Competition & Moats

At the 2014 Daily Journal (DJCO) shareholder meeting Charlie Munger said:*

How many big companies stay totally on top forever? Maybe Wrigley's Gum.

Then later added...

It's a competitive world out there. Somebody is always starting something. Even for the branded goods makers, who looked so invincible for forty years. The natural course of competition is that it gets tough. It's the people who expect everything to just keep going wonderfully who are nuts.

So at least some of these businesses are not quite as bulletproof as they used to be. Part of the challenge, at least in certain cases, is coming from private-label alternatives.

Munger, back in 2013 (see pages 26-27), specifically mentioned Costco's (COST) private-label offering, Kirkland toothpaste, as an example of one threat.

Costco got one of the major toothpaste manufacturers of the world to make their toothpaste in Costco's tube at a very low price.

He also mentions the threat of Amazon (AMZN).

It's also possible for a new entrant to reach customers in an economically viable way that didn't really exist a couple decades ago. So enough scale to reach a big audience becomes less of an advantage.

What makes the situation even more challenging these days for investors is market valuation levels (even after the recent capital markets turmoil). Many of the consumer packaged goods businesses have gone from having reasonable equity valuations several years ago to fully valued and, in some cases, even expensive.**

That also doesn't mean they've, in general, suddenly become terrible businesses. Hardly. Some continue to have some very wide and likely rather sustainable moats. The very best of the small ticket branded goods makers appear to still have very sound businesses even if somewhat less so than the past several decades. Yet, like anything else, the price paid matters and right now few, if any, seem to be selling at a meaningful discount to per share intrinsic value.

I think Charlie Munger's point, more generally, is an essential one for just about any investor. No matter how good a business has been in the past, it's necessary to carefully consider how competition, technology, regulations, and customer behavior (among other things) could end up altering the core economics of a business over time.

The competitive position of any business -- and how it might be changing -- is an all-important consideration for equity investors. Most of what matters won't necessarily -- well, at least not early enough to be useful -- show up in the numbers. So financial statements and complex spreadsheets likely won't offer much insight. Sometimes, what matters most can't be measured in a meaningful way. It ends up being more about the qualitative factors.

In other words, an investor mostly won't be able effectively anticipate changes by simply looking at what can be quantified precisely.

What was once a wide moat can become much reduced, or even disappear altogether, over time. Sometimes it happens quickly; other times it's more of a slow degradation. The key is finding those businesses with very substantial and sustainable moats run by managers focused on making those moats more formidable.

Warren Buffett once said:

"We like to own castles with large moats filled with sharks and crocodiles that can fend off marauders -- the millions of people with capital that want to take our capital. We think in terms of moats that are impossible to cross, and tell our managers to widen their moat every year, even if profits do not increase every year."

Notice that moat widening is given priority over near-term profits.

It's NOT necessarily about growth unless that growth happens to be the high return variety over the longer run.***

It's buying, at the right price, shares of businesses with high returns on capital that will likely prove sustainable.

It's NOT just about returns.

It's finding sensible ways to reduce the risk of permanent capital loss.

Adam

No position in DJCO, COST, or AMZN

* From some excellent notes that were taken at the meeting. These notes, presented in four parts, are well worth reading. Not a transcript.
** Warren Buffett recently talked about valuation levels, speaking specifically about the larger food companies, while on CNBC. He clearly doesn't see them as inexpensive these days. Of course, the fact that they may be not at all cheap reveals little or nothing about what the near or intermediate term price action might be.
*** Not all growth is good growth for investors. Growth is but one component of value that -- while sometimes a positive -- is not necessarily a positive, though some seem to assume that's the case. There are slow growth businesses that produce attractive investment results and fast growth businesses that do not. Some of this comes down to the price paid upfront but that's only part of the story.
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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 2015 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.)

Added to Existing Positions
U.S. Bancorp (USB): 1.3 mil. shares (1.5% incr.); tot. stake $ 3.69 bil.
Charter (CHTR): 2.5 mil. shares (42%); tot. stake $ 1.46 bil.

I've included above only those positions worth at least $ 1 billion at the end of the 2nd quarter. In a portfolio this size -- roughly $ 244 billion (equities, fixed income, cash, and other investments) as of the latest available filing with roughly half made up of common stocks** -- a position that's less than $ 1 billion doesn't really move the needle much.

One brand new position was also added during the quarter.

New Position
Axalta (AXTA): 20 mil. shares; tot. stake $ 662 mil.
(Previously announced.)

Not all of the activity has been disclosed. In the 2nd quarter of 2015, apparently some activity was kept confidential. Berkshire's latest filing says: "Confidential information has been omitted from the public Form 13F report and filed separately with the U.S. Securities and Exchange Commission."

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.

Reduced Positions
Positions that were reduced somewhat but not sold outright include WABCO (WBC), Chicago Bridge & Iron (CBI), and Viacom (VIAB) with each worth less than $ 1 billion.

Sold Positions
Positions that were sold include National Oilwell Varco (NOV) and Phillips 66 (PSX).

Todd Combs and Ted Weschler are responsible for an increasingly large number of the moves in the Berkshire equity 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) = $ 26.4 bil.
2. Coca-Cola (KO) = $ 15.7 bil.
3. IBM (IBM) = $ 12.9 bil.
4. American Express (AXP) = $ 11.8 bil.
5. Wal-Mart (WMT) = $ 4.28 bil.

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 fixed maturity securities, cash and cash equivalents, and other investments.

The portfolio excludes all the operating businesses that Berkshire owns outright with ~ 340,000 employees (25 being at headquarters) according to the latest letter.

Here are some examples of Berkshire's 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, and Oriental Trading Company.
(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 125 of the 2014 annual report for a full list of Berkshire's businesses.

Adam

Long positions in BRKb, WFC, KO, AXP, USB, WMT, and PSX established at much lower than recent market prices. Also, long position in IBM established at slightly higher than recent market prices. (In each case compared to average cost basis.)

* All values shown are based upon the last trading day of the 2nd quarter.
** Berkshire Hathaway's holdings of ADRs are included in the 13F. What is not included are shares listed on exchanges outside the United States. The status of those shares, if a large enough position, 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 is if Berkshire buys the ADR. Investments in things like preferred shares (and valuable warrants, where applicable, as explained in the recent letters) are also not included in the 13F. The same has been true for not only the Heinz (now Kraft Heinz) preferred shares, but also the common shares. A deal to combine Kraft and Heinz was announced earlier this year and closed on July 2nd, 2015. So, as a result, Berkshire will now own roughly 26.9% of the combined Kraft Heinz Company (KHC) with the stake being accounted for using the equity method. See Note 7 of in Berkshire's latest 10-Q for additional details. The investment will now represent one of Berkshire's largest positions.
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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.

Activists & the AmEx Buyback, Part I

On Friday of last week, the news broke that ValueAct Capital Management, an activist hedge fund, had taken a stake in American Express (AXP).

Some might think, since the stock rallied right after the announcement, that this should be received as good news by AmEx shareholders.

Clearly, for a trader (or someone who intends to sell their AmEx shares in near-term) that's understandably the case.

Yet a long-term investor in the stock shouldn't necessarily view this development as being a good thing. At most, until more is known, it logically deserves a more mixed reaction.

This has nothing specifically to do with ValueAct. They may be very good at what they do and, depending on their intentions and capabilities, could even prove helpful to AmEx's prospects over the long run.

Then why should the reaction be more mixed? Well, consider that the company has already announced it intends to repurchase "up to $6.6 billion of common shares during the period beginning in Q2 2015 through and including Q2 2016."

When a company is repurchasing stock in a meaningful way -- and for one with a market value just over $ 80 billion I think buying $ 6.6 billion of its stock over 5 quarters or so qualifies -- no long-term owner should be happy about the shares rallying. It simply means that, if the recent rally in price proves persistent (or worse...goes higher), the funds used in the AmEx buyback program will go less far and, as a result, the share count will drop by a smaller amount.

Plainly, all else equal, that is not a good thing for the long-term owner.

Also, if the rally were to continue higher, at some point the price might become such that it makes no sense to continue buying back the shares (i.e. as the price gets closer to per share intrinsic value). Again, that further rally might satisfy those who are in for the short haul but makes little sense for those who plan on being continuing owners of AmEx shares for a long time.*

It comes down to this: shareholders who prefer for their investment outcomes to be driven by what the business can produce in excess cash over decades will, inevitably, have a very different agenda than those who emphasize profiting from price action. Of course, the long-term investor will eventually want to see the share price at least roughly track changes in per share intrinsic value. It's just that a delay in the recognition can be hugely beneficial.

AmEx repurchased roughly $ 1.2 billion during Q2 2015. Not quite on pace for $ 6.6 billion but reasonably close. At least for now it appears they are following through on the plan.

Yet that's not what's most important. While sometimes a buyback plan will not become reality, it's the reason they don't become reality that matters.

Buybacks can make sense when both a stock is cheap -- i.e. selling at a nice discount to per share intrinsic value -- and available funds are more than sufficient to meet all the operational/liquidity needs of the business.

Well, at times, a buyback program will continue to be implemented even if one or both of these things no longer proves true.
(Worse yet is a buyback plan that's been put in place for the wrong reasons and is then implemented.)

Unfortunately, buyback announcements like this aren't always followed by wise action based upon changing circumstances.

How price compares to value and business needs (and how these things change over time) must be considered. Rigidity, at least when it comes to buyback programs but also more generally, isn't a virtue.

In business and investing flexibility often wins.

In other words, it's possible that circumstances will develop such that what was once a well-intentioned buyback plan shouldn't be implemented.

Back in May of this year, Warren Buffett spoke on CNBC about activist investors in the context of it's largest holdings (of which AmEx is one).

Keep in mind that he said the following well before ValueAct decided to invest in AmEx:

"I think it'd be very silly for an activist to come in and say double your dividend today or buy in a whole lot more stock or whatever it might be they would be proposing. I think the companies are well run and I think their financial policies are sound."

He added that when you have "a well-run company, the best thing to do is just to sit back and enjoy it."

Naturally, this doesn't mean ValueAct won't ultimately end up having a positive effect.

They just may.

We'll see in due time what kind of activist role, if any, they intend to play.

More in a follow-up.

Adam

Long position in AXP established at much lower than recent prices

Related posts:
Activists & the AmEx buyback, Part II (follow-up)
Altria: Price Matters
Multiple Expansion, Buybacks, & The P/E Illusion
The P/E Illusion
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?

* Some might argue the long-term owner could simply sell and either wait for a better price to buy again or invest elsewhere. That approach sounds better in theory than it is in practice. When shares sell at a substantial premium to value or, for example, when opportunity costs are high there are times selling will be warranted. Yet, at least for me, this kind of behavior can be a recipe for unnecessary mistakes. There's usually a limit to the number of businesses one can understand well. Better to own some good businesses -- at least those bought at a discount and understood well -- for a very long time. Minimize frictional costs; minimize mistakes.
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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.

What's Gold Intrinsically Worth?

For roughly a decade, starting in 2001, gold prices performed extremely well.

So fans of the yellow stuff will rightly point to that fact.

I'll say upfront that I have just about zero interest in owning gold or any other nonproductive asset. Yet I'm certainly familiar with some of the arguments that are made for owning gold. As is often the case, Jim Grant is thoughtful on the subject of gold (and many other things related to finance and financial history) and worth paying attention to whether or not you happen to agree with him.

Grant points out that the dollar -- and this clearly applies to other paper currencies -- has "no intrinsic value" and is "faith-based."

Can't really argue with that but I think Jeremy Grantham makes a fair point when he says:

"...just as Jim Grant tells us (correctly) that we all have faith-based paper currencies backed by nothing, it is equally fair to say that gold is a faith-based metal. It pays no dividend, cannot be eaten, and is mostly used for nothing more useful than jewelry."

Grant does, in fact, think it makes sense to own gold recently calling it "an investment in financial and monetary disorder."

He also makes his case for a return to the gold standard.

"...the existing monetary arrangements are so precarious, so ill-founded and so destructive of the economic activity they are supposed to support and nurture, that they will be replaced by something better."

For Grant, that'd be a monetary system directly linked to the quantity of gold that can be dug up over time.

Those who share these views (and similar ones) may even prove to be right.

I certainly agree that a paper currency, even under the very best of circumstances, is likely -- if not certain -- to diminish in value over the longer haul. Inflation of some kind or another should erode the purchasing power of just about any currency over time whether or not there is a full-blown currency crisis.

The question is what to do about it.

I think that Grantham has it essentially just about right:

"I believe that resources in the ground, forestry, agriculture, common stocks, and even real estate are more certain to resist any inflation or paper currency crisis than is gold."

For me, the problem has been and remains estimating what gold is intrinsically worth.

Unlike a high quality business it doesn't produce any cash.

Gold's value is perceived, or maybe relative, but it's not intrinsic.

Jason Zweig explains it this way:

"...you will put lightning in a bottle before you figure out what gold is really worth."

WSJ: Let's Be Honest About Gold: It's a Pet Rock

Without a stream of free cash flow how can what something is intrinsically worth, if anything, be known within a narrow enough range?

Warren Buffett, much like Grantham, also suggests that productive assets* are the way to go: "Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor" to buy something like their favorite soda or candy.

Investing in a productive asset is very different than attempting to guess what someone else will be willing to pay for a lump of metal down the road. Here's what Buffett once said on CNBC:

"...it is an entirely different game to buy a lump of something and hope that somebody else pays you more for that lump two years from now than it is to buy something you expect to produce income for you over time."

Some may know (or think they know) where the price of gold is headed.

I have no idea and never will.

In fact, I'll never spend a moment trying to guess such a thing.

Zweig writes the following about those who are the truest believers -- the so-called "gold bugs" -- in the wisdom of gold ownership.

"Recognize...that gold bugs...often resemble the subjects of a laboratory experiment on the psychology of cognitive dissonance.

When you are in the grip of cognitive dissonance, anything that could be regarded as evidence that you might be wrong becomes proof that you must be right."

He then added this line:

"You don't want to be one of these people, spending years telling reality that it is wrong."

Zweig's article shows that for the past forty years or so the faith-based yellow metal has not generated much in terms or relative or absolute returns:

Avg Annual Return Since 1975 (after inflation)
- Gold: 0.8%
- Bonds: 5.0% ,
- Stocks: 8.3%
- Cash: 1.1%

Maybe the future will prove very different.

Personally, I'd be surprised if stocks or bonds do nearly as well going forward considering current valuations especially if (when?) interest rates normalize.

Gold?

No idea.

Few asset categories, broadly speaking, are plainly inexpensive though there's almost always some individual investment that's selling at a discount for situation specific reasons.
(The tough part being to find one you understand well enough to invest.)

Charlie Munger is, to say the least, usually rather forthright and has a unique way of getting to the point. Well, here's how he looks at gold:

"I don't have the slightest interest in gold. I like understanding what works and what doesn't in human systems. To me that's not optional; that's a moral obligation. If you're capable of understanding the world, you have a moral obligation to become rational. And I don't see how you become rational hoarding gold. Even if it works, you're a jerk."

And one final thought on gold from Jeremy Grantham...

"I hate gold. It does not pay a dividend, it has no value, and you can't work out what it should or shouldn't be worth...It is the last refuge of the desperate."

Of course, for all I know, gold will do very well in the future.

This is irrelevant for me since I have no way of valuing it.

For me it's simple:

If I don't know how to value something, I shouldn't own it.

Adam

Related posts:
-Buffett & Munger on Gold
-Buffett on Productive Assets
-Buffett: Why Stocks Beat Gold
-Buffett: Why Stocks Beat Bonds
-Buffett on Gold, Farms, and Businesses
-Edison on Gold: Fictitious Value & Superstition
-Munger on Buying Gold
-Thomas Edison on Gold
-Grantham on Gold: The "Faith-based Metal"
-Buffett: Forget Gold, Buy Stocks
-Gold vs Productive Assets
-Grantham: Gold is "Last Refuge of the Desperate"
-Why Buffett's Not a Big Fan of Gold

* Examples of what Buffett calls productive assets:
    - Businesses (incl. partial ownership of businesses via marketable stocks)
    - Farms
    - Real Estate

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.

Hedge Funds: Balancing Risk & Reward?

This recent article by Brett Arends points out hedge funds have not performed all that well this year.

The same goes for recent years. Arends writes those "who put 20% of their money in a federally insured bank savings account, and the other 80% in a random collection of stocks from around the world, picked by monkeys," outperformed in a meaningful way hedge funds in 2012, 2013, 2014, and so far in 2015.

Well, at least to me, that seems a rather too short time frame to judge relative performance.

In this article, Morgan Housel looked at a somewhat longer period of time. He points out, from 2002-2013, hedge funds underperformed a simple mix of 60% in stocks and 40% in bonds.*

The 60/40 mix had slightly higher returns along with slightly lower volatility.**

Some hedge funds argue that their goal isn't to match or beat the S&P 500, it's to balance potential rewards with downside risk and limit volatility or something similar. So, with this in mind, both Arends and Housel chose to compare hedge fund returns to a mix that similarly attempts to balance rewards with downside risk.

I'd add that some make the assumption that risk and reward need always be positively correlated.

Well, that's just not necessarily the case.

Now, consider that the typical fees of a hedge fund will be something like two percent of assets under management plus twenty percent of the profits generated (if any).

The two percent is generally paid by investors whether there's a profit or loss.

Arends points out that this means...

"Do the math. If the average investment portfolio earns 6% a year, your hedge fund manager has to earn 9.5% before fees before you even break even. In other words, the manager has to beat the market by about 60%. Per year. Good luck with that."

It may not be impossible to outperform by that much, but consider how many experts underperform over the longer run with, in general, a much lower frictional drag from fees. Also, consider how these fees impact the risk-reward for investors. In other words, the act of reducing fees would, in itself, take out some of the downside risk which is what the hedge funds often contend is a prime objective.

And the above hedge fund results just might be an optimistic take. It turns out that the "hedge-fund indexes flatter the industry's performance, because they are weighted heavily towards the funds that survive and report data."

So how has hedge fund performance affected investor behavior?

Is there any evidence investors are moving out of hedge funds?

Not at all.

From an article in the Wall Street Journal:

"Large corporate pension funds have quadrupled the share of their portfolios invested in hedge funds over the past five years..."

More generally, hedge fund assets under management is now, depending on the source, something like like $ 2.5 trillion or maybe even $ 3.0 trillion in assets. Big numbers. That compares to just $ 38 billion in 1990. So hedge funds have been gathering assets in a substantial way over the past two and a half decades (and in more recent years). At their current size, these funds will collect some serious fees from their investors, including those pension funds, with just mediocre performance.
(The management fees alone would be $ 50-60 billion even if no profits are generated.)

I'm not necessarily surprised by this sort of thing. Better to simply recognize why the behavior exists then do whatever can be done to avoid it.

This paper looks specifically at hedge fund investor performance from 1980-2008:

"...we find that the real alpha of hedge fund investors is close to zero. In absolute terms, dollar-weighted returns are reliably lower than the return on the Standard & Poor's (S&P) 500 index, and are only marginally higher than the risk-free rate as of the end of 2008.The combined impression from these results is that the return experience of hedge fund investors is much worse than previously thought."

This inevitably now has a big impact on institutional investors (pensions, foundations, educational institutions). Why? Apparently, at least 60% of the money invested in hedge funds these days comes from institutional investors.

Adam

Related posts:
Index Funds vs Actively Managed Funds
John Bogle on Investor Returns
Buffett's Hedge Fund Bet
John Bogle's "Relentless Rules of Humble Arithmetic", Part II
Index Fund Investing Revisited
Charlie Munger on Complexity, Hedge Funds, and Pension Funds
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
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

* Vanguard Balanced Index Fund (60/40). The fund, like many from Vanguard, is rather low cost relative to peers.
** Volatility is not the definition of risk though some choose to treat it that way.
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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.

Analyst Ratings: When It Pays To Do The Opposite

According to this Barron's article, the highest rated stocks by Wall Street analysts between 2002-2014 collectively returned 9.5%.

So the highest rated stocks collectively did more than just fine. The funny thing is that the stocks liked least by the analysts -- those with the lowest ratings -- collectively performed even better.

In fact, the lowest rated stocks produced a 13.2% average annual return.*

Now, this outperformance by the most hated stocks apparently doesn't just apply to the 2002-2014 time period.

Back in 2006, Barron's published an article on a study that covered from 1995-2004 that noted a similar outcome:

"From 1995 through 2004, the stocks with the lowest earnings-growth forecasts and worst ratings beat those with the highest."

In the same article Charles Schwab's Greg Forsythe notes:

"You are better off doing the opposite..."

So we've got a solid couple of decades to look at here and, well, going with the opposite -- the lowest rated -- would have produced better results.

A scene from an episode of Seinfeld comes to mind. The title of that episode just happens to be "The Opposite":**

"If every instinct you have is wrong, then the opposite would have to be right." - Jerry Seinfeld speaking to George Costanza in "The Opposite"

Now, at least to me, it seems rather impractical to be attempting to buy and sell so many different stocks -- whether going with ALL the highest-rated or ALL the lowest-rated -- at just the right price/time in order to match these returns. Those who trade more frequently, or possibly some fund with enough scale, may be more comfortable with such an approach.

Also, the impact of frictional costs and mistakes on future returns must be considered. Observing what already happened in hindsight is very different than attempting to make sound investment decisions going forward, in an uncertain world, based upon the recommendations of others. Mr. Market usually throws a curve or two. Temperament, emotions, and biases become all-important factors that, in real-time, tend to have an effect on investor behavior and decision-making.

I happen to think making investment decisions based upon what others recommend is difficult at best if not inherently flawed.

The reason?

If nothing else, the necessary conviction likely won't be there when market price action happens to go the wrong way.

Lacking the necessary -- and, equally important, warranted -- conviction is just asking for inopportune buy/sell decisions.

Understanding the reason why you own something is essential. To me, that comes from doing the necessary work yourself and reaching your own conclusions. Each business comes with a unique set of risks and opportunities. Without some depth of understanding, the inevitable market fluctuations can become tough to handle. In other words, it's difficult to hang in there when a stock meaningfully drops in price if you are not rightly confident in what it's worth and how the value might change over time.

Keep in mind that knowing one's own capabilities and limits is easily as important -- if not more important -- as knowing the capabilities and limits of a particular investment opportunity.

Is it possible to buy/sell based upon the above ratings and reliably translate those actions into satisfactory real world future long-term results?

Someone may know how to do this but consider me a bit skeptical.

Will the performance of these ratings prove persistent over the long haul? What's the basis for figuring that out?

I mean, if such an approach were easy to implement, why isn't there a bunch of successful funds or individual investors out there doing just that?

None of this, of course, necessarily means owning all the highest rated or lowest rated stocks would fail going forward. Nor does it mean some clever though somewhat different approach using these ratings can't be made to work. I just think it's wise to suspect it would prove far from straightforward to implement and difficult to have justified confidence in beforehand.

Even when something does happen to work it's often difficult to judge how much of it came down to luck versus skill.

There are, in fact, many able analysts and the study of high quality research/analysis can be time well spent.***

Yet, for those who invest in individual stocks, it's likely not wise to delegate the buy/sell decision-making.

Essentially, that's what happens when an investor chooses to buy or sell a stock based upon a someone else's recommendation.

Still, if nothing else, it's at least mildly interesting that the vast majority of actively managed equity funds underperform yet the two studies seem to at least imply there might be a way to do much better than the market as a whole.

Maybe someone will figure out (has figured out?) how to convert these ratings into an approach that produces reasonable or better rewards going forward.
(If so, the results would need to be measured over decades and not just over a few years of future performance. Sometimes, an approach appears to be working until, well, it just doesn't.)

All I know is it won't be me. Even if there's some way to make these ratings work in a reliable way long-term -- and there just might be -- it's just not the kind of thing I'm interested in or capable or doing.

My interest is in figuring out, within a range, what a business is worth and, considering the risks/alternatives, whether it's likely to increase at an attractive rate over the long run. That's challenging enough. The approach taken should be compatible with your own nature. So I'll stick to buying, with the long-term in mind, shares of the businesses I can understand at a discount.

To me, the equity markets need as many market participants as possible focused on valuing individual businesses. A market where the vast majority are engaged in estimating per share intrinsic business value should at least be somewhat less likely to get mispriced (by emotions and other factors) in extreme ways.

Others may naturally have a very different view.

Recent bubbles (i.e. extreme and widespread mispricings on the high side) have revealed at least some of the economic consequences of broad-based mispriced assets.

There's certainly room for speculation in financial markets, and maybe even some gimmickry, but the proportion of participants involved in such things matters. A little bit is fine but at some point more becomes not such a wonderful thing.

Financial markets can and do facilitate the transfer of risk but shouldn't exist primarily to serve those who are inclined to gamble; they exist (or should exist) mostly to move capital that's been priced as appropriately as possible -- with an emphasis on long-term effects -- where it needs to be.

Adam

* Sources: Bespoke Investment Research and Bloomberg. The S&P 500 returned 6.5% annually over the same time frame. So it's not like the highest rated stocks did badly. Not at all. It's just that the lowest rated stocks did even better.
** In the episode, George Costanza implements an effective strategy to overcome his innately terrible instincts: 

"A job with the New York Yankees! This has been the dream of my life ever since I was a child, and it's all happening because I'm completely ignoring every urge towards common sense and good judgment I've ever had." - George Costanza in "The Opposite"

Maybe the approach isn't as crazy as it sounds.
*** Though, at least for me, it all starts with an in-depth review and analysis of the 10-Ks and 10-Qs over as many years as possible (depending on the business). Reading widely -- and thinking carefully about a particular investment -- is a crucial part of the investment process.
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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.

Buffett & Munger: Embracing the Unconventional

"Develop your eccentricities while you are young. That way, when you get old, people won't think you're going ga-ga." - David Ogilvy

Historically, Berkshire Hathaway (BRKa) has often held -- especially when compared to the norm among professional investors -- a rather concentrated equity portfolio.*

To say anything less would be a gross understatement.

In fact, having sixty percent or more of the Berkshire portfolio in just five stocks has been not at all uncommon.**

At times the portfolio has been even more concentrated. In the 1980s and early 1990s Berkshire's top equity positions frequently made up eighty to ninety percent plus of the portfolio.

1987 was one of those years.

Here's how Warren Buffett explained their approach in the 1987 Berkshire letter:

"...our insurance companies own three marketable common stocks that we would not sell even though they became far overpriced in the market. In effect, we view these investments exactly like our successful controlled businesses - a permanent part of Berkshire rather than merchandise to be disposed of once Mr. Market offers us a sufficiently high price."

It's portfolio concentration combined with a very long holding period.***

"A determination to have and to hold, which Charlie [Munger] and I share, obviously involves a mixture of personal and financial considerations. To some, our stand may seem highly eccentric."

In the letter Buffett writes, referring to the quote at the beginning of this post, that they've "long followed" the advice of David Ogilvy and went on to explain their attitude the following way:

"...in the transaction-fixated Wall Street of recent years, our posture must seem odd: To many in that arena, both companies and stocks are seen only as raw material for trades.

Our attitude, however, fits our personalities and the way we want to live our lives. Churchill once said, 'You shape your houses and then they shape you.' We know the manner in which we wish to be shaped. For that reason, we would rather achieve a return of X while associating with people whom we strongly like and admire than realize 110% of X by exchanging these relationships for uninteresting or unpleasant ones."

Similarly, Charlie Munger once said the following:

"...Warren and I do more reading and thinking and less doing than most people in business. We do that because we like that kind of a life. But we've turned that quirk into a positive outcome for ourselves."

It's not always about maximizing returns.

There's nothing wrong with embracing what's a bit unconventional when comfortable with the reasons why. On the other hand, simply being different for different's sake might prove expensive or, at the very least, a distraction.

The kind of portfolio concentration practiced by Berkshire, for example, is certainly not for everyone.

More from the Berkshire letter:

"We really don't see many fundamental differences between the purchase of a controlled business and the purchase of marketable holdings such as these. In each case we try to buy into businesses with favorable long-term economics. Our goal is to find an outstanding business at a sensible price, not a mediocre business at a bargain price."

The need for a huge discount to intrinsic value is more a bonus than a necessity for the highest quality businesses.

In other words, the margin of safety that's required -- while still crucial -- can be at least somewhat reduced when an enterprise has a tough to dislodge competitive position and sound long run core economics.

Adam

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

* The views of Warren Buffett and Charlie Munger on diversification was covered to an extent in the previous post. Berkshire's equity portfolio remains concentrated in its top positions but, due to the company's current size and breadth (including the controlled businesses), it is necessarily rather more diversified overall these days.
** See Table V of a study with the title "Imitation is the Sincerest Form of Flattery: Warren Buffett and Berkshire Hathaway".
*** One of the three common stocks mentioned is now a Berkshire controlled business (GEICO). As for the other two stocks: Capital Cities/ABC, Inc. was acquired by Disney (DIS) back in the 1990s, while The Washington Post Company has become Graham Holdings (GHC) with Berkshire reducing its stake last year after decades of ownership. Inevitably, no matter how long the intended holding period happens to be, corporate actions, changes to the competitive landscape, and other events will end up having an impact on the actual holding period. 
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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.

Portfolio Diversification: What's the Right Amount?

Portfolio diversification, something I briefly covered toward the end of this recent post, is an investment topic that necessarily leads to a wide array of opinions.

At the 2014 Daily Journal (DJCO) shareholder meeting, Charlie Munger explained that his investments are primarily invested in Berkshire Hathaway (BRKa), Costco (COST), and one other fund. He then added:*

Now, you could go to the rest of finance, they think they know how to handle money, and they'd say it's totally unthinkable, Munger doesn't know what the hell he's doing. Doesn't fit our models. But I'm right and they're wrong.

If you're shrewd enough to choose well, three holdings – any one of which would support your family in perpetuity — is enough security.

and

The people who make these crazy decisions don't actually have envy: what they have is clients who will fire them if they don't get the same results as everybody else. That is a crazy system. Everybody gets on the same merry-go-round.

Munger has offered a similar view on prior occasions and there's, to say the least, much to be learned from it. Yet, while this certainly makes sense for someone with his investing background and abilities, it hardly means such a concentrated portfolio is a brilliant way to go for everyone. The appropriate amount of diversification will be specific to an investor's capabilities and situation.

It'd likely prove a big mistake to think otherwise.

Consider that Munger also once said:

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

The question of whether it makes sense to own individual stocks at all first needs to be answered. After that question is answered, those who do decide they're comfortable picking stocks may, unlike Charlie Munger, still prefer to own more than just a few.
(Though it's generally unwise to be risking funds on a 50th best idea when those funds could, instead, be put into a top idea.)

So it's very much an individualized decision, and that decision must always be made in the context of the price environment.

More from the Daily Journal meeting:

...the consultants and investment bankers keep selling the same nostrum that you can save yourself by paying thirty times earnings for the kind of business you wish you had, instead of the one you've got.

It wasn't all that difficult to find stocks selling for huge discounts to intrinsic value four to six years ago or so.

That's far from the case now.

When shares get cheap enough (i.e. price nicely lower than intrinsic value per share offering substantial margin of safety) it's easier to accumulate lots of what you like.

In contrast, a concentrated portfolio of stocks bought at premium prices is, in the long run, just asking for trouble. Consistent correctness in such a situation is whole lot easier in theory than in the real world.

It's worth noting what initially appears to be a premium valuation at times proves to be otherwise. Sometimes, what's richly valued turns out to be worth it and then some. Figuring this out, in a reliable way, beforehand without making big mistakes and incurring big losses that mostly offset other gains -- or, maybe, more than offset other gains -- is, of course, the tough part.

In other words, the range of outcomes quickly become unacceptably wide and there's too much downside if things don't go as expected.

The avoidance of permanent capital loss is paramount. Well, paying a big premium for a stock with the hope that optimistic assumptions about the future come to fruition isn't really compatible with portfolio concentration.

The same goes for investor overconfidence.

Overconfidence combined with a concentrated portfolio -- or, for that matter, any portfolio -- is an investment disaster in the making.

A healthy dose of doubt and careful consideration of possible misjudgments can serve the investor well.

The price paid should always protect against disappointments and mistakes.

Munger was asked later at the same meeting what he viewed as the right number of companies in a portfolio. His answer was simple:

I don't think there's any one answer to that.

The right number of stocks to own is necessarily not one size fits all.

The fact is many over the long run will end up better off investing in low-cost index funds -- and this doesn't just apply to inexperienced individual investors, it also can apply to, in enough cases to matter, very able and experienced market participants** -- while avoiding leverage, the temptation to trade excessively, and needless frictional costs.

That's difficult enough to do well if for no other reason that fear, greed, and other behavioral factors come into play in a way that too often leads to inopportune buy/sell decisions and, ultimately, adverse investing outcomes.

Some will focus on the analytical challenge that's in front of them but underestimate the temperamental/emotional discipline that's required.

Buffett, also one who generally prefers portfolio concentration when possible, said the following in his most recent letter:

"Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to 'time' market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy."

Essentially, in Buffett's own investing approach, he has a preference for less diversification, but is well aware that "inadequate diversification" can get an investor in trouble. From the 1993 letter:

"By periodically investing in an index fund..... the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb.

On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you."

A very concentrated equity portfolio works just fine for some.

A diversified low-cost index fund -- accumulated over time but otherwise traded minimally -- works just fine for many.***

Portfolio concentration can work under the right circumstances but it's hardly for everyone.

Figuring out the "right circumstances" requires -- among many other things -- careful consideration of one's own temperament, aptitude, limitations, and resources.

Those who choose to concentrate their portfolio without the requisite proficiency are likely to make substantial and costly mistakes.

Deciding on the appropriate amount of diversification isn't always easy to figure out.

It's best to act accordingly and give it the careful consideration it deserves.

Adam

Long position in BRKb established at much lower than recent market prices; no position in other stocks mentioned.

* From some excellent notes that were taken at the meeting. These notes, presented in four parts, are well worth reading. Not a transcript.
** Some seem willing to believe otherwise despite evidence that refutes it. Naturally, there are some very capable investors with excellent track records but a whole bunch simply can't match their relevant benchmark index over the long haul.
*** Not necessarily a single fund. Some will consider multiple funds to be more appropriate.
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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.

Earnings Inflation: Why Some Tech Companies Earn Less Than You Think

This Barron's article covers what it calls the "weird world where a wide range of technology companies...encourage investors to ignore the large and very real cost of stock compensation when calculating expenses and earnings."

Remarkably, this kind of "inflated and distorted earnings figure...is widely embraced by analysts and investors in valuing tech companies."

This, in part, reminds me of what Jeremy Grantham once said:

"Career risk drives the institutional world. Basically,everyone behaves as if their job description is 'keep it.' [John Maynard] Keynes explains perfectly how to keep your job: never, ever be wrong on your own. You can be wrong in company; that's okay."

Well, if that's the case, then maybe this bodes well for those less influenced by "the institutional world."

Barron's estimates that a dozen large tech companies are not including roughly $ 16 billion of stock compensation expense in their non-GAAP earnings. A table in the article provides a detailed look at the relevant numbers for the twelve companies.

Some things to consider:

- Stock compensation is usually the major difference between reported GAAP earnings and non-GAAP earnings.

- Profit projections from analysts often ignore stock compensation.

- The likes of Microsoft (MSFT), Intel (INTC), Apple (AAPL), and IBM (IBM) are tech companies that report GAAP numbers only with stock compensation included.

- Some companies prefer non-GAAP earnings because they're highly dependent on stock-based compensation and, well, it makes their numbers look better. Analysts, in enough cases for it to matter, tend to use whatever approach the company thinks makes more sense. So, basically, those that don't offer much in the way of stock compensation don't mind reflecting the cost; those that do rely extensively on stock compensation, not surprisingly, choose the non-GAAP approach.

Here's three examples of how much of a difference it can make:

Google (GOOG)
2015 GAAP Estimated EPS: 22.70
2015 non-GAAP Estimated EPS: $ 28.35

2015 GAAP P/E: 24.7
2015 non-GAAP P/E: 19.8

Amazon.com (AMZN)
2015 GAAP Estimated EPS: 0.37
2015 non-GAAP Estimated EPS: 4.14

2015 GAAP P/E: 1,193
2015 non-GAAP P/E: 106

Salesforce.com (CRM)
2015 GAAP Estimated EPS: -0.05
2015 non-GAAP Estimated EPS: 0.71

2015 GAAP P/E: Not Meaningful
2015 non-GAAP P/E: 104

More from Barron's:

"Various justifications are offered for excluding equity compensation from expenses, but none hold up to scrutiny."

The argument that stock compensation isn't a real expense is a weak one at best.

If stock-based compensation expense is generally ignored by analysts and investors guess what's going to happen?

It seems rather probable it will encourage the use of stock-based compensation.

Some will no doubt continue to argue that stock compensation expense can be ignored. Arguments include that it's a non-cash expense and the additional share count captures the cost.

Well, in this case, it's a real expense even if it happens to be a non-cash expense: unless the strike price of an employee stock option fully reflects per share intrinsic value, the company is, when options are exercised, effectively selling shares at a discount (with tax implications fully considered). That discount is a real cost to continuing owners. So, in such a case, the additional share count only partially reflects that expense.*

Another argument essentially is that, since many industry peers ignore stock-based compensation, it makes sense to also ignore it for comparison purposes. Well, it's a real expense no matter how another company decides to logically present their own numbers.

When a company chooses to repurchase shares to just keep the share count from increasing, those funds could have instead been used for the direct benefit of shareholders in other ways. If the strike price is less than the repurchase price then, effectively, the company is buying high and selling low.

The difference can prove a meaningful cost especially for shareholders who intend to stick around.**

Those funds could be used for reducing share count instead of merely offsetting the dilution that occurs from stock compensation.

Those funds could be used for paying dividends.

Those funds could also be put to many other potential high return uses.

Now, if a company needs to use stock compensation to get the best employees, or to help manage cash flows, it may be very wise to do so.

Just count it as the real expense that it is.***

It simply makes little sense to ignore stock compensation for certain companies but include it for others.

When stock-based compensation is deliberately ignored -- especially for the companies who heavily rely on it -- per share intrinsic value and how it's likely to change over time is likely to be overestimated.

Stock compensation is also a real cost for shareholders even if a company chooses to NOT repurchase shares. In many ways employee stock options -- depending on how the strike/exercise price compares to per share intrinsic value -- partially function like a reverse buyback that quietly (and, sometimes, not so quietly) dilutes continuing shareholders. Keep in mind that, upon the exercise of stock options, a company will receive funds equal to the strike price for each option that's exercised plus, depending on how much the options are in the money, a tax benefit. So, effectively some capital is "raised" in the process but what matters for continuing owners is how reasonable that strike price happens to be.
(If these funds are used to buyback stock then the net dilution is reduced.)

It's hard to completely fault the companies when not enough analysts and investors seem to be forcing the issue.

It's easy to choose to not follow suit and always include stock-based compensation when attempting to estimate, within a range on a conservative basis, per share intrinsic value.

None of this necessarily means some of these tech stocks aren't fine businesses. In fact, some are already extremely valuable and will no doubt prove to be even more so. It comes down to:

Will the value per share increase sufficiently?

Does the price paid offers an acceptable or better risk versus reward against alternatives?

Is there sufficient margin of safety to protection against what might go wrong and/or misjudged prospects?

If nothing else, a willingness to ignore stock-based compensation is fundamentally at odds with the margin of safety principle.

It's worth noting that I'm not referring to the speculative buying at one premium price (premium to per intrinsic value) with the hope of later sell at an even higher price. I'm referring to whether the price paid today offers an attractive outcome compared to what these businesses will be intrinsically worth on a per share basis in 10 or 20 years.

Those who successfully buy shares at a premium to value and exit successfully are likely taking on far more risk of permanent capital loss than they realize.

Risk that's not usually obvious until it is.

Adam

Long positions in MSFT and AAPL established at much lower than recent prices; long position in IBM established at somewhat higher than current prices; very small long position in GOOG also established at much lower than recent prices. No position in the other stocks mentioned.

Related posts:
Stock-based Compensation: Impact On Tech Stock P/E Ratios
Big Cap Tech: 10-Year Changes to Share Count
Technology Stocks
Time for Dividends in Techland

* There are exceptions. When, for example, the strike price of employee stock options is well above per share intrinsic business value, then stock-based compensation can actually become beneficial to long-term owners. Of course, for these to be of any value to an employee the stock must necessarily be more than fully valued upon exercise. In this narrow (and somewhat unlikely) scenario, the company would be getting more than full value. The situation functions like capital being raised at an attractive price with a tax benefit as a bonus. This doesn't apply to stock-based compensation that's in the form of restricted stock (which is increasingly favored over stock options).
** The actual cost for shareholders is the difference between the lower strike price and the higher repurchase price. For companies where this kind of buy high/sell low behavior is the norm, this can become rather expensive (depending on the specifics of the stock-based compensation plan) for long-term owners when compounding effects are fully considered. In contrast, these still very real costs might be viewed as mere noise for those with shorter holding periods.
*** It's worth mentioning, as I noted in a previous post, it's not as if the GAAP numbers are always a terrific indication of actual business economics. Accounting can be a very useful tool but has its own real limitations.
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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.