Bogle: Arithmetic Quants vs Algorithmic Quants

From a recent speech by John Bogle:

"As I see it, the plain and simple, well-armed, lightly-dressed, unencumbered shepherd is the index fund, a portfolio holding all 500 stocks in the Standard & Poor’s 500 Index. The David approach to investing, then, is 'buy a diversified portfolio of stocks operated at rock-bottom costs, and hold it forever.' The index fund relies on simple arithmetic, a mathematical tautology that could be calculated by a second grader: gross return in the stock market, minus the frictional costs of investing, equals the net return that is shared by all investors as a group. Taking the lion's share of those costs out of the equation is the key to successful long-term investing.

In contrast, many (most?) Goliaths of academia and quantitative investing believe the contrary: the application of multiple complex equations—the language of science and technology, of engineering and mathematics (yes, STEM), developed with computers processing Big Data, and trading stocks at the speed of light—make our Goliaths far stronger and more powerful than are we indexing Davids. The question posed in my title is essentially, 'who wins?'—the arithmetic quants or the algorithmic quants."

In the early days, when the hedge fund Goliaths* were individually smaller in size and part of a much smaller industry (assets of $ 120 billion in 1997), annualized returns were impressive: 11.8 percent vs 7.2 percent for the S&P 500 from 1990 to 2008.

By 2008, the Goliaths had $ 1.4 trillion in assets that have now grown to roughly $ 2.8 trillion and their relative performance has suffered a bunch: 5.3 percent vs 13.5 percent for the S&P 500 from 2009 to 2016.

Will there prove to be, in the long run, any advantage to all this additional complexity? Is the additional size the main cause of the more recent underperformance?  Is it the additional competition from capable individuals entering what is, if nothing else, a potentially rather lucrative profession? Or is it the addition of less capable managers entering the industry? For Bogle this all just reflects what is an inevitable reversion to the mean. The extra muscle and heavy armor -- in terms of industry assets -- has certainly led to huge compensation for the Goliaths.
(Bogle estimates ~$ 84 billion in annual fees while The New York Times reported that the top 25 managers alone were paid an average of $ 465 million in 2014.)

In any case, not unlike the classic battle, all that additional muscle and armor didn't make the Hedge Fund Goliaths a more formidable opponent to the indexing Davids; instead, it appears -- at least based upon the more recent results -- to have made them vulnerable to a much simpler and low cost approach.

Huge frictional costs -- roughly 3 percent per year or more according to Bogle -- are, of course, a meaningful factor but, with a greater than 8 percent annualized gap since 2009, it comes down to more than just those costs. Keep in mind that in the early days the drag of these heavy frictional costs also existed.

The range of outcomes is also a concern. Over the past 5 years, according to Bogle, individual hedge fund returns have been between -91 percent to 157 percent.

Yikes.

These Goliaths may perform much better in the future, of course. There's, as always, just no way to know. Yet I think it's fair to ask whether such long-term outcomes deserves so much time, talent, and capital especially when much less costly, simple, and effective alternatives exist.

If nothing else, over the long haul, the headwind coming from all the frictional costs is no small thing for most to overcome. Some exceptional managers no doubt will overcome those costs -- whether through pure chance or skill or a bit of both -- but that doesn't change the reality that a hedge fund with typical fees must outperform by ~3 percent each year just to keep up with the indexing Davids.

Adam

Related posts:
Hedge Funds: Balancing Risk & Reward?
Index Funds vs Actively Managed Funds
John Bogle on Investor Returns
Buffett's Hedge Fund Bet
John Bogle's "Relentless Rules of Humble Arithmetic", Part II
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

* It's worth noting the wide variety of investment and trading strategies employed by hedge funds. Still, what most have in common is vastly greater complexity and cost.

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.

Berkshire 2016 Meeting: Charlie Munger Highlights - Part I

The following are excerpts of comments made by Charlie Munger at the 2016 Berkshire Hathaway (BRKa) shareholder meeting:

On Ignorance
"...looking back, I don't regret that I didn't make more money or become better known, or any of those things. I do regret that I didn't wise up as fast as I could have — but there's a blessing in that, too. Now that I'm 92, I still have a lot of ignorance left to work on."

So, for those who are a bit younger than Mr. Munger (and also similarly did not "wise up" as fast as they'd have liked), I guess this way of thinking potentially offers an even bigger opportunity for them. Well, at least it possibly could for the person who hasn't become convinced they already have most things figured out and, as a result, focus their efforts on confirming it.

"If others examined themselves attentively, as I do, they would find themselves, as I do, full of inanity and nonsense. Get rid of it I cannot without getting rid of myself. We are all steeped in it, one as much as another; but those who are aware of it are a little better off -- though I don't know." - Michel de Montaigne

To me, it's through the "though I don't know" that Montaigne adds a crucial element of healthy doubt (though I, as well, certainly don't know!); much like Munger, it seems a humble recognition that no matter how long and hard one attempts to better understand the world, the work is ultimately incomplete, and to a great extent this comes down to inherent limitations of the human mind.

And those who might be very smart and capable aren't exempt from it; the question is whether they think they are, in fact, entirely or mostly exempt. In other words, individuals convinced they already don't have much "ignorance left to work on" seem rather guaranteed to possess a whole lot more of it than they realize.

On Retailing & the Internet
"...I would say that we failed so thoroughly in retailing when we were young, that we pretty well avoided the worst troubles when we were old. I think net Berkshire has been helped by the Internet. The help at GEICO has been enormous and it's contributed greatly to the huge increase in market share. Our biggest retailers are so strong that they'll be among the last people to have troubles from Amazon."

What comes across loud and clear during the meeting is how much Jeff Bezos and Amazon comes into play in their thinking when it comes to retail businesses (and, who knows, maybe one day even some of their other businesses).

On the Health Effects of Carbonated Soft Drinks
"...every person has to have about eight or ten glasses of water every day to stay alive...and it improves life to add a little extra flavor to your water -- a little stimulation, and a few calories if you want to eat that way. There are huge benefits to humanity in that and it's worth having some disadvantages. We ought to almost have a law...where these people shouldn't be allowed to cite the defect without also citing the advantage. It's immature and stupid."

Munger says those who choose to look at only the downside without also weighing the benefits are making an "inexcusable" error.

On Microeconomics vs Macroeconomics
"Well, there could hardly be anything more important [than microeconomics]...Business and microeconomics are sort of the same term. Microeconomics is what we do and macroeconomics is what we put up with."

Considering how little Berkshire relies on macro factors in their investment decision-making it's notable, as a contrast, just how much time and energy is expended by a whole bunch of market participants -- as well as the many economists, consultants, and analysts who advise and opine -- on macro-oriented forms of analysis.

"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." - Charlie Munger at the University of Michigan

Here's a comprehensive transcript of what was said at the Berkshire meeting by both Warren Buffett and Charlie Munger.

Also, here's a transcript focused specifically on what Charlie had to say.

Adam

Long position in BRKb established at much lower than recent prices
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Berkshire Hathaway 1st Quarter 2016 13F-HR

The Berkshire Hathaway (BRKa) 1st Quarter 13F-HR was released yesterday. 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 4th Quarter 13F-HR.)

There was plenty of buying and selling during the quarter. Here's a quick summary of the changes:*

Added to Existing Positions
IBM (IBM): 199 thous. shares (<1% incr.); tot. stake $ 12.3 bil.
Phillips 66 (PSX): 14.1 mil. shares (22% incr.); tot. stake $ 6.54 bil.
Charter (CHTR): 45.2 thous. shares (<1%); tot. stake $ 2.09 bil.
Deere & Co. (DE): 5.83 mil. shares (1%); tot. stake $ 1.79 bil.

I've included above only those positions that were worth at least $ 1 billion at the end of the 1st quarter. In a portfolio this size -- more than $ 233 billion (equities, fixed income, cash, and other investments including Kraft Heinz: KHC at end of quarter market value) as of the latest available filing with roughly half made up of common stocks** -- a position that's less than $ 1 billion doesn't really move the needle much. It's worth noting that a bunch of cash was put to use this past quarter to complete the Precision Castparts deal. So quarter over quarter that, along with the Duracell deal, shrunk the total portfolio somewhat.

Shares that were bought among positions worth less than $ 1 billion include Bank of New York Mellon (BK), Liberty Media (LMCK & LMCA), Liberty Global (LBTYA), and Visa (V).

One brand new position was also added during the quarter.

New Position
Apple (AAPL): 9.81 mil. shares; tot. stake $ 1.07 bil.

Berkshire's latest 13F-HR filing did not indicate any activity was kept confidential.

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.

Shares that were sold among positions worth more than $ 1 billion include the following:

Reduced Positions
Wal-Mart (WMT): 949 thous. shares (1% decr.); tot. stake $ 3.78 bil.

The other reduced positions include Procter & Gamble (PG) -- a direct result of the Duracell deal -- as well as Mastercard (M) and WABCO (WBC).

Sold Positions
Berkshire's position in AT&T (T) was sold outright. The position in Precision Castparts (PCP) is also naturally no longer showing up in the latest 13F as a result of the recently completed deal (where Berkshire purchased the company outright).

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.

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. Kraft Heinz (KHC) = $ 25.6 bil.
2. Wells Fargo (WFC) = $ 23.2 bil.
3. Coca-Cola (KO) = $ 18.6 bil.
4. IBM (IBM) = $ 12.3 bil.
5. American Express (AXP) = $ 9.3 bil.

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. The relatively new and very large stake in Kraft Heinz has, in fact, simply made the portfolio even more concentrated. In addition, Berkshire owns equity securities listed on exchanges outside the U.S., plus fixed maturity securities, cash and cash equivalents, and other investments.

The portfolio excludes all the operating businesses that Berkshire owns outright with ~ 361,000 employees (25 being at headquarters) according to the latest letter.

Here are some examples of Berkshire's 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, Berkshire Hathaway Automotive, and Oriental Trading Company.
(Among others.)

As mentioned above, Berkshire also recently added Precision Castparts as well as Duracell to it's expanding list of non-insurance businesses it owns outright.

In addition to the above businesses and investment portfolio, Berkshire's large insurance operation (BH Reinsurance, General Re, GEICO etc.) has historically been rather profitable while providing plenty of "float" for their investments.

See page 115 of the 2015 annual report for a more complete listing of Berkshire's businesses.

Adam

Long positions in BRKb, WFC, KO, AXP, PSX, and AAPL established at much lower than recent market prices. Also, long positions in WMT established at slightly lower than recent market prices and IBM established at somewhat higher than recent prices. (In each case compared to average cost basis.)

* All values shown are based upon the last trading day of the 1st quarter.
** Berkshire Hathaway's holdings of ADRs are included in the 13F. What is not included are shares listed on exchanges outside the United States. The status of those shares, if a large enough position, 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 is if Berkshire buys the ADR. Investments in things like preferred shares (and valuable warrants, where applicable, as explained in the recent letters) are also not included in the 13F.
---
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.

Buffett: The "Double-Barrel Effect"

Here's what Warren Buffett and Charlie Munger had to say about the necessity to buy more capital-intensive businesses -- something that's at odds with what they mostly did in their early days -- at the most recent Berkshire Hathaway (BRKa) shareholder meeting:

"The ideal business is one that takes no capital but yet grows...if you have a business that grows, and gives you a lot of money every year, and...it [capital] isn't required in its growth, you get a double-barrel effect: from the earnings growth that occurs internally without the use of capital, and then you get the capital it produces to go and buy other businesses.

And See's Candy was a good example of that."

He later added:

"Increasing capital acts as an anchor on returns in many ways."

I'd place the emphasis on "in many ways". When a business needs to continuously absorb lots of capital the number of options available to management get reduced. These fewer options can be especially devastating during a tough business transition (whether brought on by micro or macro factors).

Over shorter time horizons -- and,in my book, a few years or less qualifies as a shorter time horizon when it comes to equity investment -- the impact on returns may not be all that obvious. Full business cycle core economics become masked. (Especially during periods of exceptional prosperity whether industry-specific or more general.) It's over longer time frames, when the impact on compounding becomes the dominant influence on total returns (instead of trading market price action), that the "anchor" becomes increasingly plain as day. This doesn't mean there aren't good capital-intensive businesses; this does mean the risk-reward profile is necessarily unique and unwise to ignore.

Buffett also mentions that Berkshire has a few businesses that earn 100 percent on capital (and this was covered to an extent in the Berkshire annual report) while their energy business produces more like 11-12 percent per year.

"And that's a very decent return, but it's a different sort of animal than the business with very low capital-intensity."  

The problem isn't only that there aren't many high return on capital businesses available; it's whether the price is right and that they're large enough to matter considering Berkshire's scale.

It's also worth remembering that it's not just about judging if a business can produce high returns on capital now. What matters most is if that business will continue doing so for a very long time -- often far from easy to judge with enough warranted confidence.

Charlie Munger followed with this...

"...when our circumstances changed, we changed our minds. In the early days quite a few times, we bought a business that was soon producing 100 percent per annum on what we paid for it and didn't require much reinvestment. If we'd been able to continue doing that, we would have loved to do it. But when we couldn't we went to Plan B. And Plan B's working pretty well and in many ways, I've gotten so where I sort of prefer it."

I'm always a bit surprised just how often I'll see an analysis or opinion on a business that places little emphasis on the importance of this "double-barrel effect".

Making an investment without giving due consideration to returns on capital --along with how competitive dynamics and technology might reduce the advantages a business possesses in a way that drastically alters future returns on capital -- is, to me, just a misjudged investment in the making. I'd have no idea how to approach risking capital in such a way.

Return on capital is all-important yet, for some reason, other factors seem to get a great deal more attention instead by some market participants. All the energy that goes into how quarterly earnings and/or some new product might impact the near-term price action of a stock -- or, alternatively, how macro factors might influence the market as a whole -- comes to mind. This is, to me, attempting to consistently guess correctly what is nearly unguessable instead of focusing that energy more productively elsewhere.

In fact, just how infrequently returns on capital comes up when someone is making a case in favor of (or against) a particular equity investment is, to me, rather revealing.

A passing mention (or no mention at all) too often is the norm whether that case is being made in writing or otherwise.*

Now, return on capital certainly isn't the only thing that matters.

Equity investing will never be that straightforward.

It just needs to be given a proper weighting.

Every business and the industry will have many unique things to consider much of which will not be quantifiable.

Well, at the very least not in a precise manner.

There's much to think about with any investment and returns on capital is just one of many important considerations. That's why trying to understand every investment opportunity is usually a recipe for understanding nothing at all with sufficient depth.

It's inevitable that a potentially attractive investment opportunity will show up on someone's radar yet should be "missed" because it just happens to be outside that investor's comfort zone.

What to avoid is necessarily unique for each investor. Knowing what one doesn't know then buying only what's understandable -- at a plain discount, of course -- generally requires the right temperament, independent thinking, discipline, and an awareness of limits over pure genius.

Here's Buffett at the 2009 Berkshire meeting:

"If you have a 150 IQ, sell 30 points to someone else. You need to be smart, but not a genius. What's most important is inner peace; you have to be able to think for yourself. It's not a complicated game."

Those who do choose to extend beyond their comfort zone might find that justified conviction won't be there when it's needed most.

Adam

Long position in BRKb established at much lower than recent prices

Related posts:
High Returns on Capital vs High Returns on Incremental Capital
Not Picking Stocks By The Numbers
Buffett: Cigar Butts & Wonderful Businesses
Buffett: Severe Change, Exceptional Returns Don't Mix
Buffett: 57% Return on Equity Capital
Inexpensive Stock?
Circle of Competence
Inactive Investing

* I do not mean to paint with too broad a brush here. Obviously many capable investors give returns on capital the consideration it deserves.
---
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.

Bezos: The "Inseparable Twins" of Failure and Invention

Here's what Jeff Bezos had to say in the latest Amazon (AMZN) shareholder letter:

"This year, Amazon became the fastest company ever to reach $100 billion in annual sales. Also this year, Amazon Web Services is reaching $10 billion in annual sales … doing so at a pace even faster than Amazon achieved that milestone.

What's going on here? Both were planted as tiny seeds and both have grown organically without significant acquisitions into meaningful and large businesses, quickly. Superficially, the two could hardly be more different. One serves consumers and the other serves enterprises. One is famous for brown boxes and the other for APIs. Is it only a coincidence that two such dissimilar offerings grew so quickly under one roof? Luck plays an outsized role in every endeavor, and I can assure you we've had a bountiful supply. But beyond that, there is a connection between these two businesses. Under the surface, the two are not so different after all. They share a distinctive organizational culture that cares deeply about and acts with conviction on a small number of principles. I'm talking about customer obsession rather than competitor obsession, eagerness to invent and pioneer, willingness to fail, the patience to think long-term, and the taking of professional pride in operational excellence. Through that lens, AWS and Amazon retail are very similar indeed.

A word about corporate cultures: for better or for worse, they are enduring, stable, hard to change. They can be a source of advantage or disadvantage. You can write down your corporate culture, but when you do so, you're discovering it, uncovering it – not creating it. It is created slowly over time by the people and by events – by the stories of past success and failure that become a deep part of the company lore. If it's a distinctive culture, it will fit certain people like a custom-made glove. The reason cultures are so stable in time is because people self-select. Someone energized by competitive zeal may select and be happy in one culture, while someone who loves to pioneer and invent may choose another. The world, thankfully, is full of many high-performing, highly distinctive corporate cultures. We never claim that our approach is the right one – just that it's ours – and over the last two decades, we've collected a large group of like-minded people. Folks who find our approach energizing and meaningful.

One area where I think we are especially distinctive is failure. I believe we are the best place in the world to fail (we have plenty of practice!), and failure and invention are inseparable twins. To invent you have to experiment, and if you know in advance that it's going to work, it's not an experiment. Most large organizations embrace the idea of invention, but are not willing to suffer the string of failed experiments necessary to get there."

One of the more challenging aspects of investing is judging the value of qualitative factors. When the focus is only on the quantitative some of the most significant elements of intrinsic value can be missed.

It's worth noting that qualitative factors do not necessarily only materially add to value; they can and often do subtract in a big way.

Adam

No position in AMZN

Related posts:
Buffett and Munger Talk Retail Businesses, NFM, and Amazon
Washington Post Sold To Jeff Bezos
Amazon, Apple, and Intrinsic Value - Part II
Amazon, Apple, and Intrinsic Value
Negative Working-Capital Cycle
Amazon, Apple, and Margin of Safety
Amazing Amazon
Barron's on Bezos: Time to Reign in Amazon's CEO?
Amazon's Jeff Bezos On Inventing & Disrupting
Amazon Sells Kindle Fire Below Cost
Technology Stocks

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.

Flying Too Close To The Sun

Warren Buffett, in last year's Berkshire Hathaway (BRKa) special letter*, explained that conglomerates have been at times very popular but became especially so back in the 1960s:

"Since I entered the business world, conglomerates have enjoyed several periods of extreme popularity, the silliest of which occurred in the late 1960s."

This was covered, to an extent, in a post from late last year.

LTV -- a company once run by Jimmy Ling during that era -- is used as an example of a conglomerate structure that goes very wrong. From the letter:

"Through a lot of corporate razzle-dazzle, Ling had taken LTV from sales of only $36 million in 1965 to number 14 on the Fortune 500 list just two years later. Ling, it should be noted, had never displayed any managerial skills. But Charlie told me long ago to never underestimate the man who overestimates himself. And Ling had no peer in that respect.

Ling's strategy...was to buy a large company and then partially spin off its various divisions. In LTV’s 1966 annual report, he explained the magic that would follow: 'Most importantly, acquisitions must meet the test of the 2 plus 2 equals 5 (or 6) formula.' The press, the public and Wall Street loved this sort of talk.

In 1967 Ling bought Wilson & Co., a huge meatpacker that also had interests in golf equipment and pharmaceuticals. Soon after, he split the parent into three businesses, Wilson & Co. (meatpacking), Wilson Sporting Goods and Wilson Pharmaceuticals, each of which was to be partially spun off. These companies quickly became known on Wall Street as Meatball, Golf Ball and Goof Ball.

Soon thereafter, it became clear that, like Icarus, Ling had flown too close to the sun. By the early 1970s, Ling's empire was melting, and he himself had been spun off from LTV . . . that is, fired.

Periodically, financial markets will become divorced from reality – you can count on that. More Jimmy Lings will appear. They will look and sound authoritative. The press will hang on their every word. Bankers will fight for their business. What they are saying will recently have 'worked.' Their early followers will be feeling very clever. Our suggestion: Whatever their line, never forget that 2+2 will always equal 4. And when someone tells you how old-fashioned that math is --- zip up your wallet, take a vacation and come back in a few years to buy stocks at cheap prices."

So a bit of healthy skepticism comes in handy when some repackaged business strategy is being promoted aggressively (especially when bankers and the press fan the flames). This is especially true when questionable accounting and aggressive financing comes into play.

CEO behavior can have a huge impact on intrinsic business value especially over the very long haul. The good news is that plenty of extremely capable business executives are out there. Unfortunately, personality and salesmanship sometimes get in the way of making a sound judgment about a CEOs overall talents. For investors, it's vital to I.D. situations beforehand that lead to inflated perceived prospects and, at least for a time, a valuation that reflects the flawed perception.

The specifics may vary but it almost always is wise to avoid of investing in -- or, at times, alongside -- those who tend to overestimate themselves no matter how smart someone is (or seems to be).

"Smart, hard-working people aren't exempted from professional disasters from overconfidence. Often, they just go aground in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods." - Charlie Munger speech to the Foundation Financial Officers Group

"We recognized early on that very smart people do very dumb things, and we wanted to know why and who, so we could avoid them." - Charlie Munger at the 2007 Berkshire Hathaway Shareholder Meeting

"If you think your IQ is 160 but it's 150, you're a disaster. It's much better to have a 130 IQ and think it's 120." - Charlie Munger at the 2009 Berkshire Hathaway Shareholder Meeting

"If you have a 150 IQ, sell 30 points to someone else. You need to be smart, but not a genius. What's most important is inner peace; you have to be able to think for yourself. It's not a complicated game." - Warren Buffett at the 2009 Berkshire Hathaway Shareholder Meeting

Humility and knowing what you don't know can go a long way in investing.

Adam

Long position in BRKb established at much lower than recent market prices

Related posts:
Berkshire's Structure: Why It Works
Corporate Hocus-Pocus
Charlie Munger: Focus Investing and Fuzzy Concepts
Grantham & Buffett: "Career Risk" & "The Institutional Imperative"
Buffett on "The Institutional Imperative"
Buffett: A Portrait of Business Discipline
Buffett on Bold & Imaginative Accounting
Charlie Munger on LTCM & Overconfidence
When Genius Failed...Again

* This is Buffett's special letter that was written for the 50th Anniversary of Berkshire. Munger also wrote a separate letter to recognize this Golden Anniversary. These can also be found at the end of the regular letter (page 24 and 39 respectively).
---
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.

Buffett on Stock-Based Compensation

From Warren Buffett's recently released 2015 Berkshire Hathaway (BRKa) shareholder letter:

"...it has become common for managers to tell their owners to ignore certain expense items that are all too real. 'Stock-based compensation' is the most egregious example. The very name says it all: 'compensation.' If compensation isn't an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?

Wall Street analysts often play their part in this charade, too, parroting the phony, compensation-ignoring 'earnings' figures fed them by managements. Maybe the offending analysts don’t know any better. Or maybe they fear losing 'access' to management. Or maybe they are cynical, telling themselves that since everyone else is playing the game, why shouldn’t they go along with it. Whatever their reasoning, these analysts are guilty of propagating misleading numbers that can deceive investors."

I've covered this subject to an extent in prior posts. Ignoring these very real costs -- especially when it comes to evaluating those businesses that happen to be highly dependent on stock-based compensation -- can lead to vastly different estimates of per share intrinsic value. It's possible that the tendency to ignore such expenses is at least in part related to what Jeremy Grantham has called "career risk" and Warren Buffett has described as "the institutional imperative".

The risk of permanent capital loss can to an extent be mitigated by using conservative assumptions about future business prospects. That way, if the least optimistic scenario -- or, worse yet, the supposed worst case turns out to be too optimistic -- is what plays out, the investor is at least somewhat protected.
(There'll obviously be no complaints if prospects prove to be surprisingly good.)

So estimate value conservatively then purchase shares when market price represents a nice discount to that estimate.

Ignoring a whole category of expenses such as stock-based compensation is hardly consistent with such a recipe.

Why there'd be a willingness to overlook -- by those who should be some of the most informed and knowledgeable no less -- what is, especially for certain tech stocks, too often a rather large expense is well worth understanding (for reasons that include but extend far beyond investing).

Estimating what'll end up being the true cost of stock-based compensation beforehand is not easy to do in a precise manner. Yet that reality doesn't justify pretending the costs don't exist at all. For investors, difficult to measure factors are often important to consider with stock-based compensation being just one of many. The correct response to this necessary imprecision is to make -- or at least attempt to make -- a rough but meaningful estimate. Existing accounting standards will always have their limitations, but at least can provide a useful starting point for the investor.

This ultimately gets back to the broader subject of risk. Investing competently starts with staying away from what's not well understood by the investor. No margin of safety should be considered large enough when outside one's comfort zone.

Sometimes it's necessary to avoid an investment with otherwise lots of potential upside because the worst case is intolerable. In other words, a known, if improbable, yet totally unacceptable outcome exists so no margin of safety seems large enough. Howard Marks has has said "I have no interest in being a skydiver who's successful 95% of the time."

That's a useful way to think about it. The outcome 5% of the time is just unacceptable no matter how good things go the other 95% of the time.

Some choose to treat volatility as a proxy for risk.

If risk analysis were only that straightforward.

It's just not and never will be.

Since, for investors, much of what matters can't be precisely quantified, it's the qualitative factors that end up deserving at least as much if not a whole lot more attention. As Charlie Munger once said:

"...practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that."

Just because something is tough to quantify doesn't necessarily reduce its significance.

Adam

Long position in BRKb established at much lower than recent market prices

Related posts:
Earnings Inflation
Howard Marks on Risk
Stock-based Compensation: Impact On Tech Stock P/E Ratios
Big Cap Tech: 10-Year Changes to Share Count
Grantham & Buffett: "Career Risk" & "The Institutional Imperative"
Buffett on "The Institutional Imperative"
Technology Stocks
Time for Dividends in Techland
Munger on Accounting

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.

Berkshire Hathaway 4th Quarter 2015 13F-HR

The Berkshire Hathaway (BRKa) 4th Quarter 13F-HR was released yesterday. 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 3rd Quarter 13F-HR.)

There was both some buying and selling during the quarter. Here's a quick summary of the changes:*

Added to Existing Positions
Wells Fargo (WFC): 9.41 mil. shares (2% incr.); tot. stake $ 26.1 bil.
Deere & Co. (DE): 5.83 mil. shares (20%); tot. stake $ 1.75 bil.

I've included above only those positions worth at least $ 1 billion at the end of the 4th quarter. In a portfolio this size -- more than $ 246 billion (equities, fixed income, cash, and other investments) as of the latest available filing with roughly half made up of common stocks** -- a position that's less than $ 1 billion doesn't really move the needle much.

Shares that were bought among positions worth less than $ 1 billion include Axalta Coating Systems (AXTA), Liberty Global (LBTYA), and an entirely

One relatively small brand new position was also added during the quarter.

New Position
Kinder Morgan (KMI): 26.5 mil. shares; tot. stake $ 396 mil.

Berkshire's latest 13F-HR filing did not indicate any activity was kept confidential.

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
AT&T (T): 12.7 million shares (21% decr.); tot. stake $ 1.60 bil.

The only other reduction was Berkshire's relatively small position in WABCO (WBC).

Sold Positions
Berkshire's position in Chicago Bridge & Iron (CBI) was sold outright.

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.

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) = $ 26.1 bil.
2. Kraft Heinz (KHC) = $ 23.7 bil.
3. Coca-Cola (KO) = $ 17.2 bil.
4. IBM (IBM) = $ 11.2 bil.
5. American Express (AXP) = $ 10.5 bil.

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. The relatively new and very large stake in Kraft Heinz has, in fact, simply made the portfolio even more concentrated. In addition, Berkshire owns equity securities listed on exchanges outside the U.S., plus fixed maturity securities, cash and cash equivalents, and other investments.

The portfolio excludes all the operating businesses that Berkshire owns outright with ~ 340,000 employees (25 being at headquarters) according to the latest letter. Numbers like these -- along with many other things of interest especially for Berkshire shareholders -- should be updated in the next annual report and letter.

Here are some examples of Berkshire's 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, and Oriental Trading Company.
(Among others.)

Berkshire recently added Precision Castparts to it's expanding list of non-insurance businesses it owns outright. At approximately $37.2 billion (including outstanding net debt), this purchase is a significant one even for an enterprise the size of Berkshire. The deal was announced in August of last year and completed in January of this year.

Also, earlier in 2015, Berkshire acquired the Van Tuyl Group, the largest privately held auto dealership in the United States.

In addition to the above businesses and investment portfolio, Berkshire's large insurance operation (BH Reinsurance, General Re, GEICO etc.) has historically been rather profitable (underwriting profits for 12 consecutive years through 2014) while providing plenty of "float" for their investments.

See page 125 of the 2014 annual report for a more complete listing of Berkshire's businesses.

Adam

Long positions in BRKb, WFC, KO, and AXP established at much lower than recent market prices. Also, long position in IBM established at higher than recent market prices. (In each case compared to average cost basis.)

* All values shown are based upon the last trading day of the 4th quarter.
** Berkshire Hathaway's holdings of ADRs are included in the 13F. What is not included are shares listed on exchanges outside the United States. The status of those shares, if a large enough position, 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 is if Berkshire buys the ADR. Investments in things like preferred shares (and valuable warrants, where applicable, as explained in the recent letters) are also not included in the 13F.
---
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.

Berkshire's Structure: Why It Works

Conglomerates, according to Warren Buffett, "have a terrible reputation with investors" that they "richly deserve".

I covered this, at least to an extent, in a post late last year.

So, if that's the case, why does the conglomerate structure work -- when it comes to maximizing the growth of capital over the long haul -- for Berkshire Hathaway (BRKa) but not some other companies?

It comes down to, at least in part, whether investors can generally count on the wise allocation of capital on a consistent basis (and, ideally, with many decades in mind).

Unfortunately, intelligent capital allocation in the real world is far from a given. Warren Buffett, in his 2014 Berkshire special letter*, uses the textile industry as one example:

"...capital withdrawals within the textile industry that should have been obvious were delayed for decades because of the vain hopes and self-interest of managements. Indeed, I myself delayed abandoning our obsolete textile mills for far too long."

He also points out that taxes and frictional costs are a big factor because "mouths with expensive tastes...clamor to be fed – among them investment bankers, accountants, consultants, lawyers and such capital-reallocators as leveraged buyout operators. Money-shufflers don't come cheap."

Now here's how Buffett goes on to explain Berkshire's advantages:

"...a conglomerate such as Berkshire is perfectly positioned to allocate capital rationally and at minimal cost. Of course, form itself is no guarantee of success: We have made plenty of mistakes, and we will make more. Our structural advantages, however, are formidable.

At Berkshire, we can – without incurring taxes or much in the way of other costs – move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise. Moreover, we are free of historical biases created by lifelong association with a given industry and are not subject to pressures from colleagues having a vested interest in maintaining the status quo. That's important: If horses had controlled investment decisions, there would have been no auto industry.

Another major advantage we possess is the ability to buy pieces of wonderful businesses – a.k.a. common stocks. That's not a course of action open to most managements. Over our history, this strategic alternative has proved to be very helpful; a broad range of options always sharpens decision-making. The businesses we are offered by the stock market every day – in small pieces, to be sure – are often far more attractive than the businesses we are concurrently being offered in their entirety. Additionally, the gains we've realized from marketable securities have helped us make certain large acquisitions that would otherwise have been beyond our financial capabilities.

In effect, the world is Berkshire's oyster – a world offering us a range of opportunities far beyond those realistically open to most companies. We are limited, of course, to businesses whose economic prospects we can evaluate. And that's a serious limitation: Charlie and I have no idea what a great many companies will look like ten years from now. But that limitation is much smaller than that borne by an executive whose experience has been confined to a single industry. On top of that, we can profitably scale to a far larger size than the many businesses that are constrained by the limited potential of the single industry in which they operate."

One of Berkshire's businesses, See's Candy, produces lots of earning power yet requires a rather small amount of capital. Unfortunately, it doesn't internally have many good uses for all the excess cash it produces. Buffett, using See's as an example of how excess capital can be moved from where it can't be put to good use to where it can be, explains it this way:

"We would have loved, of course, to intelligently use those funds to expand our candy operation. But our many attempts to do so were largely futile. So, without incurring tax inefficiencies or frictional costs, we have used the excess funds generated by See's to help purchase other businesses. If See's had remained a stand-alone company, its earnings would have had to be distributed to investors to redeploy, sometimes after being heavily depleted by large taxes and, almost always, by significant frictional and agency costs."

It seems like a structure like Berkshire should be more common but, well, it's just not. Another advantage Buffett covers is that Berkshire has become the "home of choice" for some great businesses. Berkshire is unique in that it offers a place where a "company's people and culture" has the best chance to remain in tact even if, inevitably, personnel changes will occur.

The compounded effect of wise capital allocation and low frictional costs is not small even if, due to its sheer size, Berkshire can longer compound at anywhere near as high a rate as it has in the past.

Adam

Long position in BRKb established at much lower than recent market prices

Related posts:
Corporate Hocus-Pocus
Charlie Munger: Focus Investing and Fuzzy Concepts
Grantham & Buffett: "Career Risk" & "The Institutional Imperative"
Buffett on "The Institutional Imperative"
Buffett: A Portrait of Business Discipline
Buffett on Bold & Imaginative Accounting

* This is Buffett's special letter that was written for the 50th Anniversary of Berkshire. Charlie Munger also wrote a separate letter to recognize this Golden Anniversary. These can also be found at the end of the regular letter (page 24 and 39 respectively).
---
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.

Quotes of 2015

Here's a collection of quotes said or written at some point during 2015.

John Bogle on Investor Returns
"Advisers or whoever saying you should get out of healthcare and into technology or into financials. That's a way to manage money that doesn't work. Who knows what will do best? I don't even know anybody who knows anybody who does." - John Bogle

Stocks and Risk
"Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray." - Warren Buffett

Investment Sins
"Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to 'time' market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy." - Warren Buffett

Berkshire's Architect
"What most of you do not know about Charlie [Munger] is that architecture is among his passions. Though he began his career as a practicing lawyer...he designed the house that he lives in today – some 55 years later. (Like me, Charlie can't be budged if he is happy in his surroundings.) In recent years, Charlie has designed large dorm complexes at Stanford and the University of Michigan and today, at age 91, is working on another major project.

From my perspective, though, Charlie's most important architectural feat was the design of today's Berkshire. The blueprint he gave me was simple: Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices." - Warren Buffett

What's Gold Intrinsically Worth? 
"You don't want to be one of these people, spending years telling reality that it is wrong." - Jason Zweig

Buffett on Value vs Growth 
"I always say if you aren't investing for value, what are you investing for? And the idea that value and growth are two different things makes no sense. I mean, growth is part of the value equation and a company that grows and uses little capital in doing it...is obviously worth more money than one that doesn't grow. That doesn't make the one that doesn't grow valueless though." - Warren Buffett

Bogle on Speculation 
"It's just speculators not speculating on what they think is going to happen but what they think other speculators think is going to happen..." - John Bogle

"This speculative binge that we're seeing here … has nothing to do with the fundamentals behind the long-term value of equities in particular, which are created by the values of corporations, earnings and dividends, and reinvestment in the business." - John Bogle

Activists & the AmEx Buyback, Part II 
"People assume when we buy some stock we want it to go up. We don't want it to go up. Maybe, obviously, eventually... five or ten years from now [we'd like it]." - Warren Buffett

Corporate Hocus-Pocus 
"Berkshire is now a sprawling conglomerate, constantly trying to sprawl further.

Conglomerates, it should be acknowledged, have a terrible reputation with investors. And they richly deserve it." - Warren Buffett

"Since I entered the business world, conglomerates have enjoyed several periods of extreme popularity, the silliest of which occurred in the late 1960s. The drill for conglomerate CEOs then was simple: By personality, promotion or dubious accounting – and often by all three – these managers drove a fledgling conglomerate's stock to, say, 20 times earnings and then issued shares as fast as possible to acquire another business selling at ten-or-so times earnings. They immediately applied 'pooling' accounting to the acquisition, which – with not a dime's worth of change in the underlying businesses – automatically increased per-share earnings, and used the rise as proof of managerial genius. - Warren Buffett

Munger on Efficient Markets, Indexing, & Stock Pickers 
"They were teaching my colleagues that the stock market was so efficient that nobody could beat it....I knew it was bull. When I was young I never went near a business school so I didn't get polluted by the craziness.

[laughter]

I never believed it. I never believed there was a talking snake in the Garden of Eden. I had a gift for recognizing twaddle, and there's nothing remarkable about it. I don't have any wonderful insights that other people don't have. I just avoided idiocy slightly more consistently than others." - Charlie Munger

Happy New Year,

Adam

Quotes of 2014 Part I & II 

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.