When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases. - Warren Buffett in the 1984 Berkshire Hathaway (BRKa) Shareholder Letter
Jamie Dimon of JP Morgan (JPM) said the following about buybacks recently. From this article in TheStreet.com:
...buybacks and dividend increases remain a board decision and that the bank will not buy back stock at any price. "Buying back stock makes sense when you are buying below intrinsic value. If you are buying above intrinsic value you are only benefiting exiting shareholder," he said, adding that he believes the bank's stock is cheap.
Good to hear "buying back stock makes sense when you are buying below intrinsic value" from a CEO. On too many occasions buying back stock is done for some other less economically sound reasons. Whether a buyback makes sense comes down to:
Are the shares are selling comfortably below a conservative estimate of intrinsic value?
Is the business in a financially and competitively strong position?
Are expenditures that maintain competitiveness (protect or enlarge the moat) still getting done?
Does buying back shares compare favorably, on a risk-adjusted basis, to alternative investments including high return expansion opportunities?
If the answer is clearly yes to questions like that, and intrinsic value has been estimated reasonably well (a rough estimate, of course, due to the necessarily imprecise nature of intrinsic value), then a buyback has a good chance of working very well.
What never makes sense is buying back shares when they are selling above intrinsic value though it certainly does happen.
Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason: to pump or support the stock price. The shareholder who chooses to sell today, of course, is benefitted by any buyer, whatever his origin or motives. But the continuing shareholder is penalized by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around.
Charlie and I admit that we feel confident in estimating intrinsic value for only a portion of traded equities and then only when we employ a range of values, rather than some pseudo-precise figure. - Warren Buffett in the 1999 Berkshire Hathaway Shareholder Letter
Seems incredible that buybacks were "all the rage" in 1999 when most stocks were unbelievably expensive. Of course, buyback activity was also intense leading up to the market peak in 2007.
This Barron's article points out the biggest year for buybacks was 2007 at $ 863 billion just as the market was at its peak.
So, all too often, shares are bought when they're selling plainly above intrinsic value. Also, buybacks sometimes used in an attempt to stem the decline or prop up the value of a stock. Not a good idea unless the stock happens to be selling nicely below intrinsic value at that time (just because the stock is dropping doesn't mean it's selling below intrinsic value) and the business is otherwise financially healthy enough with ample funds available:
We will never make purchases [ of Berkshire's stock] with the intention of stemming a decline in Berkshire's price. Rather we will make them if and when we believe that they represent an attractive use of the Company's money. - Warren Buffett in the in the 1999 Berkshire Hathaway Shareholder Letter
So a buyback should never be about influencing price action. It's about paying less than a dollar to get a dollar of value (a dollar of value that, if a good business, should grow) in return*.
On the other end of the spectrum is when a CEO has an extremely cheap stock but opts for an expensive acquisition instead.
That pretty much sums up Sanofi's (SNY) purchase of Genzyme. Here's what Sanofi CEO Chris Viehbacher said about buybacks when asked on a conference call:
"I personally don't believe that buybacks add any shareholder value."
This Barron's article makes the point that buying back their own stock at 7x earnings instead of buying Genzyme at 20x probably makes more sense.
When executed intelligently, buybacks work very well and, just as importantly, can reveal whether management actions are driven by shareholder wealth creation.
By making repurchases when a company's market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management's domain but that do nothing for (or even harm) shareholders. - Warren Buffett in the 1984 Berkshire Hathaway Shareholder Letter
The track record of effectively executed buybacks is certainly mixed at best but buybacks are neither inherently good nor bad. Careful consideration of the specific circumstances is always required.
I think that's worth remembering when a generalization is being made about the merits of repurchases (or the lack thereof).
Adam
Long BRKb and JPM
Related posts:
How Not to Spend $ 18.5 Billion
Sanofi to Buy Genzyme
Should Berkshire Repurchase Its Own Stock?
Buffett: When it's Advisable for a Company to Repurchase Shares
Berkshire Hathaway Authorizes Share Repurchases
* Let's say something like 70 cents is paid for a dollar of business value (as if it can be could be calculated with that kind of precision) but, of course, that dollar of value is not static. If a sound investment, that dollar in business value grows intrinsically over time. Of course, the opposite is true. Consistently judging reasonably well how value is likely to change over time matters. A discount provides only so much protection against mistakes.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Wednesday, January 11, 2012
Tuesday, January 10, 2012
John Bogle: America's Financial System - Powerful but Flawed
From this lecture by John Bogle late last year:
America's Financial System - Powerful but Flawed
Classical economics has tended to make a distinction between the real economy—the production and consumption of goods and services—and the paper economy—the vast network of financial assets and liabilities that is, finally, supported by the productive economy. The fact is that our productive economy and our financial economy are closely, indeed inextricably, interlinked.
The principal role of our nation's financial institutions is to allocate scarce investment capital among our corporations and economic sectors in a way that maximizes the growth potential of our economy. But changes in our financial sector have undermined this goal. Most notable among those changes are: first, the growing dominance of agents (giant banks and investment banks, and institutional money managers) as stock owners over principals (individual investors); and second, the ascendance of short-term speculation over long-term investment, focused on the illusion represented by the momentary precision of stock prices rather than the reality represented by intrinsic value—simply put, the discounted value of future cash flows. Both of these major changes in how we invest have played a critical role in creating a dysfunctional and expensive financial system, and in turn have ill-served our real economy.
The downside of a dominance of agents over principals? Some excerpts from this interview last year with John Bogle:
...agency dominance is never going away. The problem is if you're an agent and you're not investing your own money, you've got a lot of other things to keep you going. Adam Smith has a saying "Managers of other people's money [rarely] watch over it with the same anxious vigilance with which… they watch over their own."
The focus in the mutual fund business and in the pension business is on short-term performance. It's absolutely idiotic but it is not going to change.
In Bogle's view, we've traded an ownership society for a failed agency society. Later in the interview, Bogle added...
I'm afraid we've got to be satisfied with incremental changes that come down to investors and pension fund managers acting more intelligently. If we did have a fiduciary duty for institutional money managers, it would force the corporations that they control in today's agency system to honor the fiduciary duty to their clients.
Bogle thinks that out of this failed agency society needs to emerge a robust fiduciary society.
So, out of the ashes of our old ownership society and our failed agency society we must develop a new fiduciary society... - From "Building a Fiduciary Society" on Page 11 of America's Financial System - Powerful but Flawed
Now, what about the downside of what Bogle, in the lecture, calls "the ascendance of short-term speculation over long-term investment"?
Wall Street is raising capital for industry, as it always has, in reasonable amounts considering the needs of the corporations. The problem is that primary capital formation or capital allocation — call it whatever you want — it has been totally overshadowed by all this speculation in the secondary markets.
So, in Bogle's view, what's the result?
...speculators don't give a damn about corporate governance. They don't give a damn about executive compensation. They don't give a damn about anything except the price of the company's stock, which is basically a momentary illusion.
In the interview, Bogle refers to the "Wall Street Rule" which essentially is if you don’t like the management, sell the stock. Sounds like a perfectly reasonable practice until you realize how that view of the world might contribute to the so-called agency problem*.
Who has a better likelihood of influencing important changes at the board level to improve corporate performance?
A system where institutional money managers are held accountable to a strong fiduciary duty requirement (the duty to make sure management and the board of companies they own shares in are putting shareholders' interests first) or those that operate under something akin to the "Wall Street Rule"?
Long-term investors or speculators?
A system dominated by relatively short-term oriented agents that live by things like the "Wall Street Rule" and speculators with very short time horizons isn't likely to expend much energy influencing and trying to fix what might be broken with a company's board and management.
In the same interview, Bogle suggests a different rule:
So if you don't like the management, improve the management! It's not complicated.
Even if slowly considering the forces involved, some of the more expensive and economically useless activities in the current system could be replaced by playing a key role in forcing useful change and improvement where crucial resource utilization and investment decisions are made every day. More from Bogle:
I think each of us have a responsibility to leave everything we touch in our lifetime a little bit better. Whether it's a family. Whether it's a community. Whether it's a corporation.
It's unlikely that the current system dominated by 1) short-term oriented agents and weak fiduciary standards along with 2) speculators will play the vital role of improving corporate governance.
America has some fine companies despite the weaknesses in the system. That doesn't mean the status quo is acceptable.
Change is needed and the impact on the real world is far from academic. There's very real economic and social benefits at stake in all this.
Adam
* What's the agency problem in this context? Agents (banks and institutional money managers like mutual funds, pensions etc.) often have enough scale to influence accountability at the board level of a company they own shares in (and ultimately the management) but do not feel, too often in the current system, obligated to fulfill that responsibility. It contributes to an all too frequent outcome. Inadvertently or not, agent and/or management interests end up favored over shareholders' and beneficiaries' interests (even if cleverly cloaked otherwise). The lack of long-term investing by many institutional money managers certainly also contributes. In other words, if you aren't going to own something long-term why bother with fixing an inept board and/or management team. This has a direct and cumulative effect on corporate misbehavior and resource misallocation. The fiduciary duty of institutional money managers in representing shareholders and pension beneficiaries is overwhelmed by their financial interest in gathering and managing the assets.
---
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.
America's Financial System - Powerful but Flawed
Classical economics has tended to make a distinction between the real economy—the production and consumption of goods and services—and the paper economy—the vast network of financial assets and liabilities that is, finally, supported by the productive economy. The fact is that our productive economy and our financial economy are closely, indeed inextricably, interlinked.
The principal role of our nation's financial institutions is to allocate scarce investment capital among our corporations and economic sectors in a way that maximizes the growth potential of our economy. But changes in our financial sector have undermined this goal. Most notable among those changes are: first, the growing dominance of agents (giant banks and investment banks, and institutional money managers) as stock owners over principals (individual investors); and second, the ascendance of short-term speculation over long-term investment, focused on the illusion represented by the momentary precision of stock prices rather than the reality represented by intrinsic value—simply put, the discounted value of future cash flows. Both of these major changes in how we invest have played a critical role in creating a dysfunctional and expensive financial system, and in turn have ill-served our real economy.
The downside of a dominance of agents over principals? Some excerpts from this interview last year with John Bogle:
...agency dominance is never going away. The problem is if you're an agent and you're not investing your own money, you've got a lot of other things to keep you going. Adam Smith has a saying "Managers of other people's money [rarely] watch over it with the same anxious vigilance with which… they watch over their own."
The focus in the mutual fund business and in the pension business is on short-term performance. It's absolutely idiotic but it is not going to change.
In Bogle's view, we've traded an ownership society for a failed agency society. Later in the interview, Bogle added...
I'm afraid we've got to be satisfied with incremental changes that come down to investors and pension fund managers acting more intelligently. If we did have a fiduciary duty for institutional money managers, it would force the corporations that they control in today's agency system to honor the fiduciary duty to their clients.
Bogle thinks that out of this failed agency society needs to emerge a robust fiduciary society.
So, out of the ashes of our old ownership society and our failed agency society we must develop a new fiduciary society... - From "Building a Fiduciary Society" on Page 11 of America's Financial System - Powerful but Flawed
Now, what about the downside of what Bogle, in the lecture, calls "the ascendance of short-term speculation over long-term investment"?
Wall Street is raising capital for industry, as it always has, in reasonable amounts considering the needs of the corporations. The problem is that primary capital formation or capital allocation — call it whatever you want — it has been totally overshadowed by all this speculation in the secondary markets.
So, in Bogle's view, what's the result?
...speculators don't give a damn about corporate governance. They don't give a damn about executive compensation. They don't give a damn about anything except the price of the company's stock, which is basically a momentary illusion.
In the interview, Bogle refers to the "Wall Street Rule" which essentially is if you don’t like the management, sell the stock. Sounds like a perfectly reasonable practice until you realize how that view of the world might contribute to the so-called agency problem*.
Who has a better likelihood of influencing important changes at the board level to improve corporate performance?
A system where institutional money managers are held accountable to a strong fiduciary duty requirement (the duty to make sure management and the board of companies they own shares in are putting shareholders' interests first) or those that operate under something akin to the "Wall Street Rule"?
Long-term investors or speculators?
A system dominated by relatively short-term oriented agents that live by things like the "Wall Street Rule" and speculators with very short time horizons isn't likely to expend much energy influencing and trying to fix what might be broken with a company's board and management.
In the same interview, Bogle suggests a different rule:
So if you don't like the management, improve the management! It's not complicated.
Even if slowly considering the forces involved, some of the more expensive and economically useless activities in the current system could be replaced by playing a key role in forcing useful change and improvement where crucial resource utilization and investment decisions are made every day. More from Bogle:
I think each of us have a responsibility to leave everything we touch in our lifetime a little bit better. Whether it's a family. Whether it's a community. Whether it's a corporation.
It's unlikely that the current system dominated by 1) short-term oriented agents and weak fiduciary standards along with 2) speculators will play the vital role of improving corporate governance.
America has some fine companies despite the weaknesses in the system. That doesn't mean the status quo is acceptable.
Change is needed and the impact on the real world is far from academic. There's very real economic and social benefits at stake in all this.
Adam
* What's the agency problem in this context? Agents (banks and institutional money managers like mutual funds, pensions etc.) often have enough scale to influence accountability at the board level of a company they own shares in (and ultimately the management) but do not feel, too often in the current system, obligated to fulfill that responsibility. It contributes to an all too frequent outcome. Inadvertently or not, agent and/or management interests end up favored over shareholders' and beneficiaries' interests (even if cleverly cloaked otherwise). The lack of long-term investing by many institutional money managers certainly also contributes. In other words, if you aren't going to own something long-term why bother with fixing an inept board and/or management team. This has a direct and cumulative effect on corporate misbehavior and resource misallocation. The fiduciary duty of institutional money managers in representing shareholders and pension beneficiaries is overwhelmed by their financial interest in gathering and managing the assets.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Monday, January 9, 2012
Buffett on Efficient Market Theory
From the 1988 Berkshire Hathaway (BRKa) Shareholder Letter. In that letter, Warren Buffett provides some thoughts on "efficient market theory" (EMT).
An excerpt:
Amazingly, EMT was embraced not only by academics, but by many investment professionals and corporate managers as well. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.
In my opinion, the continuous 63-year arbitrage experience of Graham-Newman Corp. Buffett Partnership, and Berkshire illustrates just how foolish EMT is. (There's plenty of other evidence, also.) While at Graham-Newman, I made a study of its earnings from arbitrage during the entire 1926-1956 lifespan of the company. Unleveraged returns averaged 20% per year. Starting in 1956, I applied Ben Graham's arbitrage principles, first at Buffett Partnership and then Berkshire. Though I've not made an exact calculation, I have done enough work to know that the 1956-1988 returns averaged well over 20%. (Of course, I operated in an environment far more favorable than Ben's; he had 1929-1932 to contend with.)
All of the conditions are present that are required for a fair test of portfolio performance: (1) the three organizations traded hundreds of different securities while building this 63- year record; (2) the results are not skewed by a few fortunate experiences; (3) we did not have to dig for obscure facts or develop keen insights about products or managements - we simply acted on highly-publicized events; and (4) our arbitrage positions were a clearly identified universe - they have not been selected by hindsight.
Over the 63 years, the general market delivered just under a 10% annual return, including dividends. That means $1,000 would have grown to $405,000 if all income had been reinvested. A 20% rate of return, however, would have produced $97 million. That strikes us as a statistically-significant differential that might, conceivably, arouse one's curiosity.
Yet proponents of the theory have never seemed interested in discordant evidence of this type. True, they don’t talk quite as much about their theory today as they used to. But no one, to my knowledge, has ever said he was wrong, no matter how many thousands of students he has sent forth misinstructed. EMT, moreover, continues to be an integral part of the investment curriculum at major business schools. Apparently, a reluctance to recant, and thereby to demystify the priesthood, is not limited to theologians.
Naturally the disservice done students and gullible investment professionals who have swallowed EMT has been an extraordinary service to us and other followers of Graham. In any sort of a contest - financial, mental, or physical - it's an enormous advantage to have opponents who have been taught that it's useless to even try. From a selfish point of view, Grahamites should probably endow chairs to ensure the perpetual teaching of EMT.
Remarkably, you'll find EMT taught to this day at respected universities and colleges.
I've said before that it's best to never underestimate how long it takes for lousy yet influential ideas, even if they happened to be cloaked in respectability, to disappear.
Adam
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.
An excerpt:
Amazingly, EMT was embraced not only by academics, but by many investment professionals and corporate managers as well. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.
In my opinion, the continuous 63-year arbitrage experience of Graham-Newman Corp. Buffett Partnership, and Berkshire illustrates just how foolish EMT is. (There's plenty of other evidence, also.) While at Graham-Newman, I made a study of its earnings from arbitrage during the entire 1926-1956 lifespan of the company. Unleveraged returns averaged 20% per year. Starting in 1956, I applied Ben Graham's arbitrage principles, first at Buffett Partnership and then Berkshire. Though I've not made an exact calculation, I have done enough work to know that the 1956-1988 returns averaged well over 20%. (Of course, I operated in an environment far more favorable than Ben's; he had 1929-1932 to contend with.)
All of the conditions are present that are required for a fair test of portfolio performance: (1) the three organizations traded hundreds of different securities while building this 63- year record; (2) the results are not skewed by a few fortunate experiences; (3) we did not have to dig for obscure facts or develop keen insights about products or managements - we simply acted on highly-publicized events; and (4) our arbitrage positions were a clearly identified universe - they have not been selected by hindsight.
Over the 63 years, the general market delivered just under a 10% annual return, including dividends. That means $1,000 would have grown to $405,000 if all income had been reinvested. A 20% rate of return, however, would have produced $97 million. That strikes us as a statistically-significant differential that might, conceivably, arouse one's curiosity.
Yet proponents of the theory have never seemed interested in discordant evidence of this type. True, they don’t talk quite as much about their theory today as they used to. But no one, to my knowledge, has ever said he was wrong, no matter how many thousands of students he has sent forth misinstructed. EMT, moreover, continues to be an integral part of the investment curriculum at major business schools. Apparently, a reluctance to recant, and thereby to demystify the priesthood, is not limited to theologians.
Naturally the disservice done students and gullible investment professionals who have swallowed EMT has been an extraordinary service to us and other followers of Graham. In any sort of a contest - financial, mental, or physical - it's an enormous advantage to have opponents who have been taught that it's useless to even try. From a selfish point of view, Grahamites should probably endow chairs to ensure the perpetual teaching of EMT.
Remarkably, you'll find EMT taught to this day at respected universities and colleges.
I've said before that it's best to never underestimate how long it takes for lousy yet influential ideas, even if they happened to be cloaked in respectability, to disappear.
Adam
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.
Friday, January 6, 2012
The Illusion of Control
According to this Barron's article, 85 percent of investor sell or exchange decisions are wrong.
The Money Paradox
That means:
...the investor would do better by doing nothing or going the other way that 85% of the time. Simple random decision making (with no investment knowledge) would have yielded about 50% good decisions.
The article also makes the point that, in the 20 years ended in 2008, a 1.9 percent annual return was achieved by equity fund investors even though the average fund produced 8.4 percent annualized returns.
The reason? Lots of buy and sell transactions intended to preserve capital or juice returns. Moves that all likely seemed wise at the time but, in fact, were an illusory sense of control. Doing nothing would have produced much better results. More from the article:
This is a compelling demonstration of the illusion of control, the mistaken belief that better results come from more-direct, detailed control and using it to make lots of decisions and transactions.
The illusion of control explains one of the many reasons I'm in favor of an investing approach that minimizes trading activity and the associated frictional costs.
Keeping the explicit frictional costs (commissions, taxes etc.) themselves down is smart, but the above starts to get at what I think is a much more crucial, even if somewhat more subtle, reason to adopt an approach that involves as little trading as possible.
Naturally, every decision is another chance for a favorable outcome or to make a mistake.* The fact is, when a buy/sell decision is made, many don't think or realize the odds are stacked against them as much as the evidence shows.
Now, I'm guessing many think they're not one of the investors who gets it wrong 85 percent like the study shows. If so, just keep in mind the survey that revealed 90 percent of swedish drivers think they are above average.
"Demosthenes noted that: 'What a man wishes, he will believe.' And in self appraisals of prospects and talents it is the norm, as Demosthenes predicted, for people to be ridiculously over-optimistic. For instance, a careful survey in Sweden showed that 90% of automobile drivers considered themselves above average." - Charlie Munger speaking to the Foundation Financial Officers Group in 1998
So if, as the above suggests, investors tend to get their buy/sell decisions wrong 85 percent of the time what's the best way to improve performance? It's far to easy to make the mistake of overemphasizing the potential positive outcome while not properly weighing the downside. The only solution that I know of that works comes down to the following: 1) reduce the number of buy/sell decisions one has to make then 2) use that freed up time and energy to focus intensely on the relatively fewer remaining decisions.
I'll take that a bit further.
There are only so many investments that most of us can really understand well.
Developing a comprehensive understanding of the long run economic characteristics of a business and the risks involved just is not an easy thing to do.
On those rare occasions an investor is able to develop a real comfort-level with a specific investment, then it comes down to knowing how much of a discount should be paid relative to value and building a meaningful position.
That whole process sounds simple enough but in the real world, at least for most mortals, it isn't easy to get consistently right.
So, considering the difficulty of getting it right and the work involved, why then sell something just because it happens to be gyrating around in the frequently manic then depressed stock market?
The only logical reason, it seems to me, would be that the economic characteristics of the investment changes materially** or price action takes valuation to extremes.
"...when we own portions outstanding businesses with outstanding managements, our favorite holding period is forever." - Warren Buffett in the 1988 Berkshire Hathaway Shareholder Letter
The Illusion of control makes many think they'll get their buy/sell decisions right but the evidence suggests otherwise. An investor obviously has to make buy and sell decisions at least occasionally but it's wise to develop an approach that minimizes the need to do so.
"We continue to concentrate our investments in a very few companies that we try to understand well. There are only a handful of businesses about which we have strong long-term convictions. Therefore, when we find such a business, we want to participate in a meaningful way." - Warren Buffett in the 1988 Berkshire Hathaway Shareholder Letter
I think that finding good businesses with the idea of owning them "forever" and concentrating on "companies that we try to understand well" can go a long way toward solving the illusion of control problem.
Well, lets just say it works just fine as long as the ability to judge value and how it will change over time tends to be sound.
Adam
Related posts:
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again
* The error of not giving equal consideration to both a favorable outcome and the downside risks is easy to make. It's, in part, confirmation bias at work. More than a few seem to underestimate how susceptible most investors are to this kind of mistake.
** That's why finding businesses that tend to have durable economic characteristics (high return on capital) is more important than extreme growth prospects. By owning shares of durable businesses with high return on capital, the economics of the business itself (not skillful trading) does the heavy lifting when it comes to generating long-term returns for owners.
---
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 Money Paradox
That means:
...the investor would do better by doing nothing or going the other way that 85% of the time. Simple random decision making (with no investment knowledge) would have yielded about 50% good decisions.
The article also makes the point that, in the 20 years ended in 2008, a 1.9 percent annual return was achieved by equity fund investors even though the average fund produced 8.4 percent annualized returns.
The reason? Lots of buy and sell transactions intended to preserve capital or juice returns. Moves that all likely seemed wise at the time but, in fact, were an illusory sense of control. Doing nothing would have produced much better results. More from the article:
This is a compelling demonstration of the illusion of control, the mistaken belief that better results come from more-direct, detailed control and using it to make lots of decisions and transactions.
The illusion of control explains one of the many reasons I'm in favor of an investing approach that minimizes trading activity and the associated frictional costs.
Keeping the explicit frictional costs (commissions, taxes etc.) themselves down is smart, but the above starts to get at what I think is a much more crucial, even if somewhat more subtle, reason to adopt an approach that involves as little trading as possible.
Naturally, every decision is another chance for a favorable outcome or to make a mistake.* The fact is, when a buy/sell decision is made, many don't think or realize the odds are stacked against them as much as the evidence shows.
Now, I'm guessing many think they're not one of the investors who gets it wrong 85 percent like the study shows. If so, just keep in mind the survey that revealed 90 percent of swedish drivers think they are above average.
"Demosthenes noted that: 'What a man wishes, he will believe.' And in self appraisals of prospects and talents it is the norm, as Demosthenes predicted, for people to be ridiculously over-optimistic. For instance, a careful survey in Sweden showed that 90% of automobile drivers considered themselves above average." - Charlie Munger speaking to the Foundation Financial Officers Group in 1998
So if, as the above suggests, investors tend to get their buy/sell decisions wrong 85 percent of the time what's the best way to improve performance? It's far to easy to make the mistake of overemphasizing the potential positive outcome while not properly weighing the downside. The only solution that I know of that works comes down to the following: 1) reduce the number of buy/sell decisions one has to make then 2) use that freed up time and energy to focus intensely on the relatively fewer remaining decisions.
I'll take that a bit further.
There are only so many investments that most of us can really understand well.
Developing a comprehensive understanding of the long run economic characteristics of a business and the risks involved just is not an easy thing to do.
On those rare occasions an investor is able to develop a real comfort-level with a specific investment, then it comes down to knowing how much of a discount should be paid relative to value and building a meaningful position.
That whole process sounds simple enough but in the real world, at least for most mortals, it isn't easy to get consistently right.
So, considering the difficulty of getting it right and the work involved, why then sell something just because it happens to be gyrating around in the frequently manic then depressed stock market?
The only logical reason, it seems to me, would be that the economic characteristics of the investment changes materially** or price action takes valuation to extremes.
"...when we own portions outstanding businesses with outstanding managements, our favorite holding period is forever." - Warren Buffett in the 1988 Berkshire Hathaway Shareholder Letter
The Illusion of control makes many think they'll get their buy/sell decisions right but the evidence suggests otherwise. An investor obviously has to make buy and sell decisions at least occasionally but it's wise to develop an approach that minimizes the need to do so.
"We continue to concentrate our investments in a very few companies that we try to understand well. There are only a handful of businesses about which we have strong long-term convictions. Therefore, when we find such a business, we want to participate in a meaningful way." - Warren Buffett in the 1988 Berkshire Hathaway Shareholder Letter
I think that finding good businesses with the idea of owning them "forever" and concentrating on "companies that we try to understand well" can go a long way toward solving the illusion of control problem.
Well, lets just say it works just fine as long as the ability to judge value and how it will change over time tends to be sound.
Adam
Related posts:
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again
* The error of not giving equal consideration to both a favorable outcome and the downside risks is easy to make. It's, in part, confirmation bias at work. More than a few seem to underestimate how susceptible most investors are to this kind of mistake.
** That's why finding businesses that tend to have durable economic characteristics (high return on capital) is more important than extreme growth prospects. By owning shares of durable businesses with high return on capital, the economics of the business itself (not skillful trading) does the heavy lifting when it comes to generating long-term returns for owners.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Thursday, January 5, 2012
The Buffett Test
From a lecture* given by Warren Buffett to Notre Dame faculty,
MBA students, and undergraduates in 1991:
You shouldn't buy a stock, in my view, for any other reason than the fact that you think it's selling for less than it’s worth, considering all the factors about the business.
I used to tell the stock exchange people that before a person bought 100 shares of General Motors they should have to write out on a [piece of paper:] "I'm buying 100 shares of General Motors at X" and multiply that by the number of shares "and therefore General Motors is worth more than $32 billion" or whatever it multiplies out to, "because ... [fill in the reasons]" And if they couldn't answer that question, their order wouldn't be accepted.
That test should be applied. I should never buy anything unless I can fill out that piece of paper. I may be wrong, but I would know the answer to that. "I'm buying Coca Cola right now, 660 million shares of stock, a little under $50. The whole company costs me about $32 billion dollars." Before you buy 100 shares of stock at $48 you ought to be able to answer "I'm paying $32 billion today for the Coca Cola Company because..." [Banging the podium for emphasis.] If you can't answer that question, you shouldn't buy it. If you can answer that question, and you do it a few times, you'll make a lot of money.
- Warren Buffett
What a contrast to the way some buy stocks in today's environment. Investing successfully comes down to being good at estimating what something is worth now, how it's likely to change in value over time, then buying it at a comfortable discount to account for the unforeseeable.
No skillful chartology, macro analysis, sector rotation, momentum, or other similar garbage required.
If the portfolio I just updated in the Tuesday post continues to perform over the long haul, it will be the result of having judged current value and the potential for future value creation reasonably well, and that the stocks were bought with a nice margin of safety.
The rest is distraction.
Adam
* Lightly edited by Whitney Tilson
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.
You shouldn't buy a stock, in my view, for any other reason than the fact that you think it's selling for less than it’s worth, considering all the factors about the business.
I used to tell the stock exchange people that before a person bought 100 shares of General Motors they should have to write out on a [piece of paper:] "I'm buying 100 shares of General Motors at X" and multiply that by the number of shares "and therefore General Motors is worth more than $32 billion" or whatever it multiplies out to, "because ... [fill in the reasons]" And if they couldn't answer that question, their order wouldn't be accepted.
That test should be applied. I should never buy anything unless I can fill out that piece of paper. I may be wrong, but I would know the answer to that. "I'm buying Coca Cola right now, 660 million shares of stock, a little under $50. The whole company costs me about $32 billion dollars." Before you buy 100 shares of stock at $48 you ought to be able to answer "I'm paying $32 billion today for the Coca Cola Company because..." [Banging the podium for emphasis.] If you can't answer that question, you shouldn't buy it. If you can answer that question, and you do it a few times, you'll make a lot of money.
- Warren Buffett
What a contrast to the way some buy stocks in today's environment. Investing successfully comes down to being good at estimating what something is worth now, how it's likely to change in value over time, then buying it at a comfortable discount to account for the unforeseeable.
No skillful chartology, macro analysis, sector rotation, momentum, or other similar garbage required.
If the portfolio I just updated in the Tuesday post continues to perform over the long haul, it will be the result of having judged current value and the potential for future value creation reasonably well, and that the stocks were bought with a nice margin of safety.
The rest is distraction.
Adam
* Lightly edited by Whitney Tilson
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.
Wednesday, January 4, 2012
Warren Buffett: "Hyperkinetic" Investment Managers
From the 1986 Berkshire Hathaway (BRKa) shareholder letter:
"We should note that we expect to keep permanently our three primary holdings, Capital Cities/ABC, Inc., GEICO Corporation, and The Washington Post. Even if these securities were to appear significantly overpriced, we would not anticipate selling them, just as we would not sell See's or Buffalo Evening News if someone were to offer us a price far above what we believe those businesses are worth.
This attitude may seem old-fashioned in a corporate world in which activity has become the order of the day. The modern manager refers to his 'portfolio' of businesses - meaning that all of them are candidates for 'restructuring' whenever such a move is dictated by Wall Street preferences, operating conditions or a new corporate 'concept.' (Restructuring is defined narrowly, however: it extends only to dumping offending businesses, not to dumping the officers and directors who bought the businesses in the first place. 'Hate the sin but love the sinner' is a theology as popular with the Fortune 500 as it is with the Salvation Army.)
Investment managers are even more hyperkinetic: their behavior during trading hours makes whirling dervishes appear sedated by comparison. Indeed, the term 'institutional investor' is becoming one of those self-contradictions called an oxymoron...
Despite the enthusiasm for activity that has swept business and financial America, we will stick with our 'til-death-do-us-part policy. It's the only one with which Charlie and I are comfortable, it produces decent results, and it lets our managers and those of our investees run their businesses free of distractions."
Warren Buffett wrote the above in an era when the average holding period for stocks was in the 2 to 3 year range. These days, the average holding period is more like a few months. So if Buffett saw market participants as hyperkinetic, whirling dervishes back then what does he think now?
Roughly 25 years ago, Buffett said he expected to keep the three primary holdings permanently. Here's what happened to those three stocks:
-In 1995, Walt Disney Co. (DIS) offered to buy Capital Cities/ABC, Inc. and closed on the deal in early 1996. Berkshire received cash and Disney stock in exchange for the 20 million Capital Cities/ABC shares owned by Berkshire (cost basis $ 345 million but worth around $ 2.5 billion at the end of 1995). The Disney shares were only held for a few more years. The Walt Disney Co. shares haven't done much in the decade plus since they were sold, but the business has done just fine. Another case where business value had to "catch up" to a bloated price to earnings ratio.
-Also in 1996, Berkshire purchased the remainder of GEICO's stock they did not already own causing the company to be converted into a wholly-owned subsidiary.
-Washington Post (WPO), of course, remains in the Berkshire equity portfolio.
So Buffett and Munger may often go in with the intention to own something "forever". At least so far, for two out of the three that's what has happened. In fact, by buying the remaining shares of GEICO the commitment to GEICO as a long-term investment has been only increased.
Naturally, over a longer time frame, something unforeseeable comes along like the Disney-Cap Cities/ABC deal where the buyer wants the business and is willing to pay a price for the shares that is attractive enough to the seller.
It's not that selling never makes sense. If the moat deteriorates to where the economics become very unattractive (especially if a large percent of net worth), or cash is needed to fund the purchase of an unusually attractive investment, sometimes a sale makes good sense. Yet, a bias toward not selling once you own shares of a good business (or an entire business, of course) minimizes frictional costs, and potential mistakes, while allowing the long-term effects of compounding to benefit long-term owners.
Adam
Long position in BRKb established at lower prices
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
"We should note that we expect to keep permanently our three primary holdings, Capital Cities/ABC, Inc., GEICO Corporation, and The Washington Post. Even if these securities were to appear significantly overpriced, we would not anticipate selling them, just as we would not sell See's or Buffalo Evening News if someone were to offer us a price far above what we believe those businesses are worth.
This attitude may seem old-fashioned in a corporate world in which activity has become the order of the day. The modern manager refers to his 'portfolio' of businesses - meaning that all of them are candidates for 'restructuring' whenever such a move is dictated by Wall Street preferences, operating conditions or a new corporate 'concept.' (Restructuring is defined narrowly, however: it extends only to dumping offending businesses, not to dumping the officers and directors who bought the businesses in the first place. 'Hate the sin but love the sinner' is a theology as popular with the Fortune 500 as it is with the Salvation Army.)
Investment managers are even more hyperkinetic: their behavior during trading hours makes whirling dervishes appear sedated by comparison. Indeed, the term 'institutional investor' is becoming one of those self-contradictions called an oxymoron...
Despite the enthusiasm for activity that has swept business and financial America, we will stick with our 'til-death-do-us-part policy. It's the only one with which Charlie and I are comfortable, it produces decent results, and it lets our managers and those of our investees run their businesses free of distractions."
Warren Buffett wrote the above in an era when the average holding period for stocks was in the 2 to 3 year range. These days, the average holding period is more like a few months. So if Buffett saw market participants as hyperkinetic, whirling dervishes back then what does he think now?
Roughly 25 years ago, Buffett said he expected to keep the three primary holdings permanently. Here's what happened to those three stocks:
-In 1995, Walt Disney Co. (DIS) offered to buy Capital Cities/ABC, Inc. and closed on the deal in early 1996. Berkshire received cash and Disney stock in exchange for the 20 million Capital Cities/ABC shares owned by Berkshire (cost basis $ 345 million but worth around $ 2.5 billion at the end of 1995). The Disney shares were only held for a few more years. The Walt Disney Co. shares haven't done much in the decade plus since they were sold, but the business has done just fine. Another case where business value had to "catch up" to a bloated price to earnings ratio.
-Also in 1996, Berkshire purchased the remainder of GEICO's stock they did not already own causing the company to be converted into a wholly-owned subsidiary.
-Washington Post (WPO), of course, remains in the Berkshire equity portfolio.
So Buffett and Munger may often go in with the intention to own something "forever". At least so far, for two out of the three that's what has happened. In fact, by buying the remaining shares of GEICO the commitment to GEICO as a long-term investment has been only increased.
Naturally, over a longer time frame, something unforeseeable comes along like the Disney-Cap Cities/ABC deal where the buyer wants the business and is willing to pay a price for the shares that is attractive enough to the seller.
It's not that selling never makes sense. If the moat deteriorates to where the economics become very unattractive (especially if a large percent of net worth), or cash is needed to fund the purchase of an unusually attractive investment, sometimes a sale makes good sense. Yet, a bias toward not selling once you own shares of a good business (or an entire business, of course) minimizes frictional costs, and potential mistakes, while allowing the long-term effects of compounding to benefit long-term owners.
Adam
Long position in BRKb established at lower prices
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Tuesday, January 3, 2012
Six Stock Portfolio Update
Portfolio performance since mentioning on April 9, 2009 that I like these six stocks as long-term investments if bought near prevailing prices at that time (or lower, of course).
While I never make stock recommendations each of these, at the right price, are what I consider attractive long-term investments for my own capital.
Intrinsic Value: The Six Stock Portfolio
The portfolio is made up of the following stocks: Wells Fargo (WFC), Diageo (DEO), Philip Morris International (PM), Pepsi (PEP), Lowe's (LOW), and American Express (AXP).
Stock | Total Return*
WFC | 44.4%
DEO | 110.5%
PM | 135.6%
PEP | 38.5%
LOW | 31.6%
AXP | 162.5%
The total return for the six stocks combined is 87.2% (including dividends) since April 9, 2009. By comparison, the S&P 500 SPDR ETF (SPY) is up 54.0% (also including dividends) over that same time frame.
While the S&P 500 is down since I last updated this portfolio, the six stocks as a group continued to build on their gains. As a result, the portfolio's performance advantage expanded further. That certainly won't be the case in every period considering the concentration.
Unfortunately, none of these are selling at the kind of discount to intrinsic value I'd require to buy more shares.
Hopefully that will change.
The above is a relatively low turnover and concentrated portfolio of high quality businesses. It is, in part, meant to be an example of Newton's 4th Law at work (or, alternatively, a way to avoid being tripped by the invisible foot).
Adam Smith felt that all noncollusive acts in a free market were guided by an invisible hand that led an economy to maximum progress; our view is that casino-type markets and hair-trigger investment management act as an invisible foot that trips up and slows down a forward-moving economy. - Warren Buffett in the 1983 Berkshire Hathaway Shareholder Letter
The approach rejects the idea that trading rapidly in and out of different securities is necessary to create above average returns. Instead, build a concentrated portfolio of high quality businesses that can outperform over the long-haul.
Buying shares at a discount to value (conservatively calculated), low "frictional costs", and the intrinsic value created by the businesses themselves becomes the driver of total returns not some special aptitude for trading or timing the market. In short, the outperformance, if it continues, will come from owning shares of good businesses bought with an appropriate margin of safety combined with little in the way of unnecessary fees, commissions, and related costs.
Buffett on Helpers and "Frictional" Costs
My view is that many equity investors would get improved long-term returns, at lower risk, if they: 1) bought (at fair or better prices) shares in 5-10 great businesses, 2) avoided the hyperactive trading ethos that is so popular these days to minimize mistakes & "frictional" costs, and 3) sold shares in these businesses only if the core long-term economics become impaired or opportunity costs are extremely high.
This six stock portfolio is clearly very concentrated by most standards but this approach to investing rejects the idea that vast diversification is needed.
I have more than skepticism regarding the orthodox view that huge diversification is a must for those wise enough so that indexation is not the logical mode for equity investment. I think the orthodox view is grossly mistaken.
In the United States, a person or institution with almost all wealth invested, long term, in just three fine domestic corporations is securely rich. And why should such an owner care if at any time most other investors are faring somewhat better or worse. And particularly so when he rationally believes, like Berkshire, that his long-term results will be superior by reason of his lower costs, required emphasis on long-term effects, and concentration in his most preferred choices. - Charlie Munger in this speech to the Foundation Financial Officers Group
We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. - Warren Buffett in the 1993 Berkshire Hathaway Shareholder Letter
Clearly, many investors need to diversify holdings a bit more. As always, one of the most important things is to always stay well within one's own limits as an investor. Depending on background and experience, low expense index funds may make more sense for some than buying individual stocks. Yet, keeping trading and other frictional costs to a minimum is almost always wise.
Though I could surely be wrong, I consider these six stocks appropriate for my own portfolio (not someone else's) given my understanding of the downside risks and potential rewards. It doesn't make sense for others unless they do their own research and reach similar conclusions.
The above concentrated portfolio of six stocks obviously won't outperform in every period. In the long run, it has a reasonable probability of doing well compared to the S&P 500 due to lower frictional costs and the durable high return qualities of the businesses. While unlikely to outperform the very best portfolio managers**, it's likely to perform well on an absolute basis, especially when risk-adjusted, relative to the market as a whole over a period of 10 years+.
It's worth noting the unusual allocation of this portfolio.
When I put this together, I intentionally allocated one half the portfolio to consumer staples (DEO, PEP, PM), a third in financials (WFC, AXP), and a housing stock (LOW). At the time, none of these were exactly the hot trade of the moment.
Consumer staples were, of course, thought to be too defensive (lately, unfortunately, they've become a bit too popular...the substantial discounts to value that were available for many stocks in this sector have quickly disappeared) while many financial and housing stocks were in rough shape and in many ways continue to be so.
In part true, certainly, but you don't get bargains on good businesses when the outlook is sunny. Also, I consider the idea that one needs to jump in and out of stocks (or ETFs) based upon what the hot sector is to outperform is, to be kind, not a very good one (more a recipe to make mistakes and generate unnecessary fees and commissions).
Most readers of this blog will know the one thing I've said consistently is that the Coca-Cola's (KO), Pepsi's, and Philip Morris International's of the world are not defensive in the long-run.
(Okay, this has received more than its fair share of coverage on this blog but the fact is many consumer staple businesses, though each has a unique set of risks, often do not get enough respect as long-term offense while instead getting overplayed as short-term defense.)
Stocks in the consumer staples sector are, especially when bought well, often a lower risk way to outperform. For most of the time I have been making this point they've been priced from between extremely cheap to attractive. While not necessarily expensive now, most of these are no longer extremely cheap, either. So there are some great stocks in this sector to own for the long haul but the price paid still matters and the bargains, among consumer staples, have all but disappeared.
The point is I wanted this portfolio to be made up of businesses that, once shares were bought at the right price, could be, for the most part left alone to compound in value across multiple business cycles. Some may want exposure to other sectors not represented here which is fine if quality can be had at a fair or better price. We'll see how the portfolio continues to perform.
In any case, this simple example is designed so it's easy for anyone to check the results over time. If this six stock portfolio*** isn't performing well against the S&P 500 it will be obvious. The idea that a concentrated portfolio of quality businesses bought with a margin of safety can perform well while avoiding the hassle and risks of trading should, at least, be of some interest. Producing results via the increasingly popular hyperactive buying and selling of securities seems inspired by Sisyphus by comparison to me.
Finally, an opportunity may come along where the capital from one of these stocks is needed. My view is under such a scenario the threshold for making changes needs to be high. That hypothetical new investment must have clearly superior economics and relative price.
In addition, if something appears to fundamentally threaten the moat (ie. the effect of the internet on the newspaper biz) of one of these businesses a change may also be warranted.
So I may rarely add or switch some of the stocks in this portfolio but I will only make a change if the situation described above exists (ie. if the core long-term economics of one of these stocks become impaired or opportunity costs of not making a change is extremely high).
Keep in mind that even though the stocks I chose have done well versus the S&P 500, I still don't consider a little less than three years a meaningfully long enough time frame to measure performance.
Adam
Long position in DEO, AXP, PEP, PM, WFC, and LOW
* Total return is calculated using the closing price on December 31, 2011 compared to the closing price on April 9, 2011 (the date these stocks were first mentioned) plus dividends. I've used the closing price on April 9, 2011 (instead of something like average intraday price) even though it reduces the calculated total return slightly. The benefit is that it makes the calculation simpler and easier to confirm. In other words, better market prices were available intraday April 9, 2011 (and in subsequent days) so total returns could have been improved with some careful share accumulation. In any case, as always the comparison with the S&P 500 is apples to apples.
** There's no shortage of evidence that many actively managed equity mutual funds underperform the S&P 500.
"Of the 355 equity funds in 1970, fully 233 of those funds--almost two thirds--have gone out of business. Only 24 outpaced the market by more than one percentage point a year--one out of every 14. Let's face it: These are terrible odds!." - John Bogle
Also, DALBAR's Quantitative Analysis of Investor Behavior (QAIB) study released in March 2009 revealed that over the past 20 years investors in stock mutual funds have underperformed the S&P 500 by 6.5% a year (8.35% vs. 1.87%). Beyond the performance of the funds themselves, it shows that much of these poor returns come down to investor behavior. The tendency of investors to buy the hot mutual fund that has been going up while selling when the market is going down out of panic or fear.
*** I don't think these are necessarily the six best businesses in the world, but I believe they are all very good businesses that were selling at reasonable to cheap prices on April 9th, 2009. At any moment, there is always something better to own in theory but I don't think you can invest that way (as if stocks are baseball cards) and have consistent success. So there are certainly quite a few other shares in businesses that would be good alternatives to these six. The point is to get a handful of them at a fair price and then let the businesses and time work.
------------
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to be long the positions noted unless they sell significantly above intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
While I never make stock recommendations each of these, at the right price, are what I consider attractive long-term investments for my own capital.
Intrinsic Value: The Six Stock Portfolio
The portfolio is made up of the following stocks: Wells Fargo (WFC), Diageo (DEO), Philip Morris International (PM), Pepsi (PEP), Lowe's (LOW), and American Express (AXP).
Stock | Total Return*
WFC | 44.4%
DEO | 110.5%
PM | 135.6%
PEP | 38.5%
LOW | 31.6%
AXP | 162.5%
The total return for the six stocks combined is 87.2% (including dividends) since April 9, 2009. By comparison, the S&P 500 SPDR ETF (SPY) is up 54.0% (also including dividends) over that same time frame.
While the S&P 500 is down since I last updated this portfolio, the six stocks as a group continued to build on their gains. As a result, the portfolio's performance advantage expanded further. That certainly won't be the case in every period considering the concentration.
Unfortunately, none of these are selling at the kind of discount to intrinsic value I'd require to buy more shares.
Hopefully that will change.
The above is a relatively low turnover and concentrated portfolio of high quality businesses. It is, in part, meant to be an example of Newton's 4th Law at work (or, alternatively, a way to avoid being tripped by the invisible foot).
Adam Smith felt that all noncollusive acts in a free market were guided by an invisible hand that led an economy to maximum progress; our view is that casino-type markets and hair-trigger investment management act as an invisible foot that trips up and slows down a forward-moving economy. - Warren Buffett in the 1983 Berkshire Hathaway Shareholder Letter
The approach rejects the idea that trading rapidly in and out of different securities is necessary to create above average returns. Instead, build a concentrated portfolio of high quality businesses that can outperform over the long-haul.
Buying shares at a discount to value (conservatively calculated), low "frictional costs", and the intrinsic value created by the businesses themselves becomes the driver of total returns not some special aptitude for trading or timing the market. In short, the outperformance, if it continues, will come from owning shares of good businesses bought with an appropriate margin of safety combined with little in the way of unnecessary fees, commissions, and related costs.
Buffett on Helpers and "Frictional" Costs
My view is that many equity investors would get improved long-term returns, at lower risk, if they: 1) bought (at fair or better prices) shares in 5-10 great businesses, 2) avoided the hyperactive trading ethos that is so popular these days to minimize mistakes & "frictional" costs, and 3) sold shares in these businesses only if the core long-term economics become impaired or opportunity costs are extremely high.
This six stock portfolio is clearly very concentrated by most standards but this approach to investing rejects the idea that vast diversification is needed.
I have more than skepticism regarding the orthodox view that huge diversification is a must for those wise enough so that indexation is not the logical mode for equity investment. I think the orthodox view is grossly mistaken.
In the United States, a person or institution with almost all wealth invested, long term, in just three fine domestic corporations is securely rich. And why should such an owner care if at any time most other investors are faring somewhat better or worse. And particularly so when he rationally believes, like Berkshire, that his long-term results will be superior by reason of his lower costs, required emphasis on long-term effects, and concentration in his most preferred choices. - Charlie Munger in this speech to the Foundation Financial Officers Group
We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. - Warren Buffett in the 1993 Berkshire Hathaway Shareholder Letter
Clearly, many investors need to diversify holdings a bit more. As always, one of the most important things is to always stay well within one's own limits as an investor. Depending on background and experience, low expense index funds may make more sense for some than buying individual stocks. Yet, keeping trading and other frictional costs to a minimum is almost always wise.
Though I could surely be wrong, I consider these six stocks appropriate for my own portfolio (not someone else's) given my understanding of the downside risks and potential rewards. It doesn't make sense for others unless they do their own research and reach similar conclusions.
The above concentrated portfolio of six stocks obviously won't outperform in every period. In the long run, it has a reasonable probability of doing well compared to the S&P 500 due to lower frictional costs and the durable high return qualities of the businesses. While unlikely to outperform the very best portfolio managers**, it's likely to perform well on an absolute basis, especially when risk-adjusted, relative to the market as a whole over a period of 10 years+.
It's worth noting the unusual allocation of this portfolio.
When I put this together, I intentionally allocated one half the portfolio to consumer staples (DEO, PEP, PM), a third in financials (WFC, AXP), and a housing stock (LOW). At the time, none of these were exactly the hot trade of the moment.
Consumer staples were, of course, thought to be too defensive (lately, unfortunately, they've become a bit too popular...the substantial discounts to value that were available for many stocks in this sector have quickly disappeared) while many financial and housing stocks were in rough shape and in many ways continue to be so.
In part true, certainly, but you don't get bargains on good businesses when the outlook is sunny. Also, I consider the idea that one needs to jump in and out of stocks (or ETFs) based upon what the hot sector is to outperform is, to be kind, not a very good one (more a recipe to make mistakes and generate unnecessary fees and commissions).
Most readers of this blog will know the one thing I've said consistently is that the Coca-Cola's (KO), Pepsi's, and Philip Morris International's of the world are not defensive in the long-run.
(Okay, this has received more than its fair share of coverage on this blog but the fact is many consumer staple businesses, though each has a unique set of risks, often do not get enough respect as long-term offense while instead getting overplayed as short-term defense.)
Stocks in the consumer staples sector are, especially when bought well, often a lower risk way to outperform. For most of the time I have been making this point they've been priced from between extremely cheap to attractive. While not necessarily expensive now, most of these are no longer extremely cheap, either. So there are some great stocks in this sector to own for the long haul but the price paid still matters and the bargains, among consumer staples, have all but disappeared.
The point is I wanted this portfolio to be made up of businesses that, once shares were bought at the right price, could be, for the most part left alone to compound in value across multiple business cycles. Some may want exposure to other sectors not represented here which is fine if quality can be had at a fair or better price. We'll see how the portfolio continues to perform.
In any case, this simple example is designed so it's easy for anyone to check the results over time. If this six stock portfolio*** isn't performing well against the S&P 500 it will be obvious. The idea that a concentrated portfolio of quality businesses bought with a margin of safety can perform well while avoiding the hassle and risks of trading should, at least, be of some interest. Producing results via the increasingly popular hyperactive buying and selling of securities seems inspired by Sisyphus by comparison to me.
Finally, an opportunity may come along where the capital from one of these stocks is needed. My view is under such a scenario the threshold for making changes needs to be high. That hypothetical new investment must have clearly superior economics and relative price.
In addition, if something appears to fundamentally threaten the moat (ie. the effect of the internet on the newspaper biz) of one of these businesses a change may also be warranted.
So I may rarely add or switch some of the stocks in this portfolio but I will only make a change if the situation described above exists (ie. if the core long-term economics of one of these stocks become impaired or opportunity costs of not making a change is extremely high).
Keep in mind that even though the stocks I chose have done well versus the S&P 500, I still don't consider a little less than three years a meaningfully long enough time frame to measure performance.
Adam
Long position in DEO, AXP, PEP, PM, WFC, and LOW
* Total return is calculated using the closing price on December 31, 2011 compared to the closing price on April 9, 2011 (the date these stocks were first mentioned) plus dividends. I've used the closing price on April 9, 2011 (instead of something like average intraday price) even though it reduces the calculated total return slightly. The benefit is that it makes the calculation simpler and easier to confirm. In other words, better market prices were available intraday April 9, 2011 (and in subsequent days) so total returns could have been improved with some careful share accumulation. In any case, as always the comparison with the S&P 500 is apples to apples.
** There's no shortage of evidence that many actively managed equity mutual funds underperform the S&P 500.
"Of the 355 equity funds in 1970, fully 233 of those funds--almost two thirds--have gone out of business. Only 24 outpaced the market by more than one percentage point a year--one out of every 14. Let's face it: These are terrible odds!." - John Bogle
Also, DALBAR's Quantitative Analysis of Investor Behavior (QAIB) study released in March 2009 revealed that over the past 20 years investors in stock mutual funds have underperformed the S&P 500 by 6.5% a year (8.35% vs. 1.87%). Beyond the performance of the funds themselves, it shows that much of these poor returns come down to investor behavior. The tendency of investors to buy the hot mutual fund that has been going up while selling when the market is going down out of panic or fear.
*** I don't think these are necessarily the six best businesses in the world, but I believe they are all very good businesses that were selling at reasonable to cheap prices on April 9th, 2009. At any moment, there is always something better to own in theory but I don't think you can invest that way (as if stocks are baseball cards) and have consistent success. So there are certainly quite a few other shares in businesses that would be good alternatives to these six. The point is to get a handful of them at a fair price and then let the businesses and time work.
------------
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to be long the positions noted unless they sell significantly above intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
Friday, December 30, 2011
Quotes of 2011
A collection of quotes said or written at some point during this calendar year.
Amazon's Jeff Bezos on Inventing & Disrupting
"Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue. At Amazon we like things to work in five to seven years. We're willing to plant seeds, let them grow—and we're very stubborn. We say we're stubborn on vision and flexible on details." - Jeff Bezos
The Bond Market Rules
"Unrecognized as saviors, the bond vigilantes are demanding the keys to the Eternal City. If the Italian people are very lucky and very wise, they will allow themselves to be ruled by the bond market." - Thomas Donlan
PIMCO's Bill Gross
"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." - Bill Gross
Bogle Back to the Basics - Speculation Dwarfing Investment
"...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
Final Wesco Meeting: More From Charlie Munger
"I like people admitting they were complete stupid horses' asses. I know I'll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn." - Charlie Munger
Warren Buffett on the 'New Normal' & 'Black Swans'
"I think the luckiest person around is the baby that's born in the United States today. I don't think there's any question about it. I mean...that person is going, on average, to enjoy a far better life, you know, than John D. Rockefeller had many years ago or that I have now....and so I think if there's a new normal, it will be a higher normal in terms of the average person of how they lived 20 years from now and 50 years from now." - Warren Buffett
"...we will have black swans, but we'll overcome black swans." - Warren Buffett
Final Wesco Meeting: A Morning With Charlie Munger
"Clever derivatives broke dozens of companies. It killed them. Bankrupt. We don't need these kinds of innovation in finance. It's OK to be boring in finance. What we want is innovation in widgets." - Charlie Munger
"When we bought See's Candies, we didn't know the power of a good brand. Over time we just discovered that we could raise prices 10% a year and no one cared. Learning that changed Berkshire. It was really important." - Charlie Munger
Munger on the Financial Sector
"Why should an investment banker go to Greece to teach them how to pretend their finances are different from what they really are? Why isn't that a perfectly disgusting bit of human behavior?" - Charlie Munger
Klarman: Trophy Properties vs Fixer-Uppers
"Price is perhaps the single most important criterion in sound investment decision making. Every security or asset is a 'buy' at one price, a 'hold' at a higher price, and a 'sell' at some still higher price. Yet most investors in all asset classes love simplicity, rosy outlooks and the prospect of smooth sailing. They prefer what is performing well to what has recently lagged, often regardless of price. They prefer full buildings and trophy properties to fixer-uppers that need to be filled, even though empty or unloved buildings may be the far more compelling, and even safer, investments." - Seth Klarman
Barron's Interview: Donald Yacktman
"I have to go back a minimum of 18 years to find blue-chip or high-quality companies selling at these kinds of prices relative to other things out there. It is a very unique period." - Donald Yacktman
2010 Berkshire Shareholder Letter: $ 66 Billion in Cost-Free Deposits
"At Berkshire, we have now operated at an underwriting profit for eight consecutive years, our total underwriting gain for the period having been $17 billion. I believe it likely that we will continue to underwrite profitably in most – though certainly not all – future years. If we accomplish that, our float will be better than cost-free. We will benefit just as we would if some party deposited $66 billion with us, paid us a fee for holding its money and then let us invest its funds for our own benefit." - Warren Buffett
Buffett: Six-fold Increase in Living Standards
"Money will always flow toward opportunity, and there is an abundance of that in America. Commentators today often talk of "great uncertainty." But think back, for example, to December 6, 1941, October 18, 1987 and September 10, 2001. No matter how serene today may be, tomorrow is always uncertain.
Don't let that reality spook you. Throughout my lifetime, politicians and pundits have constantly moaned about terrifying problems facing America. Yet our citizens now live an astonishing six times better than when I was born. The prophets of doom have overlooked the all-important factor that is certain: Human potential is far from exhausted, and the American system for unleashing that potential – a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War – remains alive and effective.
We are not natively smarter than we were when our country was founded nor do we work harder. But look around you and see a world beyond the dreams of any colonial citizen. Now, as in 1776, 1861, 1932 and 1941, America's best days lie ahead." - Warren Buffett
Happy New Year,
Adam
Long position in Berkshire Hathaway (BRKb). No position in Amazon (AMZN).
Quotes of 2010
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.
Amazon's Jeff Bezos on Inventing & Disrupting
"Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue. At Amazon we like things to work in five to seven years. We're willing to plant seeds, let them grow—and we're very stubborn. We say we're stubborn on vision and flexible on details." - Jeff Bezos
The Bond Market Rules
"Unrecognized as saviors, the bond vigilantes are demanding the keys to the Eternal City. If the Italian people are very lucky and very wise, they will allow themselves to be ruled by the bond market." - Thomas Donlan
PIMCO's Bill Gross
"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." - Bill Gross
Bogle Back to the Basics - Speculation Dwarfing Investment
"...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
Final Wesco Meeting: More From Charlie Munger
"I like people admitting they were complete stupid horses' asses. I know I'll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn." - Charlie Munger
Warren Buffett on the 'New Normal' & 'Black Swans'
"I think the luckiest person around is the baby that's born in the United States today. I don't think there's any question about it. I mean...that person is going, on average, to enjoy a far better life, you know, than John D. Rockefeller had many years ago or that I have now....and so I think if there's a new normal, it will be a higher normal in terms of the average person of how they lived 20 years from now and 50 years from now." - Warren Buffett
"...we will have black swans, but we'll overcome black swans." - Warren Buffett
Final Wesco Meeting: A Morning With Charlie Munger
"Clever derivatives broke dozens of companies. It killed them. Bankrupt. We don't need these kinds of innovation in finance. It's OK to be boring in finance. What we want is innovation in widgets." - Charlie Munger
"When we bought See's Candies, we didn't know the power of a good brand. Over time we just discovered that we could raise prices 10% a year and no one cared. Learning that changed Berkshire. It was really important." - Charlie Munger
Munger on the Financial Sector
"Why should an investment banker go to Greece to teach them how to pretend their finances are different from what they really are? Why isn't that a perfectly disgusting bit of human behavior?" - Charlie Munger
Klarman: Trophy Properties vs Fixer-Uppers
"Price is perhaps the single most important criterion in sound investment decision making. Every security or asset is a 'buy' at one price, a 'hold' at a higher price, and a 'sell' at some still higher price. Yet most investors in all asset classes love simplicity, rosy outlooks and the prospect of smooth sailing. They prefer what is performing well to what has recently lagged, often regardless of price. They prefer full buildings and trophy properties to fixer-uppers that need to be filled, even though empty or unloved buildings may be the far more compelling, and even safer, investments." - Seth Klarman
Barron's Interview: Donald Yacktman
"I have to go back a minimum of 18 years to find blue-chip or high-quality companies selling at these kinds of prices relative to other things out there. It is a very unique period." - Donald Yacktman
2010 Berkshire Shareholder Letter: $ 66 Billion in Cost-Free Deposits
"At Berkshire, we have now operated at an underwriting profit for eight consecutive years, our total underwriting gain for the period having been $17 billion. I believe it likely that we will continue to underwrite profitably in most – though certainly not all – future years. If we accomplish that, our float will be better than cost-free. We will benefit just as we would if some party deposited $66 billion with us, paid us a fee for holding its money and then let us invest its funds for our own benefit." - Warren Buffett
Buffett: Six-fold Increase in Living Standards
"Money will always flow toward opportunity, and there is an abundance of that in America. Commentators today often talk of "great uncertainty." But think back, for example, to December 6, 1941, October 18, 1987 and September 10, 2001. No matter how serene today may be, tomorrow is always uncertain.
Don't let that reality spook you. Throughout my lifetime, politicians and pundits have constantly moaned about terrifying problems facing America. Yet our citizens now live an astonishing six times better than when I was born. The prophets of doom have overlooked the all-important factor that is certain: Human potential is far from exhausted, and the American system for unleashing that potential – a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War – remains alive and effective.
We are not natively smarter than we were when our country was founded nor do we work harder. But look around you and see a world beyond the dreams of any colonial citizen. Now, as in 1776, 1861, 1932 and 1941, America's best days lie ahead." - Warren Buffett
Happy New Year,
Adam
Long position in Berkshire Hathaway (BRKb). No position in Amazon (AMZN).
Quotes of 2010
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, December 29, 2011
Financial Amnesia
A lack of financial memory is a significant contributor to the historic pattern of recurring financial bubbles.
"Let it be emphasized once more, and especially to anyone inclined to a personally rewarding skepticism in these matters: for practical purposes, the financial memory should be assumed to last, at a maximum, no more than 20 years. This is normally the time it takes for the recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind. It is also the time generally required for a new generation to enter the scene, impressed, as had been its predecessors, with its own innovative genius." - John Kenneth Galbraith in his book: A Short History of Financial Euphoria (Page 87)
Factors that led to the financial crisis and lessons learned were recently highlighted by the Chartered Financial Analyst Society of the UK (CFA UK), a leading trade body. Below, I've included some excerpts from CFA UK's Response to the Joint Committee on the draft Financial Services Bill.
As Galbraith points out in the above quote, every 20 years or so the new players involved in the financial system, the so-called smart money, become convinced "it's different this time" because of some new innovation, financial or otherwise:
CFA UK blames what it calls "financial amnesia" among financial professionals. That a failure to learn and heed lessons of the past led to the most recent financial crisis and will likely lead to future ones.
Galbraith would approve.
From CFA UK's Response to the Joint Committee on the Draft Financial Services Bill:
Financial amnesia is when financial market participants forget or behave as if they have forgotten the lessons from financial history. Financial market participants are composed of two main groups, regulated financial firms and regulators. Despite the history of bitter experience, the same mistakes occur with alarming regularity (see Appendix 1). The three key lessons that participants appear to forget are:
Lesson 1: "Innovation", the illusion of safety and "this time it's different": "The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version" (Galbraith).The expansion of credit plays a key role in fuelling "innovation" while the creation of an illusion of safety results in a "this time it's different" approach that enables the continuation of unsustainable activity and risk taking. Sadly, each time it is always the same and never different.
Lesson 2: Regulated financial firms are prone to failure: It has been presumed that regulated financial firms by acting in their own self interest and in the interests of their shareholders, impose market discipline. History has demonstrated that because failure to impose market discipline is not uncommon, over-reliance on market forces can be misleading.
Lesson 3: Ineffective regulation. The frequency of market failure places a greater onus on the regulator to be more effective in encouraging and imposing market discipline. Sadly, regulators focus on the symptoms of failure rather than its root causes. Furthermore, regulators often ignore the root cause of their own inability to act promptly and thereby contribute to the risk of systemic governance failure.
The letter goes on to say that regulators should learn from financial history and require:
1) Firms conduct themselves to the highest professional and ethical standards and place clients’ interests first.
2) Enhance financial capability so that consumers become a more robust source of market discipline on firms.
3) Establish a regulatory philosophy and approach which acknowledges that we live in a world populated by people who do not always act rationally and imperfect markets.
Those three things are desirable outcomes that make a ton of sense. The fact that such little progress has been made in achieving those outcomes never ceases to amaze.
While this was written in the context of the United Kingdom it clearly applies to the United States. Financial professionals and market participants more generally need a better awareness of financial history.
From this Financial Times article posted on CNBC:
Financial Amnesia a Factor Behind the Crisis
Fund managers and financial advisers should be forced to study financial history to reduce the likelihood of future market panics and crashes, according to a leading trade body for investment professionals.
The article goes on to say...
CFA UK, which represents 9,000 investment professionals, argues that the study of financial history should form a major part of all compulsory education for retail and wholesale investment professionals. "Financial amnesia disarms individuals, the market and the regulator," the body said. "It causes risk to be mispriced, bubbles to develop and crises to break."
It's an uphill battle because this recurring problem goes back a long way.
Charles Mackay, author of Extraordinary Popular Delusions and the Madness of Crowds (1841)*, said it was common after an episode of financial euphoria to place blame on those in power (execs, directors, politicians etc). That's certainly not surprising. Yet, Mackay also made the point that "nobody seemed to imagine that the nation itself was as culpable". John Kenneth Galbraith made a similar assertion about the Crash of 1929 and other episodes of financial euphoria.
Here is a more complete version of the quote from Mackay. Describing the aftermath of the South Sea Bubble, he said:
"Public meetings were held in every considerable town of the empire, at which petitions were adopted, praying the vengeance of the legislature upon South Sea directors, who, by their fraudulent practices, had brought the nation to the brink of ruin. Nobody seemed to imagine that the nation itself was as culpable as the South Sea company. Nobody blamed the credulity and avarice of the people-the degrading lust of gain...or the infatuation which had made the multitude run their heads with such frantic eagerness into the net held out for them by scheming projectors. These things were never mentioned."
The above doesn't seem much different than some of our more recent bubbles. An inevitable painful economic contraction followed the bursting of the South Sea Company bubble.
History repeats frequently when it comes to financial euphoria. As James Grant wrote in his book Money of the Mind:
"Progress is cumulative in science and engineering, but cyclical in finance."
We should do everything possible to avoid the next but, if the seemingly obvious lessons from these episodes going back almost 400 years haven't been learned yet, chances are it will happen again in some form.
Still, it's good to see someone like CFA UK taking what seems a leadership role. Requiring the study of financial history is a good start but is unlikely to even begin to solve the problem. The idea of undertaking an annual "amnesia check" (as is suggested in the Financial Times article) sounds good but is likely also insufficient. Whether changes with some "teeth" can modify behavior to the point that it prevents the next crisis remains to be seen. Considering the track record some skepticism seems more than warranted.
That, of course, doesn't mean it's not well worth trying to make improvements in this area. Any sincere effort to do so should be applauded.
I'd also go a bit further. It would help if financial education was more robust in general so, as CFA UK suggests above, "consumers become a more robust source of market discipline on firms."
Adam
Related posts:
When Genius Failed...Again
Smart Money?
The Madness of Crowds
* Three chapters of that book describe bubbles like the Mississippi Company bubble in the 1700's, the South Sea Company bubble in 1700's, and the Dutch tulip mania in the 1600's.
---
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.
"Let it be emphasized once more, and especially to anyone inclined to a personally rewarding skepticism in these matters: for practical purposes, the financial memory should be assumed to last, at a maximum, no more than 20 years. This is normally the time it takes for the recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind. It is also the time generally required for a new generation to enter the scene, impressed, as had been its predecessors, with its own innovative genius." - John Kenneth Galbraith in his book: A Short History of Financial Euphoria (Page 87)
Factors that led to the financial crisis and lessons learned were recently highlighted by the Chartered Financial Analyst Society of the UK (CFA UK), a leading trade body. Below, I've included some excerpts from CFA UK's Response to the Joint Committee on the draft Financial Services Bill.
As Galbraith points out in the above quote, every 20 years or so the new players involved in the financial system, the so-called smart money, become convinced "it's different this time" because of some new innovation, financial or otherwise:
CFA UK blames what it calls "financial amnesia" among financial professionals. That a failure to learn and heed lessons of the past led to the most recent financial crisis and will likely lead to future ones.
Galbraith would approve.
From CFA UK's Response to the Joint Committee on the Draft Financial Services Bill:
Financial amnesia is when financial market participants forget or behave as if they have forgotten the lessons from financial history. Financial market participants are composed of two main groups, regulated financial firms and regulators. Despite the history of bitter experience, the same mistakes occur with alarming regularity (see Appendix 1). The three key lessons that participants appear to forget are:
Lesson 1: "Innovation", the illusion of safety and "this time it's different": "The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version" (Galbraith).The expansion of credit plays a key role in fuelling "innovation" while the creation of an illusion of safety results in a "this time it's different" approach that enables the continuation of unsustainable activity and risk taking. Sadly, each time it is always the same and never different.
Lesson 2: Regulated financial firms are prone to failure: It has been presumed that regulated financial firms by acting in their own self interest and in the interests of their shareholders, impose market discipline. History has demonstrated that because failure to impose market discipline is not uncommon, over-reliance on market forces can be misleading.
Lesson 3: Ineffective regulation. The frequency of market failure places a greater onus on the regulator to be more effective in encouraging and imposing market discipline. Sadly, regulators focus on the symptoms of failure rather than its root causes. Furthermore, regulators often ignore the root cause of their own inability to act promptly and thereby contribute to the risk of systemic governance failure.
The letter goes on to say that regulators should learn from financial history and require:
1) Firms conduct themselves to the highest professional and ethical standards and place clients’ interests first.
2) Enhance financial capability so that consumers become a more robust source of market discipline on firms.
3) Establish a regulatory philosophy and approach which acknowledges that we live in a world populated by people who do not always act rationally and imperfect markets.
Those three things are desirable outcomes that make a ton of sense. The fact that such little progress has been made in achieving those outcomes never ceases to amaze.
While this was written in the context of the United Kingdom it clearly applies to the United States. Financial professionals and market participants more generally need a better awareness of financial history.
From this Financial Times article posted on CNBC:
Financial Amnesia a Factor Behind the Crisis
Fund managers and financial advisers should be forced to study financial history to reduce the likelihood of future market panics and crashes, according to a leading trade body for investment professionals.
The article goes on to say...
CFA UK, which represents 9,000 investment professionals, argues that the study of financial history should form a major part of all compulsory education for retail and wholesale investment professionals. "Financial amnesia disarms individuals, the market and the regulator," the body said. "It causes risk to be mispriced, bubbles to develop and crises to break."
It's an uphill battle because this recurring problem goes back a long way.
Charles Mackay, author of Extraordinary Popular Delusions and the Madness of Crowds (1841)*, said it was common after an episode of financial euphoria to place blame on those in power (execs, directors, politicians etc). That's certainly not surprising. Yet, Mackay also made the point that "nobody seemed to imagine that the nation itself was as culpable". John Kenneth Galbraith made a similar assertion about the Crash of 1929 and other episodes of financial euphoria.
Here is a more complete version of the quote from Mackay. Describing the aftermath of the South Sea Bubble, he said:
"Public meetings were held in every considerable town of the empire, at which petitions were adopted, praying the vengeance of the legislature upon South Sea directors, who, by their fraudulent practices, had brought the nation to the brink of ruin. Nobody seemed to imagine that the nation itself was as culpable as the South Sea company. Nobody blamed the credulity and avarice of the people-the degrading lust of gain...or the infatuation which had made the multitude run their heads with such frantic eagerness into the net held out for them by scheming projectors. These things were never mentioned."
The above doesn't seem much different than some of our more recent bubbles. An inevitable painful economic contraction followed the bursting of the South Sea Company bubble.
History repeats frequently when it comes to financial euphoria. As James Grant wrote in his book Money of the Mind:
"Progress is cumulative in science and engineering, but cyclical in finance."
We should do everything possible to avoid the next but, if the seemingly obvious lessons from these episodes going back almost 400 years haven't been learned yet, chances are it will happen again in some form.
Still, it's good to see someone like CFA UK taking what seems a leadership role. Requiring the study of financial history is a good start but is unlikely to even begin to solve the problem. The idea of undertaking an annual "amnesia check" (as is suggested in the Financial Times article) sounds good but is likely also insufficient. Whether changes with some "teeth" can modify behavior to the point that it prevents the next crisis remains to be seen. Considering the track record some skepticism seems more than warranted.
That, of course, doesn't mean it's not well worth trying to make improvements in this area. Any sincere effort to do so should be applauded.
I'd also go a bit further. It would help if financial education was more robust in general so, as CFA UK suggests above, "consumers become a more robust source of market discipline on firms."
Adam
Related posts:
When Genius Failed...Again
Smart Money?
The Madness of Crowds
* Three chapters of that book describe bubbles like the Mississippi Company bubble in the 1700's, the South Sea Company bubble in 1700's, and the Dutch tulip mania in the 1600's.
---
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, December 28, 2011
Buffett on Gold, Farms, and Businesses
From an interview in Fortune with Warren Buffett back in 2010:
"You could take all the gold that's ever been mined, and it would fill a cube 67 feet in each direction. For what that's worth at current gold prices, you could buy all -- not some -- all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take?"
Buffett goes on to say he prefers equities.
Keep in mind he said the above when gold was much lower than it is today.
More recently, Buffett added the following during this CNBC interview:
Joe Kernen: You have said many times that if you could own, vs. gold, all the farmland in the United States, you'd rather have that than all the gold in the world. Have you gone in and looked at any farmland, any real estate like that?
Warren Buffett: No. I own one farm that I bought about 25 years ago my son farms, and so we're exposed to farming in the Buffett family. He's going to take care of me if it turns out that farms are really the thing to have instead of businesses. But I believe in owning productive assets...whether it's farms, apartment houses or businesses. And they'll do very well over time, and sometimes one class is doing better than another.
When Buffett says that he likes businesses that naturally includes stocks which are, simply put, the convenient partial ownership of businesses. In the late 90s, before one of the worst decade for stocks was about to occur, Buffett warned that equities were overvalued and that future returns were likely to be sub-par.
Buffett on Stock Valuations
Here's a good description of the situation at that time:
"Buffett was skeptical of high-tech stocks and...warned of an overvalued market that was heading for trouble. In fact, at that famous summer gathering of media, technology and financial moguls at Sun Valley, Idaho, Warren Buffett was asked to give the concluding talk in July 1999. His remarks, though politely received, supported the view among the smart set that Buffett was out of touch with the 'new paradigm' of high technology and ever-rising internet stock valuations.
Buffett's talk...delivered a message that most of his high-tech listeners and their financial sidekicks were not keen to hear. There was no 'new paradigm,' Buffett said. The market could only yield what the economy produced, and this market was way out of sync in that respect. The next seventeen years, he explained, might not look much better than the dismal 1964-to-1981 period when the Dow had gone exactly nowhere."
These two articles also help capture and summarize what Buffett said in Sun Valley and just how he was thinking back then:*
Buffett in Fortune - 1999
Warren Buffett "Preaches" to 1999's Internet Elite
When equity investors could only see blue skies and sky high returns going forward, Buffett was warning of trouble ahead. Well, it hasn't been 17 years yet -- nor does it need to end up being precisely 17 years for his essential view to end up being correct -- but so far the market has, in fact, pretty much gone nowhere.
At that time, not many seemed interested in giving his warning much weight.
Now, when many investors seem to want nothing to do with equities, Buffett is generally bullish on stocks.**
Based upon track record who's more likely to be correct?
Ten or so years from now will it be obvious that the same mistake, only in reverse, was being made?
Adam
Related posts:
-Edison on Gold: Fictitious Value & Superstition
-Munger on Buying Gold
-Thomas Edison on Gold
-Grantham on Gold: The "Faith-based Metal"
-Buffett: Forget Gold, Buy Stocks
-Gold vs Productive Assets
-Grantham: Gold is "Last Refuge of the Desperate"
-Why Buffett's Not a Big Fan of Gold
* The 1999 speech in Sun Valley was covered in Chapter 2 of 'The Snowball'.
** As always, the investing horizon has to be at least five years and more like ten years. It's about growth in intrinsic value over a long period not the price action (up or down) in a week, month, or even a couple years. What matters is the compounded return that can be produced for the risk that is taken. Near current valuations, likely risk-adjusted returns make some stocks very attractive. As always, paying a plain discount to value helps regulate the risk.
---
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.
"You could take all the gold that's ever been mined, and it would fill a cube 67 feet in each direction. For what that's worth at current gold prices, you could buy all -- not some -- all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take?"
Buffett goes on to say he prefers equities.
Keep in mind he said the above when gold was much lower than it is today.
More recently, Buffett added the following during this CNBC interview:
Joe Kernen: You have said many times that if you could own, vs. gold, all the farmland in the United States, you'd rather have that than all the gold in the world. Have you gone in and looked at any farmland, any real estate like that?
Warren Buffett: No. I own one farm that I bought about 25 years ago my son farms, and so we're exposed to farming in the Buffett family. He's going to take care of me if it turns out that farms are really the thing to have instead of businesses. But I believe in owning productive assets...whether it's farms, apartment houses or businesses. And they'll do very well over time, and sometimes one class is doing better than another.
When Buffett says that he likes businesses that naturally includes stocks which are, simply put, the convenient partial ownership of businesses. In the late 90s, before one of the worst decade for stocks was about to occur, Buffett warned that equities were overvalued and that future returns were likely to be sub-par.
Buffett on Stock Valuations
Here's a good description of the situation at that time:
"Buffett was skeptical of high-tech stocks and...warned of an overvalued market that was heading for trouble. In fact, at that famous summer gathering of media, technology and financial moguls at Sun Valley, Idaho, Warren Buffett was asked to give the concluding talk in July 1999. His remarks, though politely received, supported the view among the smart set that Buffett was out of touch with the 'new paradigm' of high technology and ever-rising internet stock valuations.
Buffett's talk...delivered a message that most of his high-tech listeners and their financial sidekicks were not keen to hear. There was no 'new paradigm,' Buffett said. The market could only yield what the economy produced, and this market was way out of sync in that respect. The next seventeen years, he explained, might not look much better than the dismal 1964-to-1981 period when the Dow had gone exactly nowhere."
These two articles also help capture and summarize what Buffett said in Sun Valley and just how he was thinking back then:*
Buffett in Fortune - 1999
Warren Buffett "Preaches" to 1999's Internet Elite
When equity investors could only see blue skies and sky high returns going forward, Buffett was warning of trouble ahead. Well, it hasn't been 17 years yet -- nor does it need to end up being precisely 17 years for his essential view to end up being correct -- but so far the market has, in fact, pretty much gone nowhere.
At that time, not many seemed interested in giving his warning much weight.
Now, when many investors seem to want nothing to do with equities, Buffett is generally bullish on stocks.**
Based upon track record who's more likely to be correct?
Ten or so years from now will it be obvious that the same mistake, only in reverse, was being made?
Adam
Related posts:
-Edison on Gold: Fictitious Value & Superstition
-Munger on Buying Gold
-Thomas Edison on Gold
-Grantham on Gold: The "Faith-based Metal"
-Buffett: Forget Gold, Buy Stocks
-Gold vs Productive Assets
-Grantham: Gold is "Last Refuge of the Desperate"
-Why Buffett's Not a Big Fan of Gold
* The 1999 speech in Sun Valley was covered in Chapter 2 of 'The Snowball'.
** As always, the investing horizon has to be at least five years and more like ten years. It's about growth in intrinsic value over a long period not the price action (up or down) in a week, month, or even a couple years. What matters is the compounded return that can be produced for the risk that is taken. Near current valuations, likely risk-adjusted returns make some stocks very attractive. As always, paying a plain discount to value helps regulate the risk.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.
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