A follow-up to this post.
Warren Buffett, in the 1985 Berkshire Hathaway (BRKa) shareholder letter, explained his thinking about commodity businesses:
"For an understanding of how the to-invest-or-not-to-invest dilemma plays out in a commodity business, it is instructive to look at Burlington Industries, by far the largest U.S. textile company both 21 years ago and now. In 1964 Burlington had sales of $1.2 billion against our $50 million. It had strengths in both distribution and production that we could never hope to match and also, of course, had an earnings record far superior to ours. Its stock sold at 60 at the end of 1964; ours was 13.
Burlington made a decision to stick to the textile business, and in 1985 had sales of about $2.8 billion. During the 1964-85 period, the company made capital expenditures of about $3 billion, far more than any other U.S. textile company and more than $200-per-share on that $60 stock. A very large part of the expenditures, I am sure, was devoted to cost improvement and expansion. Given Burlington's basic commitment to stay in textiles, I would also surmise that the company’s capital decisions were quite rational.
Nevertheless, Burlington has lost sales volume in real dollars and has far lower returns on sales and equity now than 20 years ago. Split 2-for-1 in 1965, the stock now sells at 34 -- on an adjusted basis, just a little over its $60 price in 1964. Meanwhile, the CPI has more than tripled. Therefore, each share commands about one-third the purchasing power it did at the end of 1964. Regular dividends have been paid but they, too, have shrunk significantly in purchasing power.
This devastating outcome for the shareholders indicates what can happen when much brain power and energy are applied to a faulty premise. The situation is suggestive of Samuel Johnson's horse: 'A horse that can count to ten is a remarkable horse - not a remarkable mathematician.' Likewise, a textile company that allocates capital brilliantly within its industry is a remarkable textile company - but not a remarkable business.
My conclusion from my own experiences and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row..."
Then later in the letter Buffett added...
"Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks."
Since businesses with commodity-like economic characteristics by definition have little or no pricing power, a sustainable cost advantage ends up being the crucial factor for investors.
Now, it's one thing to understand the importance of owning shares of low cost producers (or, at the very least, among the lowest cost producers), but sometimes figuring out who that actually is and why the advantage they have is sustainable isn't all that easy.
Adam
Long position in BRKb established at lower prices
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, April 16, 2012
Friday, April 13, 2012
Wells Fargo Reports 1st Quarter 2012 Earnings
From the Wells Fargo (WFC) quarterly earnings release:
Wells Fargo & Company (NYSE: WFC) reported record net income of $4.2 billion, or $0.75 per diluted common share, for first quarter 2012, compared with $3.8 billion, or $0.67 per share, for first quarter 2011...
Net interest income after provision for credit losses did grow to $ 8.89 billion from $ 8.44 in 1st quarter of 2011 but was basically flat compared to 4th quarter of 2011.
The bank's net interest margin increased to 3.91 percent from 3.89 percent in the 4th quarter of 2011. On that key measure, Wells continues to have a big advantage over most peers. Over the long haul, it should provide a big boost to returns on capital if combined with smart credit underwriting.
In the 1st quarter, the key driver of earnings growth was noninterest income:
Noninterest Income
Noninterest income was $10.7 billion, up from $9.7 billion in fourth quarter 2011. The $1.0 billion increase was driven by increases of $506 million in mortgage banking, $458 million in market sensitive revenue, and $181 million in trust and investment fees.
In the 1st quarter of 2011, noninterest income was just under $ 9.7 billion.
Wells Fargo will likely earn roughly $ 3.20/share this year. That compares to peak earnings prior to the financial crisis of $ 2.47/share. The fact that they are already displaying relatively strong earnings power in a still somewhat fragile economic environment would seem to imply they'll do just fine as conditions improve.
Yesterday's closing price was within 2% of a 52-week high yet, using the $ 3.20/share estimate, the stock currently sells for under 11x earnings.
Adam
Established a long position in WFC at much lower than recent market prices
---
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.
Wells Fargo & Company (NYSE: WFC) reported record net income of $4.2 billion, or $0.75 per diluted common share, for first quarter 2012, compared with $3.8 billion, or $0.67 per share, for first quarter 2011...
Net interest income after provision for credit losses did grow to $ 8.89 billion from $ 8.44 in 1st quarter of 2011 but was basically flat compared to 4th quarter of 2011.
The bank's net interest margin increased to 3.91 percent from 3.89 percent in the 4th quarter of 2011. On that key measure, Wells continues to have a big advantage over most peers. Over the long haul, it should provide a big boost to returns on capital if combined with smart credit underwriting.
In the 1st quarter, the key driver of earnings growth was noninterest income:
Noninterest Income
Noninterest income was $10.7 billion, up from $9.7 billion in fourth quarter 2011. The $1.0 billion increase was driven by increases of $506 million in mortgage banking, $458 million in market sensitive revenue, and $181 million in trust and investment fees.
In the 1st quarter of 2011, noninterest income was just under $ 9.7 billion.
Wells Fargo will likely earn roughly $ 3.20/share this year. That compares to peak earnings prior to the financial crisis of $ 2.47/share. The fact that they are already displaying relatively strong earnings power in a still somewhat fragile economic environment would seem to imply they'll do just fine as conditions improve.
Yesterday's closing price was within 2% of a 52-week high yet, using the $ 3.20/share estimate, the stock currently sells for under 11x earnings.
Adam
Established a long position in WFC at much lower than recent market prices
---
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, April 12, 2012
Yacktman on PepsiCo
Donald Yacktman and his team recently responded to GuruFocus readers' questions. Here's a short excerpt of what he had to say about PepsiCo (PEP):
We believe the company will need to show improved results from several of the key areas of strategic focus or there may be a new management team in place in the near future. The potential for the stock is less about the growth, which we think is mid-to high single-digit per year, and more about the combination of valuation and quality of business. - Donald Yacktman
Donald Yacktman has liked PepsiCo for some time but that seems a slightly less favorable assessment compared to previous ones by him and his team.
PepsiCo has some high quality businesses, but the execution on some fronts lately has been somewhat disappointing.
Earnings is expected to be down this year compared to last year. Using this year's number, PepsiCo is selling for nearly 16x earnings.
So, while not expensive (especially if an investor believes those earnings will begin to bounce back next year), it hardly seems like a bargain near the current valuation considering some of their recent difficulties.
A larger discount until they prove some things to shareholders seems warranted.
Check out the full article. In it, the co-managers at Yacktman Funds respond to a bunch of readers' questions.
Adam
Established a long position in PepsiCo at less than recent market prices
---
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.
We believe the company will need to show improved results from several of the key areas of strategic focus or there may be a new management team in place in the near future. The potential for the stock is less about the growth, which we think is mid-to high single-digit per year, and more about the combination of valuation and quality of business. - Donald Yacktman
Donald Yacktman has liked PepsiCo for some time but that seems a slightly less favorable assessment compared to previous ones by him and his team.
PepsiCo has some high quality businesses, but the execution on some fronts lately has been somewhat disappointing.
Earnings is expected to be down this year compared to last year. Using this year's number, PepsiCo is selling for nearly 16x earnings.
So, while not expensive (especially if an investor believes those earnings will begin to bounce back next year), it hardly seems like a bargain near the current valuation considering some of their recent difficulties.
A larger discount until they prove some things to shareholders seems warranted.
Check out the full article. In it, the co-managers at Yacktman Funds respond to a bunch of readers' questions.
Adam
Established a long position in PepsiCo at less than recent market prices
---
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, April 11, 2012
Buffett's $ 50 Billion Decision
Some comments of interest by Warren Buffett regarding his early days from this recent ForbesLife magazine article:
On Retiring
...when I got out of college, I had $9,800, but by the end of 1955, I was up to $127,000. I thought, I'll go back to Omaha, take some college classes, and read a lot—I was going to retire! I figured we could live on $12,000 a year, and off my $127,000 asset base, I could easily make that. I told my wife, Compound interest guarantees I'm going to get rich.
On Buying A House
I told my wife, "I'd be glad to buy a house, but that's like a carpenter selling his toolkit." I didn't want to use up my capital.
In the article, he adds that he had no plans to start a partnership or even get a job.
He also didn't want to sell securities to others again.
On Forming A Partnership
"You used to sell stocks, and we want you to tell us what to do with our money." I replied, "I'm not going to do that again, but I'll form a partnership...and if you want to join me, you can." ...That was the beginning—totally accidental.
Five decades plus later that simple start became what is effectively a partnership (although the form is technically corporate) with a combined value of $ 200 billion and roughly 270,000 employees.
Buffett certainly views it as a partnership. From the Berkshire Hathaway (BRKa) owners manual:
Although our form is corporate, our attitude is partnership. Charlie Munger and I think of our shareholders as owner-partners, and of ourselves as managing partners. (Because of the size of our shareholdings we are also, for better or worse, controlling partners.) We do not view the company itself as the ultimate owner of our business assets but instead view the company as a conduit through which our shareholders own the assets.
He was certainly right about compound interest making him rich, though I'm guessing he couldn't have imagined the partnership would become anything like its current size and form.
Adam
On Retiring
...when I got out of college, I had $9,800, but by the end of 1955, I was up to $127,000. I thought, I'll go back to Omaha, take some college classes, and read a lot—I was going to retire! I figured we could live on $12,000 a year, and off my $127,000 asset base, I could easily make that. I told my wife, Compound interest guarantees I'm going to get rich.
On Buying A House
I told my wife, "I'd be glad to buy a house, but that's like a carpenter selling his toolkit." I didn't want to use up my capital.
In the article, he adds that he had no plans to start a partnership or even get a job.
He also didn't want to sell securities to others again.
On Forming A Partnership
"You used to sell stocks, and we want you to tell us what to do with our money." I replied, "I'm not going to do that again, but I'll form a partnership...and if you want to join me, you can." ...That was the beginning—totally accidental.
Five decades plus later that simple start became what is effectively a partnership (although the form is technically corporate) with a combined value of $ 200 billion and roughly 270,000 employees.
Buffett certainly views it as a partnership. From the Berkshire Hathaway (BRKa) owners manual:
Although our form is corporate, our attitude is partnership. Charlie Munger and I think of our shareholders as owner-partners, and of ourselves as managing partners. (Because of the size of our shareholdings we are also, for better or worse, controlling partners.) We do not view the company itself as the ultimate owner of our business assets but instead view the company as a conduit through which our shareholders own the assets.
He was certainly right about compound interest making him rich, though I'm guessing he couldn't have imagined the partnership would become anything like its current size and form.
Adam
Tuesday, April 10, 2012
Buffett on Commodity Businesses
"...when a company is selling a product with commodity-like economic characteristics, being the low-cost producer is all-important." - Warren Buffett in the 2000 Berkshire Hathaway (BRKa) shareholder letter
In his 1985 letter, Warren Buffett focuses on a mistake he made with Berkshire's textile operations.
From the letter:
"Our Vice Chairman, Charlie Munger, has always emphasized the study of mistakes rather than successes, both in business and other aspects of life. He does so in the spirit of the man who said: 'All I want to know is where I'm going to die so I'll never go there.' You'll immediately see why we make a good team: Charlie likes to study errors and I have generated ample material for him, particularly in our textile and insurance businesses."
Early on, the cash generated by the textile business had funded Berkshire's entry into insurance. It was a crucial move since the textile business never earned much even in a good year.
Smart capital allocation led to further diversification and, over time, the textile operation became a relatively small portion of Berkshire. Excess capital was consistently put to more attractive alternative uses. If that capital had been instead invested back into the textile operation Berkshire would be a shadow of itself.
In the 1978 letter, Buffett listed the four reasons why they were staying in the textile business despite its relatively unattractive economics. The last of the 4 reasons listed by Buffett was that:
"...the business should average modest cash returns relative to investment."
He also said:
"As long as these conditions prevail - and we expect that they will - we intend to continue to support our textile business despite more attractive alternative uses for capital."
By the mid-80s there was overwhelming evidence Buffett's thinking in 1978 was incorrect. For the most part, the textile business continued to be a consumer of cash. He admits as much in the 1985 letter saying:
"It turned out that I was very wrong...Though 1979 was moderately profitable, the business thereafter consumed major amounts of cash. By mid-1985 it became clear, even to me, that this condition was almost sure to continue. Could we have found a buyer who would continue operations, I would have certainly preferred to sell the business rather than liquidate it, even if that meant somewhat lower proceeds for us. But the economics that were finally obvious to me were also obvious to others, and interest was nil.
I won't close down businesses of sub-normal profitability merely to add a fraction of a point to our corporate rate of return. However, I also feel it inappropriate for even an exceptionally profitable company to fund an operation once it appears to have unending losses in prospect. Adam Smith would disagree with my first proposition, and Karl Marx would disagree with my second; the middle ground is the only position that leaves me comfortable."
So the textile business was largely shut down during 1985. Buffett later added...
"Over the years, we had the option of making large capital expenditures in the textile operation that would have allowed us to somewhat reduce variable costs. Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable expenditures in our highly-profitable candy and newspaper businesses.
But the promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide. Viewed individually, each company's capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.
Thus, we faced a miserable choice: huge capital investment would have helped to keep our textile business alive, but would have left us with terrible returns on ever-growing amounts of capital."
Unless a commodity business has a clear and sustainable built in cost advantage over competitors, capital expenditures will likely not produce a great return for long-term owners.*
Returns of these businesses, at least as a general rule, will be subpar.
The Appendix to the 1983 Berkshire Hathaway shareholder letter is relevant here. In it, Buffett explains economic Goodwill.**
"It was not the fair market value of the inventories, receivables or fixed assets that produced the premium rates of return. Rather it was a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.
Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price. Consumer franchises are a prime source of economic Goodwill."
Yet economic Goodwill can also exist in non-consumer businesses...
"Other sources include governmental franchises not subject to profit regulation, such as television stations, and an enduring position as the low cost producer in an industry."
Otherwise, lacking a sustainable advantage, large amounts of capital investment aren't likely to work out well in the long-run for owners.
There are exceptions but most commodity businesses (excl. things like governmental franchises or a monopoly-like position) need to have a sustainable cost advantage to produce above average returns.
The lessons from Berkshire's textile business experience may be useful background for those considering an investment in a commodity-like business.
Adam
Long position in BRKb established at lower prices
Related post:
Buffett on Commodity Businesses - Part II (follow-up)
* Government interference can subsidize or support what otherwise is a commodity business. Well, at least enough help that there is less competition and no overbearing profit regulation. Eliminate the natural competing forces or provide subsidies and the underlying economics may no longer seem like that of a commodity business. Yet, if proper competition existed it would. In contrast, it is the reputation and brand of successful consumer franchises create their pricing power. No government support or monopoly required.
** Economic Goodwill is very different animal from accounting Goodwill. Buffett does a good job of describing the differences in the Appendix to the 1983 letter.
---
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.
In his 1985 letter, Warren Buffett focuses on a mistake he made with Berkshire's textile operations.
From the letter:
"Our Vice Chairman, Charlie Munger, has always emphasized the study of mistakes rather than successes, both in business and other aspects of life. He does so in the spirit of the man who said: 'All I want to know is where I'm going to die so I'll never go there.' You'll immediately see why we make a good team: Charlie likes to study errors and I have generated ample material for him, particularly in our textile and insurance businesses."
Early on, the cash generated by the textile business had funded Berkshire's entry into insurance. It was a crucial move since the textile business never earned much even in a good year.
Smart capital allocation led to further diversification and, over time, the textile operation became a relatively small portion of Berkshire. Excess capital was consistently put to more attractive alternative uses. If that capital had been instead invested back into the textile operation Berkshire would be a shadow of itself.
In the 1978 letter, Buffett listed the four reasons why they were staying in the textile business despite its relatively unattractive economics. The last of the 4 reasons listed by Buffett was that:
"...the business should average modest cash returns relative to investment."
He also said:
"As long as these conditions prevail - and we expect that they will - we intend to continue to support our textile business despite more attractive alternative uses for capital."
By the mid-80s there was overwhelming evidence Buffett's thinking in 1978 was incorrect. For the most part, the textile business continued to be a consumer of cash. He admits as much in the 1985 letter saying:
"It turned out that I was very wrong...Though 1979 was moderately profitable, the business thereafter consumed major amounts of cash. By mid-1985 it became clear, even to me, that this condition was almost sure to continue. Could we have found a buyer who would continue operations, I would have certainly preferred to sell the business rather than liquidate it, even if that meant somewhat lower proceeds for us. But the economics that were finally obvious to me were also obvious to others, and interest was nil.
I won't close down businesses of sub-normal profitability merely to add a fraction of a point to our corporate rate of return. However, I also feel it inappropriate for even an exceptionally profitable company to fund an operation once it appears to have unending losses in prospect. Adam Smith would disagree with my first proposition, and Karl Marx would disagree with my second; the middle ground is the only position that leaves me comfortable."
So the textile business was largely shut down during 1985. Buffett later added...
"Over the years, we had the option of making large capital expenditures in the textile operation that would have allowed us to somewhat reduce variable costs. Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable expenditures in our highly-profitable candy and newspaper businesses.
But the promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide. Viewed individually, each company's capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.
Thus, we faced a miserable choice: huge capital investment would have helped to keep our textile business alive, but would have left us with terrible returns on ever-growing amounts of capital."
Unless a commodity business has a clear and sustainable built in cost advantage over competitors, capital expenditures will likely not produce a great return for long-term owners.*
Returns of these businesses, at least as a general rule, will be subpar.
The Appendix to the 1983 Berkshire Hathaway shareholder letter is relevant here. In it, Buffett explains economic Goodwill.**
"It was not the fair market value of the inventories, receivables or fixed assets that produced the premium rates of return. Rather it was a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.
Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price. Consumer franchises are a prime source of economic Goodwill."
Yet economic Goodwill can also exist in non-consumer businesses...
"Other sources include governmental franchises not subject to profit regulation, such as television stations, and an enduring position as the low cost producer in an industry."
Otherwise, lacking a sustainable advantage, large amounts of capital investment aren't likely to work out well in the long-run for owners.
There are exceptions but most commodity businesses (excl. things like governmental franchises or a monopoly-like position) need to have a sustainable cost advantage to produce above average returns.
The lessons from Berkshire's textile business experience may be useful background for those considering an investment in a commodity-like business.
Adam
Long position in BRKb established at lower prices
Related post:
Buffett on Commodity Businesses - Part II (follow-up)
* Government interference can subsidize or support what otherwise is a commodity business. Well, at least enough help that there is less competition and no overbearing profit regulation. Eliminate the natural competing forces or provide subsidies and the underlying economics may no longer seem like that of a commodity business. Yet, if proper competition existed it would. In contrast, it is the reputation and brand of successful consumer franchises create their pricing power. No government support or monopoly required.
** Economic Goodwill is very different animal from accounting Goodwill. Buffett does a good job of describing the differences in the Appendix to the 1983 letter.
---
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, April 9, 2012
The Illusion of Skill
This article is adapted from the book "Thinking, Fast and Slow" by Professor Daniel Kahneman that was published last year. The Princeton professor is known for research on how quirks in human behavior lead to illogical decision-making and outcomes.
In the 2nd half of the article, Professor Kahneman focuses on results from studies of active traders, professional fund managers, and wealth advisers.
Active Traders, Take a Nap
According to the article, an analysis of trading records by Professor Terrance Odean* revealed that individual investors lose consistently by actively trading:
"On average, the shares investors sold did better than those they bought, by a very substantial margin: 3.3 percentage points per year..."
This doesn't include the not insignificant costs of trading. The article later added:
"...the large majority of individual investors would have done better by taking a nap rather than by acting on their ideas."
I've covered this "illusion of control" in a prior post:
The Illusion of Control
Later in the article, Professor Kahneman examines a somewhat different illusion but, before looking at that, here's some more evidence from the article that less activity produces superior results.**
"Odean and his colleague Brad Barber showed that, on average, the most active traders had the poorest results, while those who traded the least earned the highest returns."
The Illusion of Skill
While professional investors and traders may have (or at least would be expected to have) the skill needed to outperform the market compared to amateurs, the evidence from 50 plus years of research suggests:
"...for a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker. At least two out of every three mutual funds underperform the overall market in any given year."
Now, what about wealth advisors? Kahneman looked at data for some anonymous wealth advisers to figure out whether the same advisers consistently achieved better returns for clients and display more skill than others. Once again...
"The results resembled what you would expect from a dice-rolling contest, not a game of skill."
So what was the response from the directors when they heard of the findings? Kahneman says he and Richard Thaler told the directors the following:
"What we told the directors of the firm was that, at least when it came to building portfolios, the firm was rewarding luck as if it were skill. This should have been shocking news to them, but it was not. There was no sign that they disbelieved us. How could they? After all, we had analyzed their own results, and they were certainly sophisticated enough to appreciate their implications, which we politely refrained from spelling out."
Then later Kahneman added:
"...I am quite sure that both our findings and their implications were quickly swept under the rug and that life in the firm went on just as before. The illusion of skill is not only an individual aberration; it is deeply ingrained in the culture of the industry. Facts that challenge such basic assumptions — and thereby threaten people's livelihood and self-esteem — are simply not absorbed."
Not surprisingly, when they reported the finding to the wealth advisers themselves the response was similar. Kahneman closed with the following:
"...overconfident professionals sincerely believe they have expertise, act as experts and look like experts. You will have to struggle to remind yourself that they may be in the grip of an illusion."
In the 1970s, the work of Kahneman (in collaboration with Amos Tversky) challenged the flawed but once prevailing wisdom in social science that people generally acted rationally and selfishly (in some ways still alive and well even if to a lesser extent). First, they showed that mental shortcuts (heuristics) are useful but "lead to severe and systematic errors." Experiments they did revealed "cognitive biases" or unconscious errors of reasoning. Later, their prospect theory exposed flaws in the dominant models in economics at the time. The basic assumption that people will always act rationally and in their own interests was wrong.
For Kahneman and Tversky, it was obvious that people are not fully rational nor selfish.
In 2002, Kahneman won the Nobel in economic science. What's at least notable about winning such an award is that Kahneman is a Professor of Psychology.
I am currently reading Kahneman's "Thinking, Fast and Slow". The book covers, along with much else, the many forms of cognitive bias. It does a good job of explaining why the assumption embedded in traditional economic models that humans are coldly rational actors is flawed. I've found it insightful and useful for investing and beyond. It is a comprehensive (and, though accessible, I mean comprehensive!) look at the reasons why we sometimes act just a bit less than rational.
To me, Kahneman seems most interested in allowing the implications of the better ideas in his field to speak for themselves, while recognizing their limitations, and noting some of the key disagreements among colleagues, where applicable.
To me, it's a refreshingly humble approach.
Adam
Related posts:
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
* Terrance Odean is the Professor of Finance at the University of California, Berkeley.
** Based upon Terrance Odean's and Brad Barber's paper: "Trading Is Hazardous To Your Wealth".
---
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.
In the 2nd half of the article, Professor Kahneman focuses on results from studies of active traders, professional fund managers, and wealth advisers.
Active Traders, Take a Nap
According to the article, an analysis of trading records by Professor Terrance Odean* revealed that individual investors lose consistently by actively trading:
"On average, the shares investors sold did better than those they bought, by a very substantial margin: 3.3 percentage points per year..."
This doesn't include the not insignificant costs of trading. The article later added:
"...the large majority of individual investors would have done better by taking a nap rather than by acting on their ideas."
I've covered this "illusion of control" in a prior post:
The Illusion of Control
Later in the article, Professor Kahneman examines a somewhat different illusion but, before looking at that, here's some more evidence from the article that less activity produces superior results.**
"Odean and his colleague Brad Barber showed that, on average, the most active traders had the poorest results, while those who traded the least earned the highest returns."
The Illusion of Skill
While professional investors and traders may have (or at least would be expected to have) the skill needed to outperform the market compared to amateurs, the evidence from 50 plus years of research suggests:
"...for a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker. At least two out of every three mutual funds underperform the overall market in any given year."
Now, what about wealth advisors? Kahneman looked at data for some anonymous wealth advisers to figure out whether the same advisers consistently achieved better returns for clients and display more skill than others. Once again...
"The results resembled what you would expect from a dice-rolling contest, not a game of skill."
So what was the response from the directors when they heard of the findings? Kahneman says he and Richard Thaler told the directors the following:
"What we told the directors of the firm was that, at least when it came to building portfolios, the firm was rewarding luck as if it were skill. This should have been shocking news to them, but it was not. There was no sign that they disbelieved us. How could they? After all, we had analyzed their own results, and they were certainly sophisticated enough to appreciate their implications, which we politely refrained from spelling out."
Then later Kahneman added:
"...I am quite sure that both our findings and their implications were quickly swept under the rug and that life in the firm went on just as before. The illusion of skill is not only an individual aberration; it is deeply ingrained in the culture of the industry. Facts that challenge such basic assumptions — and thereby threaten people's livelihood and self-esteem — are simply not absorbed."
Not surprisingly, when they reported the finding to the wealth advisers themselves the response was similar. Kahneman closed with the following:
"...overconfident professionals sincerely believe they have expertise, act as experts and look like experts. You will have to struggle to remind yourself that they may be in the grip of an illusion."
In the 1970s, the work of Kahneman (in collaboration with Amos Tversky) challenged the flawed but once prevailing wisdom in social science that people generally acted rationally and selfishly (in some ways still alive and well even if to a lesser extent). First, they showed that mental shortcuts (heuristics) are useful but "lead to severe and systematic errors." Experiments they did revealed "cognitive biases" or unconscious errors of reasoning. Later, their prospect theory exposed flaws in the dominant models in economics at the time. The basic assumption that people will always act rationally and in their own interests was wrong.
For Kahneman and Tversky, it was obvious that people are not fully rational nor selfish.
In 2002, Kahneman won the Nobel in economic science. What's at least notable about winning such an award is that Kahneman is a Professor of Psychology.
I am currently reading Kahneman's "Thinking, Fast and Slow". The book covers, along with much else, the many forms of cognitive bias. It does a good job of explaining why the assumption embedded in traditional economic models that humans are coldly rational actors is flawed. I've found it insightful and useful for investing and beyond. It is a comprehensive (and, though accessible, I mean comprehensive!) look at the reasons why we sometimes act just a bit less than rational.
To me, Kahneman seems most interested in allowing the implications of the better ideas in his field to speak for themselves, while recognizing their limitations, and noting some of the key disagreements among colleagues, where applicable.
To me, it's a refreshingly humble approach.
Adam
Related posts:
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
* Terrance Odean is the Professor of Finance at the University of California, Berkeley.
** Based upon Terrance Odean's and Brad Barber's paper: "Trading Is Hazardous To Your Wealth".
---
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, April 5, 2012
Jamie Dimon's 2011 Annual Shareholder Letter
In his latest letter to the shareholders of Berkshire Hathaway (BRKa), Warren Buffett had this to say about the CEO of J.P. Morgan ((JPM), Jamie Dimon:
One CEO who always stresses the price/value factor in repurchase decisions is Jamie Dimon at J.P. Morgan; I recommend that you read his annual letter.
Recently on CNBC, he also was very complimentary of Jamie Dimon's annual letter and said he owns some J.P. Morgan shares personally.
Well, Jamie Dimon's 2011 letter to J.P. Morgan shareholders was just released and it is a very good one.
Some excerpts from Dimon's latest letter:
$ 1.8 Trillion of Capital and Credit
During 2011, the firm raised capital and provided credit of over $1.8 trillion for our commercial and consumer clients, up 18% from the prior year.
On Buybacks and Dividends
We also bought back $9 billion of stock and recently received permission to buy back an additional $15 billion of stock during the remainder of 2012 and the first quarter of 2013. We reinstated our annual dividend to $1.00 a share in April 2011 and recently announced that we are increasing it to $1.20 a share in April 2012.
J.P Morgan's Stock
Normally, we don't comment on the stock price. However, we make an exception in Section VIII of this letter because we are buying back a substantial amount of stock and because there are many concerns about investing in bank stocks.
It Could Have Been Much Better
Recently, we have begun to achieve modest economic growth around the globe, somewhat held back by certain natural disasters such as the tsunami in Japan. But I have no doubt that our own actions – from the debt ceiling fiasco to bad and uncoordinated policy, including the somewhat dramatic restraining of bank leverage in the United States and Europe at precisely the wrong time – made the recovery worse than it otherwise would have been. You cannot prove this in real time, but when economists 20 years from now write the book on the recovery, it may well be entitled, It Could Have Been Much Better.
A Stronger System
There also should be recognition that the whole system is stronger. Accounting and disclosure are better, most off-balance sheet vehicles are gone, underwriting standards are higher, there is much less leverage in the system, many of the bad actors are gone and, last but not least, each remaining bank is individually stronger.
Best and Highest Use of Capital
Our best and highest use of capital (after the dividend) is always to build our business organically – particularly where we have significant competitive advantages and good returns. We already have described many of those opportunities in this letter, and I won’t repeat them here. The second-highest use would be great acquisitions, but, as I also have indicated, it is unlikely that we will do one that requires substantial amounts of capital.
More on Buybacks
If you like our businesses, buying back stock at tangible book value is a very good deal. So you can assume that we are a buyer in size around tangible book value. Unfortunately, we were restricted from buying back more stock when it was cheap – below tangible book value – and we did not get permission to buy back stock until it was selling at $45 a share.
Our appetite for buying back stock is not as great (of course) at higher prices.
Dimon does also say that they plan to buy back the amount of stock that we issue every year for employee compensation because "we think this is just good discipline". I find that to be a bit disappointing but the statement that follows provides some reassurance they won't do that kind of thing at any price:
Rest assured, the Board will continuously reevaluate our capital plans and make changes as appropriate but will authorize a buyback of stock only when we think it is a great deal for you, our shareholders.
The statements "our appetite for buying back stock is not as great" and "will authorize a buyback of stock only when we think it is a great deal" should be the norm among CEOs but that kind of discipline is far from a given.
Adam
Established long positions in BRKb and JPM at less than recent market prices
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.
One CEO who always stresses the price/value factor in repurchase decisions is Jamie Dimon at J.P. Morgan; I recommend that you read his annual letter.
Recently on CNBC, he also was very complimentary of Jamie Dimon's annual letter and said he owns some J.P. Morgan shares personally.
Well, Jamie Dimon's 2011 letter to J.P. Morgan shareholders was just released and it is a very good one.
Some excerpts from Dimon's latest letter:
$ 1.8 Trillion of Capital and Credit
During 2011, the firm raised capital and provided credit of over $1.8 trillion for our commercial and consumer clients, up 18% from the prior year.
On Buybacks and Dividends
We also bought back $9 billion of stock and recently received permission to buy back an additional $15 billion of stock during the remainder of 2012 and the first quarter of 2013. We reinstated our annual dividend to $1.00 a share in April 2011 and recently announced that we are increasing it to $1.20 a share in April 2012.
J.P Morgan's Stock
Normally, we don't comment on the stock price. However, we make an exception in Section VIII of this letter because we are buying back a substantial amount of stock and because there are many concerns about investing in bank stocks.
It Could Have Been Much Better
Recently, we have begun to achieve modest economic growth around the globe, somewhat held back by certain natural disasters such as the tsunami in Japan. But I have no doubt that our own actions – from the debt ceiling fiasco to bad and uncoordinated policy, including the somewhat dramatic restraining of bank leverage in the United States and Europe at precisely the wrong time – made the recovery worse than it otherwise would have been. You cannot prove this in real time, but when economists 20 years from now write the book on the recovery, it may well be entitled, It Could Have Been Much Better.
A Stronger System
There also should be recognition that the whole system is stronger. Accounting and disclosure are better, most off-balance sheet vehicles are gone, underwriting standards are higher, there is much less leverage in the system, many of the bad actors are gone and, last but not least, each remaining bank is individually stronger.
Best and Highest Use of Capital
Our best and highest use of capital (after the dividend) is always to build our business organically – particularly where we have significant competitive advantages and good returns. We already have described many of those opportunities in this letter, and I won’t repeat them here. The second-highest use would be great acquisitions, but, as I also have indicated, it is unlikely that we will do one that requires substantial amounts of capital.
More on Buybacks
If you like our businesses, buying back stock at tangible book value is a very good deal. So you can assume that we are a buyer in size around tangible book value. Unfortunately, we were restricted from buying back more stock when it was cheap – below tangible book value – and we did not get permission to buy back stock until it was selling at $45 a share.
Our appetite for buying back stock is not as great (of course) at higher prices.
Dimon does also say that they plan to buy back the amount of stock that we issue every year for employee compensation because "we think this is just good discipline". I find that to be a bit disappointing but the statement that follows provides some reassurance they won't do that kind of thing at any price:
Rest assured, the Board will continuously reevaluate our capital plans and make changes as appropriate but will authorize a buyback of stock only when we think it is a great deal for you, our shareholders.
The statements "our appetite for buying back stock is not as great" and "will authorize a buyback of stock only when we think it is a great deal" should be the norm among CEOs but that kind of discipline is far from a given.
Adam
Established long positions in BRKb and JPM at less than recent market prices
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, April 4, 2012
Is a $ 1 Trillion Market Cap in Apple's Future?
There have been some recent headlines made by analysts who are predicting that Apple (AAPL) stock will hit $ 1,000/share.
Brian White of Topeka Capital Markets said he expected it to happen within 12 months while Gene Munster of Piper Jaffrey said it would be more like by 2014.
Apple May Be World's First Trillion Dollar Company
Are these predictions at all similar to the kind of price targets that happened during the tech bubble?
Well, I doubt we are there yet but I readily admit to not being a fan of the whole price target game. Never have been and never will be. I also realize the price target folly that goes on is not going away anytime soon.
So I'll leave the guessing what a stock will do over a shorter time frame like 2 or 3 years to others.
To me, it has always made more sense to to buy what I understand at a discount to a conservative estimate of hopefully well-judged worth, then let it compound for years to come.
Other than that, just monitor the strength of the core franchise and sell only if something fundamental materially breaks (and occasionally, if reluctantly, when it gets extremely expensive or the capital is needed for a clearly superior alternative).
Well, that's true for most investments I've made but, as I'll get to later in this post, it's not easy to do with something like Apple (at least not easy for me).
So will Apple soon be intrinsically worth $ 1 trillion? More importantly, will it be able sustain and increase that value for a long time?
Let's look, somewhat simplistically, at the kind of assumptions that are needed to get Apple to a $ 1 trillion valuation.
Assumptions
15% earnings growth in 2013 and 2014 (I think many are expecting more than that)
Dividends and buyback plan is executed as announced
15x enterprise value/earnings
Shares outstanding remain roughly the same (per Apple's recent announcement, buybacks are to neutralize share dilution)
With 15% growth in earnings through 2014, by my math Apple will have over $ 200 billion in cash after paying the dividends and executing the buyback. That 15% level of growth suggests Apple will be earning roughly $ 55 billion in 2014.
15x that amount of earnings results in an enterprise value/earnings of $ 825 billion.
Add in the $ 200 billion of cash and you get a $ 1 trillion market cap.
For those willing to buy the above assumptions the stock may not seem expensive now. Yet, while I own shares of Apple (disclosure: purchased at less than 1/3 of yesterday's closing price), the risk/reward of buying near what it sells at now is far less comfortable for me.
It's not that the stock is expensive compared to current earnings. Certainly not at roughly 12x enterprise value to 2012 earnings even after this most recent run up in the stock price.
It's that, unlike most other things I own, it's difficult to judge what Apple's normalized earnings are likely to be longer term. There is a wide range of outcomes (seemingly now more on the upside than downside these days, but that's often the time to start being skeptical) and the safety margin seems either too small or not knowable.
I can see why others will likely still see the stock as still a good opportunity and they may turn out to be right. Apple's near term prospects are hard to argue with and, considering their track record, will probably even continue to surprise on the upside.
I just have no idea and I'm not willing to risk additional capital based upon the assumption that $ 50 billion plus in earnings, if achieved in 2014, will be a sustainable number that can be built upon for years to come. (Apple very well may prove it is more than sustainable, but no one gets to invest in retrospect.)
In other words, I'm being conservative in my estimate of intrinsic value by not assuming that $ 50 billion plus will be sustainable.*
What's the normalized earnings for a company like Apple that has seen its recent earnings explode higher?
Maybe still a lot higher but who knows in an industry as dynamic as the one Apple competes in. Among other scenarios, it's also possible this is a temporary explosive spike in earnings that, as competition pressure margins somewhat, eventually settles in at a lower level and then Apple grows from there. Apple would remain a terrific business if that happened, but the stock would seem a whole lot less cheap.
(Of course, this was also a possibility a few years back. It's just worth considering that Apple has gone from earning just under $ 5 billion in 2008 to a current estimate of ~$ 40 billion this year. So while, with the benefit of hindsight, this concern may also prove to be too early at least some caution seems warranted considering how dramatically the earnings picture has changed in a short time.)
When earnings capacity changes this much in a relatively small window of time (both a large percentage change and a large absolute number by any measure), it seems wise to at least start considering some of the less desirable scenarios instead of blindly extrapolating into what now seems a blissful future.
I don't doubt the stock could go up from here but eventually an investment gets to the point where, at least near the current price, it's not clear to the owner (me) what the longer run downside risk is (again, even if it turns out to be a wrong judgment after the fact).
So, while I may not be selling the shares I already own anytime soon, what seemed a clear margin of safety when I initially purchased Apple's stock is, to me, much harder to see.
Can Apple can become worth $ 1 trillion and make it stick longer term? As good as Apple is, that's still too hard to figure out. I mean, the durability of any company that resides in a dynamic industry is difficult to figure out but, of course, Apple is not just any company.
Over the next five years or so, Apple's upside is or at least seems just fine compared to just about any large cap. I don't doubt they may get to $ 1 trillion or more in market value. They may even seem worth it for a while (Or end up actually being worth it. Remember: I'm not selling yet...I'm just not buying!).
The math required to get there isn't aggressive.
Having said that, I know of some great (if far more boring) business franchises in less dynamic industries that, if bought at the right price, still have a far easier to gauge long-term risk/reward for my money.
That's my comfort zone.
Apple's business is not. As I've explained here and on other occasions, there's just no technology business that I'm comfortable with as a long-term investment.
Of course, few can probably match Apple's potential near-term (and possibly even longer-term) term prospects.
I have owned Apple's stock the past three years or so for the simple reason that the price became ludicrously low compared to its rapidly growing intrinsic value. Its cash generation and net cash on the balance sheet provided a margin of safety. That margin of safety seemed large and turned out to be even larger than could have been known at the time (at least by me). As always, the price paid relative to likely value dictates the risk one takes on an investment.
Eventually, the discount to value gets so low that something I normally would not like to own becomes attractive.
Apple's business has a far wider range of outcomes than I usually like so it's kept on a shorter leash than most other things I own. The underlying economics are terrific now, but the durability of it's economics over many years will never be easy to judge. In contrast, selling something like Coca-Cola (KO) would never be a consideration just because it became somewhat expensive (Though if it ever becomes late 1990s expensive again I certainly will be selling some shares!)
The fact is, I never will be the best candidate to own Apple's shares long-term (others are more qualified), but I wouldn't want to be betting against the company's future prospects either.
It's always about price versus value and I've just decided to think more conservatively about Apple's likely intrinsic value. As more evidence comes in, I will adjust accordingly.
Adam
Established a long position in AAPL at much lower than recent market prices
Related post:
Technology Stocks
* Others, of course, can do whatever they want but, for me, capital preservation is paramount. Apple may continue to do very well but missing that kind of opportunity doesn't bother me. I like certain attractive returns...not risky ones. It's not difficult to understand why value-oriented investors sometimes buy "too early" and sell "too early". What seems to be a bargain becomes an even bigger one. When something becomes expensive it ends getting even more so.
---
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.
Brian White of Topeka Capital Markets said he expected it to happen within 12 months while Gene Munster of Piper Jaffrey said it would be more like by 2014.
Apple May Be World's First Trillion Dollar Company
Are these predictions at all similar to the kind of price targets that happened during the tech bubble?
Well, I doubt we are there yet but I readily admit to not being a fan of the whole price target game. Never have been and never will be. I also realize the price target folly that goes on is not going away anytime soon.
So I'll leave the guessing what a stock will do over a shorter time frame like 2 or 3 years to others.
To me, it has always made more sense to to buy what I understand at a discount to a conservative estimate of hopefully well-judged worth, then let it compound for years to come.
Other than that, just monitor the strength of the core franchise and sell only if something fundamental materially breaks (and occasionally, if reluctantly, when it gets extremely expensive or the capital is needed for a clearly superior alternative).
Well, that's true for most investments I've made but, as I'll get to later in this post, it's not easy to do with something like Apple (at least not easy for me).
So will Apple soon be intrinsically worth $ 1 trillion? More importantly, will it be able sustain and increase that value for a long time?
Let's look, somewhat simplistically, at the kind of assumptions that are needed to get Apple to a $ 1 trillion valuation.
Assumptions
15% earnings growth in 2013 and 2014 (I think many are expecting more than that)
Dividends and buyback plan is executed as announced
15x enterprise value/earnings
Shares outstanding remain roughly the same (per Apple's recent announcement, buybacks are to neutralize share dilution)
With 15% growth in earnings through 2014, by my math Apple will have over $ 200 billion in cash after paying the dividends and executing the buyback. That 15% level of growth suggests Apple will be earning roughly $ 55 billion in 2014.
15x that amount of earnings results in an enterprise value/earnings of $ 825 billion.
Add in the $ 200 billion of cash and you get a $ 1 trillion market cap.
For those willing to buy the above assumptions the stock may not seem expensive now. Yet, while I own shares of Apple (disclosure: purchased at less than 1/3 of yesterday's closing price), the risk/reward of buying near what it sells at now is far less comfortable for me.
It's not that the stock is expensive compared to current earnings. Certainly not at roughly 12x enterprise value to 2012 earnings even after this most recent run up in the stock price.
It's that, unlike most other things I own, it's difficult to judge what Apple's normalized earnings are likely to be longer term. There is a wide range of outcomes (seemingly now more on the upside than downside these days, but that's often the time to start being skeptical) and the safety margin seems either too small or not knowable.
I can see why others will likely still see the stock as still a good opportunity and they may turn out to be right. Apple's near term prospects are hard to argue with and, considering their track record, will probably even continue to surprise on the upside.
I just have no idea and I'm not willing to risk additional capital based upon the assumption that $ 50 billion plus in earnings, if achieved in 2014, will be a sustainable number that can be built upon for years to come. (Apple very well may prove it is more than sustainable, but no one gets to invest in retrospect.)
In other words, I'm being conservative in my estimate of intrinsic value by not assuming that $ 50 billion plus will be sustainable.*
What's the normalized earnings for a company like Apple that has seen its recent earnings explode higher?
Maybe still a lot higher but who knows in an industry as dynamic as the one Apple competes in. Among other scenarios, it's also possible this is a temporary explosive spike in earnings that, as competition pressure margins somewhat, eventually settles in at a lower level and then Apple grows from there. Apple would remain a terrific business if that happened, but the stock would seem a whole lot less cheap.
(Of course, this was also a possibility a few years back. It's just worth considering that Apple has gone from earning just under $ 5 billion in 2008 to a current estimate of ~$ 40 billion this year. So while, with the benefit of hindsight, this concern may also prove to be too early at least some caution seems warranted considering how dramatically the earnings picture has changed in a short time.)
When earnings capacity changes this much in a relatively small window of time (both a large percentage change and a large absolute number by any measure), it seems wise to at least start considering some of the less desirable scenarios instead of blindly extrapolating into what now seems a blissful future.
I don't doubt the stock could go up from here but eventually an investment gets to the point where, at least near the current price, it's not clear to the owner (me) what the longer run downside risk is (again, even if it turns out to be a wrong judgment after the fact).
So, while I may not be selling the shares I already own anytime soon, what seemed a clear margin of safety when I initially purchased Apple's stock is, to me, much harder to see.
Can Apple can become worth $ 1 trillion and make it stick longer term? As good as Apple is, that's still too hard to figure out. I mean, the durability of any company that resides in a dynamic industry is difficult to figure out but, of course, Apple is not just any company.
Over the next five years or so, Apple's upside is or at least seems just fine compared to just about any large cap. I don't doubt they may get to $ 1 trillion or more in market value. They may even seem worth it for a while (Or end up actually being worth it. Remember: I'm not selling yet...I'm just not buying!).
The math required to get there isn't aggressive.
Having said that, I know of some great (if far more boring) business franchises in less dynamic industries that, if bought at the right price, still have a far easier to gauge long-term risk/reward for my money.
That's my comfort zone.
Apple's business is not. As I've explained here and on other occasions, there's just no technology business that I'm comfortable with as a long-term investment.
Of course, few can probably match Apple's potential near-term (and possibly even longer-term) term prospects.
I have owned Apple's stock the past three years or so for the simple reason that the price became ludicrously low compared to its rapidly growing intrinsic value. Its cash generation and net cash on the balance sheet provided a margin of safety. That margin of safety seemed large and turned out to be even larger than could have been known at the time (at least by me). As always, the price paid relative to likely value dictates the risk one takes on an investment.
Eventually, the discount to value gets so low that something I normally would not like to own becomes attractive.
Apple's business has a far wider range of outcomes than I usually like so it's kept on a shorter leash than most other things I own. The underlying economics are terrific now, but the durability of it's economics over many years will never be easy to judge. In contrast, selling something like Coca-Cola (KO) would never be a consideration just because it became somewhat expensive (Though if it ever becomes late 1990s expensive again I certainly will be selling some shares!)
The fact is, I never will be the best candidate to own Apple's shares long-term (others are more qualified), but I wouldn't want to be betting against the company's future prospects either.
It's always about price versus value and I've just decided to think more conservatively about Apple's likely intrinsic value. As more evidence comes in, I will adjust accordingly.
Adam
Established a long position in AAPL at much lower than recent market prices
Related post:
Technology Stocks
* Others, of course, can do whatever they want but, for me, capital preservation is paramount. Apple may continue to do very well but missing that kind of opportunity doesn't bother me. I like certain attractive returns...not risky ones. It's not difficult to understand why value-oriented investors sometimes buy "too early" and sell "too early". What seems to be a bargain becomes an even bigger one. When something becomes expensive it ends getting even more so.
---
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, April 3, 2012
Buffett on Berkshire's Earnings Mix: Operating Earnings Versus Gains from the Sale of Securities
Analyzing Berkshire Hathaway's (BRKa) earnings isn't always straightforward.
The year 1985 wasn't especially confusing compared to other years but serves as a useful example. The shareholder letter from that year shows that Berkshire's pre-tax earnings grew substantially year over year from $ 200.5 million to $ 613.4 million.
On the surface a great year but, unfortunately, that bottom line number doesn't reveal much about what Berkshire's true earnings power was at the time.
It was, in fact, a very good year but not nearly as good as the tripling would indicate.
The reason? Much of the increase came from the sale of marketable securities. Here's how the picture looked that year with gains from the sale of securities separated from the earnings (in millions) from Berkshire's operating businesses:*
1984 1985
Operating earnings $ 87.7 $125.4
Gain from Sale of Securities $104.7 $468.9
Other $ 8.1 $ 19.0
Total Earnings $200.5 $613.4
Here's how Warren Buffett explained the year over year performance in the 1985 shareholder letter:
"Our 1985 results include unusually large earnings from the sale of securities. This fact, in itself, does not mean that we had a particularly good year (though, of course, we did). Security profits in a given year bear similarities to a college graduation ceremony in which the knowledge gained over four years is recognized on a day when nothing further is learned. We may hold a stock for a decade or more, and during that period it may grow quite consistently in both business and market value. In the year in which we finally sell it there may be no increase in value, or there may even be a decrease. But all growth in value since purchase will be reflected in the accounting earnings of the year of sale. (If the stock owned is in our insurance subsidiaries, however, any gain or loss in market value will be reflected in net worth annually.) Thus, reported capital gains or losses in any given year are meaningless as a measure of how well we have done in the current year."
The bulk of that gain from sale of securities was the result of selling General Foods.
Now, Berkshire had bought General Foods at what they viewed to be a substantial discount to per share business value back in 1980. Also, the business had fine underlying economics and, according to Buffett, a management that was focused on increasing that business value.
Shares bought cheap compared to 1980 value and, as a result of attractive underlying economics along with sound management, intrinsic value grew substantially over the five years or so.
None of the above led to a reported gain while the next thing that happened did. Philip Morris (now Altria: MO) came along and made a nice buyout offer for the shares of General Foods. More from the letter:
"We thus benefited from four factors: a bargain purchase price, a business with fine underlying economics, an able management concentrating on the interests of shareholders, and a buyer willing to pay full business value. While that last factor is the only one that produces reported earnings, we consider identification of the first three to be the key to building value for Berkshire shareholders. In selecting common stocks, we devote our attention to attractive purchases, not to the possibility of attractive sales."
So value was enhanced over many years but the gains had to be recognized all at once as accounting earnings in that one year.
Adam
Long position in BRKb and MO established at less than recent market prices
* Earnings do not include the amortization of Goodwill. From the letter: "...amortization of Goodwill is not charged against the specific businesses but, for reasons outlined in the Appendix to my letter in the 1983 annual report, is aggregated as a separate item." The reason comes down to the difference between economic and accounting Goodwill. The Appendix in the 1983 letter does a nice job of explaining this.
---
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 year 1985 wasn't especially confusing compared to other years but serves as a useful example. The shareholder letter from that year shows that Berkshire's pre-tax earnings grew substantially year over year from $ 200.5 million to $ 613.4 million.
On the surface a great year but, unfortunately, that bottom line number doesn't reveal much about what Berkshire's true earnings power was at the time.
It was, in fact, a very good year but not nearly as good as the tripling would indicate.
The reason? Much of the increase came from the sale of marketable securities. Here's how the picture looked that year with gains from the sale of securities separated from the earnings (in millions) from Berkshire's operating businesses:*
1984 1985
Operating earnings $ 87.7 $125.4
Gain from Sale of Securities $104.7 $468.9
Other $ 8.1 $ 19.0
Total Earnings $200.5 $613.4
Here's how Warren Buffett explained the year over year performance in the 1985 shareholder letter:
"Our 1985 results include unusually large earnings from the sale of securities. This fact, in itself, does not mean that we had a particularly good year (though, of course, we did). Security profits in a given year bear similarities to a college graduation ceremony in which the knowledge gained over four years is recognized on a day when nothing further is learned. We may hold a stock for a decade or more, and during that period it may grow quite consistently in both business and market value. In the year in which we finally sell it there may be no increase in value, or there may even be a decrease. But all growth in value since purchase will be reflected in the accounting earnings of the year of sale. (If the stock owned is in our insurance subsidiaries, however, any gain or loss in market value will be reflected in net worth annually.) Thus, reported capital gains or losses in any given year are meaningless as a measure of how well we have done in the current year."
The bulk of that gain from sale of securities was the result of selling General Foods.
Now, Berkshire had bought General Foods at what they viewed to be a substantial discount to per share business value back in 1980. Also, the business had fine underlying economics and, according to Buffett, a management that was focused on increasing that business value.
Shares bought cheap compared to 1980 value and, as a result of attractive underlying economics along with sound management, intrinsic value grew substantially over the five years or so.
None of the above led to a reported gain while the next thing that happened did. Philip Morris (now Altria: MO) came along and made a nice buyout offer for the shares of General Foods. More from the letter:
"We thus benefited from four factors: a bargain purchase price, a business with fine underlying economics, an able management concentrating on the interests of shareholders, and a buyer willing to pay full business value. While that last factor is the only one that produces reported earnings, we consider identification of the first three to be the key to building value for Berkshire shareholders. In selecting common stocks, we devote our attention to attractive purchases, not to the possibility of attractive sales."
So value was enhanced over many years but the gains had to be recognized all at once as accounting earnings in that one year.
Adam
Long position in BRKb and MO established at less than recent market prices
* Earnings do not include the amortization of Goodwill. From the letter: "...amortization of Goodwill is not charged against the specific businesses but, for reasons outlined in the Appendix to my letter in the 1983 annual report, is aggregated as a separate item." The reason comes down to the difference between economic and accounting Goodwill. The Appendix in the 1983 letter does a nice job of explaining this.
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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, April 2, 2012
John Maynard Keynes, The Investor
An excerpt from chapter 12 of The General Theory of Employment, Interest, and Money by John Maynard Keynes:
The chapter is one of three that Warren Buffett has said investors should read.
"Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of "liquid" securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is "to beat the gun", as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.
This battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years, does not even require gulls amongst the public to feed the maws of the professional; — it can be played by professionals amongst themselves."
Later in the chapter Keynes equates this to games like Musical Chairs among others:
"These games can be played with zest and enjoyment, though...when the music stops some of the players will find themselves unseated."
In this Wall Street Journal article, Jason Zweig points out that Keynes was quite an investor. Well, at least he was once a change in investing styles occurred mid-career:
So an eight percent annual outperformance from 1924 to 1946.
Impressive, but clearly most of these exceptional results came after Keynes switched from the "macro" or "top-down" style to fundamental stock-picking.
In his earlier years, Keynes relied heavily upon monetary/economic signals to switch in and out of assets.
Using this earlier approach, Keynes went into the fall of 1929 with way too much stock exposure (83%) and paid for it.
Less than a few years after that experience, he switched from this "top down" approach to pure stock-picking focusing instead on the "bottom up" analysis of fundamentals.
Keynes also was known to concentrate his holdings (top five positions sometimes made up as much as 50% of the portfolio) and held shares for often more than five years.
Sound familiar? In Chapter 12 of The General Theory, Keynes said that the "spectacle of modern investment markets has sometimes moved me towards the conclusion" that they be set up in a way that will "force the investor to direct his mind to the long-term prospects and to those only."
Yet, Keynes also understood how difficult it was to get most market participants to act in this way.
The reason? There's a fundamental dilemma that impedes this from happening. More from Chapter 12:
"...the liquidity of investment markets often facilitates, though it sometimes impedes, the course of new investment. For the fact that each individual investor flatters himself that his commitment is "liquid" (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk."
Finding the right balance is a problem persists to this day. I think it's safe to say we've gone too far in the direction of liquidity by a long shot but the same forces seem at work.
You don't have to agree with some of the economic theories of Keynes (on things like the need, at times, for government intervention in the economy) to learn from him when it comes to investing.
Adam
Keynes: One Mean Money Manager - Jason Zweig, Wall Street Journal
The General Theory of Employment, Interest, and Money - John Maynard Keynes
HT: Gaurang Sathaye
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.
The chapter is one of three that Warren Buffett has said investors should read.
"Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of "liquid" securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is "to beat the gun", as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.
This battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years, does not even require gulls amongst the public to feed the maws of the professional; — it can be played by professionals amongst themselves."
Later in the chapter Keynes equates this to games like Musical Chairs among others:
"These games can be played with zest and enjoyment, though...when the music stops some of the players will find themselves unseated."
In this Wall Street Journal article, Jason Zweig points out that Keynes was quite an investor. Well, at least he was once a change in investing styles occurred mid-career:
Impressive, but clearly most of these exceptional results came after Keynes switched from the "macro" or "top-down" style to fundamental stock-picking.
In his earlier years, Keynes relied heavily upon monetary/economic signals to switch in and out of assets.
Using this earlier approach, Keynes went into the fall of 1929 with way too much stock exposure (83%) and paid for it.
Less than a few years after that experience, he switched from this "top down" approach to pure stock-picking focusing instead on the "bottom up" analysis of fundamentals.
Keynes also was known to concentrate his holdings (top five positions sometimes made up as much as 50% of the portfolio) and held shares for often more than five years.
Sound familiar? In Chapter 12 of The General Theory, Keynes said that the "spectacle of modern investment markets has sometimes moved me towards the conclusion" that they be set up in a way that will "force the investor to direct his mind to the long-term prospects and to those only."
Yet, Keynes also understood how difficult it was to get most market participants to act in this way.
The reason? There's a fundamental dilemma that impedes this from happening. More from Chapter 12:
"...the liquidity of investment markets often facilitates, though it sometimes impedes, the course of new investment. For the fact that each individual investor flatters himself that his commitment is "liquid" (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk."
Finding the right balance is a problem persists to this day. I think it's safe to say we've gone too far in the direction of liquidity by a long shot but the same forces seem at work.
You don't have to agree with some of the economic theories of Keynes (on things like the need, at times, for government intervention in the economy) to learn from him when it comes to investing.
Adam
Keynes: One Mean Money Manager - Jason Zweig, Wall Street Journal
The General Theory of Employment, Interest, and Money - John Maynard Keynes
HT: Gaurang Sathaye
---
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.
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