berkshire equity portfolio during that quarter.
(For a convenient comparison, here's a post from last quarter that summarizes Berkshire's 1st Quarter 13F-HR.)

There was plenty of buying and selling during the quarter. Here's a quick summary of the changes:*

New Positions
Charter Communicatons (CHTR): Bought 2.31 million shares worth $ 361 million
Now Inc. (DNOW): Bought 1.83 million shares worth $ 58.1 million

Berkshire's latest filing did not indicate any activity was kept confidential. Occasionally, the SEC allows Berkshire to keep certain moves in the portfolio confidential. The permission is granted by the SEC when a case can be made that the disclosure may cause buyers to drive up the price before Berkshire makes its additional purchases.

Added to Existing Positions
IBM (IBM): 1.82 million shares worth $ 342 million, total stake $ 13.2 billion
Wal-Mart (WMT): 745 thousand shares worth $ 55.4 million, total stake $ 4.37 billion
U.S. Bancorp (USB): 67.8 thousand shares worth $ 2.82 million, total stake $ 3.33 billion
General Motors (GM): 2.96 million shares worth $ 100 million, total stake $ 1.12 billion
USG Corporation (USG): 4.11 million shares worth $ 113 million, total stake $ 1.07 billion**
Verizon (VZ): 3.98 million shares worth $ 195 million, total stake $ 735 million
Verisign (VRSN): 1.30 million shares worth $ 72.1 million, total stake $ 721 million
Suncor (SU): 3.46 million shares worth $ 133 million, total stake $ 633 million
Chicago Bridge & Iron (CBI): 1.15 million shares worth $ 66.8 million, total stake $ 621 million
Liberty Global Class A (LBTYA): 2.52 million shares worth $ 109 million, total stake $ 428 million
Visa (V): 244 thousand shares worth $ 51.9 million, total stake $ 382 million

Reduced Positions
DirecTV (DTV): 11.0 million shares worth $ 933 million, total stake $ 1.98 billion
National Oilwell Varco (NOV): 1.58 million shares worth $ 127 million, total stake $ 590 million
Liberty Media (LMCA): 1.30 million shares worth $ 184 million, total stake $ 565 million
Phillips 66 (PSX): 3.25 million shares worth $ 272 million, total stake $ 544 million
Precision Castparts (PCP): 101 thousand shares worth $ 24.2 million, total stake $ 451 million
ConocoPhillips (COP): 9.72 million shares worth $ 780 million, total stake $ 109 million

Graham Holdings (GHC): 1.62 million shares worth $ 1.14 billion, total stake $ 76 million

The reduction in shares of Graham Holdings came about as a result of this deal.

Sold Positions
Starz (STRZA): 1.92 million shares worth $ 55.2 million

Todd Combs and Ted Weschler are responsible for an increasingly large number of the moves in the Berkshire equity portfolio, even if they still manage a small percentage of the overall portfolio.

These days, any changes involving smaller positions will generally be the work of the two portfolio managers.
(Though some of the holdings they're responsible for have become more substantial over time.)

Top Five Holdings
After the changes, Berkshire Hathaway's portfolio of equity securities remains mostly made up of financial, consumer and, to a lesser extent, technology stocks (mostly IBM).

1. Wells Fargo (WFC) = $ 23.3 billion
2. Coca-Cola (KO) = $ 16.1 billion
3. American Express (AXP) = $ 13.2 billion
4. IBM (IBM) = $ 13.2 billion
5. Wal-Mart (WMT) = $ 4.37 billion

The Wal-Mart position is only barely larger than Berkshire's position in Procter & Gamble (PG).

As is almost always the case it's a very concentrated portfolio.

The top five often represent 60-70 percent and, at times, even more of the equity portfolio. In addition, Berkshire owns equity securities listed on exchanges outside the U.S., plus cash and cash equivalents, fixed income, and other investments.***

According to their latest filing, the combined portfolio value (equities, cash, bonds, and other investments) at the end of the most recent quarter was ~ $ 233 billion (including the investment in Heinz).

The portfolio, of course, excludes all the operating businesses that Berkshire owns outright with, according to the latest letter, a bit more than 330,000 employees combined.

Here are some examples of the non-insurance businesses:

MidAmerican Energy, Burlington Northern Santa Fe, McLane Company, The Marmon Group, Shaw Industries, Benjamin Moore, Johns Manville, Acme Building, MiTek, Fruit of the Loom, Russell Athletic Apparel, NetJets, Nebraska Furniture Mart, See's Candies, Dairy Queen, The Pampered Chef, Business Wire, Iscar, Lubrizol, Oriental Trading Company, as well as 50% of Heinz.
(Among others.)

In addition, the insurance businesses (BH Reinsurance, General Re, GEICO etc.) owned by Berkshire have naturally provided plenty of "float" for their investments over time and continue to do so.

See page 111 of the annual report for a full list of Berkshire's businesses.

Adam

Long positions in BRKb, WFC, KO, AXP, PG, USB, WMT, DTV, COP, and PSX established at much lower than recent market prices. Small long position in IBM established at slightly less than recent market prices. Also, small long positions in USG and GHC established near current prices.

* All values shown are based upon Thursday's closing price with the exception of Liberty Media. After the 2nd quarter ended, Liberty Media implemented a stock split and spin-off. The numbers shown above for Liberty Media are based upon the closing price as of the last trading day prior to the stock split and spin-off.
** This is resulting from USG notes held by Berkshire that were converted into USG common stock. The SC 13D/A reflects all of the 43.39 million shares (30.4%) of USG owned by Berkshire. 
*** Berkshire Hathaway's holdings of ADRs are included in the 13F-HR. What is not included are the shares listed on exchanges outside the United States. The status of those shares are updated in the annual letter. So the only way any of the stocks listed on exchanges outside the U.S. will show up in the 13F-HR is if Berkshire happens to buy the ADR. Investments in things like the preferred shares (and, where applicable, related warrants) are also not included in the 13F-HR. The same is true for the Heinz common shares (i.e. not just the Heinz preferred shares).
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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.