This previous post, Turning Gold into Lead, covers why Warren Buffett thinks all earnings are not created equal calling the inferior variety "restricted earnings".
In the following excerpt, also from the 1984 Berkshire Hathaway (BRKa) shareholder letter, Buffett covers the exact opposite type of earnings: "unrestricted".
Here's his explanation of how unrestricted earnings should be treated:
"For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders - to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc. But we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect - backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future - that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.
To illustrate, let’s assume that an investor owns a risk-free 10% perpetual bond with one very unusual feature. Each year the investor can elect either to take his 10% coupon in cash, or to reinvest the coupon in more 10% bonds with identical terms; i.e., a perpetual life and coupons offering the same cash-or-reinvest option. If, in any given year, the prevailing interest rate on long-term, risk-free bonds is 5%, it would be foolish for the investor to take his coupon in cash since the 10% bonds he could instead choose would be worth considerably more than 100 cents on the dollar. Under these circumstances, the investor wanting to get his hands on cash should take his coupon in additional bonds and then immediately sell them. By doing that, he would realize more cash than if he had taken his coupon directly in cash. Assuming all bonds were held by rational investors, no one would opt for cash in an era of 5% interest rates, not even those bondholders needing cash for living purposes.
If, however, interest rates were 15%, no rational investor would want his money invested for him at 10%. Instead, the investor would choose to take his coupon in cash, even if his personal cash needs were nil. The opposite course - reinvestment of the coupon - would give an investor additional bonds with market value far less than the cash he could have elected. If he should want 10% bonds, he can simply take the cash received and buy them in the market, where they will be available at a large discount.
An analysis similar to that made by our hypothetical bondholder is appropriate for owners in thinking about whether a company’s unrestricted earnings should be retained or paid out. Of course, the analysis is much more difficult and subject to error because the rate earned on reinvested earnings is not a contractual figure, as in our bond case, but rather a fluctuating figure. Owners must guess as to what the rate will average over the intermediate future. However, once an informed guess is made, the rest of the analysis is simple: you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of reinvestment."
For many years Berkshire Hathaway has been able to earn far better than market returns on the earnings it retains. Much of those returns came down to Buffett's enormous skill. It made sense to not pay a dividend.
Today, considering Berkshire Hathaway's size, how long before it cannot put those earnings to good use and earn a greater than market rate of return with all of the dollars?
It could be a while yet, but it seems likely that the distribution of at least a small portion of its sizable quantity of unrestricted earnings in the form of dividends will need to begin.
Adam
Long BRKb
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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.
Thursday, January 13, 2011
Wednesday, January 12, 2011
Stocks with 8% Plus Earnings Yield
The following is a list of Dow Jones Industrials that still have an 8% or greater earnings yield based upon 2010 consensus operating earnings estimates:
Chevron (CVX): Earnings Yield 10.2%
Hewlett Packard (HPQ): 10.6%
Intel (INTC): 9.6%
Merck (MRK): 9.1%
J.P. Morgan Chase (JPM): 8.6%
Pfizer (PFE): 12.2%
Travelers (TRV): 11.1%
Naturally, earnings yield for these stocks is generally a bit higher based upon current 2011 estimates.
Microsoft (MSFT) was close to making this list but could not make the cut with a 7.9% earnings yield. If the company's $ 30 billion+ net cash position is taken into account (ie enterprise value) the earnings yield sits comfortably above 8%. The same holds true for Cisco (CSCO).
Here's a simple way to check the consensus earnings for the 30 DJIA stocks.
Adam
Currently have long positions in MSFT, CSCO, CVX, and PFE
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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.
Chevron (CVX): Earnings Yield 10.2%
Hewlett Packard (HPQ): 10.6%
Intel (INTC): 9.6%
Merck (MRK): 9.1%
J.P. Morgan Chase (JPM): 8.6%
Pfizer (PFE): 12.2%
Travelers (TRV): 11.1%
Naturally, earnings yield for these stocks is generally a bit higher based upon current 2011 estimates.
Microsoft (MSFT) was close to making this list but could not make the cut with a 7.9% earnings yield. If the company's $ 30 billion+ net cash position is taken into account (ie enterprise value) the earnings yield sits comfortably above 8%. The same holds true for Cisco (CSCO).
Here's a simple way to check the consensus earnings for the 30 DJIA stocks.
Adam
Currently have long positions in MSFT, CSCO, CVX, and PFE
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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.
Tuesday, January 11, 2011
Diageo Dividend Stock Analysis
Diageo's (DEO) brands include Johnnie Walker, Smirnoff, Baileys, Captain Morgan, Jose Cuervo, J&B Scotch, Tanqueray, and Guinness among others. Here's an excerpt from an analysis of Diageo by Dividend Growth Investor:
The company has managed to deliver an average increase in EPS of 8.20% per year since 2000. Analysts expect Diageo to earn $4.97 per share in 2011 and $5.50 per share in 2012. This would be a nice increase from the $4.18/share the company earned in 2010. The company's premium spirits brands have been popular with US consumers who traded up to these premium brands. The North American market accounts for 34% of the company's sales, while emerging markets account for 33% of its sales. Emerging markets have been a bright spot, as the company has been able to achieve strong double digit growth there.
Some previous posts on Diageo:
As a long-term investment I still like Diageo's combination of brands and distribution but in my view the stock is currently a bit too expensive.
Adam
Long position in Diageo established at much lower prices
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
The company has managed to deliver an average increase in EPS of 8.20% per year since 2000. Analysts expect Diageo to earn $4.97 per share in 2011 and $5.50 per share in 2012. This would be a nice increase from the $4.18/share the company earned in 2010. The company's premium spirits brands have been popular with US consumers who traded up to these premium brands. The North American market accounts for 34% of the company's sales, while emerging markets account for 33% of its sales. Emerging markets have been a bright spot, as the company has been able to achieve strong double digit growth there.
Some previous posts on Diageo:
As a long-term investment I still like Diageo's combination of brands and distribution but in my view the stock is currently a bit too expensive.
Adam
Long position in Diageo established at much lower prices
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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.
Monday, January 10, 2011
Stock Market Morphs into Casino
As background, here's a quick summary of something that was covered in this previous post:
The average holding period for stocks was between 4 and 8 years from the early 1930s until the late 1970s.
In the 1980s it dropped to more like 2 years.
At the time of that previous post last March, the average holding period for stocks had fallen to more like 6 months and James Montier had the following to say about it:
The average holding period for stocks was between 4 and 8 years from the early 1930s until the late 1970s.
In the 1980s it dropped to more like 2 years.
At the time of that previous post last March, the average holding period for stocks had fallen to more like 6 months and James Montier had the following to say about it:
"...the average holding period for a stock listed on its exchange is just 6 months. This seems like the investment equivalent of attention deficit hyperactivity disorder." - James Montier
Fast forward to today. According to this recent CNBC article, the average holding period has now dropped to 2.8 months (in the 1980s it was more like 2 years) with high frequency trading accounting for 70 percent of market volume.
"The theory that buy-and-hold was the superior way to ensure gains over the long term, has been ditched completely in favor of technology," said Alan Newman, author of the monthly newsletter. "HFT promises gains are best provided by holding periods measuring as few as microseconds, possibly a few minutes, or at worst, a few hours."
Then later in the article...
"The capital raising stock market of the past hundred years has morphed in just the last 10 years into a casino," said Sal Arnuk of Themis Trading and a market infrastructure expert who advised the SEC after last year's so-called Flash Crash. "Who is doing the fundamental work analyzing stocks? In the end, we've greatly increased systemic risk."
The frictional costs and mostly (if not entirely) non-productive activity associated with all this hyperactive trading makes capital raising and allocation systemically less effective. It's a hidden "tax" on the capital raising/allocation system and ignores Newton's 4th Law ("for investors as a whole, returns decrease as motion increases").
John Bogle recently said that the SPDR S&P 500 ETF (SPY) turns over at 10,000% annualized rate. At that rate, the gap between the returns investors as a whole actually achieve and what the fund returns could easily approach 5% per year due to frictional costs. In the interview, John Bogle references a study of 175 ETFs that showed it was more like a 6% gap per year for investors. In other words, the typical investor would fall behind by 30% over a five year period. I'm guessing most of the active traders involved think they will be above average and end up on the winning side:
"All the equity investors, in total, will surely bear a performance disadvantage per annum equal to the total croupiers' costs they have jointly elected to bear. This is an inescapable fact of life. And it is also inescapable that exactly half of the investors will get a result below the median result after the croupiers' take, which median result may well be somewhere between unexciting and lousy." - Charlie Munger Speech to the Foundation Financial Officers Group
John Bogle recently said that the SPDR S&P 500 ETF (SPY) turns over at 10,000% annualized rate. At that rate, the gap between the returns investors as a whole actually achieve and what the fund returns could easily approach 5% per year due to frictional costs. In the interview, John Bogle references a study of 175 ETFs that showed it was more like a 6% gap per year for investors. In other words, the typical investor would fall behind by 30% over a five year period. I'm guessing most of the active traders involved think they will be above average and end up on the winning side:
"All the equity investors, in total, will surely bear a performance disadvantage per annum equal to the total croupiers' costs they have jointly elected to bear. This is an inescapable fact of life. And it is also inescapable that exactly half of the investors will get a result below the median result after the croupiers' take, which median result may well be somewhere between unexciting and lousy." - Charlie Munger Speech to the Foundation Financial Officers Group
In this case, the total croupiers' cost is the 5-6% of frictional expenses noted above. The fact is all this extra activity means by definition that investors as a whole end up with a 5-6% lower per annum return. Pretty expensive when the 8-10% expected long-term annual market returns are far from a certainty. So in this example the system as we know it today is transferring half or more of returns to the croupiers instead of investors. Jeremy Grantham made the point that fees like this actually "raid the balance sheet".
Yet, keep in mind it is only those participants who decide to play the trading game that have to collectively pay this "tax". An investor who either buys and holds long-term something like the SPY or buys great businesses at fair prices and holds those shares a very long time avoids these frictional costs.
Check out the full CNBC article.
Check out the full CNBC article.
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.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Friday, January 7, 2011
Buffett: Turning Gold Into Lead - Berkshire Shareholder Letter Highlights
Warren Buffett wrote the following in the 1984 Berkshire Hathaway (BRKa) shareholder letter:
"The first point to understand is that all earnings are not created equal. In many businesses particularly those that have high asset/profit ratios - inflation causes some or all of the reported earnings to become ersatz. The ersatz portion - let's call these earnings 'restricted' - cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.
Restricted earnings are seldom valueless to owners, but they often must be discounted heavily. In effect, they are conscripted by the business, no matter how poor its economic potential. (This retention-no-matter-how-unattractive-the-return situation was communicated unwittingly in a marvelously ironic way by Consolidated Edison a decade ago. At the time, a punitive regulatory policy was a major factor causing the company’s stock to sell as low as one-fourth of book value; i.e., every time a dollar of earnings was retained for reinvestment in the business, that dollar was transformed into only 25 cents of market value. But, despite this gold-into-lead process, most earnings were reinvested in the business rather than paid to owners. Meanwhile, at construction and maintenance sites throughout New York, signs proudly proclaimed the corporate slogan, 'Dig We Must'.)"
Businesses with relatively more "restricted earnings" generally require a higher margin of safety (all other things being equal) to account for the potential gold-into-lead folly. From the 1997 Berkshire shareholder meeting:
"If you're driving a truck across a bridge that says it holds 10,000 pounds and you've got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it's over the Grand Canyon, you may feel you want a little larger margin of safety..."
Also, those businesses with fewer "restricted earnings" are intrinsically more valuable as they have greater flexibility to invest earnings in a manner producing a high return on capital for investors.
The problem is, of course, financial statements alone don't explicitly reveal how much of a businesses earnings is restricted. I mean, it would be nice if "restricted earnings" could be found somewhere on an income statement. Still, it's fairly simple to figure out. Any business that has a high ratio of assets on the balance sheet relative to the profits it generates on average over the entire business cycle is a likely candidate.
The bottom line is it makes sense to pay less for companies with a lot of "restricted earnings" both because the intrinsic value of the earnings is lower and a larger margin of safety is required.
It'd be a lot easier if more businesses were like Coca-Cola (KO) but unfortunately most are not.
Adam
Long BRKb and KO
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
"The first point to understand is that all earnings are not created equal. In many businesses particularly those that have high asset/profit ratios - inflation causes some or all of the reported earnings to become ersatz. The ersatz portion - let's call these earnings 'restricted' - cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.
Restricted earnings are seldom valueless to owners, but they often must be discounted heavily. In effect, they are conscripted by the business, no matter how poor its economic potential. (This retention-no-matter-how-unattractive-the-return situation was communicated unwittingly in a marvelously ironic way by Consolidated Edison a decade ago. At the time, a punitive regulatory policy was a major factor causing the company’s stock to sell as low as one-fourth of book value; i.e., every time a dollar of earnings was retained for reinvestment in the business, that dollar was transformed into only 25 cents of market value. But, despite this gold-into-lead process, most earnings were reinvested in the business rather than paid to owners. Meanwhile, at construction and maintenance sites throughout New York, signs proudly proclaimed the corporate slogan, 'Dig We Must'.)"
Businesses with relatively more "restricted earnings" generally require a higher margin of safety (all other things being equal) to account for the potential gold-into-lead folly. From the 1997 Berkshire shareholder meeting:
"If you're driving a truck across a bridge that says it holds 10,000 pounds and you've got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it's over the Grand Canyon, you may feel you want a little larger margin of safety..."
Also, those businesses with fewer "restricted earnings" are intrinsically more valuable as they have greater flexibility to invest earnings in a manner producing a high return on capital for investors.
The problem is, of course, financial statements alone don't explicitly reveal how much of a businesses earnings is restricted. I mean, it would be nice if "restricted earnings" could be found somewhere on an income statement. Still, it's fairly simple to figure out. Any business that has a high ratio of assets on the balance sheet relative to the profits it generates on average over the entire business cycle is a likely candidate.
The bottom line is it makes sense to pay less for companies with a lot of "restricted earnings" both because the intrinsic value of the earnings is lower and a larger margin of safety is required.
It'd be a lot easier if more businesses were like Coca-Cola (KO) but unfortunately most are not.
Adam
Long BRKb and KO
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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.
Thursday, January 6, 2011
Bigger After 7 Years, Google or Facebook?
A comparison of Google's (GOOG) market valuation and financial performance in its seventh year of operation [2005] to Facebook's in its seventh year of operation [2010].
In 2005 (roughly its seventh full year of operation), Google generated revenues of $ 6.14 billion and net income of $ 1.46 billion.
Google went public with an initial market valuation just under $ 30 billion in 2004 but within a year had a market value north of $ 100 billion. A valuation that seemed extreme but Google had no trouble quickly justifying.
That initial ~$ 30 billion valuation looks like a bargain today.
How does this compare to Facebook?
In 2010, according to this article, Facebook (also in its seventh year of operation) generated revenues of $ 2 billion and had net income of $ 400 million. Impressive. The growth rate is spectacular as Facebook's 2009 revenue was $ 777 million with $ 200 million of net income.
According to this, Goldman recently invested in Facebook at a $ 50 billion valuation. At that valuation, Facebook is being valued at 25x revenue and 125x earnings.
It's very hard to know what Facebook is/will be worth. We do know that, comparing both companies seventh year of operation apples to apples, Facebook is being given a valuation that is almost 2x that of Google while generating less than 1/3 as much revenue and net income.
Obviously, with Google now earning in two weeks what Facebook earns in a year there's a bit of a gap to close before you can consider these two in the same league financially.
Still, I wouldn't want to bet against Facebook.
...or Google.
I'll be surprised if both don't win big in very different ways.
Adam
Long position in GOOG
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.
Long position in GOOG
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Wednesday, January 5, 2011
Microsoft: Stock vs Business Performance
Microsoft (MSFT) has been a go nowhere stock for a decade (a fact seemingly mentioned daily on business news) but not because it lacked in business performance. A decade ago, Microsoft generated revenue of ~ $ 25 billion and was earning just over $ 7 billion dollars each year. Microsoft, a large company when it entered the decade, was able to grow that revenue from $ 25 billion to $ 68 billion and earnings from $ 7 billion to north of $ 20 billion in the past ten years.
So more than a respectable decade of work. I'm not a huge fan of Microsoft but its business performance is sometimes ignored because the stock has not performed.
For a short time period in the year 2000, Microsoft had an enterprise value (market cap - net cash on the balance sheet) of over $ 600 billion. Just over a decade ago an investor was paying more than $ 600 billion in enterprise value for $ 7 billion of demonstrated earning power. Today, an investor is paying a bit over $ 200 billion in enterprise value for more than $ 20 billion in earning power.
Adam
Small long position in MSFT
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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.
So more than a respectable decade of work. I'm not a huge fan of Microsoft but its business performance is sometimes ignored because the stock has not performed.
For a short time period in the year 2000, Microsoft had an enterprise value (market cap - net cash on the balance sheet) of over $ 600 billion. Just over a decade ago an investor was paying more than $ 600 billion in enterprise value for $ 7 billion of demonstrated earning power. Today, an investor is paying a bit over $ 200 billion in enterprise value for more than $ 20 billion in earning power.
Also, consider that there is now 20% less shares outstanding compared to a decade ago. So the stock didn't do well because it entered this past decade overvalued.
The business did just fine.
Adam
Small long position in MSFT
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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.
Tuesday, January 4, 2011
4 Dividend Stocks
Here's a recent post on some dividend paying stocks from Dividend Growth Investor.
Each of the 4 stocks have been on my Stocks to Watch list since it was first created.
Johnson & Johnson (JNJ) - Dividend Yield: 3.5%
Procter & Gamble (PG) - Dividend Yield: 3.0%
Philip Morris International (PM) - Dividend Yield: 4.4%
PepsiCo, Inc. (PEP) - Dividend Yield: 2.9%
While JNJ has had many issues with product recalls lately, over the long run each of these businesses are likely to make good long-term core holdings especially when bought at the right price. As I've noted previously, I like the businesses of PG and PM but both now are selling at higher prices than what I'd be willing to pay. The other two are close or currently at prices where I'd consider adding some more shares.*
Great Franchises
What they have in common is a combination of strong brands, global distribution (PM is purely international since the spinoff from Altria), excellent balance sheets, and durable high return on capital. In the long run, it is the durable high return on capital that makes these businesses compounding machines even if the stock prices often don't provide much short term excitement.
As in all cases, some of the excess returns come down to whether the management allocates capital wisely.
In other words: does not overpay for acquisitions, isn't tempted by growth for growth's sake, and buys back stock only when it is selling below intrinsic value, etc.
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. - Warren Buffett in the 1984 Berkshire Hathaway (BRKa) shareholder letter
Predicting how management is going to behave when it comes to capital allocation is not easy (a long track record is a useful guide though few have one as long as Buffett), but the risk/reward on these seem reasonable. These kinds of businesses are strong enough to overcome some of the more probable dumb moves.
Valuations range from 12.5x 2011 earnings for JNJ to just under 15x earnings for PG.
Adam
* I have long positions in all stocks mentioned.
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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.
* I have long positions in all stocks mentioned.
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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.
Monday, January 3, 2011
Munger on Incentives
From Charlie Munger's 1995 speech at Harvard University:
"Well, the top guy is sitting there, he's an authority figure. He's doing asinine things, you look around the board, nobody else is objecting, social proof, it's okay? Reciprocation tendency, he's raising the directors fees every year, he's flying you around in the corporate airplane to look at interesting plants, or whatever in hell they do, and you go and you really get extreme dysfunction as a corrective decision-making body in the typical American board of directors.
They only act, again the power of incentives, they only act when it gets so bad it starts making them look foolish, or threatening legal liability to them. That's Munger's rule. I mean there are occasional things that don't follow Munger's rule, but by and large the board of directors is a very ineffective corrector if the top guy is a little nuts, which, of course, frequently happens."
Check out the entire speech.
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 are never a recommendation to buy or sell anything.
"Well, the top guy is sitting there, he's an authority figure. He's doing asinine things, you look around the board, nobody else is objecting, social proof, it's okay? Reciprocation tendency, he's raising the directors fees every year, he's flying you around in the corporate airplane to look at interesting plants, or whatever in hell they do, and you go and you really get extreme dysfunction as a corrective decision-making body in the typical American board of directors.
They only act, again the power of incentives, they only act when it gets so bad it starts making them look foolish, or threatening legal liability to them. That's Munger's rule. I mean there are occasional things that don't follow Munger's rule, but by and large the board of directors is a very ineffective corrector if the top guy is a little nuts, which, of course, frequently happens."
Check out the entire speech.
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 are never a recommendation to buy or sell anything.
Stocks to Watch
Below is an update of the list of stocks I like* for my own portfolio at the right price.
From my point of view, the shares listed are attractive long-term investments below the prices (preferably well below, of course) I've indicated. Unlike when I first published this list most have become too expensive to buy. A symptom of a happier market.
Naturally, the objective is to buy these significantly below the maximum prices I've indicated I'd pay when the opportunity presents itself. So, for now, some patience is needed then decisiveness if there's an opportunity.
From my point of view, the shares listed are attractive long-term investments below the prices (preferably well below, of course) I've indicated. Unlike when I first published this list most have become too expensive to buy. A symptom of a happier market.
Naturally, the objective is to buy these significantly below the maximum prices I've indicated I'd pay when the opportunity presents itself. So, for now, some patience is needed then decisiveness if there's an opportunity.
Since creating the initial Stocks to Watch list, none of the 20+ stocks on the list is selling lower. Johnson & Johnson (JNJ) is the worst performer at an 8% total return. All others have returned more (in some cases much more). I don't view that as great news. It'd be safer and easier to invest right now if some of these stocks were selling at much lower prices. The further below intrinsic value the better. Not only does it allow accumulation of more shares below intrinsic value to happen, the company itself can use excess free cash flow to do the same.
"When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases." - Warren Buffett in the 1984 Berkshire Hathaway (BRKb) Shareholder Letter
"When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases." - Warren Buffett in the 1984 Berkshire Hathaway (BRKb) Shareholder Letter
Johnson & Johnson (JNJ) is selling slightly higher than when I first posted it but remains the only stock that still sells below the max. price I'd be willing to pay for it (some others are border line). Pepsi (PEP) is a close call as I've raised what I'd be willing to pay from $ 60/share to $ 65/share. Others on the list are fine businesses and, in my view, if held for a long enough period are likely to create solid returns for shareholders even when bought at current prices. I just prefer a higher margin of safety.
Those below the dashed line are companies I like but prevailing prices have become too high.
As always, the stocks in bold have two things in common. They are:
1) currently owned by Berkshire Hathaway (as of 9/30/10) and,
2) selling below the price that Warren Buffett paid in recent years.
There are several other Berkshire Hathaway holdings on this list but they don't have the 2nd thing going for them.
This list is intended to remain very stable over time with few additions or deletions. I never have a "price target" (A term you'll hear all too often on Wall Street and business news). I'm looking to buy a great business at a reasonable price then allow it to compound in value over a very long time frame. What drives the buy/sell behavior will be when Mr. Market goes to extremes. So these are all intended to be long-term investments. A ten year horizon or longer. No trades here.
All of the stocks on the current list were part of the original Stocks to Watch list unless otherwise noted.
All of the stocks on the current list were part of the original Stocks to Watch list unless otherwise noted.
Stock|Max Price I'd Pay|Recent Price (12-31-10)
JNJ|65.00|61.85
-------------------------
WFC|28.00|30.99
WFC|28.00|30.99
USB|24.00|26.90
MHK|45.00|56.76
KFT|30.00|31.51
NSC|54.00|62.82 - added to the original list on 12/17/09
MCD|63.00|76.76 - added to the original list on 12/17/09
MCD|63.00|76.76 - added to the original list on 12/17/09
KO|55.00|65.77
COP|50.00|68.10
PM|45.00|58.53
PG|60.00|64.33
PEP|65.00|65.33
LOW|19.00|25.08
AXP|35.00|42.92
ADP|37.00|46.28
DEO|60.00|74.33
BRKb|68.00|80.11
MO|16.00|24.62
HANS|30.00|52.28
PKX|80.00|107.69
RMCF|6.00|9.65
(Splits, spinoffs, and similar actions inevitably will occur going forward. Will adjust as necessary to make meaningful comparisons.)
Stocks removed from the list:
- BNI - I liked purchasing BNI up to $ 80/share. It was bought out by Berkshire Hathaway for $ 100/share in late 2009. Deal closed in early 2010.
The max price I'd pay takes into account an acceptable margin of safety**. That margin of safety differs for each company.
In other words, I believe these are intrinsically worth quite a bit more than the max price I've indicated in this post and in prior Stocks to Watch posts. I also believe most of these companies generally have favorable long-term economics (i.e. the best of them have high and durable return on capital) and, as a result, intrinsic values will increase over time. Of course, I may be misjudging the core economics and that margin of safety could provide insufficient protection against a loss. Still, a year from now I would expect to be willing to pay more for many of these based upon each company's intrinsic value growth over that time frame.
Though I could easily be wrong, at the right price I consider these stocks appropriate for my own portfolio (i.e. not for someone else's) given my understanding of the downside risks and potential rewards.
So these don't make sense for others unless they do their own research and reach their own similar conclusions.
In other words, I believe these are intrinsically worth quite a bit more than the max price I've indicated in this post and in prior Stocks to Watch posts. I also believe most of these companies generally have favorable long-term economics (i.e. the best of them have high and durable return on capital) and, as a result, intrinsic values will increase over time. Of course, I may be misjudging the core economics and that margin of safety could provide insufficient protection against a loss. Still, a year from now I would expect to be willing to pay more for many of these based upon each company's intrinsic value growth over that time frame.
Though I could easily be wrong, at the right price I consider these stocks appropriate for my own portfolio (i.e. not for someone else's) given my understanding of the downside risks and potential rewards.
So these don't make sense for others unless they do their own research and reach their own similar conclusions.
Even if not wildly overvalued, these stocks are mostly too expensive to buy right now. The margin of safety is too narrow for my money. There has been no shortage of chances to buy these at a discount to value in the not too distant past. That was the time to act. The risk of missing the chance to own a well understood investment when a fair price is available (error of omission) can be more costly than suffering a short-term paper loss (though, due to loss aversion, many focus much more on the latter). Hopefully, at least some of them will get cheap again.
Here are some thoughts on errors of omission by Buffett from an article in The Motley Fool.
Also, from the 2008 letter:
Also, from the 2008 letter:
"During 2008 I did some dumb things in investments. I made at least one major mistake of commission and several lesser ones that also hurt... Furthermore, I made some errors of omission, sucking my thumb when new facts came in." - Warren Buffett
In other words, not buying what's attractively valued to avoid short-term paper losses is far from a perfect solution with your best long-term investment ideas.
To me, if an investment is initially bought at a fair price, and is likely to increase substantially in intrinsic value over 20 years, it makes no sense to be bothered by a temporary paper loss. Of course, make a misjudgment on the quality of a business and that paper loss becomes a real one (error of commission).
There is no perfect answer to this problem. When highly confident that a great business is available at a fair price it's important to accumulate enough while the window of opportunity exists.
Sometimes accepting the risk of short-term losses is necessary to make sure a meaningful stake is acquired.
Finally, above average long-term returns at lower risk is the objective. Performance over the complete market cycle without needing to trade. For me, performance during a down market and tough economy matters more. Truly good businesses should become stronger in a tough economic environment. Having said that, I am not tempted to trade from "defensive" to "cyclical" stocks (or anything similar to that approach) depending on the market environment. Too much trading leads to unnecessary mistakes. This is about part ownership of businesses. I'll let others play the trading game.
I believe this approach will do just fine in the long run even if it offers a little less excitement.
Sometimes accepting the risk of short-term losses is necessary to make sure a meaningful stake is acquired.
Finally, above average long-term returns at lower risk is the objective. Performance over the complete market cycle without needing to trade. For me, performance during a down market and tough economy matters more. Truly good businesses should become stronger in a tough economic environment. Having said that, I am not tempted to trade from "defensive" to "cyclical" stocks (or anything similar to that approach) depending on the market environment. Too much trading leads to unnecessary mistakes. This is about part ownership of businesses. I'll let others play the trading game.
I believe this approach will do just fine in the long run even if it offers a little less excitement.
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 are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to remain long the above stocks (at least those that at some point became cheap enough to buy) unless market prices become significantly higher than intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
** The required margin of safety is naturally larger for a bank than for something like KO. When I make a mistake and misjudge a company's economics in a major way, the margin of safety may still not be sufficient. Judging the durability of the economics correctly matters most. If the economics remain intact but the stock goes down that is a very good thing in the long run.
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