I think it's fair to say that it's never been easier to minimize frictional costs when it comes to investing in stocks.
Transaction costs these days are, at many brokerages, reasonable or better for stocks and ETFs.
Many fine low cost fund alternatives exist.
Yet what should be plain advantage is often converted into a curse.
In this CNBC appearance back in October, Warren Buffett said that "if you are buying a business to own...the idea of what the market does on any given day, it's just meaningless. What you really have to look at is where you expect the business to be 5 or 10 or 20 years from now."
That's how most will think about businesses that aren't traded daily but, because stocks are quoted so frequently, behavior is changed for the worse.
"...you can look at stock prices minute by minute. And that should be an advantage but many people turn it into a disadvantage."
Buffett wrote something similar earlier this year:
"Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of 'Don't just sit there, do something.' For these investors, liquidity is transformed from the unqualified benefit it should be to a curse." - From the 2013 Berkshire Hathaway (BRKa) Shareholder Letter
Low frictional costs and the convenience of buying and selling creates a temptation to try and be in and out of certain things at just the right time. What then usually happens is -- as a result of this behavior -- not only is the low frictional cost advantage lost or reduced, unnecessary mistakes get made. Making judgments about how price compares to value is far from easy, but it can be done. Mistakes occur when attempts at timing is added to the equation. Stocks move unexpectedly. Timing when to buy or sell, if not impossible, is difficult to do reliably well. Nor is it necessary. What matters far more is a reasonable appraisal of business value combined with patience and price discipline. Get that right and, in the long run, good things are more likely to happen.
Attempts at timing are more likely to subtract or, at a minimum, distract from what really counts.
So that means the relationship between price and value -- along with opportunity costs -- should primarily dictate action; timing should not.
Part of the problem is that some behave as if the mistakes will only be made by the other participants. Morgan Housel explains this tendency -- what's known as the bias blind spot -- the following way:
"People love reading about flaws people fall for when handling money. But few of them admit, or even realize, that they're reading about themselves."
He adds: "We're blind to our blindness."
Some think they can be in the right stock (or stock fund) at just the right time. What happens instead is they end up just compounding mistakes and incurring unnecessary costs when much less activity would have yielded a vastly better outcome.
Liquidity is much overrated. It can be an advantage, of course, but only up to a point.
"A modest amount of liquidity will service the true needs of a civilization. A large amount of liquidity will bring out the worst in human nature." - Charlie Munger at the 2008 Wesco Financial Shareholder Meeting
The risk that a stock or fund that's been bought might drop substantially gets most of the consideration. Loss aversion contributes greatly to this. Yet the risk that what can be bought sensibly today may at some point not be available at attractive prices -- though not in a predictable manner as far as timing goes -- deserves at least equal attention.
"Since the basic game is so favorable, Charlie and I believe it's a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of 'experts,' or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it." - From the 2012 Berkshire Hathaway (BRKa) Shareholder Letter
Those who try to "dance in and out" aren't giving due consideration to the risk of not participating sufficiently. They think they'll be in and out at the right times. Somehow, they'll consistently avoid the downside while capturing the upside. Easier said. If the share price of a lousy business drops that, of course, can be a real problem. On the other hand, for those who feel comfortable judging prospects and value, if the share price of a sound business temporarily drops that's far from a problem for the long-term investor.
More from Buffett's CNBC appearance back in October:
"I don't know how to tell what the markets going to do. I do know how to pick out reasonable businesses to own over a long period of time. And a lot of people do, incidentally."
It's, in fact, an opportunity when prices fall.
"The stocks I was buying yesterday I hope go down today. Put it that way. And I hope they go down next week, and I hope they go down the week after. Nothing is going wrong with the companies."
Effectively judging business economics is paramount when buying an individual stock. For some, that's where a good fund might be more suitable.
Many stocks, these days, have become quite expensive or, at least, not cheap. Though there are always individual exceptions, the time to buy with a substantial margin of safety, at least for now, has mostly passed.
Stocks may continue rising, of course, but those gains increasingly will be driven by speculation instead of increases to intrinsic value. When stocks will become broadly undervalued again, and what the cause will be, is always uncertain. Those who still think bull markets are such a wonderful thing might want to keep these things in mind.
Bull markets make it more difficult to accumulate meaningful positions.
Managing risk and reward just becomes more challenging.
Liquidity should be an advantage. Well, at least it should be for those who tend to buy pieces of sound businesses with the idea that gains will come primarily via long-term intrinsic value increases. Returns should mostly driven by the compounded effect of what the businesses produce -- free cash flow generated at high returns on capital -- for owners over the long haul. Too often, instead, the focus is profiting from near-term price action; the focus is on speculative bets on where prices are going.
So, as a result, what ought to be beneficial liquidity morphs into a curse.
Broadly speaking, outcomes likely improve when there's greater emphasis on what businesses -- whether owned as individual stocks or through a fund -- can produce over a very long time.*
To me, there should be much less emphasis on the wonders of liquidity.
As always, what's sensible to buy at one price becomes less so as prices increase.
So buying at least reasonably well (i.e. a nice discount to conservatively estimated value) in the first place naturally matters a great deal.
Investment results ought to be mostly about long-term increases to per share intrinsic value.
They shouldn't be dependent on selling at speculative prices.
Adam
Long position in BRKb established at much lower than recent market prices
* This naturally also applies to owning a business outright for those inclined and able to do so.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Friday, November 28, 2014
Friday, November 21, 2014
Mr. Market
Roughly 15 years ago, Warren Buffett was asked to speak at Sun Valley not long before the tech bubble burst.*
Here's how an article on CNBC described the reaction:
"Many of the people in the room had amassed vast paper profits from stocks shooting ever higher in the Internet boom. Buffett wasn't playing that game, and some of the younger people in the audience thought he was stuck in the past, unable to understand that this time it would be 'different.'"
His message to the audience was rather straightforward:
"There was no new paradigm..."
Despite his long-term investing track record, many chose to discount or ignore what Buffett was saying back in 1999. There was, in a similar way, a fair amount of skepticism toward his favorable views of stocks during the financial crisis and even more recently (in both cases the market overall was substantially lower than it is now).
It's not that Buffett gets the timing right. In fact, Buffett doesn't try to guess where prices are going or to get the timing right.
"...we have no idea - and never have had - whether the market is going to go up, down, or sideways in the near- or intermediate term future." - From the 1986 Berkshire Hathaway (BRKa) Shareholder Letter
Predicting, in a reliable manner, where prices will be going is close to impossible and mostly a waste of energy.
Fortunately, being a successful long-term investor doesn't require brilliant timing.
"I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two.
But I think it is very easy to see what is likely to happen over the long term." - Warren Buffett in Fortune, December 2001
Trying to guess where prices are going in the coming weeks, months, or even over several years ends up best case being a distraction and, more likely, is just a plain foolish thing to do. Investing is (or should be) about how price compares to intrinsic value and how that value is likely to change over a longer time horizon. The emphasis is long-term effects instead of some unusual acuity for jumping in and out at just the right time.
Attempting to time things is a great way to make unnecessary mistakes and incur unnecessary frictional costs. The emphasis on what market prices might do next can end up being a big contributor to unsatisfactory investment outcomes (or worse).
In 1999, it was all about the upside. At the time there was lots of enthusiastic buying of stocks that offered incredibly high risk of permanent capital loss. For too many, those losses indeed became very real and very permanent.
Errors of commission.
In 2008, when the world was a real economic mess -- with compelling and scary headlines everywhere -- buying seemed dangerous and the enthusiasm for stocks all but disappeared. At that time many stocks were unusually undervalued. The risk of permanent capital loss -- especially for those with a long-term investment time horizon -- was rather low. Those missed gains were also very real and very permanent.
Errors of omission.
With the benefit of hindsight, these outcomes may seem obvious, but being correct and decisive in real time while keeping emotions in check just isn't the easiest thing to do.
Errors of commission might be more plain to see but that doesn't mean errors of omission don't matter a whole bunch.
They certainly do.
These days, many stocks have become rather, at the very least, not at all cheap. The risk of permanent loss -- or, at least, subpar returns considering the risks -- is now much higher and getting worse as the rally continues. Margin of safety is, in many cases, way too low for incremental purchases as far as I'm concerned.
Unfortunately, some will make of mistake of getting interested in stocks now after having mostly missed the chance to buy when prices were attractive.
"Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can't buy what is popular and do well." - Warren Buffett
Prices may continue to go up, of course. What's already not cheap goes on to become plainly expensive.
There's no way to know this beforehand.
There's also no need to know it.
"Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game." - From the 1987 Berkshire Letter
For those with a long investing time horizon, if prices do continue to rise in the near-term or intermediate-term, it's not a good thing at all.
To me, while there are naturally always individual exceptions, the chance to buy part of a good business at a really substantial discount is, at least until the next bear market or substantial market correction, mostly in the rear-view mirror.
Investing well inevitably involves lots of waiting for a good opportunity to present itself; it inevitably involves lots of preparation. Ultimately, it requires sound business judgment and price discipline. So energy should be spent trying to better understand existing or potential investments. In combination, this makes it possible to act decisively while others -- those caught up in the emotions of the moment and less prepared -- simply cannot.
In the end, how the business performs is what mostly matters while price action does not.
"...Charlie [Munger] and I let our marketable equities tell us by their operating results - not by their daily, or even yearly, price quotations - whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it." - From the 1987 Berkshire Letter
These days, while most things are far from cheap, it is still nothing like 1999. Back then valuations became completely nonsensical for way too many assets. That doesn't mean right now is a wonderful time to be buying stocks.
Far from it.
Those who think results over the next five years are likely to be as attractive as the past five years are likely to be disappointed. Put another way, the only way for stocks to produce similar results is if prices run far ahead of increases to per share intrinsic value.
That can happen, of course, but I certainly hope it does not. Bubbles do real damage. Some of it subtle; some of it not.
In fact, a good chunk of the returns these past five years have been, in many cases, driven by a closing of the discount to value gap. It's not that per share intrinsic value didn't increase somewhat. For good businesses they did and will continue to do so. It just that the increases were far less than the returns would imply.
In the very long run, as long as the purchase price was reasonable in the first place, what matters is whether a business can increase per share intrinsic value at attractive rate. The bonus returns in recent years resulted from the big discounts to value that existed for a time.
The crisis created those big discounts and, for the most part, they are now gone. So price has caught up -- and in some instances no doubt now has even exceeded -- per share intrinsic value.
So total return expectations -- even for very high quality businesses -- should be more modest going forward (at least until the market goes meaningfully south again).
Otherwise, allow the market to serve.
Adam
Long position in BRKb established at much lower than recent market prices
* The 1999 Sun Valley speech by Buffett that I mentioned above was covered in Chapter 2 of 'The Snowball'. It was also covered in a 1999 Fortune article where he said the following: "Investors in stocks these days are expecting far too much, and I'm going to explain why. That will inevitably set me to talking about the general stock market, a subject I'm usually unwilling to discuss."
---
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.
Here's how an article on CNBC described the reaction:
"Many of the people in the room had amassed vast paper profits from stocks shooting ever higher in the Internet boom. Buffett wasn't playing that game, and some of the younger people in the audience thought he was stuck in the past, unable to understand that this time it would be 'different.'"
His message to the audience was rather straightforward:
"There was no new paradigm..."
Despite his long-term investing track record, many chose to discount or ignore what Buffett was saying back in 1999. There was, in a similar way, a fair amount of skepticism toward his favorable views of stocks during the financial crisis and even more recently (in both cases the market overall was substantially lower than it is now).
It's not that Buffett gets the timing right. In fact, Buffett doesn't try to guess where prices are going or to get the timing right.
"...we have no idea - and never have had - whether the market is going to go up, down, or sideways in the near- or intermediate term future." - From the 1986 Berkshire Hathaway (BRKa) Shareholder Letter
Predicting, in a reliable manner, where prices will be going is close to impossible and mostly a waste of energy.
Fortunately, being a successful long-term investor doesn't require brilliant timing.
"I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two.
But I think it is very easy to see what is likely to happen over the long term." - Warren Buffett in Fortune, December 2001
Trying to guess where prices are going in the coming weeks, months, or even over several years ends up best case being a distraction and, more likely, is just a plain foolish thing to do. Investing is (or should be) about how price compares to intrinsic value and how that value is likely to change over a longer time horizon. The emphasis is long-term effects instead of some unusual acuity for jumping in and out at just the right time.
Attempting to time things is a great way to make unnecessary mistakes and incur unnecessary frictional costs. The emphasis on what market prices might do next can end up being a big contributor to unsatisfactory investment outcomes (or worse).
In 1999, it was all about the upside. At the time there was lots of enthusiastic buying of stocks that offered incredibly high risk of permanent capital loss. For too many, those losses indeed became very real and very permanent.
Errors of commission.
In 2008, when the world was a real economic mess -- with compelling and scary headlines everywhere -- buying seemed dangerous and the enthusiasm for stocks all but disappeared. At that time many stocks were unusually undervalued. The risk of permanent capital loss -- especially for those with a long-term investment time horizon -- was rather low. Those missed gains were also very real and very permanent.
Errors of omission.
With the benefit of hindsight, these outcomes may seem obvious, but being correct and decisive in real time while keeping emotions in check just isn't the easiest thing to do.
Errors of commission might be more plain to see but that doesn't mean errors of omission don't matter a whole bunch.
They certainly do.
These days, many stocks have become rather, at the very least, not at all cheap. The risk of permanent loss -- or, at least, subpar returns considering the risks -- is now much higher and getting worse as the rally continues. Margin of safety is, in many cases, way too low for incremental purchases as far as I'm concerned.
Unfortunately, some will make of mistake of getting interested in stocks now after having mostly missed the chance to buy when prices were attractive.
"Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can't buy what is popular and do well." - Warren Buffett
There's no way to know this beforehand.
There's also no need to know it.
"Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game." - From the 1987 Berkshire Letter
For those with a long investing time horizon, if prices do continue to rise in the near-term or intermediate-term, it's not a good thing at all.
To me, while there are naturally always individual exceptions, the chance to buy part of a good business at a really substantial discount is, at least until the next bear market or substantial market correction, mostly in the rear-view mirror.
Investing well inevitably involves lots of waiting for a good opportunity to present itself; it inevitably involves lots of preparation. Ultimately, it requires sound business judgment and price discipline. So energy should be spent trying to better understand existing or potential investments. In combination, this makes it possible to act decisively while others -- those caught up in the emotions of the moment and less prepared -- simply cannot.
In the end, how the business performs is what mostly matters while price action does not.
"...Charlie [Munger] and I let our marketable equities tell us by their operating results - not by their daily, or even yearly, price quotations - whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it." - From the 1987 Berkshire Letter
These days, while most things are far from cheap, it is still nothing like 1999. Back then valuations became completely nonsensical for way too many assets. That doesn't mean right now is a wonderful time to be buying stocks.
Far from it.
Those who think results over the next five years are likely to be as attractive as the past five years are likely to be disappointed. Put another way, the only way for stocks to produce similar results is if prices run far ahead of increases to per share intrinsic value.
That can happen, of course, but I certainly hope it does not. Bubbles do real damage. Some of it subtle; some of it not.
In fact, a good chunk of the returns these past five years have been, in many cases, driven by a closing of the discount to value gap. It's not that per share intrinsic value didn't increase somewhat. For good businesses they did and will continue to do so. It just that the increases were far less than the returns would imply.
In the very long run, as long as the purchase price was reasonable in the first place, what matters is whether a business can increase per share intrinsic value at attractive rate. The bonus returns in recent years resulted from the big discounts to value that existed for a time.
The crisis created those big discounts and, for the most part, they are now gone. So price has caught up -- and in some instances no doubt now has even exceeded -- per share intrinsic value.
So total return expectations -- even for very high quality businesses -- should be more modest going forward (at least until the market goes meaningfully south again).
Otherwise, allow the market to serve.
Adam
Long position in BRKb established at much lower than recent market prices
* The 1999 Sun Valley speech by Buffett that I mentioned above was covered in Chapter 2 of 'The Snowball'. It was also covered in a 1999 Fortune article where he said the following: "Investors in stocks these days are expecting far too much, and I'm going to explain why. That will inevitably set me to talking about the general stock market, a subject I'm usually unwilling to discuss."
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Monday, November 17, 2014
Berkshire Hathaway 3rd Quarter 2014 13F-HR
The Berkshire Hathaway (BRKa) 3rd Quarter 13F-HR was released on Friday. Below is a summary of the changes that were made to the Berkshire equity portfolio during that quarter.
(For a convenient comparison, here's a post from last quarter that summarizes Berkshire's 2nd Quarter 13F-HR.)
There was plenty of buying and selling during the quarter. Here's a quick summary of the changes:*
New Positions
Liberty Media (LMCK): 8.0 million shares worth $ 376 million**
Express Scripts (ESRX): 449 thousand shares worth $ 31.7 million
Added to Existing Positions
IBM (IBM): 304 thousand shares worth $ 57.7 million, total stake $ 13.4 billion
Wal-Mart (WMT): 1.59 million shares worth $ 121 million, total stake $ 4.62 billion
DirecTV (DTV): 6.53 million shares worth $ 565 million, total stake $ 2.60 billion
General Motors (GM): 7.04 million shares worth $ 225 million, total stake $ 1.28 billion
Charter (CHTR): 2.64 million shares worth $ 400 million, total stake $ 749 million
Suncor (SU): 2.02 million shares worth $ 73.0 million, total stake $ 668 million
Viacom (VIAB): 101 thousand shares worth $ 7.77 million, total stake $ 593 million
Precision Castparts (PCP): 206 thousand shares worth $ 48.7 million, total stake $ 493 million
Visa (V): 347 thousand shares worth $ 73.9 million, total stake $ 458 million
Liberty Global (LBTYA): 534 thousand shares worth $ 22.7 million, total stake $ 442 million
Mastercard (MA): 665 thousand shares worth $ 49.2 million, total stake $ 349 million
Not all of the activity has been disclosed. In the 3rd quarter of 2014, apparently some activity was kept confidential. Berkshire's latest filing says: "Confidential information has been omitted from the public Form 13F report and filed separately with the U.S. Securities and Exchange Commission."
Occasionally, the SEC allows Berkshire to keep certain moves in the portfolio confidential. The permission is granted by the SEC when a case can be made that the disclosure may cause buyers to drive up the price before Berkshire makes its additional purchases.
Reduced Positions
Bank of New York Mellon (BK): 1.28 million shares worth $ 49.4 million, total stake $ 905 million
Phillips 66 (PSX): 293 thousand shares worth $ 23.9 million, total stake $ 504 million
National Oilwell Varco (NOV): 920 thousand shares worth $ 70.0 million, total stake $ 486 million
ConocoPhillips (COP): 883 thousand shares worth $ 67.6 million, total stake $ 36.1 million
Todd Combs and Ted Weschler are responsible for an increasingly large number of the moves in the Berkshire equity portfolio. These days, any changes involving smaller positions will generally be the work of the two portfolio managers.
(Though some of the holdings they're responsible for have become more substantial over time.)
Top Five Holdings
After the changes, Berkshire Hathaway's portfolio of equity securities remains mostly made up of financial, consumer and, to a lesser extent, technology stocks (mostly IBM).
1. Wells Fargo (WFC) = $ 24.0 billion
2. Coca-Cola (KO) = $ 17.1 billion
3. IBM (IBM) = $ 13.4 billion
4. American Express (AXP) = $ 13.3 billion
5. Wal-Mart (WMT) = $ 4.62 billion
As of the end of the quarter, Berkshire's Wal-Mart position was only somewhat larger than its Procter & Gamble (PG) position. Well, that's going to change with Berkshire recently agreeing to acquire Duracell from P&G in exchange for Berkshire's ownership stake in the consumer goods company.
(P&G will also contribute some cash.)
As is almost always the case it's a very concentrated portfolio. The top five often represent 60-70 percent and, at times, even more of the equity portfolio. In addition, Berkshire owns equity securities listed on exchanges outside the U.S., plus cash and cash equivalents, fixed income, and other investments.***
According to their latest filing, the combined portfolio value (equities, cash, bonds, and other investments) is ~ $ 240 billion including the investment in Heinz.
(Heinz is separately on the books for just under $ 12 billion, but that book value is likely to diverge greatly from economic value over time.)
The portfolio, of course, excludes all the operating businesses that Berkshire owns outright with, according to the latest letter, a bit more than 330,000 employees combined.
Here are some examples of the non-insurance businesses:
MidAmerican Energy, Burlington Northern Santa Fe, McLane Company, The Marmon Group, Shaw Industries, Benjamin Moore, Johns Manville, Acme Building, MiTek, Fruit of the Loom, Russell Athletic Apparel, NetJets, Nebraska Furniture Mart, See's Candies, Dairy Queen, The Pampered Chef, Business Wire, Iscar, Lubrizol, Oriental Trading Company, as well as 50% of Heinz.
(Among others.)
In addition, the insurance businesses (BH Reinsurance, General Re, GEICO etc.) owned by Berkshire have naturally provided plenty of "float" for their investments over time and continue to do so.
See page 111 of the annual report for a full list of Berkshire's businesses.
Adam
Long positions in BRKb, WFC, KO, AXP, USB, WMT, PG, DTV, COP, and PSX established at much lower than recent market prices. Also, small long position in IBM established at slightly higher than recent market prices.
* All values shown are based upon the last trading day of the 3rd quarter.
** Resulting from Liberty Media's stock split.
*** Berkshire Hathaway's holdings of ADRs are included in the 13F-HR. What is not included are the shares listed on exchanges outside the United States. The status of those shares are updated in the annual letter. So the only way any of the stocks listed on exchanges outside the U.S. will show up in the 13F-HR is if Berkshire happens to buy the ADR. Investments in things like the preferred shares (and, where applicable, related warrants) are also not included in the 13F-HR. The same is true for the Heinz common shares (i.e. not just the Heinz preferred shares).
---
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.
(For a convenient comparison, here's a post from last quarter that summarizes Berkshire's 2nd Quarter 13F-HR.)
There was plenty of buying and selling during the quarter. Here's a quick summary of the changes:*
New Positions
Liberty Media (LMCK): 8.0 million shares worth $ 376 million**
Express Scripts (ESRX): 449 thousand shares worth $ 31.7 million
Added to Existing Positions
IBM (IBM): 304 thousand shares worth $ 57.7 million, total stake $ 13.4 billion
Wal-Mart (WMT): 1.59 million shares worth $ 121 million, total stake $ 4.62 billion
DirecTV (DTV): 6.53 million shares worth $ 565 million, total stake $ 2.60 billion
General Motors (GM): 7.04 million shares worth $ 225 million, total stake $ 1.28 billion
Charter (CHTR): 2.64 million shares worth $ 400 million, total stake $ 749 million
Suncor (SU): 2.02 million shares worth $ 73.0 million, total stake $ 668 million
Viacom (VIAB): 101 thousand shares worth $ 7.77 million, total stake $ 593 million
Precision Castparts (PCP): 206 thousand shares worth $ 48.7 million, total stake $ 493 million
Visa (V): 347 thousand shares worth $ 73.9 million, total stake $ 458 million
Liberty Global (LBTYA): 534 thousand shares worth $ 22.7 million, total stake $ 442 million
Mastercard (MA): 665 thousand shares worth $ 49.2 million, total stake $ 349 million
Not all of the activity has been disclosed. In the 3rd quarter of 2014, apparently some activity was kept confidential. Berkshire's latest filing says: "Confidential information has been omitted from the public Form 13F report and filed separately with the U.S. Securities and Exchange Commission."
Occasionally, the SEC allows Berkshire to keep certain moves in the portfolio confidential. The permission is granted by the SEC when a case can be made that the disclosure may cause buyers to drive up the price before Berkshire makes its additional purchases.
Bank of New York Mellon (BK): 1.28 million shares worth $ 49.4 million, total stake $ 905 million
Phillips 66 (PSX): 293 thousand shares worth $ 23.9 million, total stake $ 504 million
National Oilwell Varco (NOV): 920 thousand shares worth $ 70.0 million, total stake $ 486 million
ConocoPhillips (COP): 883 thousand shares worth $ 67.6 million, total stake $ 36.1 million
Todd Combs and Ted Weschler are responsible for an increasingly large number of the moves in the Berkshire equity portfolio. These days, any changes involving smaller positions will generally be the work of the two portfolio managers.
(Though some of the holdings they're responsible for have become more substantial over time.)
Top Five Holdings
After the changes, Berkshire Hathaway's portfolio of equity securities remains mostly made up of financial, consumer and, to a lesser extent, technology stocks (mostly IBM).
1. Wells Fargo (WFC) = $ 24.0 billion
2. Coca-Cola (KO) = $ 17.1 billion
3. IBM (IBM) = $ 13.4 billion
4. American Express (AXP) = $ 13.3 billion
5. Wal-Mart (WMT) = $ 4.62 billion
As of the end of the quarter, Berkshire's Wal-Mart position was only somewhat larger than its Procter & Gamble (PG) position. Well, that's going to change with Berkshire recently agreeing to acquire Duracell from P&G in exchange for Berkshire's ownership stake in the consumer goods company.
(P&G will also contribute some cash.)
As is almost always the case it's a very concentrated portfolio. The top five often represent 60-70 percent and, at times, even more of the equity portfolio. In addition, Berkshire owns equity securities listed on exchanges outside the U.S., plus cash and cash equivalents, fixed income, and other investments.***
According to their latest filing, the combined portfolio value (equities, cash, bonds, and other investments) is ~ $ 240 billion including the investment in Heinz.
(Heinz is separately on the books for just under $ 12 billion, but that book value is likely to diverge greatly from economic value over time.)
Here are some examples of the non-insurance businesses:
MidAmerican Energy, Burlington Northern Santa Fe, McLane Company, The Marmon Group, Shaw Industries, Benjamin Moore, Johns Manville, Acme Building, MiTek, Fruit of the Loom, Russell Athletic Apparel, NetJets, Nebraska Furniture Mart, See's Candies, Dairy Queen, The Pampered Chef, Business Wire, Iscar, Lubrizol, Oriental Trading Company, as well as 50% of Heinz.
(Among others.)
In addition, the insurance businesses (BH Reinsurance, General Re, GEICO etc.) owned by Berkshire have naturally provided plenty of "float" for their investments over time and continue to do so.
See page 111 of the annual report for a full list of Berkshire's businesses.
Adam
Long positions in BRKb, WFC, KO, AXP, USB, WMT, PG, DTV, COP, and PSX established at much lower than recent market prices. Also, small long position in IBM established at slightly higher than recent market prices.
* All values shown are based upon the last trading day of the 3rd quarter.
** Resulting from Liberty Media's stock split.
*** Berkshire Hathaway's holdings of ADRs are included in the 13F-HR. What is not included are the shares listed on exchanges outside the United States. The status of those shares are updated in the annual letter. So the only way any of the stocks listed on exchanges outside the U.S. will show up in the 13F-HR is if Berkshire happens to buy the ADR. Investments in things like the preferred shares (and, where applicable, related warrants) are also not included in the 13F-HR. The same is true for the Heinz common shares (i.e. not just the Heinz preferred shares).
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Friday, November 14, 2014
Berkshire Agrees To Acquire Duracell
Procter & Gamble (PG) is in the process of shedding brands to simplify its business and focus more on its core products.
Well, consistent with that objective, Berkshire Hathaway (BRKa) yesterday agreed to acquire Duracell from the company. Berkshire will acquire Duracell, in part, by exchanging the P&G shares that Berkshire currently owns for the battery business.
P&G will also contribute some cash.
According to P&G's filing:
Berkshire's stock ownership is currently valued at approximately $4.7 billion. P&G said it expects to contribute approximately $1.8 billion in cash to the Duracell Company in the pre-transaction recapitalization.
P&G said the transaction maximizes the after-tax value of the Duracell business and is tax efficient for P&G. The value received for Duracell in the exchange is approximately 7-times fiscal year 2014 adjusted EBITDA. This equates to a cash sale valued at approximately 9-times adjusted EBITDA.
Essentially, Buffett is paying 7-times this EBITDA for Duracell but, for P&G, this is equivalent to selling the company for 9-times EBITDA to a cash buyer. So, based upon the numbers available, Berkshire is paying net $ 2.9 billion ($ 4.7 billion - $ 1.8 billion) for a bit more than $ 400 million in EBITDA.
Well, if that's the case, then pre-tax operating earnings of $ 250-300 million or so doesn't seem like a stretch.
As it stands, the cost basis of Berkshire's current stake in P&G is $ 336 million.*
Simply put, that $ 336 million initial investment has resulted in current annual operating earnings that's not much less than the initial amount paid for the shares.
(If the current earning power remains at all durable, that's certainly quite an earnings yield compared to the original investment.)
Plus $ 1.8 billion in cash.
Plus the very nice and growing stream of dividends that P&G has paid to Berkshire over the years.
(Some of those dividends no doubt have helped fund other investments during that time.)
All accomplished very efficiently as far as taxes go.
Berkshire's ownership of P&G's stock began in 2005 but is directly related to a much earlier investment in Gillette. Initially, Berkshire invested $ 600 million in Gillette convertible preferred shares back in 1989. That original investment became shares of Gillette common stock in 1991. Then Berkshire became a shareholder of P&G in 2005 when P&G purchased Gillette.
In the recent past, Berkshire has done some similar deals that involved the exchange of stock to acquire business assets in a tax efficient manner.
Adam
Long positions in BRKb and PG established at much lower than recent market prices
* Before selling some shares both during and after the financial crisis, Berkshire previously had a higher cost basis in P&G. In fact, as recently as 2007, Berkshire's cost basis was as high as ~ $ 1 billion.
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.
Well, consistent with that objective, Berkshire Hathaway (BRKa) yesterday agreed to acquire Duracell from the company. Berkshire will acquire Duracell, in part, by exchanging the P&G shares that Berkshire currently owns for the battery business.
P&G will also contribute some cash.
According to P&G's filing:
Berkshire's stock ownership is currently valued at approximately $4.7 billion. P&G said it expects to contribute approximately $1.8 billion in cash to the Duracell Company in the pre-transaction recapitalization.
P&G said the transaction maximizes the after-tax value of the Duracell business and is tax efficient for P&G. The value received for Duracell in the exchange is approximately 7-times fiscal year 2014 adjusted EBITDA. This equates to a cash sale valued at approximately 9-times adjusted EBITDA.
Essentially, Buffett is paying 7-times this EBITDA for Duracell but, for P&G, this is equivalent to selling the company for 9-times EBITDA to a cash buyer. So, based upon the numbers available, Berkshire is paying net $ 2.9 billion ($ 4.7 billion - $ 1.8 billion) for a bit more than $ 400 million in EBITDA.
Well, if that's the case, then pre-tax operating earnings of $ 250-300 million or so doesn't seem like a stretch.
As it stands, the cost basis of Berkshire's current stake in P&G is $ 336 million.*
(If the current earning power remains at all durable, that's certainly quite an earnings yield compared to the original investment.)
Plus the very nice and growing stream of dividends that P&G has paid to Berkshire over the years.
(Some of those dividends no doubt have helped fund other investments during that time.)
All accomplished very efficiently as far as taxes go.
Berkshire's ownership of P&G's stock began in 2005 but is directly related to a much earlier investment in Gillette. Initially, Berkshire invested $ 600 million in Gillette convertible preferred shares back in 1989. That original investment became shares of Gillette common stock in 1991. Then Berkshire became a shareholder of P&G in 2005 when P&G purchased Gillette.
In the recent past, Berkshire has done some similar deals that involved the exchange of stock to acquire business assets in a tax efficient manner.
Adam
Long positions in BRKb and PG established at much lower than recent market prices
* Before selling some shares both during and after the financial crisis, Berkshire previously had a higher cost basis in P&G. In fact, as recently as 2007, Berkshire's cost basis was as high as ~ $ 1 billion.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Friday, November 7, 2014
The Seventh Best Idea
From this Warren Buffett speech at the University of Florida:
"If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into a seventh one instead of putting more money into your first one is gotta be terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea. So I would say for anyone working with normal capital who really knows the businesses they have gone into, six is plenty, and I probably have half of what I like best. I don't diversify personally."
Clearly, this view on diversification is far from conventional. Charlie Munger -- and this is not exactly a surprise -- once said something rather similar in a speech to the Foundation Financial Officers Group:*
"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."
Identifying what, over the long run, will end up being six wonderful businesses to own then waiting patiently until the shares can be bought at attractive prices may not be impossible to do, but it is easier said than done. Unwarranted confidence in a concentrated portfolio is, at the very least, simply a recipe for big and expensive mistakes.
Many will find they do need to have broader diversification or that they are better off in an index fund. That's, of course, necessarily unique for each investor. Some of this will come down to one's own realistically assessed capabilities, but much else comes down to temperament and other psychological factors.
Beyond the requisite skills and background, patience followed by decisiveness when the opportunity presents itself is needed. Here's Munger's take from the 2004 Wesco shareholder meeting:
"It wasn't hyperactivity, but a hell of a lot of patience. You stuck to your principles and when opportunities came along, you pounced on them with vigor."
and
"Success means being very patient, but aggressive when it's time."
Now, the fact is that Buffett's current equity portfolio has far more than six stocks in it. This would appear at odds with Buffett says above, but the top 5 or 6 stocks continue to make up a substantial proportion of the portfolio.
Among the reasons for the large number of stocks in the current portfolio, is that many of the smaller positions are the work of his two investment managers, Todd Combs and Ted Weschler.
Then there's just the sheer scale of what Buffett has to manage these days compared to earlier times.**
Some commentators, when asked, seem willing to opine on just about any equity investment alternative. Well, maybe someone can actually understand such a wide variety of businesses and industries with sufficient depth, just consider me just a little bit skeptical of this. I mean, who can properly understand nearly everything in the equity investment universe? Focus is needed. Otherwise, brilliant outcomes in terms of risk and reward just don't seem likely.
Lots of breadth might mean too little depth. In other words, knowing just enough to be dangerous about many different stocks. Eventually, this way of operating seems almost certain to take an investor far outside their own necessarily unique circle of competence. That's a great way to get spread too thin and make unnecessary mistakes.
"To kill an error is as good a service as, and sometimes even better than, the establishing of a new truth or fact." - Charles Darwin
"...Warren and I are better at tuning out the standard stupidities. We've left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error." - Charlie Munger in Stanford Lawyer
My own favorite stocks may or may not prove to be great long-term investments but, to me, essentially none of them are selling at attractive enough prices to buy these days. As usual, the buying needed to happen in a decisive manner when it felt most uncomfortable. That, of course, was during the financial crisis and, well, even as recently as a few years ago. Some very good assets were properly cheap three to five years ago even if wild near-term price action -- especially during the height of the crisis -- had to be tolerated.***
(What appeared rather cheap often temporarily became cheaper. This was the case even among the very highest quality businesses.)
Will stocks rise or fall from here? No idea. I never try to figure out such things. The focus, instead, is on how price compares to estimated intrinsic value. It's never about trying to guess how stock prices might fluctuate. That sort of thing is a total waste of energy.
In any case, at least for now, the balance of risk and reward has changed dramatically for the worse. Prices would need to meaningfully fall -- or, alternatively, per share intrinsic values would need to increase over time without much change in price -- for the balance of risk and reward to improve.
When stocks do not sell at a plain discount to a conservative estimate of value, it's time to be patient. It's time to keep chipping away at the ongoing process of understanding what I own -- and what I might someday like to own -- in a better way. It's time to make sure I'm prepared to act decisively if/when they become cheap again.
This doesn't necessarily mean all my favorite investments are overvalued.
This doesn't necessarily mean I'll be selling; attempting to frequently buy and sell is a recipe for unnecessary mistakes and frictional costs.
This does mean, at the very least, that the margin of safety is currently insufficient for me to be willing to make incremental purchases.
Adam
Related posts:
Portfolio Theory & Diversification
Buffett on Diversification
Munger & Buffett on Diversification - Part II
Munger & Buffett on Diversification
* Here are some additional examples of Munger's view of diversification:
"We believe almost all good investments will involve relatively low diversification." - From the 2004 Wesco meeting
"The academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification." - From an interview in Kiplinger's
** Some other reasons it can be challenging to have a concentrated portfolio include the fact that a best idea may not be available at a attractive enough market price, insufficient funds are available when the market price is right, and, well, pure indecision (i.e. an error of omission).
*** The key thing was recognizing when the drop in price was far greater than the reduction in per share intrinsic value. Well, at least what intrinsic value would look like in a more normalized environment. It's worth noting that the very good businesses can actually increase their per share intrinsic value during a crisis (even if near-term market price action would temporarily seem to indicate otherwise).
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
"If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into a seventh one instead of putting more money into your first one is gotta be terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea. So I would say for anyone working with normal capital who really knows the businesses they have gone into, six is plenty, and I probably have half of what I like best. I don't diversify personally."
Clearly, this view on diversification is far from conventional. Charlie Munger -- and this is not exactly a surprise -- once said something rather similar in a speech to the Foundation Financial Officers Group:*
"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."
Identifying what, over the long run, will end up being six wonderful businesses to own then waiting patiently until the shares can be bought at attractive prices may not be impossible to do, but it is easier said than done. Unwarranted confidence in a concentrated portfolio is, at the very least, simply a recipe for big and expensive mistakes.
Many will find they do need to have broader diversification or that they are better off in an index fund. That's, of course, necessarily unique for each investor. Some of this will come down to one's own realistically assessed capabilities, but much else comes down to temperament and other psychological factors.
Beyond the requisite skills and background, patience followed by decisiveness when the opportunity presents itself is needed. Here's Munger's take from the 2004 Wesco shareholder meeting:
"It wasn't hyperactivity, but a hell of a lot of patience. You stuck to your principles and when opportunities came along, you pounced on them with vigor."
and
"Success means being very patient, but aggressive when it's time."
Now, the fact is that Buffett's current equity portfolio has far more than six stocks in it. This would appear at odds with Buffett says above, but the top 5 or 6 stocks continue to make up a substantial proportion of the portfolio.
Among the reasons for the large number of stocks in the current portfolio, is that many of the smaller positions are the work of his two investment managers, Todd Combs and Ted Weschler.
Then there's just the sheer scale of what Buffett has to manage these days compared to earlier times.**
Some commentators, when asked, seem willing to opine on just about any equity investment alternative. Well, maybe someone can actually understand such a wide variety of businesses and industries with sufficient depth, just consider me just a little bit skeptical of this. I mean, who can properly understand nearly everything in the equity investment universe? Focus is needed. Otherwise, brilliant outcomes in terms of risk and reward just don't seem likely.
Lots of breadth might mean too little depth. In other words, knowing just enough to be dangerous about many different stocks. Eventually, this way of operating seems almost certain to take an investor far outside their own necessarily unique circle of competence. That's a great way to get spread too thin and make unnecessary mistakes.
"To kill an error is as good a service as, and sometimes even better than, the establishing of a new truth or fact." - Charles Darwin
"...Warren and I are better at tuning out the standard stupidities. We've left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error." - Charlie Munger in Stanford Lawyer
My own favorite stocks may or may not prove to be great long-term investments but, to me, essentially none of them are selling at attractive enough prices to buy these days. As usual, the buying needed to happen in a decisive manner when it felt most uncomfortable. That, of course, was during the financial crisis and, well, even as recently as a few years ago. Some very good assets were properly cheap three to five years ago even if wild near-term price action -- especially during the height of the crisis -- had to be tolerated.***
(What appeared rather cheap often temporarily became cheaper. This was the case even among the very highest quality businesses.)
Will stocks rise or fall from here? No idea. I never try to figure out such things. The focus, instead, is on how price compares to estimated intrinsic value. It's never about trying to guess how stock prices might fluctuate. That sort of thing is a total waste of energy.
In any case, at least for now, the balance of risk and reward has changed dramatically for the worse. Prices would need to meaningfully fall -- or, alternatively, per share intrinsic values would need to increase over time without much change in price -- for the balance of risk and reward to improve.
When stocks do not sell at a plain discount to a conservative estimate of value, it's time to be patient. It's time to keep chipping away at the ongoing process of understanding what I own -- and what I might someday like to own -- in a better way. It's time to make sure I'm prepared to act decisively if/when they become cheap again.
This doesn't necessarily mean all my favorite investments are overvalued.
This doesn't necessarily mean I'll be selling; attempting to frequently buy and sell is a recipe for unnecessary mistakes and frictional costs.
This does mean, at the very least, that the margin of safety is currently insufficient for me to be willing to make incremental purchases.
Adam
Related posts:
Portfolio Theory & Diversification
Buffett on Diversification
Munger & Buffett on Diversification - Part II
Munger & Buffett on Diversification
* Here are some additional examples of Munger's view of diversification:
"We believe almost all good investments will involve relatively low diversification." - From the 2004 Wesco meeting
"The academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification." - From an interview in Kiplinger's
** Some other reasons it can be challenging to have a concentrated portfolio include the fact that a best idea may not be available at a attractive enough market price, insufficient funds are available when the market price is right, and, well, pure indecision (i.e. an error of omission).
*** The key thing was recognizing when the drop in price was far greater than the reduction in per share intrinsic value. Well, at least what intrinsic value would look like in a more normalized environment. It's worth noting that the very good businesses can actually increase their per share intrinsic value during a crisis (even if near-term market price action would temporarily seem to indicate otherwise).
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Friday, October 31, 2014
Quality Stocks & the Risk-Return Tradeoff
Roughly five years ago, Jeremy Grantham said the following about what he calls "quality stocks".
"Quality stocks have outperformed the market since 1965 (when our quality data begins)..."
When Grantham talks about "quality stocks", he is referring to those that produce a "high and stable return".
He then adds:
"...Fama and French adopted a circular argument rather typical of finance academics in the 1970 to 2000 era: the market is efficient; P/B and small cap outperform, ergo they must be risk factors. That the result in this case happens to get to the right result is luck. The real behavioral market is perfectly happy not rewarding 'risk' when it feels like it, as is shown by the 70-year underperformance of high beta stocks. But this time it worked. Price-to-book, despite its low beta, is a risk factor because of its low fundamental quality and its vulnerability to failure in a depression. This is true with small cap as well. But what about 'Quality?' This factor has outperformed forever. (The S&P had a High Grade Index that started in 1925 and handsomely outperformed the S&P 500 to the end of 1965 when our data starts.) Since the market is efficient, to Fama and French quality must be a risk factor! So, by protecting you in the 1929 Crash and in 2008, and by having a low beta for that matter, Quality as represented by Coca-Cola and Johnson & Johnson must be a hidden risk factor. Oh, I know: 'The real world is merely an inconvenient special case!'"
The bad news is, unlike when Grantham wrote the above, quality stocks aren't at all cheap these days. Still, the above makes an important broader point about risk and return even if the stocks themselves -- at current prices -- are far less attractive.*
So let's start by looking at a rather conventional explanation of the tradeoff between risk and return.
From Investopedia:
"...potential return rises with an increase in risk. Low levels of uncertainty (low-risk) are associated with low potential returns, whereas high levels of uncertainty (high-risk) are associated with high potential returns."
So many assume that more risk must be taken to produce greater rewards. That might at first glance seem very reasonable but, well, it's just not.
Brett Arends explains it this way:
"Conventional wisdom will often tell you that the only way to earn higher returns than the overall stock market — the only way to 'beat the market' — is to take more risk.
This idea is at the heart of the 'modern portfolio theory' that is probably practiced by your investment manager. It sounds plausible. It sounds credible. Everyone can understand it, and it is a generally accepted assumption.
The only problem? It's wrong. New research has found that you could have earned higher returns than the market in the past while taking on lower risk. This isn't a minor detail. This turns conventional finance upside-down."
Howard Marks put forward two useful and relevant charts on risk and return (at the bottom of page 6 of this memo). The first presents risk and return the traditional way (with risk and return positively correlated).
The second chart explains the relationship between risk and reward in a way that, to me, much more closely represents the world as it is.
Here's how Howard Marks explains it:
"We hear it all the time: 'Riskier investments produce higher returns' and 'If you want to make more money, take more risk.'
Both of these formulations are terrible. In brief, if riskier investments could be counted on to produce higher returns, they wouldn't be riskier."
Howard Marks on Risk
So risk and return need not be positively correlated.
It's simple, important, and too often ignored.
In the past I've referred to the following quote from the Superinvestors of Graham-and-Doddsville but it's worth repeating here:**
"Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, 'I have here a six-shooter and I have slipped one cartridge into it. Why don't you just spin it and pull it once? If you survive, I will give you $1 million.' I would decline -- perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice -- now that would be a positive correlation between risk and reward!
The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it's riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is."
The math is obviously pretty simple but let's quickly walk through this:
A dollar bill is found on the ground by two people.
It's probably real.
It might not be.
One person is willing to pay 60 cent (i.e. less than the face value because, if not real, it might be worth zero).
The second is willing to pay 40 cents.
Well, the first person can make 67% if the dollar bill is real and, of course, can lose the 60 cents if it's a fake.
The second person can make 150%, if real, and lose the 40 cents, if not.
Two-thirds the possible loss; more than twice the return. Reduced risk of permanent capital loss; greater reward. Things like the capital asset pricing model (CAPM) and the three factor model are not built for the possibility of a negative correlation between risk and reward. So the higher return produced at less risk ends up as alpha. Well, at least it does for those who buy into modern finance theory.
To me, this makes alpha the ultimate fudge factor because, in a scenario like the above, it masks what's really going on.
It masks the reality that, sometimes, risk and reward need not be positively correlated. This might seem harmless but I think the relationship between risk and reward as it is (whether positive or negative) should be explained in clear terms (i.e. instead of calling it an abnormal rate of return compared to what's predicted by an equilibrium model like CAPM).
So the assumption more risk must be taken to get more reward is an incorrect one. This idea is not exactly new -- considering that Buffett's comments, for example, were made roughly 30 years ago -- even if frequently ignored.
Somehow, that more risk must be taken to increase rewards remains at the core of modern finance to this day.
Adam
Related posts:
-Howard Marks on Risk
-Altria: Timing Isn't Everything, Part II
-Altria: Timing Isn't Everything
-Grantham on Efficient Markets, Bubbles, and Ignoble Prizes
-Efficient Markets - Part II
-Risk and Reward Revisited
-Boring Stocks
-Efficient Markets
-Modern Portfolio Theory, Efficient Markets, and the Flat Earth Revisited
-Buffett on Risk and Reward
-Buffett: Why Stocks Beat Bonds
-Beta, Risk, & the Inconvenient Real World Special Case
-Howard Marks: The Two Main Risks in the Investment World
-Black-Scholes and the Flat Earth Society
-Buffett: Indebted to Academics
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind
-Defensive Stocks?
* The higher quality stocks mostly are not selling at a discount to value these days. At least that is my view. They're still good businesses but the shares just don't provide any protection against what might go wrong. It's, of course, impossible to predict when shares are going to sell at attractive prices. The risk of not owning a good stock at a fair price is a real one (error of omission) that sometimes doesn't get enough consideration. It's why buying what becomes cheap (for those comfortable buying individual stocks) when the opportunity arise is so important. It wasn't tough to buy shares in some of the highest quality businesses at a nice discount to per share intrinsic value several years ago. The situation is very different now. Unfortunately, it's just not possible to know if/when they'll be available at a discount in the future. So decisive action with an eye toward the long-term (i.e. that means mostly ignoring the near-term and even intermediate-term price action after purchase) is required whenever they happen to get cheap enough. The time to buy with a big margin of safety, at least for now, seems to have passed.
** See toward the end of the Superinvestors of Graham-and-Doddsville for more on risk and reward and why it need not be correlated in a positive manner. That more risk must be taken to achieve greater rewards, along with efficient markets and rational expectations, still somehow take center stage within much modern finance theory. They remain at the heart of modern financial and economic theory though, fortunately, some of these theories have taken a real hit. Their influence over time -- sometimes quietly, sometimes less so -- can do real world economic damage.
---
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.
"Quality stocks have outperformed the market since 1965 (when our quality data begins)..."
When Grantham talks about "quality stocks", he is referring to those that produce a "high and stable return".
He then adds:
"...Fama and French adopted a circular argument rather typical of finance academics in the 1970 to 2000 era: the market is efficient; P/B and small cap outperform, ergo they must be risk factors. That the result in this case happens to get to the right result is luck. The real behavioral market is perfectly happy not rewarding 'risk' when it feels like it, as is shown by the 70-year underperformance of high beta stocks. But this time it worked. Price-to-book, despite its low beta, is a risk factor because of its low fundamental quality and its vulnerability to failure in a depression. This is true with small cap as well. But what about 'Quality?' This factor has outperformed forever. (The S&P had a High Grade Index that started in 1925 and handsomely outperformed the S&P 500 to the end of 1965 when our data starts.) Since the market is efficient, to Fama and French quality must be a risk factor! So, by protecting you in the 1929 Crash and in 2008, and by having a low beta for that matter, Quality as represented by Coca-Cola and Johnson & Johnson must be a hidden risk factor. Oh, I know: 'The real world is merely an inconvenient special case!'"
The bad news is, unlike when Grantham wrote the above, quality stocks aren't at all cheap these days. Still, the above makes an important broader point about risk and return even if the stocks themselves -- at current prices -- are far less attractive.*
So let's start by looking at a rather conventional explanation of the tradeoff between risk and return.
From Investopedia:
"...potential return rises with an increase in risk. Low levels of uncertainty (low-risk) are associated with low potential returns, whereas high levels of uncertainty (high-risk) are associated with high potential returns."
So many assume that more risk must be taken to produce greater rewards. That might at first glance seem very reasonable but, well, it's just not.
Brett Arends explains it this way:
"Conventional wisdom will often tell you that the only way to earn higher returns than the overall stock market — the only way to 'beat the market' — is to take more risk.
This idea is at the heart of the 'modern portfolio theory' that is probably practiced by your investment manager. It sounds plausible. It sounds credible. Everyone can understand it, and it is a generally accepted assumption.
The only problem? It's wrong. New research has found that you could have earned higher returns than the market in the past while taking on lower risk. This isn't a minor detail. This turns conventional finance upside-down."
Howard Marks put forward two useful and relevant charts on risk and return (at the bottom of page 6 of this memo). The first presents risk and return the traditional way (with risk and return positively correlated).
The second chart explains the relationship between risk and reward in a way that, to me, much more closely represents the world as it is.
Here's how Howard Marks explains it:
"We hear it all the time: 'Riskier investments produce higher returns' and 'If you want to make more money, take more risk.'
Both of these formulations are terrible. In brief, if riskier investments could be counted on to produce higher returns, they wouldn't be riskier."
Howard Marks on Risk
So risk and return need not be positively correlated.
It's simple, important, and too often ignored.
In the past I've referred to the following quote from the Superinvestors of Graham-and-Doddsville but it's worth repeating here:**
"Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, 'I have here a six-shooter and I have slipped one cartridge into it. Why don't you just spin it and pull it once? If you survive, I will give you $1 million.' I would decline -- perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice -- now that would be a positive correlation between risk and reward!
The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it's riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is."
The math is obviously pretty simple but let's quickly walk through this:
A dollar bill is found on the ground by two people.
It's probably real.
It might not be.
One person is willing to pay 60 cent (i.e. less than the face value because, if not real, it might be worth zero).
The second is willing to pay 40 cents.
Well, the first person can make 67% if the dollar bill is real and, of course, can lose the 60 cents if it's a fake.
The second person can make 150%, if real, and lose the 40 cents, if not.
Two-thirds the possible loss; more than twice the return. Reduced risk of permanent capital loss; greater reward. Things like the capital asset pricing model (CAPM) and the three factor model are not built for the possibility of a negative correlation between risk and reward. So the higher return produced at less risk ends up as alpha. Well, at least it does for those who buy into modern finance theory.
To me, this makes alpha the ultimate fudge factor because, in a scenario like the above, it masks what's really going on.
It masks the reality that, sometimes, risk and reward need not be positively correlated. This might seem harmless but I think the relationship between risk and reward as it is (whether positive or negative) should be explained in clear terms (i.e. instead of calling it an abnormal rate of return compared to what's predicted by an equilibrium model like CAPM).
So the assumption more risk must be taken to get more reward is an incorrect one. This idea is not exactly new -- considering that Buffett's comments, for example, were made roughly 30 years ago -- even if frequently ignored.
Somehow, that more risk must be taken to increase rewards remains at the core of modern finance to this day.
Adam
Related posts:
-Howard Marks on Risk
-Altria: Timing Isn't Everything, Part II
-Altria: Timing Isn't Everything
-Grantham on Efficient Markets, Bubbles, and Ignoble Prizes
-Efficient Markets - Part II
-Risk and Reward Revisited
-Boring Stocks
-Efficient Markets
-Modern Portfolio Theory, Efficient Markets, and the Flat Earth Revisited
-Buffett on Risk and Reward
-Buffett: Why Stocks Beat Bonds
-Beta, Risk, & the Inconvenient Real World Special Case
-Howard Marks: The Two Main Risks in the Investment World
-Black-Scholes and the Flat Earth Society
-Buffett: Indebted to Academics
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind
-Defensive Stocks?
* The higher quality stocks mostly are not selling at a discount to value these days. At least that is my view. They're still good businesses but the shares just don't provide any protection against what might go wrong. It's, of course, impossible to predict when shares are going to sell at attractive prices. The risk of not owning a good stock at a fair price is a real one (error of omission) that sometimes doesn't get enough consideration. It's why buying what becomes cheap (for those comfortable buying individual stocks) when the opportunity arise is so important. It wasn't tough to buy shares in some of the highest quality businesses at a nice discount to per share intrinsic value several years ago. The situation is very different now. Unfortunately, it's just not possible to know if/when they'll be available at a discount in the future. So decisive action with an eye toward the long-term (i.e. that means mostly ignoring the near-term and even intermediate-term price action after purchase) is required whenever they happen to get cheap enough. The time to buy with a big margin of safety, at least for now, seems to have passed.
** See toward the end of the Superinvestors of Graham-and-Doddsville for more on risk and reward and why it need not be correlated in a positive manner. That more risk must be taken to achieve greater rewards, along with efficient markets and rational expectations, still somehow take center stage within much modern finance theory. They remain at the heart of modern financial and economic theory though, fortunately, some of these theories have taken a real hit. Their influence over time -- sometimes quietly, sometimes less so -- can do real world economic damage.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Friday, October 24, 2014
Buffett on Investing Mistakes
There have been plenty of headlines lately about things not going Warren Buffett's way -- at least in the short-term -- with some of his investments.
As long time owners and followers of Berkshire Hathaway (BRKa) know well, Buffett over the years has gone out of his way -- usually in the annual letters -- to point out when he makes a misjudgment that ends up costing Berkshire investors. Some of these -- though not necessarily all -- will prove to be just the latest examples. That investing mistakes will be made is close to inevitable even for those who are very good at it. From the 2013 Berkshire Hathaway shareholder letter:
"It's vital, however, that we recognize the perimeter of our 'circle of competence' and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses."
IBM's (IBM) stock -- one of Berkshire's bigger equity holdings -- recently took a particularly significant hit. The company's stock fell as a result of disappointing near-term results and the outlook. It's, in fact, now selling a bit below the price that Buffett paid a few years back. Time will tell whether the investment wasn't a good one for Berkshire. I'm sure some will conclude that, based upon the price action, the market has spoken and therefore it has not been a good investment. What will really matter, as Buffett explained in the 2011 letter, is this:
"In the end, the success of our IBM investment will be determined primarily by its future earnings. But an important secondary factor will be how many shares the company purchases with the substantial sums it is likely to devote to this activity."
Maybe IBM will prove to be a case of Buffett stepping outside of his 'circle'. I'm not convinced of that just yet but it's certainly possible.
IBM's recent challenges in meeting near-term expectations does cast at least some doubt on IBM's future earning power. So far it's hardly catastrophic but we'll see how it develops over time. The company, though it faces real challenges, still has far better core economics today compared to a decade or so ago. What they've done in that regard has been no small achievement. Revenue growth has been and likely will continue to be nonexistent. Yet IBM's return on capital has been improved substantially over the years. In the end, it's returns on capital and the price paid compared to intrinsic business value that mostly dictates future risk and reward. Revenue growth -- as long as it's high return variety -- can certainly be a good thing. It's just not necessarily a good thing. The problem is that some act as if, unless there is revenue growth, the results must be some form of financial engineering. Well, revenue growth for it's own sake may serve the speculator but doesn't serve the long-term owner. Some companies undoubtedly do engage in what appear to be questionable financial practices but, as far as I can tell, IBM does not seem like one of them. Now, I've written on prior occasions that -- and it continues to be the case -- I'm not a big fan of owning shares of technology businesses unless they are very inexpensive. Even then I'll, in general, only own certain tech stocks in small amounts.
Of course, some could fairly argue that IBM has already been a mistake.
It might just prove to be.
To me, it's a mistake if per share intrinsic value drops in a meaningful and permanent way*; it's a mistake if an unsatisfactory return is generated compared to understood alternatives; it's also a mistake if risks were taken that were poorly understood even if the investment happens to work out. For the long-term investor, the fact that the stock is currently higher or lower than the purchase price has nothing to do with this assessment. In fact, a stock falling stock even further below intrinsic value can be an unqualified advantage for the long-term owner if the business itself remains sound. Stock price action often fluctuates far more wildly than per share intrinsic business value. Lets say, for example, when quarterly results -- or even several quarterly results -- turn out to be disappointing.
Check out some of the recent headlines:
Warren Buffett just lost about $ 1 billion on this
Warren Buffett just lost ANOTHER $1B on this
Warren Buffett loses $2.5 billion in three days on Coca-Cola and IBM
Those headlines might just be more a reflection of an ethos that focuses on near-term price action and the speculative renting of stocks -- even if based upon fundamentals -- instead of ownership with an eye towards intrinsic values.
In each case the billions of dollars "lost" simply hasn't been lost unless Buffett needs to sell or the fundamentals have changed such that real intrinsic value has been or will be destroyed.
(It would end up being a loss, for example, if he required the funds near-term to buy an alternative investment that's more attractive -- opportunity costs.)
I'm definitely NOT a huge fan of IBM. It's a business that's constantly dealing with change. Far from the ideal investment. The stock may in fact turn out to be a subpar investment or worse. It's just not yet clear, at least to me, that the longer term investment outcomes will be unfavorable despite the real current difficulties. Even good businesses experience challenges from time to time and one usually doesn't get a chance to buy something sensible (for the long-term) at a nice discount when the near-term outlook seems rosy. IBM's stock may in fact underperform for some time, but the long-term oriented owner should be hoping for this so the buybacks can more effective.
Otherwise, the price paid along with how the business performs will ultimately have the most influence over long-term results. For investors that pay a fair (or better than fair) price, what's likely to happen to per share intrinsic value over long time frames, considering the risks and in comparison to well understood alternatives, is what really matters.
It's not about quarterly results.
It's absolutely not about what the stock does in the next few days, weeks, or even years.
It will be interesting to see what Buffett has to say about IBM at some point down the road. Maybe he's already concluded that buying IBM's stock wasn't a brilliant move on his part. If history is any guide he will make it clear if and when he considers it a mistake.
My own expectation is that IBM's specific challenges aren't going away anytime soon. Still, while IBM is not exactly my favorite business in the world, I do still plan to maintain a small long position.**
Errors of commission, where it's rather obvious what went wrong and how costly it ended up being, aren't necessarily the biggest problem for investors. Buffett has in the past emphasized the very costly, less explicit, but sometimes at least as important errors of omission. In recent years I've probably made too few errors of commission but too many errors of omission.***
Too few errors of commission may seem like an odd self-criticism but, in attempting to avoid possible losses, I sometimes end up not owning (or owning too little) of something sensible (when it was cheap enough to buy). So the too few errors of commission directly relates to making too many errors of omission. The power of loss aversion no doubt contributes to this. The risk that shares at a particular point in time sell at a reasonable discount to value might soon get too expensive to buy is a real one. Think about how many good businesses had shares that were selling at substantial discounts to value not all that long ago. The situation is very different these days.The avoidance of permanent loss should, of course, be the top priority. The tough part is not allowing that prime objective to get in the way of doing something sensible when the opportunity presents itself. It's easy to focus too much on the possibility of loss and not enough on well understood missed opportunities.
Investing always comes down to working within one's own limits. I don't doubt for a minute that others do a better job finding a good balance.
So the more explicit mistakes -- those of commission -- are not necessarily the most costly. There have been many times where I own a small amount of something when I should own a lot. It's a weakness that I've attempted to fix but, while some progress has been made, it's rather amazing how often I still end up owning too few shares of a business that I like and think I understand well.
It's worth pointing out that I'm not talking about missing the next transformational business. If I don't buy the next Facebook (FB) that's not a mistake even if it proves to produce a brilliant investment outcome. I'll almost always miss those kind of opportunities and I'm fine with it. That sort of thing is almost always going to be well outside my own "circle of competence". If I don't know how to value a business (within a narrow enough range), and it can't be bought at a nice discount to that estimate, the right move is to avoid.
Some might choose to focus on investments that went right and gloss over those that did not.
Successful investing requires a serious assessment of what didn't go right and why.
I'd add that few of us are able to understand how to value lots of different businesses.
"If you are really a value investor and do deep research, how many investments can you be involved in at the same time? If you are a high-frequency trader, you could trade 100 securities today. The real value investors are lucky if they can do 10 investments at a time." - Marty Whitman in this Barron's Interview
For me, it's important to stick to what I understand and, more importantly, knowing what I don't really understand. Maybe others can truly understand hundreds of different stocks but I'm more than a bit skeptical of this.
Some commentators seem willing to offer opinions on just about every investment alternative that comes up. Well, if someone has an opinion on just about every investment that's out there, it's probably going to be tough to figure which ones they truly understand.
I'm always impressed when someone responds with something along the lines of "I don't know".
Adam
Established a long position in BRKb at much lower than recent market prices; small long position in IBM established at slightly higher than recent market prices.
Related posts:
Buffett's Purchase of IBM Revisited
Why Buffett Wants IBM's Shares "To Languish"
Buffett on IBM: Berkshire Buys Big Blue
Technology Stocks
* IBM should earn ~ $ 16 per share this year. The company earned $ 11.52 per share in 2010 and $ 4.93 per share in 2004. That's certainly not a bad decade of performance for a larger company. The question is, of course, what will happen in the future. Maybe IBM's earnings are about to meaningfully decline. Does what happened this past decade say much about what's in store going forward? It may not. There's certainly no guarantee that the current earnings power will be persistent. That's only one of the many important judgments -- some easily quantifiable, many that are not -- any investor has to make.
** My position in the stock would change if the core business economics were to become materially altered, prospects have been misjudged by me (more likely to happen with IBM than some of my other investments), or maybe if opportunity costs come into play. If it does end up working out okay as an investment, it's going to be over a rather long time horizon. In fact, I won't be surprised if IBM's stock continues to disappoint for quite a while. In other words, those who like to profit from near-term price action will likely, and understandably, not find much use for it. The speculator naturally has a very different set of priorities.
*** Some focus on the risk of temporary loss but forget to consider the risk of losing the chance to own something sensible when it becomes available at an attractive price.
---
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.
As long time owners and followers of Berkshire Hathaway (BRKa) know well, Buffett over the years has gone out of his way -- usually in the annual letters -- to point out when he makes a misjudgment that ends up costing Berkshire investors. Some of these -- though not necessarily all -- will prove to be just the latest examples. That investing mistakes will be made is close to inevitable even for those who are very good at it. From the 2013 Berkshire Hathaway shareholder letter:
"It's vital, however, that we recognize the perimeter of our 'circle of competence' and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses."
IBM's (IBM) stock -- one of Berkshire's bigger equity holdings -- recently took a particularly significant hit. The company's stock fell as a result of disappointing near-term results and the outlook. It's, in fact, now selling a bit below the price that Buffett paid a few years back. Time will tell whether the investment wasn't a good one for Berkshire. I'm sure some will conclude that, based upon the price action, the market has spoken and therefore it has not been a good investment. What will really matter, as Buffett explained in the 2011 letter, is this:
"In the end, the success of our IBM investment will be determined primarily by its future earnings. But an important secondary factor will be how many shares the company purchases with the substantial sums it is likely to devote to this activity."
Maybe IBM will prove to be a case of Buffett stepping outside of his 'circle'. I'm not convinced of that just yet but it's certainly possible.
IBM's recent challenges in meeting near-term expectations does cast at least some doubt on IBM's future earning power. So far it's hardly catastrophic but we'll see how it develops over time. The company, though it faces real challenges, still has far better core economics today compared to a decade or so ago. What they've done in that regard has been no small achievement. Revenue growth has been and likely will continue to be nonexistent. Yet IBM's return on capital has been improved substantially over the years. In the end, it's returns on capital and the price paid compared to intrinsic business value that mostly dictates future risk and reward. Revenue growth -- as long as it's high return variety -- can certainly be a good thing. It's just not necessarily a good thing. The problem is that some act as if, unless there is revenue growth, the results must be some form of financial engineering. Well, revenue growth for it's own sake may serve the speculator but doesn't serve the long-term owner. Some companies undoubtedly do engage in what appear to be questionable financial practices but, as far as I can tell, IBM does not seem like one of them. Now, I've written on prior occasions that -- and it continues to be the case -- I'm not a big fan of owning shares of technology businesses unless they are very inexpensive. Even then I'll, in general, only own certain tech stocks in small amounts.
Of course, some could fairly argue that IBM has already been a mistake.
It might just prove to be.
To me, it's a mistake if per share intrinsic value drops in a meaningful and permanent way*; it's a mistake if an unsatisfactory return is generated compared to understood alternatives; it's also a mistake if risks were taken that were poorly understood even if the investment happens to work out. For the long-term investor, the fact that the stock is currently higher or lower than the purchase price has nothing to do with this assessment. In fact, a stock falling stock even further below intrinsic value can be an unqualified advantage for the long-term owner if the business itself remains sound. Stock price action often fluctuates far more wildly than per share intrinsic business value. Lets say, for example, when quarterly results -- or even several quarterly results -- turn out to be disappointing.
Check out some of the recent headlines:
Warren Buffett just lost about $ 1 billion on this
Warren Buffett just lost ANOTHER $1B on this
Warren Buffett loses $2.5 billion in three days on Coca-Cola and IBM
Those headlines might just be more a reflection of an ethos that focuses on near-term price action and the speculative renting of stocks -- even if based upon fundamentals -- instead of ownership with an eye towards intrinsic values.
In each case the billions of dollars "lost" simply hasn't been lost unless Buffett needs to sell or the fundamentals have changed such that real intrinsic value has been or will be destroyed.
(It would end up being a loss, for example, if he required the funds near-term to buy an alternative investment that's more attractive -- opportunity costs.)
I'm definitely NOT a huge fan of IBM. It's a business that's constantly dealing with change. Far from the ideal investment. The stock may in fact turn out to be a subpar investment or worse. It's just not yet clear, at least to me, that the longer term investment outcomes will be unfavorable despite the real current difficulties. Even good businesses experience challenges from time to time and one usually doesn't get a chance to buy something sensible (for the long-term) at a nice discount when the near-term outlook seems rosy. IBM's stock may in fact underperform for some time, but the long-term oriented owner should be hoping for this so the buybacks can more effective.
Otherwise, the price paid along with how the business performs will ultimately have the most influence over long-term results. For investors that pay a fair (or better than fair) price, what's likely to happen to per share intrinsic value over long time frames, considering the risks and in comparison to well understood alternatives, is what really matters.
It's not about quarterly results.
It's absolutely not about what the stock does in the next few days, weeks, or even years.
It will be interesting to see what Buffett has to say about IBM at some point down the road. Maybe he's already concluded that buying IBM's stock wasn't a brilliant move on his part. If history is any guide he will make it clear if and when he considers it a mistake.
My own expectation is that IBM's specific challenges aren't going away anytime soon. Still, while IBM is not exactly my favorite business in the world, I do still plan to maintain a small long position.**
Errors of commission, where it's rather obvious what went wrong and how costly it ended up being, aren't necessarily the biggest problem for investors. Buffett has in the past emphasized the very costly, less explicit, but sometimes at least as important errors of omission. In recent years I've probably made too few errors of commission but too many errors of omission.***
Too few errors of commission may seem like an odd self-criticism but, in attempting to avoid possible losses, I sometimes end up not owning (or owning too little) of something sensible (when it was cheap enough to buy). So the too few errors of commission directly relates to making too many errors of omission. The power of loss aversion no doubt contributes to this. The risk that shares at a particular point in time sell at a reasonable discount to value might soon get too expensive to buy is a real one. Think about how many good businesses had shares that were selling at substantial discounts to value not all that long ago. The situation is very different these days.The avoidance of permanent loss should, of course, be the top priority. The tough part is not allowing that prime objective to get in the way of doing something sensible when the opportunity presents itself. It's easy to focus too much on the possibility of loss and not enough on well understood missed opportunities.
Investing always comes down to working within one's own limits. I don't doubt for a minute that others do a better job finding a good balance.
So the more explicit mistakes -- those of commission -- are not necessarily the most costly. There have been many times where I own a small amount of something when I should own a lot. It's a weakness that I've attempted to fix but, while some progress has been made, it's rather amazing how often I still end up owning too few shares of a business that I like and think I understand well.
It's worth pointing out that I'm not talking about missing the next transformational business. If I don't buy the next Facebook (FB) that's not a mistake even if it proves to produce a brilliant investment outcome. I'll almost always miss those kind of opportunities and I'm fine with it. That sort of thing is almost always going to be well outside my own "circle of competence". If I don't know how to value a business (within a narrow enough range), and it can't be bought at a nice discount to that estimate, the right move is to avoid.
Some might choose to focus on investments that went right and gloss over those that did not.
Successful investing requires a serious assessment of what didn't go right and why.
I'd add that few of us are able to understand how to value lots of different businesses.
"If you are really a value investor and do deep research, how many investments can you be involved in at the same time? If you are a high-frequency trader, you could trade 100 securities today. The real value investors are lucky if they can do 10 investments at a time." - Marty Whitman in this Barron's Interview
For me, it's important to stick to what I understand and, more importantly, knowing what I don't really understand. Maybe others can truly understand hundreds of different stocks but I'm more than a bit skeptical of this.
Some commentators seem willing to offer opinions on just about every investment alternative that comes up. Well, if someone has an opinion on just about every investment that's out there, it's probably going to be tough to figure which ones they truly understand.
I'm always impressed when someone responds with something along the lines of "I don't know".
Adam
Established a long position in BRKb at much lower than recent market prices; small long position in IBM established at slightly higher than recent market prices.
Related posts:
Buffett's Purchase of IBM Revisited
Why Buffett Wants IBM's Shares "To Languish"
Buffett on IBM: Berkshire Buys Big Blue
Technology Stocks
* IBM should earn ~ $ 16 per share this year. The company earned $ 11.52 per share in 2010 and $ 4.93 per share in 2004. That's certainly not a bad decade of performance for a larger company. The question is, of course, what will happen in the future. Maybe IBM's earnings are about to meaningfully decline. Does what happened this past decade say much about what's in store going forward? It may not. There's certainly no guarantee that the current earnings power will be persistent. That's only one of the many important judgments -- some easily quantifiable, many that are not -- any investor has to make.
** My position in the stock would change if the core business economics were to become materially altered, prospects have been misjudged by me (more likely to happen with IBM than some of my other investments), or maybe if opportunity costs come into play. If it does end up working out okay as an investment, it's going to be over a rather long time horizon. In fact, I won't be surprised if IBM's stock continues to disappoint for quite a while. In other words, those who like to profit from near-term price action will likely, and understandably, not find much use for it. The speculator naturally has a very different set of priorities.
*** Some focus on the risk of temporary loss but forget to consider the risk of losing the chance to own something sensible when it becomes available at an attractive price.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Friday, October 17, 2014
John Bogle's "Relentless Rules of Humble Arithmetic", Part II
Back in 2007 at NYU, John Bogle talked what he calls his "second relentless rule of humble arithmetic."
During his remarks he said that: "Successful investing is not about the stock market, but about owning all of America's businesses and reaping the huge rewards provided by the dividends and earnings growth of our nation's—and, for that matter, our world's—corporations. For in the very long run, it is how businesses actually perform that determines the return on our invested capital. Dividend yields, plus earnings growth, account for substantially 100 percent of the return on stocks."
Here's a post on the first rule.
Bogle then references -- with the wording only slightly altered -- something that Warren Buffett once wrote.
Bogle's version:
"The most that owners in the aggregate can earn between now and Judgment Day is what their business in the aggregate earns..."*
Bogle calls this "the central reality of investing" then goes on to also mention the following from Buffett:
"When the stock temporarily overperforms or underperforms the business, a limited number of shareholders—either sellers or buyers—receive outsized benefits at the expense of those they trade with."
A whole lot of time and energy goes into trying to gain at the expense of other market participants when the focus really should be on what the businesses themselves produce in value over time. Bogle adds:
"How often investors lose sight of that eternal principle!"
Consider this as many expend lots of effort -- while incurring lots of frictional costs -- attempting to speculate on where the stock prices might be going in the near-term. If the emphasis was instead on the cash an asset can produce over a longer time frame (i.e. the fundamentals that determine intrinsic value) many participants would likely end up better off.**
More from Bogle:
"History, if only we would take the trouble to look at it, reveals the remarkable, if essential, linkage between the cumulative long-term returns earned by business—the annual dividend yield plus the annual rate of earnings growth—and the cumulative returns earned by the U.S. stock market. Think about that certainty for a moment. Can you see that it is simple common sense?
Need proof? Just look at the record since the twentieth century began. The average annual total return on stocks was 9.6 percent, virtually identical to the investment return of 9.5 percent—4.5 percent from dividend yield and 5 percent from earnings growth. That tiny difference of 0.1 percent per year arose from what I call speculative return, depending on how one looks at it. Perhaps it is merely statistical noise, or perhaps it reflects a generally upward long-term trend in stock valuations, a willingness of investors to pay higher prices for each dollar of earnings at the end of the period than at the beginning."
I personally never have any idea what the stock market is going to do nor do I even spend a moment thinking about it. The same goes for macroeconomic factors. Will the market drop dramatically? Will it rally? How will the global economy perform in the next 12 months? The only thing I feel reasonably comfortable with when it comes to prognostication is that's it's usually wise to ignore the prognosticators.
That's why I've not once attempted to forecast or predict anything. The good news is that a sound investment approach doesn't require such forecasting abilities. Lately, the markets have fluctuated a bit more intensely and, as a result, the investing world probably seems to have become more unpredictable, uncertain, and risky. I say "seems" because the future is always unpredictable and uncertain. It's merely the perception of that unpredictability and uncertainty that changes.
No doubt many will continue to try and figure out how the economic outlook might be changing and what the markets will do next despite the futility of doing so.
I think Morgan Housel recently made this point very well:
"The four most important words in investing are probably, 'I have no idea.'
I have no idea what the market will do next.
I have no idea if we'll have a recession this year.
I have no idea when interest rates will rise.
I have no idea what the Fed will do next.
Neither do you.
The sooner you admit that, the better."
Charlie Munger once explained it this way:
"Our system is to swim as competently as we can and sometimes the tide will be with us and sometimes it will be against us. But by and large we don't much bother with trying to predict the tides because we plan to play the game for a long time.
I recommend to all of you exactly the same attitude.
It's kind of a snare and a delusion to outguess macroeconomic cycles...very few people do it successfully and some of them do it by accident. When the game is that tough, why not adopt the other system of swimming as competently as you can and figuring that over a long life you'll have your share of good tides and bad tides?"
Some act as if they can read the macroeconomic tea leaves and reliably make effective investing decisions based upon that reading. Others seem to think it's possible to guess what the markets are going to do in the near-term in a way that will produce attractive overall results (their emphasis is on price action). Of course, it's certainly possible that some participants actually get good results this way. Yet I suspect that those who actually pull it off is a very small number compared to those who attempt to do so.
The good news is that judging macroeconomic factors, and guessing what the markets are going to do near-term, isn't what really matters for those of us who invest with the long-term in mind. What matters is whether you can judge the value of a business and buy it cheap enough so there is enough protection against what might go wrong.
(In many cases the worst possible outcome is unacceptable -- or too difficult to understand -- making avoidance of an investment altogether the right course of action. In other words, no price is low enough.)
Let's say the equity markets do eventually fall dramatically from current levels.***
Well, then the shares of some great businesses should temporarily become much cheaper to buy.
How's that a bad thing unless selling is required in the near-term?
Prices fluctuate far more than intrinsic business values, and reduced prices become an ally when someone is justifiably confident in their estimate of value.
A sound investment process should include the disciplined pursuit of the largest possible margin of safety. Generally speaking, if market participants become unusually concerned about future prospects then the likelihood of finding shares at a big discount to value will increase.
The cheaper the better as long as the intrinsic business qualities have been mostly judged well. It's, in part, learning to ignore the quoted prices of what's owned for the long-term and, instead, focusing on what can be bought at attractive prices. That means being ready to act when others are less inclined to do so.
There may be no way to eliminate investing mistakes but, via things like margin of safety and an awareness of limits, there are ways to reduce the quantity and costliness of those mistakes.
Focus on what businesses can produce in cash over time -- and, as a result, what they're intrinsically worth -- instead of how shares might be trading day to day.
Adam
Related posts:
Index Fund Investing Revisited
Charlie Munger on Complexity, Hedge Funds, and Pension Funds
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again
* Warren Buffett, earlier this year, said something very similar in a CNBC interview: "...in the end, a stock today is worth all of the cash you can distribute between now and Judgment Day."
** With the vast majority of participants underperforming the markets as a whole -- despite all the unnecessary effort -- this seems rather evident. Too often investors do end up being their own worst enemy. Unfortunately, it's the thinking that it's possible to be in and out of positions at the right time -- with the idea of improving investment results, of course - that gets investors in trouble.
*** A near certainty but, practically speaking, attempts to figure out when the market will decline should be viewed as distraction and, again, an exercise in futility.
During his remarks he said that: "Successful investing is not about the stock market, but about owning all of America's businesses and reaping the huge rewards provided by the dividends and earnings growth of our nation's—and, for that matter, our world's—corporations. For in the very long run, it is how businesses actually perform that determines the return on our invested capital. Dividend yields, plus earnings growth, account for substantially 100 percent of the return on stocks."
Here's a post on the first rule.
Bogle then references -- with the wording only slightly altered -- something that Warren Buffett once wrote.
Bogle's version:
"The most that owners in the aggregate can earn between now and Judgment Day is what their business in the aggregate earns..."*
Bogle calls this "the central reality of investing" then goes on to also mention the following from Buffett:
"When the stock temporarily overperforms or underperforms the business, a limited number of shareholders—either sellers or buyers—receive outsized benefits at the expense of those they trade with."
A whole lot of time and energy goes into trying to gain at the expense of other market participants when the focus really should be on what the businesses themselves produce in value over time. Bogle adds:
"How often investors lose sight of that eternal principle!"
More from Bogle:
"History, if only we would take the trouble to look at it, reveals the remarkable, if essential, linkage between the cumulative long-term returns earned by business—the annual dividend yield plus the annual rate of earnings growth—and the cumulative returns earned by the U.S. stock market. Think about that certainty for a moment. Can you see that it is simple common sense?
Need proof? Just look at the record since the twentieth century began. The average annual total return on stocks was 9.6 percent, virtually identical to the investment return of 9.5 percent—4.5 percent from dividend yield and 5 percent from earnings growth. That tiny difference of 0.1 percent per year arose from what I call speculative return, depending on how one looks at it. Perhaps it is merely statistical noise, or perhaps it reflects a generally upward long-term trend in stock valuations, a willingness of investors to pay higher prices for each dollar of earnings at the end of the period than at the beginning."
I personally never have any idea what the stock market is going to do nor do I even spend a moment thinking about it. The same goes for macroeconomic factors. Will the market drop dramatically? Will it rally? How will the global economy perform in the next 12 months? The only thing I feel reasonably comfortable with when it comes to prognostication is that's it's usually wise to ignore the prognosticators.
That's why I've not once attempted to forecast or predict anything. The good news is that a sound investment approach doesn't require such forecasting abilities. Lately, the markets have fluctuated a bit more intensely and, as a result, the investing world probably seems to have become more unpredictable, uncertain, and risky. I say "seems" because the future is always unpredictable and uncertain. It's merely the perception of that unpredictability and uncertainty that changes.
No doubt many will continue to try and figure out how the economic outlook might be changing and what the markets will do next despite the futility of doing so.
I think Morgan Housel recently made this point very well:
"The four most important words in investing are probably, 'I have no idea.'
I have no idea what the market will do next.
I have no idea if we'll have a recession this year.
I have no idea when interest rates will rise.
I have no idea what the Fed will do next.
Neither do you.
The sooner you admit that, the better."
Charlie Munger once explained it this way:
"Our system is to swim as competently as we can and sometimes the tide will be with us and sometimes it will be against us. But by and large we don't much bother with trying to predict the tides because we plan to play the game for a long time.
I recommend to all of you exactly the same attitude.
It's kind of a snare and a delusion to outguess macroeconomic cycles...very few people do it successfully and some of them do it by accident. When the game is that tough, why not adopt the other system of swimming as competently as you can and figuring that over a long life you'll have your share of good tides and bad tides?"
Some act as if they can read the macroeconomic tea leaves and reliably make effective investing decisions based upon that reading. Others seem to think it's possible to guess what the markets are going to do in the near-term in a way that will produce attractive overall results (their emphasis is on price action). Of course, it's certainly possible that some participants actually get good results this way. Yet I suspect that those who actually pull it off is a very small number compared to those who attempt to do so.
The good news is that judging macroeconomic factors, and guessing what the markets are going to do near-term, isn't what really matters for those of us who invest with the long-term in mind. What matters is whether you can judge the value of a business and buy it cheap enough so there is enough protection against what might go wrong.
(In many cases the worst possible outcome is unacceptable -- or too difficult to understand -- making avoidance of an investment altogether the right course of action. In other words, no price is low enough.)
Let's say the equity markets do eventually fall dramatically from current levels.***
Well, then the shares of some great businesses should temporarily become much cheaper to buy.
How's that a bad thing unless selling is required in the near-term?
Prices fluctuate far more than intrinsic business values, and reduced prices become an ally when someone is justifiably confident in their estimate of value.
A sound investment process should include the disciplined pursuit of the largest possible margin of safety. Generally speaking, if market participants become unusually concerned about future prospects then the likelihood of finding shares at a big discount to value will increase.
The cheaper the better as long as the intrinsic business qualities have been mostly judged well. It's, in part, learning to ignore the quoted prices of what's owned for the long-term and, instead, focusing on what can be bought at attractive prices. That means being ready to act when others are less inclined to do so.
Focus on what businesses can produce in cash over time -- and, as a result, what they're intrinsically worth -- instead of how shares might be trading day to day.
Adam
Related posts:
Index Fund Investing Revisited
Charlie Munger on Complexity, Hedge Funds, and Pension Funds
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again
* Warren Buffett, earlier this year, said something very similar in a CNBC interview: "...in the end, a stock today is worth all of the cash you can distribute between now and Judgment Day."
** With the vast majority of participants underperforming the markets as a whole -- despite all the unnecessary effort -- this seems rather evident. Too often investors do end up being their own worst enemy. Unfortunately, it's the thinking that it's possible to be in and out of positions at the right time -- with the idea of improving investment results, of course - that gets investors in trouble.
*** A near certainty but, practically speaking, attempts to figure out when the market will decline should be viewed as distraction and, again, an exercise in futility.
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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.
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