Zero-Sum Games

While sports is not a subject that's covered much on this blog, I'll use the upcoming Super Bowl -- with consideration for the amount of betting on the event that will occur in mind -- as a convenient excuse to revisit some of the differences between gambling, speculation, and investment.

Naturally, a variety of bets will be placed on that big game. Also, plenty of bets were made on game outcomes and individual player performance (through, for example, various forms of fantasy football) during the regular football season. On occasion, I'll hear someone suggest that owning stocks is just another form of gambling. Well, it certainly can be turned into gambling -- or a gambling-like activity -- but it need not be. It all comes down to behavior. Those who trade rather frequently are doing what, at least to me, is effectively gambling. There's nothing inherently wrong with that approach other than too often it tends to be not all that lucrative.

In fact, what happens to a stock over short amounts of time is essentially a coin flip. The price action of a stock is moved in the near-term by the voting machine. The price level in the long run is set, within a range, by the weighing machine. In the short run it's a popularity contest; in the long run it mostly comes down to what something is intrinsically worth.

Now let's say, for example, someone participated in fantasy football league and ended up winning 7-8 times their money that was put at risk.
(Over the course of the regular football season.)

That's a nice rate of return by any standard, right?

It would be tough to match that by owning common stocks -- other than , maybe, the most speculative variety -- even with some leverage involved (e.g. via margin or equity options).

Yet such an impressive return can't viewed in a vacuum.

First, the fact is it's likely that all or a good chunk of that money put at risk in the sports bet could be permanently lost. In contrast, that can be a much lower probability outcome with, for example, a quality common stock that's bought well (i.e. plain discount to a conservative estimate of value) and owned for a very long time.

A sports bet -- or any bet -- is generally a zero-sum outcome. The reward comes at the expense of at least one other person.*

A good investment is -- or should be  -- very different. Capital certainly can and does get permanently lost with equity investments but, with a sound overall approach, the probability of it happening can be much reduced (over the long haul relative to typical pure zero-sum bets).

The value of a dollar bill will not increase in purchasing power over time. Well, at least that's the case if history is any guide. The fact is, especially over the very long run, most currencies tend to decline in purchasing power rather substantially. For a business -- whether owned outright or via common stock -- this need not be the case. Good businesses, unlike dollar bills, can intrinsically increase in value especially over the longer haul. They do so because, through their competitive advantages, quality businesses can profitably produce something of value year after year at an attractive rate of return on capital.** A business that is financially sound with a strong at least sustainable (though ideally improving) competitive position has the potential to generate attractive returns for quite some time.

So a key difference is investment can provide an outcome that is not zero-sum:

"...stocks grow in value over time because they retain earnings and they expand basically the companies underneath you." - Warren Buffett on CNBC

Those retained earnings may or may not be put to good use but, at least with capable management in place, it's unlikely the cash that's generated is being thrown into a furnace (though sometimes dumb capital expenditures and acquisitions act as a functional equivalent to this behavior). The earnings from a business with durable advantages should directly benefit long-term owners (via dividends and buybacks) or be of indirect benefit as the retained earnings are put to work (on hopefully what are high return investments) with an eye toward the longer term.

If two people put $ 100 each into a bet with each other then the winner walks away with $ 200 and the other walks away with, well, nothing.

Zero sum.

One winner.

One loser.

Much like the big football game this weekend.

If the same two people put $ 100 each into an investment that doubles in value both end up with $ 200. Both win.

Of course, it's also possible, unlike the bet, that they could have both ended up with a loss.

Now, an investment generally require much longer time horizons than a bet. Think decades. So they mostly will just not produce lottery ticket like outcomes. For those stocks that do happen to produce quick and spectacular returns, the risk of permanent loss was likely very high.

A big part of the challenge is minimizing the possibility of capital being permanently lost while still generating an attractive return. Risk and reward need not be positively correlated. Temporary paper losses are acceptable; permanent losses are not. Mistakes will inevitably be made but, when you can minimize the big losers then the winning decisions usually take care of things.

So returns need to be viewed in the context of the possibility of permanent capital loss. Most forms of gambling fail miserably in this regard. Gambling might provide some entertainment but, otherwise, it has little in common with investment.

I'd rather do something that's not such a zero-sum game. If I invest in equities – the businesses are growing; for example, Wrigley's will make more gum. It's automatically working for me, even if I do nothing. But if I invest in currencies, it's not working for me. - Charlie Munger at the 2005 Wesco Annual Meeting

Speculation and gambling are similar in many ways yet they are not the same:

"...I would distinguish between speculative and gambling. Gambling involves, in my view, the creation of a risk where no risk need be created." - Warren Buffett at the FCIC

Buffett contrasts pure gambling -- the taking on of risk that need not be taken on -- with someone who plants a crop early in the year, now has locked in expenses, and needs to speculate on what commodity prices will be late in the year.

The possible price fluctuation represents a real risk that already exists and needs to be managed. That kind of speculation is necessary and very important.

Lions, leopards, and house cats have some similarities but the differences matter.

Gambling, speculation, and investment might also have some similarities but the differences matter.

Investing well requires, among other things, figuring out what something is conservatively worth then buying when the discount becomes meaningful. A margin of safety is what protects against the unexpected and mistakes.

Buying a dollar bill for 50 cents makes permanent capital loss rather a lot less likely. The same goes for buying all or part of a good business at a 50% discount to intrinsic value (again, conservatively estimated) especially since there's the potential for increases to value.

Along the way market prices may fluctuate quite a bit but that, in itself, doesn't necessarily make the asset risky.

Adam

Related posts:
On Speculation and Investment
Bogle on the Financial System
Graham on Investment: "Most Intelligent When It Is Most Businesslike"
John Bogle on Speculation & Capitalism's "Pathological Mutation"
Bogle: Back to the Basics - Speculation Dwarfing Investment
Buffett on Gambling and Speculation
Buffett on Speculation and Investment - Part II
Buffett on Speculation and Investment - Part I

* For simplicity, I'm ignoring frictional costs here though many forms of gambling have huge frictional costs. So it's actually a negative-sum game for the participants putting money at risk (though not for the croupier).
** High returns on capital beats growth for its own sake. Businesses with exciting growth prospects understandably get plenty of attention. The question is (or should be) whether that growth can be achieved in a way that is beneficial to owners. Durable high returns on capital -- whether growing quickly or not -- is what matters. Growth can certainly be a good thing; it's just not inevitably a good thing.
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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.

Forecasting Folly

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

With this Galbraith quote in mind, consider what Professor Daniel Kahneman wrote in an article back in 2011.

In that article, Kahneman explains that he was responsible for evaluating candidates for officer training during his time in the military several decades ago. The methods he and others at the time used were apparently developed by the British Army during World War II. Part of his job was to, after careful observation of potential officers, offer what were thought to be useful predictions about how these candidates were likely to perform in the future. Seems straightforward enough: simply figure out who was clearly qualified and who was not via a sound methodology.

Since certain individuals appeared to have strong leadership skills while others plainly did not, Kahneman (and others) felt quite comfortable making definitive predictions.

Unfortunately, that confidence was unfounded:

"...despite our certainty about the potential of individual candidates, our forecasts were largely useless. The evidence was overwhelming."

In the same article Kahneman also added -- and this might at least partially help explain why prognosticators continue to confidently prognosticate despite the folly of it -- the following:

"The statistical evidence of our failure should have shaken our confidence in our judgments of particular candidates, but it did not. It should also have caused us to moderate our predictions, but it did not. We knew as a general fact that our predictions were little better than random guesses, but we continued to feel and act as if each particular prediction was valid. I was reminded of visual illusions, which remain compelling even when you know that what you see is false. I was so struck by the analogy that I coined a term for our experience: the illusion of validity.

I had discovered my first cognitive fallacy."

If it's difficult to predict how one individual is going to perform, then the inherent difficulty of predicting what will happen with the stock market or something as complex as the global economy shouldn't exactly be a surprise.

Forecasting is tough to do reliably well. This article by Barry Ritholtz puts its more bluntly:

Pro Forecasters Stink, You're Worse

That doesn't stop many from trying to predict what is mostly just not predictable. There is, and there will continue to be, no shortage of experts making forecasts about, among other things, the markets and the economy. Many of them are extremely smart, informed, well-intentioned, credible sounding, and a number even have some interesting things to say.

The problem is that those well-intentioned experts may not necessarily be producing something that's genuinely useful. There naturally will be exceptions but, especially as the forecasts become more macro-oriented, I think it increasingly makes sense to be skeptical. The world has always been an uncertain place and will continue to be that way. Being flexible and open-minded beats rigid certitude.

Expert forecasters will no doubt continue looking into their crystal ball and offer what at least sounds like compelling thoughts about the future.

The fact that they continue to do so with a high level of confidence just might be, at least in part, the "illusion of validity" at work.

Unfortunately, some of us will also likely pay way too much attention to it.

From a separate article written by Ritholtz late last year:

"Despite the abysmal track record of almost all forecasters, the news media still loves them. It has air time and pages to fill and seems little concerned about giving space to money-losing prognosticators.

As I first wrote a decade ago, to forecast is folly. Today, we have Google Search to help us prove it. Pundits may forget, but not the Internet."

At a minimum, it seems like not a bad idea at all to at least pause for a second or two and consider carefully whether someone's predictions deserves any more consideration than the outcome of a coin flip.

Adam

Related posts:
Henry Singleton: Why Flexibility Beats Long-Range Planning
Forecasters & Fortune Tellers
Charlie Munger: Snare and a Delusion
On Forecasting
James Grant on Economic Forecasting

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.

High Returns on Capital vs High Returns on Incremental Capital

The importance of high returns on capital has been covered a number of times in prior posts over the years.*

Well, it's not just the overall return on capital that needs to be considered. Some good businesses can generate very attractive returns on capital but not nearly as much on incremental capital. Naturally, some not so good businesses, whether they are growing or not, don't earn an attractive return on capital on much of anything. In this context, here's what Warren Buffett said about Coca-Cola (KO), See's Candies, and Buffalo News at the 2003 Berkshire Hathaway (BRKa) meeting:**

"The ideal business is one that generates very high returns on capital and can invest that capital back into the business at equally high rates. Imagine a $100 million business that earns 20% in one year, reinvests the $20 million profit and in the next year earns 20% of $120 million and so forth. But there are very very few businesses like this. Coke has high returns on capital, but incremental capital doesn't earn anything like its current returns. We love businesses that can earn high rates on even more capital than it earns. Most of our businesses generate lots of money, but can't generate high returns on incremental capital -- for example, See's and Buffalo News. We look for them [areas to wisely reinvest capital], but they don't exist.

So, what we do is take money and move it around into other businesses. The newspaper business earned great returns but not on incremental capital. But the people in the industry only knew how to reinvest it [so they squandered a lot of capital]. But our structure allows us to take excess capital and invest it elsewhere, wherever it makes the most sense. It's an enormous advantage."

One thing I think gets too little emphasis capital allocation decisions -- and doesn't get challenged nearly enough -- is the probability that the capital needed to pursue incremental growth will produce lousy returns or losses.

Questions like: Is the capital that's being allocated in pursuit of growth likely to produce an attractive rate of return adjusting (qualitatively) for the risks and considering alternatives? Are the range of outcomes narrow or wide? Is the worst case acceptable?

In other words, maybe the company will get bigger -- even impressively so -- but the shareholders end up no richer or even worse off and management ends up with a huge headache. Well, that headache just might lead to a core business that's not getting the attention it needs.

A number of otherwise sound businesses just can't get high returns on incremental capital. So it makes little sense for them to invest for growth. Unfortunately, this reality doesn't necessarily prevent the capital from being allocated imprudently anyway.

Intelligent capital allocation is one of those hard to measure but extremely important contributors to how much per share intrinsic business value will change, for better or worse, over time. Maintaining a comfortable financial position -- one that supports the business even in very difficult economic environments -- and competitive position is all-important. These things interact. Financial strength and flexibility allows the focus to be on creating/enhancing durable competitive advantages over time.

A business with a moat has a long-term competitive advantage.

Buffett calls activities that increase those advantages "widening the moat" and is paramount for investors.

Capital that's allocated to build, or at least maintain, long-lasting competitive advantages should take priority over, well, pretty much everything else.

Buffett on Widening The Moat

Wide Moat Businesses at the Right Price

Investment decision-making should come down to what will produce the highest returns on capital, with all risks and alternatives carefully considered, over the long haul. That, first and foremost, includes incremental investments aimed at protecting and strengthening the existing franchise(s).

The fact is that growth is too often pursued for its own sake and ends up destroying investment returns. As an example, costly and less than successful international expansions comes to mind. Lots of effort and capital put to work that ends up producing subpar results and even losses. Before meaningful capital is put at risk some healthy skepticism isn't the worst thing. Opportunity costs matter. An ill-conceived expansion or acquisition can become an expensive and high risk distraction. On the other hand, growth (whether organic or through acquisition) can at times be both high return while also making the moat wider.***

It's just not inevitably the case.

Some businesses have substantial financial strength along with durable competitive advantages but not much ability to make high return incremental investments. In those cases buying back stock can make a lot of sense if the shares are selling at a plain discount to per share intrinsic value.

From the 1984 Berkshire Hathaway shareholder letter:

"By making repurchases when a company's market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management's domain but that do nothing for (or even harm) shareholders."

The pursuit of dumb growth at the expense of moat widening initiatives should be avoided. This seems like it should be obvious but, even with good intentions, growth initiatives too often end up producing lousy or negative returns at significant risk compared to simply buying back a cheap stock.

Charlie Munger added this at the 2003 Berkshire meeting:

"There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there's never any cash. It reminds me of the guy who looks at all of his equipment and says, 'There's all of my profit.' We hate that kind of business."

There's too much emphasis on growth with the implied or explicit assumption that all growth must be a good thing. Well, growth is just not necessarily a good thing.

There's too little emphasis on returns on capital (incremental or otherwise) and "widening the moat." 

Considering their importance to investors these things still often don't seem to get the attention that's warranted.

Adam

Long position in KO and BRKb established at much lower than recent prices

* Charlie Munger explains it this way: "Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. 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."
** From notes taken by Whitney Tilson.
*** Or, at the very least, does no damage to the existing 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.

Charlie Munger on Focus Investing

Charlie Munger once said:

"Our standard prescription for the know-nothing investor with a long-term time horizon is a no-load index fund."

It's simple.

There's plenty of low cost alternatives available.

Historically, index funds have performed better than the vast majority of active market participants over the longer haul.

So it at least seems a very reasonable prescription for many.

Well, what about those who think they aren't in the "know-nothing" category?

More from Munger:

"You're back to basic Ben Graham, with a few modifications. You really have to know a lot about business. You have to know a lot about competitive advantage. You have to know a lot about the maintainability of competitive advantage. You have to have a mind that quantifies things in terms of value. And you have to be able to compare those values with other values available in the stock market. So you're talking about a pretty complex body of knowledge."

Here's where his thinking gets more than just a bit less than conventional. He also happens to think, for those who are rightly confident and comfortable picking individual stocks, it makes little sense to diversify a whole lot.

"Our investment style has been given a name - focus investing - which implies ten holdings, not one hundred or four hundred. The idea that it is hard to find good investments, so concentrate in a few, seems to me to be an obvious idea. But 98% of the investment world does not think this way." - From Poor Charlie's Almanack

In a 1998 speech, Munger said he has "more than skepticism regarding the orthodox view that huge diversification is a must for those wise enough so that indexation is not the logical mode for equity investment."

So just how far from the "orthodox view" does he think it can make sense to go in some cases?*

"In the United States, a person or institution with almost all wealth invested, long term, in just three fine domestic corporations is securely rich. And why should such an owner care if at any time most other investors are faring somewhat better or worse. And particularly so when he rationally believes, like Berkshire, that his long-term results will be superior by reason of his lower costs, required emphasis on long-term effects, and concentration in his most preferred choices.

I go even further. I think it can be a rational choice, in some situations, for a family or a foundation to remain 90% concentrated in one equity. Indeed, I hope the Mungers follow roughly this course."

That is, to say the least, far from conventional thinking, but the point is that diversification can be overrated.

Munger also once said:**

What's funny is that most big investment organizations don't think like this. They hire lots of people, evaluate Merck vs. Pfizer and every stock in the S&P 500, and think they can beat the market. You can't do it. Very few people have adopted our approach.

Now, the amount of portfolio concentration described above probably will likely be too extreme for most investors. It not only requires, after paying at least a fair price, having enough justified confidence in a very limited number of equities, it requires confidence that they will remain fine businesses long-term (and, as a result, will increase in per share value at a satisfactory rate).

So a concentrated portfolio becomes a recipe for real trouble for those who overestimate their own investing abilities. As always, it comes down to an awareness of limitations.

I think correctly judging which end of the spectrum -- with owning index funds being at one end, and owning a very limited number stocks at the other end -- is closer to the right approach for someone is easier said than done. At least it is based upon how poorly so many market participants have historically performed compared to the market overall.

At some level it comes down to knowing what you know and don't know.

Am I actually good at picking stocks?

Or am I getting into something I'm likely to not do very well?

It seems pretty clear that many don't quite get the answer to these kind of questions right. Too many think they're good at picking individual stocks and end up learning the hard way that they're just not; they attempt to outdo the market averages and, well, just don't in the long run. Lots of energy expended doing something that produces a result that's less than, all risks considered, what could have been accomplished simply buying a low-cost index fund (and learning to ignore the noise).

The reality seems to be that there are lots of active stock pickers --  some professional, some not -- who would be plainly better off NOT owning individual stocks. For these investors, index funds would not only improve long-term returns, they'd offer the bonus of additional free time to do something else more fruitful. I mean, the reality is that individual stocks often require a whole lot of work whether or not results turn out to be satisfactory.

Some might choose to think of an index fund as a way to simply match the "market average". Well, the word average is a distraction in this case. It turns out that, while it might called a "market average", it has hardly been an average result once frictional costs and mistakes are taken into account.
(i.e. If the vast majority of active participants are underperforming, then that by definition means simply matching the average is an outperformance. The word average in this context seems unfortunate.)

Now, it's worth pointing that index funds will only work if they're left alone over the long haul as the market (or individual stocks) goes through the inevitable -- occasionally rather wild -- fluctuations.

So fund investor behavior is a big factor and too often it is a negative one.

Unfortunately, it's the well-intentioned temptation to jump in and out of investments that too often contributes to bad outcomes. In other words, those fluctuations should either serve or be ignored. It's also worth pointing out that future expectations for long-term returns should probably be much reduced compared to the historic norms. Those who don't temper their long-term return expectations for the market as a whole going forward just might end up being rather disappointed.

As far as I'm concerned, though forecasters and fortune tellers will no doubt keep trying to prove otherwise, it's nearly impossible to know what's likely to happen in the future. The world for investors always has been, and always will be, an uncertain place. This reality need not adversely impact investment performance but too often that's exactly what happens. There's just no point in trying to foresee the mostly unforeseeable. Yet that doesn't stop smart people from wasting way too much energy trying to do just that. Instead of focusing on what's in their control (price paid, estimates of value, emotions, etc.) they focus on those things they mostly control or reliably predict.

I'll take someone any day who just says "I don't know" what an individual stock or the market as a whole is likely to do (near-term and even much longer) over those who are willing to make prognostications. Better to just expect difficult market conditions from time to time and realize that those difficulties may look nothing like those of the past; maintain reasonable but conservative expectations then end up pleasantly surprised if things go a bit better.

Also, having a flexible approach doesn't hurt.

Effectively picking individual stocks doesn't just come down to whether an individual possesses the necessary background technical abilities, it just as often comes down to psychological factors. For starters, it's not a bad idea to consider overconfidence the greatest enemy of all for investors. More generally, investing well means having a realistic sense of limits, abilities, and characteristics. Those that possess an ability to be sensible and long-term oriented when the markets become emotionally-charged from time to time (and they surely will!) have a big advantage.

So index funds, individual stocks, or some combination can be a logical approach depending on circumstances, skill set, and temperament (among other things). There is also, of course, a number of very capable active fund managers. It's one thing to identify who has done well in the past but it's much tougher to identify who will do well, over the long run, going forward.

In any case, no matter what the necessarily-unique-for-each-investor approach might be, lots of trading activity will likely do more damage (via additional mistakes and frictional costs) than good to long-term results. In other words, it's buying what makes sense consistently, trading minimally, then allowing those investments to compound over many years. The emphasis being on what's produced over time. Price and value should dictate investor action; market price action should not. Again, how prices fluctuate near-term or even longer should either serve the investor or be ignored.

Unfortunately, stocks are hardly cheap these days. So, for those with a long enough time horizon, a rising market is the last thing they should want right now. A rising market would make what is not particularly cheap even less so. More risk; less potential reward.

Whatever approach happens to make sense a very long time horizon is essential. Investment requires that the capital won't be needed anytime soon. Think decades not years.***

I'd add that who offer opinions on and attempt to understand hundreds of different stocks (and other investments) aren't acting in a way that's likely to produce great overall results. At least not for most of us mere mortals. Some skepticism seems in order for those who confidently offer a view on practically every investment alternative.

To me, the expert who frequently says "I don't know" when asked a question deserves credit instead of criticism. Though in itself insufficient, it's at least one indication that they're aware of their limitations.

Investment results are heavily influenced by the avoidance of big mistakes (i.e. permanent loss of capital that's substantial relative to the portfolio being managed). It's not that mistakes won't be made. In fact, they're unavoidable even for those who are very capable. The key is that they're kept small in relation to the overall portfolio. The possibility of a big gain should take a back seat the risk of permanent losses. Sticking with what you really know goes a long way towards this.

It's worth noting that Berkshire Hathaway's (BRKa) current size (and other factors) doesn't allow it concentrate the way it once did.

Still, if you look at the Berkshire equity porfolio, most of the dollars are invested in just five stocks.

It's also worth mentioning that, other than Berkshire's portfolio, the other (much, much, much smaller) portfolio that Charlie Munger apparently has some influence over these days is, I think it's fair to say, rather concentrated.

It's very much consistent with what Munger said above.

Adam

Long position in BRKb established quite a while back at much less than recent market prices. No intent to buy or sell near current prices.

Related posts:
The Seventh Best Idea
Index Fund Investing Revisited
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
Investor Overconfidence Revisited
Investor Overconfidence
Charlie Munger: Focus Investing and Fuzzy Concepts
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again

* Munger also once said: "The academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification. Because I just think the whole concept is literally almost insane. It emphasizes feeling good about not having your investment results depart very much from average investment results. But why would you get on the bandwagon like that if somebody didn't make you with a whip and a gun?"
** This Charlie Munger comment comes from notes taken by Whitney Tilson.
*** Returns measured over time frames like two to three years or less are essentially coin flips. I'd argue five years is the absolute minimum and more like ten to twenty years or longer should be the focus.
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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.

Quotes of 2014 - Part II

Some additional quotes from 2014 as a follow up to this recent post.

Quotes of 2014

In the quote below, Buffett explains why liquidity sometimes is converted into a curse when it should be a clear advantage:

Buffett on Farms, Real Estate, and Stocks - Part II

"Stocks provide you minute-to-minute valuations for your holdings whereas I have yet to see a quotation for either my farm or the New York real estate.

It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings – and for some investors, it is. After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his – and those prices varied widely over short periods of time depending on his mental state – how in the world could I be other than benefited by his erratic behavior? If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.

Owners of stocks, however, too often let the capricious and often irrational behavior of their fellow owners cause them to behave irrationally as well. Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits – and, worse yet, important to consider acting upon their comments.

Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of 'Don't just sit there, do something.' For these investors, liquidity is transformed from the unqualified benefit it should be to a curse." - Warren Buffett

He then explains how both he and Charlie Munger like to think about stocks:

"When Charlie and I buy stocks – which we think of as small portions of businesses – our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out, or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings – which is usually the case – we simply move on to other prospects. In the 54 years we have worked together, we have never foregone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions.

It's vital, however, that we recognize the perimeter of our 'circle of competence' and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses." - Warren Buffett

Here's Charlie Munger's take on some of the boardroom dynamics that can cause compensation to end up being less than optimal for shareholders:

Buffett & Munger on Compensation - Part II

"You start paying directors of corporations two or three hundred thousand dollars a year, it creates a daisy chain of reciprocity where they keep raising the CEO and he keeps recommending more pay for the directors..." - Charlie Munger

He also explained why lots of disclosure regarding executive compensation is not necessarily the best thing for shareholders:

"I think envy is one of the major problems of the human condition... And so I think this race to have high compensation because other people do, has been fomented by all this publicity about higher earnings. I think it's quite counterproductive for the nation. There's a natural reaction to all this disclosure because everybody wants to match the highest." - Charlie Munger

In a memo written by Howard Marks back in September of 2014, he offered some thoughts about the various forms of risk. It is, to say the least, rather comprehensive. In my view, the memo is well worth reading -- not at all surprising since it is written by Marks -- in its entirety.

Some thoughts from Marks on risk:

Howard Marks on Risk

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

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

"...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." - Howard Marks

Here's how Buffett and Munger view macro factors in the context of investing:

Buffett: We Ignore the Macro Factors

"We look at opportunities, as they come along, we try to figure whether we can understand the long term economic prospects of the business. A lot of times the answer is no, then we forget it. We are not making any judgment about where the market is going or we are not looking at any macro factors.

My partner Charlie Munger and I have been working together now 55 years. We've talked about every business you can imagine and stocks. We have never had one decision that involved a macro factor. It just doesn't come up." - Warren Buffett

Buffett then added:

"We don't get into macro. It just doesn't make any difference. We do decide whether we think we know where that business will be in 10 years or 20 years, and we know what we'll pay in terms of valuation." - Warren Buffett

More from Buffett on why liquidity can become a curse when it really should not be:

The Curse of Liquidity

"...if you are buying a business to own...the idea of what the market does on any given day, it's just meaningless. What you really have to look at is where you expect the business to be 5 or 10 or 20 years from now." - Warren Buffett

That's how most will think about businesses that aren't traded daily but, because stocks are quoted so frequently, behavior is changed for the worse.

 "...you can look at stock prices minute by minute. And that should be an advantage but many people turn it into a disadvantage." - Warren Buffett

Happy New Year,

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.

Quotes of 2014

A collection of quotes said or written at some point during this calendar year.

In a review of the book: Fortune Tellers, James Grant offered the following on the limitations of forecasting and predictions:

Henry Singleton: Why Flexibility Beat Long-Range Planning

"Henry Singleton (1916-99), longtime chief executive officer of the technology conglomerate Teledyne Inc...understood the limits of forecasting. Once a Business Week reporter asked him if he had a long-range plan. No, Singleton replied, 'we're subject to a tremendous number of outside influences and the vast majority of them cannot be predicted. So my idea is to stay flexible.' His plan was to bring an open mind to work every morning." - James Grant

Some thoughts from Warren Buffett on Berkshire Hathaway's (BRKa) intrinsic value and buybacks:

Intrinsic Value

"As I've long told you, Berkshire's intrinsic value far exceeds its book value. Moreover, the difference has widened considerably in recent years. That's why our 2012 decision to authorize the repurchase of shares at 120% of book value made sense. Purchases at that level benefit continuing shareholders because per-share intrinsic value exceeds that percentage of book value by a meaningful amount. We did not purchase shares during 2013, however, because the stock price did not descend to the 120% level. If it does, we will be aggressive.

Charlie Munger, Berkshire's vice chairman and my partner, and I believe both Berkshire's book value and intrinsic value will outperform the S&P in years when the market is down or moderately up. We expect to fall short, though, in years when the market is strong – as we did in 2013. We have underperformed in ten of our 49 years, with all but one of our shortfalls occurring when the S&P gain exceeded 15%." - Warren Buffett

Sometimes, the ability to calculate extremely well can be an obvious advantage yet also a blind spot. Earlier this year, in a review of the book Brilliant Blunders, Freeman Dyson offered up Lord Kelvin as an example. Dyson describes "Kelvin's wrong calculation of the age of the earth" as resulting from "blindness to obvious facts." He attributes the misjudgment, at least in part, to Kelvin's exceptional math skills. In other words, too much focus on what can be calculated without due consideration for other, more important, less quantifiable factors can lead to avoidable misjudgments/incorrect conclusions. This can be as relevant to investment decision-making as it is to the development of scientific theory.*

On the downside of calculating too much:

Intrinsic Value

"Kelvin lacked our modern knowledge of the structure and dynamics of the earth, but he could see with his own eyes the eruptions of volcanoes bringing hot liquid from deep underground to the surface. His skill as a calculator seems to have blinded him to messy processes such as volcanic eruptions that could not be calculated." - Freeman Dyson

Here's Buffett on some of the fundamental elements of investing:

Buffett on Farms, Real Estate, and Stocks

"You don't need to be an expert in order to achieve satisfactory investment returns. But if you aren't, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don't swing for the fences. When promised quick profits, respond with a quick 'no.'" - Warren Buffett

"Focus on the future productivity of the asset you are considering. If you don't feel comfortable making a rough estimate of the asset's future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility. But omniscience isn't necessary; you only need to understand the actions you undertake." - Warren Buffett

"If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so. Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game." - Warren Buffett

"Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays." - Warren Buffett

"...macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle's scathing comment: 'You don't know how easy this game is until you get into that broadcasting booth.')" - Warren Buffett

Below, Warren Buffett and Charlie Munger offer some views on retail businesses:

Buffett and Munger Talk Retail Businesses, Nebraska Furniture Mart, and Amazon

MUNGER: I think Warren and I can match anybody's failures in retail.

BUFFETT: Yeah, we have a really bad record, starting in 1966. We bought what we thought was a second-rate department store in Baltimore at a third-rate price, but we found out very quickly that we bought a fourth-rate department store at a third-rate price. And we failed at it, and we failed...

MUNGER: Quickly.

BUFFETT: Yeah, quickly. That's true. We failed other times in retailing. Retailing is a tough, tough business, partly because your competitors are always attempting and very frequently successfully attempting to copy anything you do that's working. And so the world keeps moving. It's hard to establish a permanent moat that your competitor can't cross. And you've seen the giants of retail...a lot of giants have been toppled.

MUNGER: Most of the giants of yesteryear are done.

More specifically, here's how they view Amazon (AMZN):

MUNGER: Well, I think it's very disruptive compared to everybody else, I think it's a formidable model that is going to change America.

BUFFETT: I agree. It's one of the most powerful models that I've seen in a lifetime, and it's being run by a fellow that has had a very clear view of what he wants to do, and does it every day when he goes to work, and is not hampered by external factors like people telling him what he should earn quarterly or something of the sort. And ungodly smart, focused. He's really got a powerful business, and he's got satisfied customers. That's hugely important.

More in a follow-up.

Adam

Long position in BRKb established at much lower prices. No position in AMZN.

Quotes of 2013 Part I & II

* Here's how Charlie Munger explained it at the 2002 Wesco annual meeting: "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."

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.

Should Buffett Buy Uber?

A recent Fortune article made the case for something that at first glance seems rather unlikely. In it, Dan Primack argues that Warren Buffett should consider buying Uber. With this in mind and for context, let's look at some things Buffett has written over the years. Back in 2007, Berkshire Hathaway's (BRKa) four largest equity investments were Coca-Cola (KO) Wells Fargo (WFC), American Express (AXP), P&G (PG).

Here's what he had to say about those investments:

"...note that American Express and Wells Fargo were both organized by Henry Wells and William Fargo, Amex in 1850 and Wells in 1852. P&G and Coke began business in 1837 and 1886 respectively. Start-ups are not our game." - From the 2007 Berkshire letter

Three of those stocks remain top four holdings. More recently (over the past five years or so) some of Buffett's bigger purchases -- everything from partial ownership via equities to outright acquisitions -- have included things like Burlington Northern Santa Fe, Lubrizol, IBM (IBM), Heinz, Exxon Mobil (XOM), and Duracell. The youngest of these businesses is 86 years old. So, to say the very least, Buffett generally likes businesses with a very long track record that are less likely to experience major change* -- especially the kind of change that fundamentally alters the core business economics -- going forward.

"In studying the investments we have made in both subsidiary companies and common stocks, you will see that we favor businesses and industries unlikely to experience major change. The reason for that is simple: Making either type of purchase, we are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek." - From the 1996 Berkshire letter

So Uber would be a rather significant break, I think it's fair to say, from Berkshire's traditional approach.  Startups -- even very successful ones -- that compete in a rapidly changing environment isn't usually a part of the Berkshire playbook. Yet you never know. If the price was right, maybe something that now seems rather improbable could suddenly make a whole lot of sense.

The fact is that there have been many great businesses launched -- and Uber just might prove to be one of them though, at this point, I have no idea -- during the period that Buffett has been managing Berkshire (roughly five decades).

Berkshire's success over that time -- a 693,518% total return through the end of last year -- has essentially come from none of them.**

Many more great businesses will no doubt be created in the coming decades.

It seems likely they also won't be contributing much to Berkshire's intrinsic value going forward.

If nothing else, Berkshire's approach shows that attractive investment results do not necessarily depend on some unusual acuity for finding the next big thing. Exciting growth prospects and dynamic change might, in fact, offer the possibility for big investment gains. The problem is they also sometimes offer the chance to lose a whole lot of money. Big wins and big losses usually reside in the same neighborhood. They can be tough to reliably tell apart beforehand without making large mistakes.

This is not only due to unpredictable future prospects and a wide range of possible outcomes; this is also because the price one usually has to pay upfront for the most promising businesses is rather high.

Insufficient margin of safety.

Of course, some might be able to reliably pick the big winners, but it's easy to underestimate how difficult this is to do without also incurring big losses.

That may offer a more exciting ride but it's the net result, in the context of risk, that matters.

Owning businesses that can maintain attractive economics for decades, bought at a reasonable price or, better yet, at a meaningful discount to a conservative estimate of value, isn't a bad way to balance risk and reward. Exciting growth prospects not required.

Almost any business -- even a very good one -- will eventually experience real difficulties and unexpected challenges. Buffett's approach is, in part, an attempt to reduce the likelihood that investment results will be ruined by what are almost inevitable future business challenges.

"It's vital, however, that we recognize the perimeter of our 'circle of competence' and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses." - From the 2013 Berkshire Hathaway letter

So, even with such an approach, mistakes will still get made.

Just because a particular business has succeeded for a very long time guarantees absolutely nothing.

Adam

Long positions in all common stocks mentioned excluding XOM

* This is not meant to be an all-inclusive list of Berkshire's more recent investment activity but, instead, just some good examples of the larger moves that have been made. Burlington Northern's historical lineage dates back to the late 1840s. Heinz was founded in 1869. Exxon was formed in 1870. IBM was founded in 1911. Duracell began in 1916. Lubrizol was founded in 1928. The names may have changed over time but all of these go back quite a ways. Naturally, all of these businesses have dealt with change over time but the question is how likely those changes will damage business economics. IBM would seem to fit the least well when it comes down to whether its business is likely to experience major change going forward. The Heinz investment is made up of common stock, warrants, and preferred shares. Berkshire also made a large investment in Bank of America (BAC) preferred stock and warrants. It won't be clear for some time how much BofA common stock Berkshire will end up owning though at this point it appears that it will be substantial. Once again, the bank isn't exactly a startup.
** This total return over five decades or so means that $ 10,000 invested in Berkshire would have grown to just under $ 70 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.

Wide Moat Businesses at the Right Price

For equity investors, it's not enough that a business currently possesses real competitive advantages if those advantages can't be sustained and, better yet, even strengthened over time.

Warren Buffett explained it this way in the 2007 Berkshire Hathaway (BRKa) shareholder letter:

"A truly great business must have an enduring 'moat' that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business 'castle' that is earning high returns."

An enduring 'moat' can come from things like an ongoing cost advantage or a strong brand that creates pricing power. Buffett later adds:

"Our criterion of 'enduring' causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism's 'creative destruction' is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all."

That the 'moat' remains robust -- and, in fact, is made even stronger -- requires that management isn't too distracted by short-term goals in lieu of what Buffett calls 'widening the moat'. A management who chooses the former over the latter can do real and permanent damage.

From the 2005 letter:

"Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous.

When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as 'widening the moat.'"

A business might currently have -- or appear to have -- a decent (or better) competitive advantages, but what those advantages will look like further down the road is questionable or difficult to understand. Well, big investment mistakes can get made when that's the case. If the moat that now exists will be meaningfully reduced, or worse, disappear altogether, then the estimate of intrinsic value has a great chance of being very wrong. When attractive core economics today become much less so later on, misjudgments regarding current valuation -- and how valuation will change over time -- are more likely. An unreliable moat means that, as time passes, future free cash flows become increasingly uncertain. The result possibly being poor investment results or even permanent capital loss.

Exciting growth rates may not prove to be worth much if the moat collapses sooner than expected.

So quality businesses are those with advantages that are obvious, sustainable, and can be strengthened by competent management over time. A management who knows how to enhance whatever advantages exist, smooth out the important imperfections, and ultimately make the business tougher to dislodge from what is already an enviable position, can create a lot of long-term value.

The very best businesses can comfortably withstand mediocre (or worse) business leadership from time to time even if some real, at the very least temporary but possibly permanent, economic damage is caused by their actions (and maybe inactions).

Yet, as always, shares of even the best business needs to bought at a large enough discount to value to protect the investor from what is necessarily an uncertain future.

How price compares to a conservative estimate of value is one way -- though this has its limits -- to manage the unknown and often unknowable future risks. Always buying at a comfortable discount -- and what will be comfortable is necessarily stock specific -- protects, up to a point, against what might go wrong. Most of the time it's just not possible for me to come up with a reliable estimate of per share valuation for a particular stock. Well, at least not within a narrow enough range. This could be due to my own limitations or the characteristics of the business itself.

Either way, the right course of action will always be to stay well clear of any investment alternative where per share value within a range isn't obvious. The good news is that the investor always has the option of moving onto something else that's more understandable. For most stocks, it is simple avoidance that will be the way to go. The possibility of permanent capital loss is best reduced by paying an appropriately discounted price, considering the specific risks, for well understood businesses where per share intrinsic value can be estimated with high levels of confidence.

Buying the highest quality businesses -- those that generally have the very widest moats -- feels safer and certainly can be. At least that's the case if the price is right. In the late 1990s -- as well as with the so-called Nifty Fifty of the early 1970s -- some very good businesses became riskier to buy simply because of the extremely high prices relative to per share intrinsic value. Many still produced good investment results over the very long run but, since none of us have the luxury of investing with a rear-view mirror, paying such high prices did not offer much protection against what might go wrong. Just because it worked out that time tells you nothing about what's in store in the coming decades.

That's why margin of safety is such a fundamental investing principle.

In a 2007 memo, Howard Marks wrote the following:

"...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."

Shares of a merely decent business -- one with a moat though it may not be particularly wide -- bought at a huge discount to intrinsic value can actually be safer than the best businesses selling at a substantial premium. Still, all else equal and with the long-term in mind, I'd generally rather buy the higher quality businesses at merely reasonable prices than the lesser businesses with seemingly much bigger discounts. It's a matter of balancing the risk of permanent loss with potential reward.

The more uncertain something is, the bigger the discount to value one should pay. The tough part is that it's impossible to quantify all the risks. Judgment calls have to be made without precise numbers to rely on.

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

I mentioned above that price has its limits when it comes balancing risk and reward. At times, the worst case scenario is so unacceptable that avoiding an investment with otherwise lots of potential upside is the right course of action. In other words no price will be low enough.

Later in the same memo, Marks offered the example of not wanting to be a skydiver who's successful just 95% of the time. With this in mind I added the following in a prior post:

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.

Otherwise, the price paid often dictates the risks that are taken. If a high quality business is selling at 50x earnings -- or maybe even 100x earnings -- it is possibly far riskier than a decent business with some real challenges and little or no growth selling at 5x normalized earnings. The decent business may lack a compelling 'story' but, then again, the 'story' is often just a distraction from what really matters when it comes to investment risk and reward.

Again, this works only up to a point because many moat-less businesses are to be avoided altogether -- because of the worst case downside -- no matter how cheap they seem to be.

Notice that growth hasn't been mentioned at all. Growth can be an important ingredient but it is just not necessarily an important ingredient.

Adam

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

Related posts:
Howard Marks on Risk
Risk and Reward Revisited
Buffett on Risk and Reward
Nifty Fifty - Part II
Nifty Fifty
Buffett on Widening the Moat

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.