Warren Buffett explains below why, in certain business situations, it sometimes makes sense to embrace a substantial decline in revenue.
What?
This may not exactly be intuitive but, for investors, coming to grips with some of the thinking behind this is very worthwhile.
Shouldn't a business be striving for growth? Since a little growth is good shouldn't a little more growth generally be better?
I mean, who in their right mind would want to deliberately allow their business to shrink?
Buffett explains below precisely why growth at times is your worst enemy and why Berkshire Hathaway will, in fact, deliberately shrink an insurance business, at times even dramatically so, and for extended periods of time.
It's a mindset rarely understood and even more infrequently implemented. Yet, it gets near the heart of one key reason for the phenomenal success of Berkshire.
Now, though the example Buffett uses below is specifically about insurance, in my view it often applies to other types of businesses even if in more subtle ways.
To me, it is an idea that can be of substantial use to any business person or investor.
The concept can seem a bit odd at first but is certainly worth taking some time to understand. Occasionally, good ideas reside near those things that -- at least on the surface -- might seem to make little sense.
From the 2004 Berkshire Hathaway (BRKa) shareholder letter:
National Indemnity
"Since Berkshire purchased National Indemnity ('NICO') in 1967, property-casualty insurance has
been our core business and the propellant of our growth. Insurance has provided a fountain of funds with
which we've acquired the securities and businesses that now give us an ever-widening variety of earnings
streams."
Insurance Float
"Float is wonderful – if it doesn't come at a high price. Its cost is determined by underwriting
results, meaning how the expenses and losses we will ultimately pay compare with the premiums we have
received. When an underwriting profit is achieved...float is better than free. In such years, we are actually
paid for holding other people's money. For most insurers, however, life has been far more difficult: In
aggregate, the property-casualty industry almost invariably operates at an underwriting loss. When that
loss is large, float becomes expensive, sometimes devastatingly so.
Insurers have generally earned poor returns for a simple reason: They sell a commodity-like product. Policy forms are standard, and the product is available from many suppliers, some of whom are mutual companies ('owned' by policyholders rather than stockholders) with profit goals that are limited. Moreover, most insureds don't care from whom they buy. Customers by the millions say 'I need some Gillette blades' or 'I'll have a Coke' but we wait in vain for 'I'd like a National Indemnity policy, please.' Consequently, price competition in insurance is usually fierce. Think airline seats.
So, you may ask, how do Berkshire's insurance operations overcome the dismal economics of the industry and achieve some measure of enduring competitive advantage?"
The answer comes down to a simple if not easy to implement strategy. Buffett goes on to explain it.
NICO's Strategy
"When we purchased the company – a specialist in commercial auto and general liability insurance – it did not appear to have any attributes that would overcome the industry's chronic troubles. It was not well-known, had no informational advantage (the company has never had an actuary), was not a low-cost operator, and sold through general agents, a method many people thought outdated. Nevertheless, for almost all of the past 38 years, NICO has been a star performer. Indeed, had we not made this acquisition, Berkshire would be lucky to be worth half of what it is today.
What we've had going for us is a managerial mindset that most insurers find impossible to
replicate."
In the letter, there is a table that shows NICO allowed written premiums to drop from $ 366 million in 1986 to $ 54 million in 1999. An 85 percent decline.
It is this kind of discipline that, as Buffett explains next, many in business find so difficult to copy.
The Colossal Slide
"Can you imagine any public company embracing a business model that would lead to the decline in revenue that we experienced from 1986 through 1999? That colossal slide, it should be emphasized, did not occur because business was unobtainable. Many billions of premium dollars were readily available to NICO had we only been willing to cut prices. But we instead consistently priced to make a profit, not to match our most optimistic competitor. We never left customers – but they left us.
Most American businesses harbor an 'institutional imperative' that rejects extended decreases in volume. What CEO wants to report to his shareholders that not only did business contract last year but that it will continue to drop? In insurance, the urge to keep writing business is also intensified because the consequences of foolishly-priced policies may not become apparent for some time. If an insurer is optimistic in its reserving, reported earnings will be overstated, and years may pass before true loss costs are revealed (a form of self-deception that nearly destroyed GEICO in the early 1970s)."
Again, it's not just the insurance business. Shareholders of many commodity-like businesses that are run with the Berkshire mindset have a much better chance of being served well in the long run. For example, the next time a banker is promising consistently high earnings growth it would be wise to remember the above because it generally applies.
That is not a bank I'd want to own.
For some commodity-like businesses, at times the smartest thing to do is intelligently shrink, even if less dramatically than the NICO example above, until the competitive landscape produces a pricing environment supportive of high returns.
A disciplined management and the kind of culture that supports this way of thinking is harder to find than it sounds.
What about the employees? In the letter Buffett explains:
"To combat employees' natural tendency to save their own skins, we have always promised
NICO's workforce that no one will be fired because of declining volume, however severe the contraction."
Now, they'd be unwise to just say they are going to do that and then not follow through. The key is to have the discipline, patience, and integrity in combination with sufficient financial capacity.
Buffett also makes the crucial point that an insurance business can live with some excess overhead but not underpriced business.
It just requires the kind of senior management who will behave consistent with that reality.
Adam
Long position in BRKb
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.
Friday, November 11, 2011
Thursday, November 10, 2011
Markel's Tom Gayner on How to Outperform the S&P 500
Tom Gayner is Markel's (MKL) President and CIO and manages roughly $ 2 billion of equity investments for the company.
Over the past 20 years or so he has managed a fund at Markel Gayner Asset Management, Markel's Investment Division, that has outperformed the S&P 500 by several hundred basis points per year.
One nice thing about following Tom Gayner is that, much like Donald Yacktman, the turnover in his portfolio is relatively low so when he commits capital to something it's not some short-term trade.
Major holdings are generally high quality businesses with the potential for long run value creation.
Last May, he spoke at the 8th Annual Value Investor Conference in Omaha. It occurs each year right before Berkshire Hathaway's annual shareholder meeting.
Some excerpts from the Q&A session:
On beating the S&P 500
"...sometimes, I think that is easier than others to do. So for instance, going back ten years ago, I owned a lot of small-cap stuff and tiny companies. That's because, or 12 years ago, that was the era when Coke (KO), Pepsi (PEP), GE (GE), blue chips were all selling for 30-40-50 times earnings, and at that time we owned zero, none of them."
"...well here's a joke that picks on the airline businesses because that's sort of an easy target: If you want to beat the S&P 500, here's what you do, you buy 500 stocks, and then you sell the airlines. You should do better. Probably won't be 500 basis points, but it will get you something."
Better days ahead for the S&P 500
"...the S&P is probably due for a pretty good day. As I look at the businesses that comprise the S&P, and really let's talk about the S&P 50, the biggest 50 companies that earn 90% of the dollars, those are good businesses, global-spreading businesses, they're efficiently run, they're doing the rights sort of things with their balance sheets."
"...if I was guessing, over a long period of time, I think the S&P 500 will be a pretty tough index to beat...in general, it's kind of a good place to be. And what that implies is that generally, a lot of large companies are pretty attractive investments."
On Berkshire Hathaway
"...it has been the largest holding in our portfolio since 1990 and it continues to be so. I think the powerhouse that is Berkshire continues unabated. So I'm very comfortable with that being the largest holding that we have."
On selling
"I tend to be a pretty slow seller. There's two reasons I would sell something, let's start with that: A) I made a mistake, it was wrong, and that usually involves some sort of character judgment I made about the management, being disappointed in some sort of tainted investing that seems inconsistent with what I wanted to see. Or secondly, and this is a little bit true right now, there are ideas that are just less compelling than a new idea that you might have and you need some money to pay for what you're buying. Generally speaking, it's not just a matter of the fact that I don't like to sell, but actually there's huge tax efficiencies for Markel for us to be able to buy and hold something for a long period of time."
On Wal-Mart
"I look at the numbers, I look at the annual reports, I look at the quarterly updates, I see the sales going up, the share count going down, the balance sheet in great shape, the dividend going up. I see thousands of people going in every Walmart every single day, I see the global expansion, I'm aware of the risk of the political unpopularity of the company from time to time, but at the kind of prices that I started buying it, where it was 16-17 times earnings, now it's at 12ish, I continue to buy that sort of thing. There's not a whole lot of rocket science or higher math involved in deciding that it's a good investment. But in this environment, it's typical of this sort of thing."
Examples of some recent top holdings include: Berkshire Hathaway (BRKa), CarMax (KMX), Fairfax Financial (FRFHF), Brookfield Asset Management (BAM), Diageo (DEO), Exxon Mobil Corp. (XOM), Walt Disney (DIS), WalMart (WMT), and United Parcel Service (UPS).
So mostly larger capitalization stocks.
It's a recurring theme but, unlike ten year ago, it's the larger companies that have become more attractively valued while smaller caps in general (though, of course, there are many exceptions) look by comparison relatively expensive.
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.
Over the past 20 years or so he has managed a fund at Markel Gayner Asset Management, Markel's Investment Division, that has outperformed the S&P 500 by several hundred basis points per year.
One nice thing about following Tom Gayner is that, much like Donald Yacktman, the turnover in his portfolio is relatively low so when he commits capital to something it's not some short-term trade.
Major holdings are generally high quality businesses with the potential for long run value creation.
Last May, he spoke at the 8th Annual Value Investor Conference in Omaha. It occurs each year right before Berkshire Hathaway's annual shareholder meeting.
Some excerpts from the Q&A session:
On beating the S&P 500
"...sometimes, I think that is easier than others to do. So for instance, going back ten years ago, I owned a lot of small-cap stuff and tiny companies. That's because, or 12 years ago, that was the era when Coke (KO), Pepsi (PEP), GE (GE), blue chips were all selling for 30-40-50 times earnings, and at that time we owned zero, none of them."
"...well here's a joke that picks on the airline businesses because that's sort of an easy target: If you want to beat the S&P 500, here's what you do, you buy 500 stocks, and then you sell the airlines. You should do better. Probably won't be 500 basis points, but it will get you something."
Better days ahead for the S&P 500
"...the S&P is probably due for a pretty good day. As I look at the businesses that comprise the S&P, and really let's talk about the S&P 50, the biggest 50 companies that earn 90% of the dollars, those are good businesses, global-spreading businesses, they're efficiently run, they're doing the rights sort of things with their balance sheets."
"...if I was guessing, over a long period of time, I think the S&P 500 will be a pretty tough index to beat...in general, it's kind of a good place to be. And what that implies is that generally, a lot of large companies are pretty attractive investments."
On Berkshire Hathaway
"...it has been the largest holding in our portfolio since 1990 and it continues to be so. I think the powerhouse that is Berkshire continues unabated. So I'm very comfortable with that being the largest holding that we have."
On selling
"I tend to be a pretty slow seller. There's two reasons I would sell something, let's start with that: A) I made a mistake, it was wrong, and that usually involves some sort of character judgment I made about the management, being disappointed in some sort of tainted investing that seems inconsistent with what I wanted to see. Or secondly, and this is a little bit true right now, there are ideas that are just less compelling than a new idea that you might have and you need some money to pay for what you're buying. Generally speaking, it's not just a matter of the fact that I don't like to sell, but actually there's huge tax efficiencies for Markel for us to be able to buy and hold something for a long period of time."
On Wal-Mart
"I look at the numbers, I look at the annual reports, I look at the quarterly updates, I see the sales going up, the share count going down, the balance sheet in great shape, the dividend going up. I see thousands of people going in every Walmart every single day, I see the global expansion, I'm aware of the risk of the political unpopularity of the company from time to time, but at the kind of prices that I started buying it, where it was 16-17 times earnings, now it's at 12ish, I continue to buy that sort of thing. There's not a whole lot of rocket science or higher math involved in deciding that it's a good investment. But in this environment, it's typical of this sort of thing."
Examples of some recent top holdings include: Berkshire Hathaway (BRKa), CarMax (KMX), Fairfax Financial (FRFHF), Brookfield Asset Management (BAM), Diageo (DEO), Exxon Mobil Corp. (XOM), Walt Disney (DIS), WalMart (WMT), and United Parcel Service (UPS).
So mostly larger capitalization stocks.
It's a recurring theme but, unlike ten year ago, it's the larger companies that have become more attractively valued while smaller caps in general (though, of course, there are many exceptions) look by comparison relatively expensive.
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.
Wednesday, November 9, 2011
Wall Street: Home of the Vanishing IPO
In this recent CNBC interview, David Weild of Grant Thornton describes the current state of the IPO. market:
Weild points out the following:
The article makes a direct connection between some of the reforms (an example being decimalization) and the steep decline in initial public offerings...
"By eliminating human traders, NMS killed off the culture of honest service that underpinned capital formation, freeing the former investment banks to focus instead on speculation. Investment banks and bankers were transformed from socially useful capital raisers to socially harmful, too-big-to-fail problems for the U.S. taxpayer. It was not a good trade."
Not at all.
David Weild and Edward Kim further explain the connection in this June 2010 Grant Thornton study, Market Structure is Causing the IPO Crisis - and More.
Here's a few relevant excerpts from a New York Times article published late last year. The economy suffers if businesses can't or won't raise funds in capital markets.
"We should be very concerned about this trend," said Andrew W. Lo, the director of the MIT Laboratory for Financial Engineering. "Capital markets are central to business formation and economic growth..."
More on the steep drop in initial public offerings. According to the article, IPOs peaked at 756 in 1996 and fell to 36 during the financial crisis. In 2010 it was up to around 100.
Now, we're still barely doing 1/5 that peak amount. So IPOs are...
"...still running below the level required to hold constant the number of public companies. And that, analysts say, has unsettling implications for American job growth."
More recently, John Bogle said this in a Morningstar interview:
"...our financial system has directed around $200 billion a year into initial public offerings and additional new public offerings and then additional offerings of company stock--$200 billion. We trade $40 trillion worth of stocks a year. So, that's 200 times as much speculation as there is investment. One only has to understand that all this trading back and forth, by definition, doesn't enrich the investor, because if I buy, you sell and vice versa, but what it does is enrich the croupier in the middle, which we call Wall Street..." - John Bogle
I think it is fair to say that the proportion of pure speculation to capital formation that facilitates new business creation is just a little out of balance.
The above New York Times article said it best:
"It is a remarkable turnabout for the nation's markets and, to some, deeply unsettling. This is Wall Street, after all — home to the largest and deepest capital markets on the planet."
What used to be a vibrant capital raising community now uses the bulk of its energy to speculate. As the Barron's article says, from "socially useful capital raisers to socially harmful".
The cost? Something that was for good reason an admired, effective, and vital system is allowed to fall by the wayside. It can be fixed but, for now, it's less admirable, less effective, while remaining just as vital to our capital development.
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.
Weild points out the following:
- Small Cap initial public offerings are at their worst level since 1985
- 500+ initial public offerings per year was the norm in the 1990s
- We have a bigger economy now so we should be doing around 700 yet we're only doing 150
- Private companies in need of capital these days are starved of it
- There's nothing better than confidence in the IPO market to jump start investment in private startups
- Fundamentally-oriented investors are increasingly replaced by a market that lends itself to electronic speculative trading/information mining technologies
The article makes a direct connection between some of the reforms (an example being decimalization) and the steep decline in initial public offerings...
"By eliminating human traders, NMS killed off the culture of honest service that underpinned capital formation, freeing the former investment banks to focus instead on speculation. Investment banks and bankers were transformed from socially useful capital raisers to socially harmful, too-big-to-fail problems for the U.S. taxpayer. It was not a good trade."
Not at all.
David Weild and Edward Kim further explain the connection in this June 2010 Grant Thornton study, Market Structure is Causing the IPO Crisis - and More.
Here's a few relevant excerpts from a New York Times article published late last year. The economy suffers if businesses can't or won't raise funds in capital markets.
"We should be very concerned about this trend," said Andrew W. Lo, the director of the MIT Laboratory for Financial Engineering. "Capital markets are central to business formation and economic growth..."
More on the steep drop in initial public offerings. According to the article, IPOs peaked at 756 in 1996 and fell to 36 during the financial crisis. In 2010 it was up to around 100.
Now, we're still barely doing 1/5 that peak amount. So IPOs are...
"...still running below the level required to hold constant the number of public companies. And that, analysts say, has unsettling implications for American job growth."
More recently, John Bogle said this in a Morningstar interview:
"...our financial system has directed around $200 billion a year into initial public offerings and additional new public offerings and then additional offerings of company stock--$200 billion. We trade $40 trillion worth of stocks a year. So, that's 200 times as much speculation as there is investment. One only has to understand that all this trading back and forth, by definition, doesn't enrich the investor, because if I buy, you sell and vice versa, but what it does is enrich the croupier in the middle, which we call Wall Street..." - John Bogle
I think it is fair to say that the proportion of pure speculation to capital formation that facilitates new business creation is just a little out of balance.
The above New York Times article said it best:
"It is a remarkable turnabout for the nation's markets and, to some, deeply unsettling. This is Wall Street, after all — home to the largest and deepest capital markets on the planet."
What used to be a vibrant capital raising community now uses the bulk of its energy to speculate. As the Barron's article says, from "socially useful capital raisers to socially harmful".
The cost? Something that was for good reason an admired, effective, and vital system is allowed to fall by the wayside. It can be fixed but, for now, it's less admirable, less effective, while remaining just as vital to our capital development.
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.
Monday, November 7, 2011
Buffett Invests Over $ 20 Billion in 3Q 2011
In what was a very rough quarter for stocks, Buffett went on a bit of a buying spree.
Bloomberg: Buffett Broaden Portfolio By Spending $ 23.9 Billion
The bulk of Berkshire Hathaway's (BRKa) investment dollars in 3Q went into the following:
$ 6.9 billion in miscellaneous equities
$ 5.0 billion in Bank of America (BAC) preferred shares/warrants
$ 9.0 billion acquisition of Lubrizol
This Bloomberg article:
Berkshire bought just under $ 7 billion in equities in the quarter (equity purchases were ~$ 3.6 billion in the prior quarter and a bit more than $ 800 million the quarter before that).
According to their latest filing, just $ 676 million of equities were sold in the latest quarter.
Unless permission is granted by the SEC to withhold data on some holdings, there'll be more details on the specific equities that were purchased by Berkshire when the 13F* is filed later this month.
Core operating earnings at Berkshire were just fine but wild swings in the derivatives portfolio, a non-cash accounting matter that reveals nothing about long run economic performance, reduced net income 24% to $ 2.28 billion.
This Wall Street Journal article points out:
- Derivatives losses are mostly an accounting matter
- Berkshire does not part with any of its cash
- Buffett calls the large quarterly swings "meaningless" and says operating results are a better measure
- Operating earnings were $ 3.81 billion versus $ 2.79 billion a year ago.
Now, while the swings in accounting value of these derivatives may be meaningless in the short run, the "float" these derivatives provide to Berkshire is not meaningless at all. They have profited significantly from the float the derivatives contracts provide:
...our derivatives "float"...is similar to insurance float: If we break even on an underlying transaction, we will have enjoyed the use of free money for a long time. Our expectation, though it is far from a sure thing, is that we will do better than break even and that the substantial investment income we earn on the funds will be frosting on the cake. - 2008 Berkshire Hathaway Shareholder Letter
In the 2008 letter, Buffett also said:
We have told you before that our derivative contracts, subject as they are to mark-to-market accounting, will produce wild swings in the earnings we report. The ups and downs neither cheer nor bother Charlie and me. Indeed, the "downs" can be helpful in that they give us an opportunity to expand a position on favorable terms. I hope this explanation of our dealings will lead you to think similarly. - 2008 Berkshire Hathaway Shareholder Letter
Interpreting Berkshire's operating performance quarter-to-quarter isn't always straightforward. Lots of noise in the numbers.
Net income reveals little. A reflection of accounting limitations, not Berkshire's core economics.
In the 3rd quarter of 2011, derivatives happened to lower net income but this cuts both ways. Consider that, just as an example, in 2009 derivatives pre-tax mark-to-market gains (losses) for Berkshire were as follows:
1Q ($ 1,517)
2Q $ 2,357
3Q $ 1,732
4Q $ 1,052
Source: 2009 Berkshire Hathaway Shareholder Letter
So, that year, in 3 of the 4 quarters derivatives provided substantial mark-to-market gains and, in contrast to the most recent quarter, boosted net income. Naturally, mark-to-market accounting results that have no cash impact are just as meaningless when they happen to artificially inflate net income as when they reduce it.
The bottom line is that derivatives do definitely add complexity and certainly some noise to the numbers reported by Berkshire.
Yet, if you step back it's a company with a nearly $ 150 billion equity/bond/cash portfolio, a balance sheet providing very low cost capital**, and the combined earning power of the 68 non-insurance businesses that produced nearly $ 10 billion in pre-tax earnings in 2010 (a more than 6x increase on a per share basis compared to 2000).
Ultimately, where the value comes from is pretty straightforward.
The Berkshire portfolio, its low cost float (actually less than zero cost historically), and the earning power of the non-insurance businesses are key elements of Berkshire's value creation machine. These elements of value won't change but, increasingly, non-insurance operations should continue to become more the driving force.
In Berkshire's early years, we focused on the investment side. During the past two decades, however, we've increasingly emphasized the development of earnings from non-insurance businesses, a practice that will continue. - 2010 Berkshire Hathaway Shareholder Letter
Finally, there is another important, if more subjective, element that drives the growth in Berkshire's intrinsic value. More from the 2010 letter:
We, as well as many other businesses, are likely to retain earnings over the next decade that will equal, or even exceed, the capital we presently employ. Some companies will turn these retained dollars into fifty-cent pieces, others into two-dollar bills.
This "what-will-they-do-with-the-money" factor must always be evaluated along with the "what-do-we-have-now" calculation in order for us, or anybody, to arrive at a sensible estimate of a company's intrinsic value. That's because an outside investor stands by helplessly as management reinvests his share of the company's earnings. If a CEO can be expected to do this job well, the reinvestment prospects add to the company's current value; if the CEO's talents or motives are suspect, today's value must be discounted. - 2010 Berkshire Hathaway Shareholder Letter
As an example, Buffett points out that a dollar in the hands of Sears or Montgomery Ward in the late 1960s "had a far different destiny than did a dollar entrusted to Sam Walton."
For Berkshire, it is the long-term performance of the equity/bond/cash portfolio, effective insurance underwriting (to deliver a low cost of float), non-insurance operating business performance, and how effectively retained earnings is deployed that determines Berkshire's growth in intrinsic value.
The kinds of gains and losses produced by derivatives may affect Berkshire's reported net income in a substantial way. Yet, when there is no affect on cash and investment holdings, they are meaningless economically, do not impact Berkshire's core economic performance, and tell the investor nothing about operating performance and value***.
Operating earnings, despite having some shortcomings, are in general a reasonable guide as to how our businesses are doing. Ignore our net income figure, however. Regulations require that we report it to you. But if you find reporters focusing on it, that will speak more to their performance than ours. - 2010 Berkshire Hathaway Shareholder Letter
The less than perfect but more meaningful operating earnings for Berkshire Hathaway was $ 8.1 billion over the first nine months of 2011 and should easily exceed $ 10 billion for the full year.
I won't be surprised if that level of operating earnings will grow nicely over the coming years along with the value of the portfolio.
Adam
Long BRKb
* Permission is granted when a case can be made that the disclosure would cause buyers to drive up the price before Berkshire makes additional purchases.
** Much of this, of course, being insurance float that often ends up free or better. The underwriting results over Berkshire's entire history have been significantly profitable. Underwriting results determine the long run cost of the float even if inevitably short run volatile. Producing long run underwriting profits is the equivalent of being paid to hold someone's money.
*** The potential value to Berkshire shareholders is a different story. In the latest annual report Buffett said the remaining derivatives "float" on the "equity put" portfolio was $4.2 billion. Buffett said: What is sure is that we will have the use of our remaining "float" of $4.2 billion for an average of about 10 more years. Crucially, almost all Berkshire derivatives contracts are free from obligation to post collateral.
Bloomberg: Buffett Broaden Portfolio By Spending $ 23.9 Billion
The bulk of Berkshire Hathaway's (BRKa) investment dollars in 3Q went into the following:
$ 6.9 billion in miscellaneous equities
$ 5.0 billion in Bank of America (BAC) preferred shares/warrants
$ 9.0 billion acquisition of Lubrizol
This Bloomberg article:
Berkshire bought just under $ 7 billion in equities in the quarter (equity purchases were ~$ 3.6 billion in the prior quarter and a bit more than $ 800 million the quarter before that).
According to their latest filing, just $ 676 million of equities were sold in the latest quarter.
Unless permission is granted by the SEC to withhold data on some holdings, there'll be more details on the specific equities that were purchased by Berkshire when the 13F* is filed later this month.
Core operating earnings at Berkshire were just fine but wild swings in the derivatives portfolio, a non-cash accounting matter that reveals nothing about long run economic performance, reduced net income 24% to $ 2.28 billion.
This Wall Street Journal article points out:
- Derivatives losses are mostly an accounting matter
- Berkshire does not part with any of its cash
- Buffett calls the large quarterly swings "meaningless" and says operating results are a better measure
- Operating earnings were $ 3.81 billion versus $ 2.79 billion a year ago.
Now, while the swings in accounting value of these derivatives may be meaningless in the short run, the "float" these derivatives provide to Berkshire is not meaningless at all. They have profited significantly from the float the derivatives contracts provide:
...our derivatives "float"...is similar to insurance float: If we break even on an underlying transaction, we will have enjoyed the use of free money for a long time. Our expectation, though it is far from a sure thing, is that we will do better than break even and that the substantial investment income we earn on the funds will be frosting on the cake. - 2008 Berkshire Hathaway Shareholder Letter
In the 2008 letter, Buffett also said:
We have told you before that our derivative contracts, subject as they are to mark-to-market accounting, will produce wild swings in the earnings we report. The ups and downs neither cheer nor bother Charlie and me. Indeed, the "downs" can be helpful in that they give us an opportunity to expand a position on favorable terms. I hope this explanation of our dealings will lead you to think similarly. - 2008 Berkshire Hathaway Shareholder Letter
Interpreting Berkshire's operating performance quarter-to-quarter isn't always straightforward. Lots of noise in the numbers.
Net income reveals little. A reflection of accounting limitations, not Berkshire's core economics.
In the 3rd quarter of 2011, derivatives happened to lower net income but this cuts both ways. Consider that, just as an example, in 2009 derivatives pre-tax mark-to-market gains (losses) for Berkshire were as follows:
1Q ($ 1,517)
2Q $ 2,357
3Q $ 1,732
4Q $ 1,052
Source: 2009 Berkshire Hathaway Shareholder Letter
So, that year, in 3 of the 4 quarters derivatives provided substantial mark-to-market gains and, in contrast to the most recent quarter, boosted net income. Naturally, mark-to-market accounting results that have no cash impact are just as meaningless when they happen to artificially inflate net income as when they reduce it.
The bottom line is that derivatives do definitely add complexity and certainly some noise to the numbers reported by Berkshire.
Yet, if you step back it's a company with a nearly $ 150 billion equity/bond/cash portfolio, a balance sheet providing very low cost capital**, and the combined earning power of the 68 non-insurance businesses that produced nearly $ 10 billion in pre-tax earnings in 2010 (a more than 6x increase on a per share basis compared to 2000).
Ultimately, where the value comes from is pretty straightforward.
The Berkshire portfolio, its low cost float (actually less than zero cost historically), and the earning power of the non-insurance businesses are key elements of Berkshire's value creation machine. These elements of value won't change but, increasingly, non-insurance operations should continue to become more the driving force.
In Berkshire's early years, we focused on the investment side. During the past two decades, however, we've increasingly emphasized the development of earnings from non-insurance businesses, a practice that will continue. - 2010 Berkshire Hathaway Shareholder Letter
Finally, there is another important, if more subjective, element that drives the growth in Berkshire's intrinsic value. More from the 2010 letter:
We, as well as many other businesses, are likely to retain earnings over the next decade that will equal, or even exceed, the capital we presently employ. Some companies will turn these retained dollars into fifty-cent pieces, others into two-dollar bills.
This "what-will-they-do-with-the-money" factor must always be evaluated along with the "what-do-we-have-now" calculation in order for us, or anybody, to arrive at a sensible estimate of a company's intrinsic value. That's because an outside investor stands by helplessly as management reinvests his share of the company's earnings. If a CEO can be expected to do this job well, the reinvestment prospects add to the company's current value; if the CEO's talents or motives are suspect, today's value must be discounted. - 2010 Berkshire Hathaway Shareholder Letter
As an example, Buffett points out that a dollar in the hands of Sears or Montgomery Ward in the late 1960s "had a far different destiny than did a dollar entrusted to Sam Walton."
For Berkshire, it is the long-term performance of the equity/bond/cash portfolio, effective insurance underwriting (to deliver a low cost of float), non-insurance operating business performance, and how effectively retained earnings is deployed that determines Berkshire's growth in intrinsic value.
The kinds of gains and losses produced by derivatives may affect Berkshire's reported net income in a substantial way. Yet, when there is no affect on cash and investment holdings, they are meaningless economically, do not impact Berkshire's core economic performance, and tell the investor nothing about operating performance and value***.
Operating earnings, despite having some shortcomings, are in general a reasonable guide as to how our businesses are doing. Ignore our net income figure, however. Regulations require that we report it to you. But if you find reporters focusing on it, that will speak more to their performance than ours. - 2010 Berkshire Hathaway Shareholder Letter
The less than perfect but more meaningful operating earnings for Berkshire Hathaway was $ 8.1 billion over the first nine months of 2011 and should easily exceed $ 10 billion for the full year.
I won't be surprised if that level of operating earnings will grow nicely over the coming years along with the value of the portfolio.
Adam
Long BRKb
* Permission is granted when a case can be made that the disclosure would cause buyers to drive up the price before Berkshire makes additional purchases.
** Much of this, of course, being insurance float that often ends up free or better. The underwriting results over Berkshire's entire history have been significantly profitable. Underwriting results determine the long run cost of the float even if inevitably short run volatile. Producing long run underwriting profits is the equivalent of being paid to hold someone's money.
*** The potential value to Berkshire shareholders is a different story. In the latest annual report Buffett said the remaining derivatives "float" on the "equity put" portfolio was $4.2 billion. Buffett said: What is sure is that we will have the use of our remaining "float" of $4.2 billion for an average of about 10 more years. Crucially, almost all Berkshire derivatives contracts are free from obligation to post collateral.
Friday, November 4, 2011
Yacktman 3Q 2011 Letter: "It's Almost All About The Price"
From the most recent Yacktman quarterly letter:
On Price/Quality
One of the common phrases we use at our firm is, "It's almost all about the price". Often, the most important variable in having a successful investment and managing risk is the price paid for a security. Many of our top holdings are now at lower prices than they sold for five or ten years ago even though the earnings of the businesses are significantly higher today.
Although price is typically the most important investment consideration, we also like to invest in businesses we think have the ability to perform in both good and bad economic times. These companies often have dominant market share in products that are inexpensive and consumed frequently or as part of a monthly subscription. Examples include PepsiCo selling snack chips and beverages, News Corp selling television content, and Microsoft selling software. PepsiCo, News Corp, and Microsoft are among our largest holdings because each company has a good business and is selling at a very attractive price.
Some may get caught up in a good story about a stock and forget the role that price plays in regulating risk.
A somewhat awful sounding story behind a decent business with real fixable problems can become a good investment at a low enough price (collapsed economic moats excluded). Just pay a price that provides at least an acceptable return if nothing great happens and a very nice return if things go better than most expect.
At the same time, an outstanding business with a terrific story can become an awful investment if the price paid for the stock is too high.
Wal-Mart (WMT) wasn't a terrible investment a decade ago because the business didn't end up doing well.
In fact, Wal-Mart tripled its earnings per share in the decade that followed. Shareowners were compensated poorly because they paid a price far above intrinsic value. So the inevitable result was little to no return for getting it right. If things had gone poorly for Wal-Mart a really bad result would have occurred. Both outcomes are just the opposite of what an investor should be attempting to accomplish.
I suspect there are a few high multiple stocks right now that will similarly have terrific business performance over the next decade but shareowners will be compensated poorly for it, or worse, experience permanent capital loss.
Price regulates risk.
On Pepsi
PepsiCo declined more than 11% during the quarter amid short-term business struggles and general market declines. At the end of the quarter, PepsiCo's shares traded at lower prices than they did three years prior, even though earnings have increased by more than 35% since that time. PepsiCo now sells for less than 13 times our estimate of next year’s earnings which we think is very inexpensive given the quality and predictability of its businesses.
How persistent the earnings of a business is gets revealed in a financial crisis. There are many good examples but lets again use Wal-Mart. The company's earnings per share did not drop off at all during the crisis. In fact, Wal-Mart's earnings is roughly now 50% above its peak pre-crisis level.
Microsoft (MSFT) is another good example:
In 2006, Microsoft earned $ 12.6 billion or $ 1.20/share.
Its share price at the end of 2006 was $ 29.86/share with $ 3.24/share in net cash.
Enterprise Value: $ 29.86/share - $ 3.24/share = $ 26.62/share
So $ 26.62/$ 1.20 = 22x multiple
In the fiscal year 2011 that ended in June, Microsoft earned $ 23.2 billion, nearly twice as much as 2006. On a per share basis because there are far fewer shares outstanding that translates into $ 2.69/share or much more than twice as much. Shares outstanding has fallen from 10.53 billion shares to 8.49 billion shares or by nearly 20%.
Its share price as of yesterday was $ 26.53/share with $ 5.35/share in net cash.
Enterprise Value: $ 26.53/share - $ 5.35/share = $ 21.18/share
So $ 21.18/$ 2.69 = 7.9x
Microsoft's business is substantially more valuable per share today than back in 2006. The stock has gone nowhere but that's because, like many large cap stocks, the multiple has contracted.
A company that has more than doubled its earnings per share since 2006 is selling at less than an 8 multiple of trailing earnings.
With a multiple that low not much good has to happen. That kind of multiple suggests that earnings will be diminished rather substantially in the coming years.
If earnings do not shrink, and Microsoft does a decent job in capital allocation, returns have a good chance of being just fine. Add in even modest growth and the situation becomes very attractive.
So what is the consensus expectations for Microsoft's fiscal year 2012 and 2013 earnings/share?
Higher.
It's not that Microsoft is my favorite business or stock by any means.
Maybe their earnings will, in fact, actually shrink in a material way.
It's just that sometimes it makes sense to step back a bit.
Adam
Long PEP, MSFT, WMT
----
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.
On Price/Quality
One of the common phrases we use at our firm is, "It's almost all about the price". Often, the most important variable in having a successful investment and managing risk is the price paid for a security. Many of our top holdings are now at lower prices than they sold for five or ten years ago even though the earnings of the businesses are significantly higher today.
Although price is typically the most important investment consideration, we also like to invest in businesses we think have the ability to perform in both good and bad economic times. These companies often have dominant market share in products that are inexpensive and consumed frequently or as part of a monthly subscription. Examples include PepsiCo selling snack chips and beverages, News Corp selling television content, and Microsoft selling software. PepsiCo, News Corp, and Microsoft are among our largest holdings because each company has a good business and is selling at a very attractive price.
Some may get caught up in a good story about a stock and forget the role that price plays in regulating risk.
A somewhat awful sounding story behind a decent business with real fixable problems can become a good investment at a low enough price (collapsed economic moats excluded). Just pay a price that provides at least an acceptable return if nothing great happens and a very nice return if things go better than most expect.
At the same time, an outstanding business with a terrific story can become an awful investment if the price paid for the stock is too high.
Wal-Mart (WMT) wasn't a terrible investment a decade ago because the business didn't end up doing well.
In fact, Wal-Mart tripled its earnings per share in the decade that followed. Shareowners were compensated poorly because they paid a price far above intrinsic value. So the inevitable result was little to no return for getting it right. If things had gone poorly for Wal-Mart a really bad result would have occurred. Both outcomes are just the opposite of what an investor should be attempting to accomplish.
I suspect there are a few high multiple stocks right now that will similarly have terrific business performance over the next decade but shareowners will be compensated poorly for it, or worse, experience permanent capital loss.
Price regulates risk.
On Pepsi
PepsiCo declined more than 11% during the quarter amid short-term business struggles and general market declines. At the end of the quarter, PepsiCo's shares traded at lower prices than they did three years prior, even though earnings have increased by more than 35% since that time. PepsiCo now sells for less than 13 times our estimate of next year’s earnings which we think is very inexpensive given the quality and predictability of its businesses.
How persistent the earnings of a business is gets revealed in a financial crisis. There are many good examples but lets again use Wal-Mart. The company's earnings per share did not drop off at all during the crisis. In fact, Wal-Mart's earnings is roughly now 50% above its peak pre-crisis level.
Microsoft (MSFT) is another good example:
In 2006, Microsoft earned $ 12.6 billion or $ 1.20/share.
Its share price at the end of 2006 was $ 29.86/share with $ 3.24/share in net cash.
Enterprise Value: $ 29.86/share - $ 3.24/share = $ 26.62/share
So $ 26.62/$ 1.20 = 22x multiple
In the fiscal year 2011 that ended in June, Microsoft earned $ 23.2 billion, nearly twice as much as 2006. On a per share basis because there are far fewer shares outstanding that translates into $ 2.69/share or much more than twice as much. Shares outstanding has fallen from 10.53 billion shares to 8.49 billion shares or by nearly 20%.
Its share price as of yesterday was $ 26.53/share with $ 5.35/share in net cash.
Enterprise Value: $ 26.53/share - $ 5.35/share = $ 21.18/share
So $ 21.18/$ 2.69 = 7.9x
Microsoft's business is substantially more valuable per share today than back in 2006. The stock has gone nowhere but that's because, like many large cap stocks, the multiple has contracted.
A company that has more than doubled its earnings per share since 2006 is selling at less than an 8 multiple of trailing earnings.
With a multiple that low not much good has to happen. That kind of multiple suggests that earnings will be diminished rather substantially in the coming years.
If earnings do not shrink, and Microsoft does a decent job in capital allocation, returns have a good chance of being just fine. Add in even modest growth and the situation becomes very attractive.
So what is the consensus expectations for Microsoft's fiscal year 2012 and 2013 earnings/share?
Higher.
It's not that Microsoft is my favorite business or stock by any means.
Maybe their earnings will, in fact, actually shrink in a material way.
It's just that sometimes it makes sense to step back a bit.
Adam
Long PEP, MSFT, WMT
----
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, November 3, 2011
PIMCO's Bill Gross: "Wall Street Sort of Lost Its Way"
According to Bill Gross, getting back to a system where traditional banking and investment banking are separate would be a good thing in terms of reform.
Here's what he had to say about it in this Reuters article:
"Do we have a better example today than MF Global in terms of the mingling of those two particular aspects of capital allocation...the closer we get back to separating the two, I suppose the better from the standpoint of reform."
In 1933 the Glass-Steagall Act introduced reforms that were, in part, designed to control speculation and separate investment banking from commercial banking. We'd just learned the hard way the dangers of intermingling the two. The repeal of Glass–Steagall by the Gramm–Leach–Bliley Act in 1999 effectively removed the separation.
For 66 years that separation seemed to serve us well.
Yet, by 1999 many with enough influence had come to believe that human nature had somehow changed. In their view, the world was now once again ready to combine the two activities.
"The problem today is to look ahead, and try to anticipate the problems that may arise that will give rise to the next crisis. And I tell you, sure as I am sitting here, that if banking institutions are protected by the taxpayer and they are given free rein to speculate, I may not live long enough to see the crisis, but my soul is going to come back and haunt you." - Paul Volcker speaking to the Senate Banking Committee in February 2010
The Volcker rule is a sort of Glass-Steagall-Light. It has been a struggle to put the rule in place (entrenched interests don't like it, of course) but the rule attempts to move us back toward what Carter Glass and Henry Steagall had in mind back in 1933.
More from the Reuters article:
"Wall Street sort of lost its way, in that investment banking became a function not of allocating capital properly, but levering capital and levering the returns on capital as opposed to transferring capital to productive industries," Gross said.
Gross added that banks should be more conservatively capitalized to create confidence in the system.
I think it comes down to:
Adam
Here's what he had to say about it in this Reuters article:
"Do we have a better example today than MF Global in terms of the mingling of those two particular aspects of capital allocation...the closer we get back to separating the two, I suppose the better from the standpoint of reform."
In 1933 the Glass-Steagall Act introduced reforms that were, in part, designed to control speculation and separate investment banking from commercial banking. We'd just learned the hard way the dangers of intermingling the two. The repeal of Glass–Steagall by the Gramm–Leach–Bliley Act in 1999 effectively removed the separation.
For 66 years that separation seemed to serve us well.
Yet, by 1999 many with enough influence had come to believe that human nature had somehow changed. In their view, the world was now once again ready to combine the two activities.
"The problem today is to look ahead, and try to anticipate the problems that may arise that will give rise to the next crisis. And I tell you, sure as I am sitting here, that if banking institutions are protected by the taxpayer and they are given free rein to speculate, I may not live long enough to see the crisis, but my soul is going to come back and haunt you." - Paul Volcker speaking to the Senate Banking Committee in February 2010
The Volcker rule is a sort of Glass-Steagall-Light. It has been a struggle to put the rule in place (entrenched interests don't like it, of course) but the rule attempts to move us back toward what Carter Glass and Henry Steagall had in mind back in 1933.
More from the Reuters article:
"Wall Street sort of lost its way, in that investment banking became a function not of allocating capital properly, but levering capital and levering the returns on capital as opposed to transferring capital to productive industries," Gross said.
Gross added that banks should be more conservatively capitalized to create confidence in the system.
I think it comes down to:
- Separating speculative activities from traditional banking
- Making short-term highly leveraged trading less attractive via disincentives
- Making long-term capital formation and allocation more attractive via incentives
- Requiring more capital in the system
- Changing the compensation systems at the executive level
Adam
Wednesday, November 2, 2011
Yacktman Funds 3Q 2011 Portfolio Update
Donald Yacktman and his team have a very solid long-term track record.*
The funds they manage, Yacktman Fund (YACKX) and Yacktman Focused (YAFFX), are up more than 226% and 195% over the past ten years.
For a comparison, the return of the S&P 500 is up a bit over 30% for the same time frame.
Additions that had greater than .5 percent impact on the portfolios
Pepsi (PEP)
News Corp (NWSA)
Avon Products (AVP), new position
Stryker (SYK)
Corning (GLW)
Procter & Gamble (PG)
Hewlett-Packard (HPQ)
Bank of New York Mellon (BK)
Sysco (SYY)
Patterson (PDCO)
Additions that had between .2 percent and .5 percent impact on the porfolios
Cisco (CSCO)
Johnson & Johnson (JNJ)
C.R. Bard (BCR)
Janus (JNS), new position
Wal-Mart (WMT)
Some other very small additions include Microsoft (MSFT), Pfizer (PFE), Becton Dickinson (BDX), H&R Block (HRB), Research in Motion (RIMM), and Exxon Mobil (XOM).
The biggest addition in terms of percentage impact on the portfolio was Pepsi at just over 2.8%.
Yacktman also sold all shares of Kraft (KFT).
Adam
* From the letter: The performance data quoted for The Yacktman Fund and The Yacktman Focused Fund represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that the investor's shares, when redeemed, may be worth more or less than their original cost. The current performance may be higher or lower than the performance data quoted.
Long positions in PEP, PG, MSFT, CSCO, HPQ, JNJ, USB, and WMT
---
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 funds they manage, Yacktman Fund (YACKX) and Yacktman Focused (YAFFX), are up more than 226% and 195% over the past ten years.
For a comparison, the return of the S&P 500 is up a bit over 30% for the same time frame.
At the end of the most recent quarter, Yacktman continued to hold positions in large capitalization stocks that are household names. These are relatively concentrated portfolios. The Yacktman Fund usually has 30% in the top 5 stocks while the Yacktman Focused top 5 is often closer to 40%.
With these funds, the annual turnover of the portfolio is usually less than 10%. Impressive and something not seen often enough.
With these funds, the annual turnover of the portfolio is usually less than 10%. Impressive and something not seen often enough.
Top 5 Holdings
1 Pepsi (PEP)
4 Microsoft (MSFT)
5 Cisco (CSCO)
Yacktman Funds continue to have minimal exposure to financials with only 2 banks in the top 25 (U.S. Bancorp: USB and Bank of New York Mellon: BK).
Additions that had greater than .5 percent impact on the portfolios
Pepsi (PEP)
News Corp (NWSA)
Avon Products (AVP), new position
Stryker (SYK)
Corning (GLW)
Procter & Gamble (PG)
Hewlett-Packard (HPQ)
Bank of New York Mellon (BK)
Sysco (SYY)
Patterson (PDCO)
Additions that had between .2 percent and .5 percent impact on the porfolios
Cisco (CSCO)
Johnson & Johnson (JNJ)
C.R. Bard (BCR)
Janus (JNS), new position
Wal-Mart (WMT)
Some other very small additions include Microsoft (MSFT), Pfizer (PFE), Becton Dickinson (BDX), H&R Block (HRB), Research in Motion (RIMM), and Exxon Mobil (XOM).
The biggest addition in terms of percentage impact on the portfolio was Pepsi at just over 2.8%.
Yacktman also sold all shares of Kraft (KFT).
Adam
* From the letter: The performance data quoted for The Yacktman Fund and The Yacktman Focused Fund represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that the investor's shares, when redeemed, may be worth more or less than their original cost. The current performance may be higher or lower than the performance data quoted.
Long positions in PEP, PG, MSFT, CSCO, HPQ, JNJ, USB, and WMT
---
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, November 1, 2011
The Perils of High-P/E Investing
It's always difficult to predict when a speculative stock's valuation will come back down to earth. Once a stock has an extreme valuation the time it takes for economic gravity to kick can, more than occasionally, be measured in years.
From this article on GuruFocus:
The fact that the valuations of certain companies can hold their sky-high multiples for an extended period gives the investor the illusion of safety; nothing could be further from the truth.
The article goes on to equate the practice to...
...performing a high-wire act without a safety net. The fact that the performer has navigated the wire successfully a thousand times does not remove the element of risk from his performance.
What seems an obviously overvalued stock will often just get more overvalued. So, on the surface, it would seem there's plenty of time to play the speculative game. Many actually try to time getting out before the other speculators head for the door. Some succeed, most don't, but either way the winner is the croupier.
For me, the highflyers always fall into the category of avoid.
From this article on GuruFocus:
The fact that the valuations of certain companies can hold their sky-high multiples for an extended period gives the investor the illusion of safety; nothing could be further from the truth.
The article goes on to equate the practice to...
...performing a high-wire act without a safety net. The fact that the performer has navigated the wire successfully a thousand times does not remove the element of risk from his performance.
What seems an obviously overvalued stock will often just get more overvalued. So, on the surface, it would seem there's plenty of time to play the speculative game. Many actually try to time getting out before the other speculators head for the door. Some succeed, most don't, but either way the winner is the croupier.
For me, the highflyers always fall into the category of avoid.
Occasionally, a high flying stock will actually justify what seemed like an inflated valuation. In that case, the investor took a huge risk over time by buying at an inflated earnings multiple, in the long run turned out to be right, and ended up making some money but not necessarily enough to compensate for the risks taken. In other words, too much risk for too modest a reward.
Yes, and at times an exceptional situation comes along that completely justifies the earnings multiple and then some.
Still, much of the time, if you play in the inflated P/E arena, most of the time you'd better get the trading right or you'll lose. In any case, if you pay an extremely high multiple for a stock, huge risks of permanent capital loss are being taken compared to the potential rewards. It's a game where the odds are against the participants but if you can control for those losses it may work out.
Yes, and at times an exceptional situation comes along that completely justifies the earnings multiple and then some.
Still, much of the time, if you play in the inflated P/E arena, most of the time you'd better get the trading right or you'll lose. In any case, if you pay an extremely high multiple for a stock, huge risks of permanent capital loss are being taken compared to the potential rewards. It's a game where the odds are against the participants but if you can control for those losses it may work out.
So, at least for me, there's too much risk of permanent loss of capital. The above article refers to a quote from Seth Klarman:
"People who chase growth, who chase highfliers, inevitably lose because they paid a premium price." - Seth Klarman
When you avoid the big losses in investing, the gains take care of themselves.
"People who chase growth, who chase highfliers, inevitably lose because they paid a premium price." - Seth Klarman
When you avoid the big losses in investing, the gains take care of themselves.
Instead of buying the highflyers, the risk of permanent capital loss can be reduced substantially if a business with sound economics is bought at a nice discount to intrinsic value. The favorable long-term returns are driven by the core proven economics of the business and, the fact a discount to value was paid, there's more downside protection if a misjudgment is made and things go materially wrong.
No timing or trading skills required. In this situation, a stock that happens to go down from the price paid is not a problem for the long-term investor.
The core economics will still drive your returns over the long run even if what you see as far as the near term stock quotes go gets a bit ugly.
In fact, as a long-term owner, the even cheaper stock will just serve to enhance returns via buybacks.
Adam
No timing or trading skills required. In this situation, a stock that happens to go down from the price paid is not a problem for the long-term investor.
The core economics will still drive your returns over the long run even if what you see as far as the near term stock quotes go gets a bit ugly.
In fact, as a long-term owner, the even cheaper stock will just serve to enhance returns via buybacks.
Adam
Monday, October 31, 2011
What's Driving the High Correlation?
Here's a good Michael Santoli article in the most recent Barron's that covers the extreme correlation we've seen in recent times.
It turns out that since 1972, the median correlation of an S&P 500 stock to the index itself (over the prior three months) has been .46 (46% of individual stocks move the same way as the index).
According to the article, we're at .86 as of a week ago.
According to the article, the number of days at least 90% of all stocks in the S&P 1500 moved in one direction has progressed as follows:
2006: 14 times
2007: 23
2008: 39
2009: 44
2010: 47
2011: 58 (and 33 of the past 62 days)
Santoli also mentions that explanations range from high speed trading to ETFs.
So the number of days that 90% of all stocks in the S&P 1500 were up or down on a given day has progressed from 14 to 23 to 39 to 44 to 47 to this year's 58 and counting (this seems just a variation of the Bespoke Investment Group's 'All or Nothing' Markets that instead uses 80% of the S&P 500 instead of 90% of the S&P 1500).
More recently, it has been 33 out of the past 62. So every other day?
(By the way...it's too early to tell but I think we are having another 90% day on the downside as I write this)
Some assume this is driven by unprecedented systemic risks.
Maybe.
It's also a good bet that the many changes to equity market structure are a contributor:
"Unintended, yet permitted advantages within market structure have come to dominate and overshadow the true intent of the capital markets - to facilitate the allocation of capital from investors to businesses. The market has become a servant to short-term professional traders, in particular high-frequency traders ('HFT')." - Mason Hawkins of Southeastern Asset Management
Changes that may be progressively making it behave in a more correlated and erratic manner.
In other words, the all or nothing market behavior is only partly explained by nervousness over perceived real world macro systemic risks. Yet, to what extent it is market structure changes versus macro systemic risks is tough to call.
The global economy clearly does have serious problems with excessive sovereign debt, a need for deleveraging, and undercapitalized banks among others things. Much of it, of course, is centered in Europe.
The question I have is this: Is the increased correlation and volatility mostly just a reflection of these serious macro problems or is it, at least to a material degree, the continuation of a trend caused by changes in market structure?
Some seem to assume it is mostly just a reflection of the former and do not consider the possible role of the latter. That seems a mistake. If it is, to a meaningful extent the latter, then the changes to market structure over the past decade or so are making already difficult problems even harder to solve.
Why? They become more difficult to solve, in part, because perceived market instability feeds into less confidence by business and consumers that potentially leads to reduced investment and consumption. In the long run it's healthy economies that give us the best shot to dig out of the excess global leverage.
From removal of the uptick rule, to Regulation NMS (implemented in 2007), to decimalization (2001), and other changes, there has been many reforms to the equity markets in the past 15 years. High frequency trading is but one by-product of these many changes.
Here's a good overview of the changes: Concept Release on Equity Market Structure
"High frequency trading is a product of Reg NMS, decimalization and technology improvements," says John Knuff, general manager of global financial markets for Equinix... - From Inside the Machine
It seems reasonable to expect high frequency trading oriented participants will continue to get a little smarter and, under the current rules of the game, their influence on the markets will continue to grow.
So, if they are at or near the root of these changes to market behavior, their influence on the markets isn't going to be reduced anytime soon without material changes. Does that mean we'll see even more highly correlated markets with excessive volatility in the coming years? Is this just an expensive nuisance (as measured by additional frictional costs and engineering/math/scientific talent used to design and build algorithms instead of more useful more things) or destined to eventually evolve into a system that becomes even less stable over time until its flaws become so obvious we are forced to change it?
It seems more than just possible that these market structure changes are driving up the frequency of 90% days and we've convinced ourselves that it's the real and perceived macroeconomic risks - not changes to the market structure itself - that is a material contributor.
Here's another way to look at it. Those year over year increases to the number of 90% days that have occurred since 2006 may just continue to grow until we really understand what is going on.
So is it high frequency trading that's behind this?
Removal of the uptick rule?
The increasingly widespread use of traditional and, more recently, leveraged ETFs?
Is the additional not-so-transparent financial leverage, that comes from things like options and derivatives of various kinds, if not a root cause at least a contributing factor to volatility*?
Munger on Derivatives
"We're not controlling financial leverage if we have option exchanges. So these changes repealed longtime control of margin credit by the Federal Reserve System." - Charlie Munger
"Unlimited leverage comes automatically with an option exchange. Then, next, derivative trading made the option exchange look like a benign event." - Charlie Munger
All the above? Something else altogether?
Or is it just the cumulative effect of all these many changes to capital market structure in combination with some of the very real macroeconomic and systemic risks?
I certainly don't know the answer but this needs some quality exploration and, ultimately, some solutions with teeth.
Who knows if this current way of doing business in markets is stable under times of real stress. It's all too new to know. To me, with something this crucial and increasingly complex, far to many fundamental changes have happened in too short a period of time for anyone to fully appreciate the ramifications.
Many have opinions as to why the market has been behaving this way and some are probably even partly right. I know one thing. It's important to not be too certain about the root cause until those who are unbiased with the right expertise have given it a rigorous look.
I just figure that, at least from the outside looking in, there's no way to know what's definitively at the root of something like this. It's too complex.
All I know is that looking at what has changed is usually a good place to start. The markets exist to serve us, not the other way around, and they're role is too vital to not fix if they get broken from time to time.
In the current form, whatever the root cause, capital markets seems designed in a way that creates an amplified response to news and events of various kinds. That, it seems, would serve no one other than possibly some of the participants.
As Mason Hawkins said, in this letter to the SEC, the intent of capital markets are "to facilitate the allocation of capital from investors to businesses." In the same letter, Hawkins also said "markets do not exist as an end in and of themselves."
If you believe that, the current way it is working for us seems rather foolish.
It all seems like one heck of an unnecessary self-inflicted wound.
Adam
Related post:
'All or Nothing' Markets
* During the financial crisis a substantial amount of trading was financed by the "repo" market and the amount in use on any given day is far from transparent (best case, all we have is end of quarter snapshots). The repurchase or "repo" desks were responsible for borrowing money every night to finance a securities portfolio. Here's a quick look at the repo system's role in the crisis. How much of this form of leverage is a factor today? "Our regulators allowed the proprietary trading departments at investment banks to become hedge funds in disguise, using the 'repo' system—one of the most extreme credit-granting systems ever devised. The amount of leverage was utterly awesome." - Charlie Munger in the Stanford Lawyer
---
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.
It turns out that since 1972, the median correlation of an S&P 500 stock to the index itself (over the prior three months) has been .46 (46% of individual stocks move the same way as the index).
According to the article, we're at .86 as of a week ago.
According to the article, the number of days at least 90% of all stocks in the S&P 1500 moved in one direction has progressed as follows:
2006: 14 times
2007: 23
2008: 39
2009: 44
2010: 47
2011: 58 (and 33 of the past 62 days)
Santoli also mentions that explanations range from high speed trading to ETFs.
So the number of days that 90% of all stocks in the S&P 1500 were up or down on a given day has progressed from 14 to 23 to 39 to 44 to 47 to this year's 58 and counting (this seems just a variation of the Bespoke Investment Group's 'All or Nothing' Markets that instead uses 80% of the S&P 500 instead of 90% of the S&P 1500).
More recently, it has been 33 out of the past 62. So every other day?
(By the way...it's too early to tell but I think we are having another 90% day on the downside as I write this)
Some assume this is driven by unprecedented systemic risks.
Maybe.
It's also a good bet that the many changes to equity market structure are a contributor:
"Unintended, yet permitted advantages within market structure have come to dominate and overshadow the true intent of the capital markets - to facilitate the allocation of capital from investors to businesses. The market has become a servant to short-term professional traders, in particular high-frequency traders ('HFT')." - Mason Hawkins of Southeastern Asset Management
Changes that may be progressively making it behave in a more correlated and erratic manner.
In other words, the all or nothing market behavior is only partly explained by nervousness over perceived real world macro systemic risks. Yet, to what extent it is market structure changes versus macro systemic risks is tough to call.
The global economy clearly does have serious problems with excessive sovereign debt, a need for deleveraging, and undercapitalized banks among others things. Much of it, of course, is centered in Europe.
The question I have is this: Is the increased correlation and volatility mostly just a reflection of these serious macro problems or is it, at least to a material degree, the continuation of a trend caused by changes in market structure?
Some seem to assume it is mostly just a reflection of the former and do not consider the possible role of the latter. That seems a mistake. If it is, to a meaningful extent the latter, then the changes to market structure over the past decade or so are making already difficult problems even harder to solve.
Why? They become more difficult to solve, in part, because perceived market instability feeds into less confidence by business and consumers that potentially leads to reduced investment and consumption. In the long run it's healthy economies that give us the best shot to dig out of the excess global leverage.
From removal of the uptick rule, to Regulation NMS (implemented in 2007), to decimalization (2001), and other changes, there has been many reforms to the equity markets in the past 15 years. High frequency trading is but one by-product of these many changes.
Here's a good overview of the changes: Concept Release on Equity Market Structure
"High frequency trading is a product of Reg NMS, decimalization and technology improvements," says John Knuff, general manager of global financial markets for Equinix... - From Inside the Machine
It seems reasonable to expect high frequency trading oriented participants will continue to get a little smarter and, under the current rules of the game, their influence on the markets will continue to grow.
So, if they are at or near the root of these changes to market behavior, their influence on the markets isn't going to be reduced anytime soon without material changes. Does that mean we'll see even more highly correlated markets with excessive volatility in the coming years? Is this just an expensive nuisance (as measured by additional frictional costs and engineering/math/scientific talent used to design and build algorithms instead of more useful more things) or destined to eventually evolve into a system that becomes even less stable over time until its flaws become so obvious we are forced to change it?
It seems more than just possible that these market structure changes are driving up the frequency of 90% days and we've convinced ourselves that it's the real and perceived macroeconomic risks - not changes to the market structure itself - that is a material contributor.
Here's another way to look at it. Those year over year increases to the number of 90% days that have occurred since 2006 may just continue to grow until we really understand what is going on.
So is it high frequency trading that's behind this?
Removal of the uptick rule?
The increasingly widespread use of traditional and, more recently, leveraged ETFs?
Is the additional not-so-transparent financial leverage, that comes from things like options and derivatives of various kinds, if not a root cause at least a contributing factor to volatility*?
Munger on Derivatives
"We're not controlling financial leverage if we have option exchanges. So these changes repealed longtime control of margin credit by the Federal Reserve System." - Charlie Munger
"Unlimited leverage comes automatically with an option exchange. Then, next, derivative trading made the option exchange look like a benign event." - Charlie Munger
All the above? Something else altogether?
Or is it just the cumulative effect of all these many changes to capital market structure in combination with some of the very real macroeconomic and systemic risks?
I certainly don't know the answer but this needs some quality exploration and, ultimately, some solutions with teeth.
Who knows if this current way of doing business in markets is stable under times of real stress. It's all too new to know. To me, with something this crucial and increasingly complex, far to many fundamental changes have happened in too short a period of time for anyone to fully appreciate the ramifications.
Many have opinions as to why the market has been behaving this way and some are probably even partly right. I know one thing. It's important to not be too certain about the root cause until those who are unbiased with the right expertise have given it a rigorous look.
I just figure that, at least from the outside looking in, there's no way to know what's definitively at the root of something like this. It's too complex.
All I know is that looking at what has changed is usually a good place to start. The markets exist to serve us, not the other way around, and they're role is too vital to not fix if they get broken from time to time.
In the current form, whatever the root cause, capital markets seems designed in a way that creates an amplified response to news and events of various kinds. That, it seems, would serve no one other than possibly some of the participants.
As Mason Hawkins said, in this letter to the SEC, the intent of capital markets are "to facilitate the allocation of capital from investors to businesses." In the same letter, Hawkins also said "markets do not exist as an end in and of themselves."
If you believe that, the current way it is working for us seems rather foolish.
It all seems like one heck of an unnecessary self-inflicted wound.
Adam
Related post:
'All or Nothing' Markets
* During the financial crisis a substantial amount of trading was financed by the "repo" market and the amount in use on any given day is far from transparent (best case, all we have is end of quarter snapshots). The repurchase or "repo" desks were responsible for borrowing money every night to finance a securities portfolio. Here's a quick look at the repo system's role in the crisis. How much of this form of leverage is a factor today? "Our regulators allowed the proprietary trading departments at investment banks to become hedge funds in disguise, using the 'repo' system—one of the most extreme credit-granting systems ever devised. The amount of leverage was utterly awesome." - Charlie Munger in the Stanford Lawyer
---
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, October 28, 2011
Buffett: "Disinvestors Lose As Market Falls -- But Investors Gain"
Warren Buffett wrote the following in the 1997 Berkshire Hathaway (BRKa) shareholder letter:
If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.
But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.
Now, consider this headline from yesterday:
US Stocks Soar In Global Market Rally As Investors Cheer European Pact
Well, a trader who is long may want to cheer but certainly not an investor.
Anyone investing for the long haul should logically cheer just the opposite. More from the letter:
For shareholders of Berkshire who do not expect to sell, the choice is even clearer. To begin with, our owners are automatically saving even if they spend every dime they personally earn: Berkshire "saves" for them by retaining all earnings, thereafter using these savings to purchase businesses and securities. Clearly, the more cheaply we make these buys, the more profitable our owners' indirect savings program will be.
Furthermore, through Berkshire you own major positions in companies that consistently repurchase their shares. The benefits that these programs supply us grow as prices fall: When stock prices are low, the funds that an investee spends on repurchases increase our ownership of that company by a greater amount than is the case when prices are higher. For example, the repurchases that Coca-Cola, The Washington Post and Wells Fargo made in past years at very low prices benefitted Berkshire far more than do today's repurchases, made at loftier prices.
At the end of every year, about 97% of Berkshire's shares are held by the same investors who owned them at the start of the year. That makes them savers. They should therefore rejoice when markets decline and allow both us and our investees to deploy funds more advantageously.
So smile when you read a headline that says "Investors lose as market falls." Edit it in your mind to "Disinvestors lose as market falls -- but investors gain." Though writers often forget this truism, there is a buyer for every seller and what hurts one necessarily helps the other. (As they say in golf matches: "Every putt makes someone happy.")
We gained enormously from the low prices placed on many equities and businesses in the 1970s and 1980s. Markets that then were hostile to investment transients were friendly to those taking up permanent residence.
The S&P 500 index has rallied from a low of 1,074.77 to a close of 1,284.59 yesterday, a 19.5% move off the intraday bottom on October 4th.
Many individual stocks are up much more from their recent lows.
At what level is it easier to find undervalued equities and make a long-term investment in shares of a good business?
The answer is obvious yet, for whatever reason, when it comes to stocks it is rising prices that get "cheered".
With everything else, from buying burgers to cars, it is falling prices that get the favorable reaction.
Adam
Long BRKb
---
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.
If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.
But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.
Now, consider this headline from yesterday:
US Stocks Soar In Global Market Rally As Investors Cheer European Pact
Well, a trader who is long may want to cheer but certainly not an investor.
Anyone investing for the long haul should logically cheer just the opposite. More from the letter:
For shareholders of Berkshire who do not expect to sell, the choice is even clearer. To begin with, our owners are automatically saving even if they spend every dime they personally earn: Berkshire "saves" for them by retaining all earnings, thereafter using these savings to purchase businesses and securities. Clearly, the more cheaply we make these buys, the more profitable our owners' indirect savings program will be.
Furthermore, through Berkshire you own major positions in companies that consistently repurchase their shares. The benefits that these programs supply us grow as prices fall: When stock prices are low, the funds that an investee spends on repurchases increase our ownership of that company by a greater amount than is the case when prices are higher. For example, the repurchases that Coca-Cola, The Washington Post and Wells Fargo made in past years at very low prices benefitted Berkshire far more than do today's repurchases, made at loftier prices.
At the end of every year, about 97% of Berkshire's shares are held by the same investors who owned them at the start of the year. That makes them savers. They should therefore rejoice when markets decline and allow both us and our investees to deploy funds more advantageously.
So smile when you read a headline that says "Investors lose as market falls." Edit it in your mind to "Disinvestors lose as market falls -- but investors gain." Though writers often forget this truism, there is a buyer for every seller and what hurts one necessarily helps the other. (As they say in golf matches: "Every putt makes someone happy.")
We gained enormously from the low prices placed on many equities and businesses in the 1970s and 1980s. Markets that then were hostile to investment transients were friendly to those taking up permanent residence.
The S&P 500 index has rallied from a low of 1,074.77 to a close of 1,284.59 yesterday, a 19.5% move off the intraday bottom on October 4th.
Many individual stocks are up much more from their recent lows.
At what level is it easier to find undervalued equities and make a long-term investment in shares of a good business?
The answer is obvious yet, for whatever reason, when it comes to stocks it is rising prices that get "cheered".
With everything else, from buying burgers to cars, it is falling prices that get the favorable reaction.
Adam
Long BRKb
---
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.
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