Warren Buffett wrote, in the 1989 Berkshire Hathaway (BRKa) shareholder letter, the following about its new investment -- well, at least at the time -- in Coca-Cola (KO):
This Coca-Cola investment provides yet another example of the incredible speed with which your Chairman responds to investment opportunities, no matter how obscure or well-disguised they may be. I believe I had my first Coca-Cola in either 1935 or 1936. Of a certainty, it was in 1936 that I started buying Cokes at the rate of six for 25 cents from Buffett & Son, the family grocery store, to sell around the neighborhood for 5 cents each. In this excursion into high-margin retailing, I duly observed the extraordinary consumer attractiveness and commercial possibilities of the product.
I continued to note these qualities for the next 52 years as Coke blanketed the world. During this period, however, I carefully avoided buying even a single share, instead allocating major portions of my net worth to street railway companies, windmill manufacturers, anthracite producers, textile businesses, trading-stamp issuers, and the like. (If you think I'm making this up, I can supply the names.) Only in the summer of 1988 did my brain finally establish contact with my eyes.
...Of course, we should have started buying Coke much earlier, soon after Roberto and Don began running things. In fact, if I had been thinking straight I would have persuaded my grandfather to sell the grocery store back in 1936 and put all of the proceeds into Coca-Cola stock. I've learned my lesson: My response time to the next glaringly attractive idea will be slashed to well under 50 years.
If a business is durable enough you can afford to be "too late" on an investment. KO is up over 700% (700% excluding dividends but the total return would be over 1,000% if you include the dividend payments) since Berkshire bought the stock back in 1988.
There is a good probability that KO will increase in value just fine over the next twenty years.
Adam
Long KO and BRKb
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Thursday, May 28, 2009
Tuesday, May 26, 2009
Best Performing Mutual Funds - 20 Years
"By periodically investing in an index fund..... the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb.
On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you." - Warren Buffett in the 1993 Berkshire Hathaway (BRKa) Shareholder Letter
There are many thousands of open-ended mutual funds -- as well as an increasing number of exchange-traded funds (ETFs) -- to choose from for a retail investor these days.
This article, from 2007, lists the 20 best-performing open-ended mutual funds over a 20-year period. The number one fund (Vanguard Healthcare: VGHCX) produced a 16.84% annualized 20-year return. A 20-year record like those listed in this article is certainly no small accomplishment for a money manager.
Having said that, with all the funds to choose from, it is unlikely that an investor would have a mutual fund portfolio that performs anywhere near this well in the real world. Why?
First, the probability that an investor would have chosen (and held onto through the ups and downs) one of these 20 among all available funds is low (of course, there are quite a few others that did very well compared to a benchmark that just did not quite make this list). The fact is many funds do not even keep up with the S&P 500 because of fees, taxes, too much trading activity, and, well, poor investment decision-making.
Second, mutual fund investors themselves can be their own worst enemy. There's plenty of evidence that investors tend to buy more during the good times and sell during the not-so-good times which erodes long-term returns. So what fund investors actually earn ends up being much lower than the funds themselves.
The reason is simple: Investors attempt to time their investments and redemptions, often unsuccessfully.
They buy when others are fearless....sell the opposite. Not good.
From this extract of DALBAR's Quantitative Analysis of Investor Behavior (QAIB) that looked at 20-year returns through 2007:
"The results have shown, to varying degrees, that the average investor earns significantly less than mutual fund performance reports suggest...Investment return is far more dependent on investor behavior than on fund performance. Mutual fund investors who hold their investments typically earn higher returns over time than those who time the market."
Here are the results from DALBAR's more recent QAIB. According to the latest QAIB, the S&P 500 returned 8.35% over the 20 years that ended in 2008 while, on average, equity fund investors earned just 1.87% (less than the inflation rate of 2.89%). From this DALBAR press release:
"The dramatic events that continue to plague our financial markets have provoked panic, which exacerbates the ongoing carnage," said Lou Harvey, president of DALBAR. "For 15 years, QAIB has shown that investor returns lag what performance reports and prospectuses would lead one to believe is achievable. While those returns are, in fact, theoretically achievable, the reality is that investors are not rational, and make buy and sell decisions at the worst possible moments," he said.
Now, consider that each of the following boring stocks -- those often described as "defensive" -- produced total returns (incl. dividends) competitive with or better than the 20 best-performing funds over the same 20-year period.
Procter & Gamble (PG)
Pepsi (PEP)
Coca-Cola (KO)
That's just three examples. There are certainly others. Also, this isn't the only longer time horizon (i.e. choose another ~ 20-year period) that the above stocks -- along with others that have similar business characteristics -- have performed just fine. In other words, it's not unusual to find more than solid performance in other similarly long time frames even if that, of course, guarantees nothing going forward.
Now, while many of these boring stocks seem rather unlikely to do as well going forward on an absolute basis, their relative merits -- especially the best of these -- remain not insignificant.
(I mean, it would seem more than a little unwise to view that particular 20-year period as being anything less than exceptional; better to have more conservative expectations built into the investment process. There'll be no complaints if it turns out that being more optimistic was warranted.)
These are not just defensive stocks, they are quality businesses with attractive and durable core long-term economics. My preference among so-called defensive stocks (though there are certainly some fine alternatives) happens to be Philip Morris International (PM), and Diageo (DEO) despite the fact that they lack easy to confirm 20-year historical performance.*
Again, just because something that seems to be a higher quality investment has done well in the past guarantees nothing. Still, it's likely a mistake to discount these results as being just some one time anomaly or random real world special case without, at least, digging into this a bit deeper.
There are exceptions, of course, but generally the companies like Coca-Cola -- those that make and distribute leading branded small-ticket consumer products on a big scale -- have attractive long-term economics. The best among them are compounding machines that need not be traded (in fact, it's the attempt at trading that will likely hurts returns) though, as always, buying with a margin of safety matters. That means, for example, they can't be bought blindly at a time like the bubble of the late 1990s (it wasn't just tech stocks that were expensive) or during the "Nifty Fifty" era of the early 1970s. In both cases, stocks like Coca-Cola were selling at extraordinarily high multiples of earnings (30, 40, 50 times earnings and even higher). An investor can't pay that much and expect a good long-term result no matter how fine the companies themselves may be.
Otherwise, it's just not all that complicated.
"...most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising 'Take two aspirins'." - Warren Buffett in the 1987 Berkshire Hathaway Shareholder Letter
"There seems to be some perverse human characteristic that likes to make easy things difficult." - Warren Buffett in the Superinvestors of Graham-and-Doddsville
The easy to confirm fact that shares of businesses with great brands and strong distribution have produced such attractive long run returns should be at least noteworthy and, for those curious, deserving of further investigation.**
Those producing the stuff typically found in a cupboard, refrigerator, and medicine cabinet have performed very well (with less risk I think it is safe to say when bought at an attractive valuation) long-term compared to alternatives because they have historically had favorable economics (attractive return on capital).
They've generally had and the best are likely to continue having difficult to disrupt durable competitive advantages.
Has something fundamentally changed their long-term core economics? If not, intrinsic business value should still increase at a satisfactory or better rate over time. A bit boring, maybe, but potentially attractive returns in the long run nonetheless.
My point, in part, is that there's a cost to complexity. When a relatively simple (not easy) approach is likely to produce results similar to (or better than) the more complex one, it's the more straightforward one that is preferable.
Now, it's true that a bunch of investors would do better relying on the skills of a capable money manager (as long as the fees are reasonably low and their own behavior doesn't get in the way of long-term performance). There are certainly some very talented money managers out there. The problem is that too many individual investors do not actually benefit from the expertise. Some of this comes down to investor behavior as pointed out in DALBAR's QAIB, but part of the problem is it's just not that easy to figure out which funds are likely to provide attractive risk-adjusted returns going forward.
Also, professional money managers certainly do, on average, underperform the S&P 500 index over the long haul. According to Vanguard founder John Bogle, from 1984 to 2002 the average stock mutual fund delivered a 9.3% annual return compared to the S&P 500's return of 12.2% a year.
"The reason for that lag is not very complicated: As the trained, experienced investment professionals employed by the industry's managers compete with one another to pick the best stocks, their results average out. Thus, the average mutual fund should earn the market's return—before costs. Since all-in fund costs can be estimated at something like 3% per year, the annual lag of 2.9% in after-cost return seems simply to confirm that eminently reasonable hypothesis." - John Bogle
It gets worse. During that same period the average fund investor, according to DALBAR, earned just 2.6% a year.
(Again, the average fund investor underperformance is largely due to ill-timed buy/sell decisions and fund selection. In other words, a timing penalty and a selection penalty. Bogle adds why he thinks the DALBAR study might actually overstate the annual returns. See his explanation under the Is the DALBAR Study Accurate? section for more details.)
So the sub-par returns were a combination of both fund performance and investor behavior. Also, it's not just that the average mutual fund does poorly compared to a broad-based index. It's quite a bit worse than that. Bogle wrote the following back in 2007:
"The percentage of managers outperformed by the broad market index is, well, time-dependent. On a given day, it's likely about 55%; over a year maybe 60-65%, over a decade perhaps 75-80%, and over 50 years...well, there's no data (yet!) on that!
But the probability statistics suggest that over a 50-year period, some 98% of managers will lose to the market index."
There's a good chart in Bogle's "Little Book" (page 124) that covers this.
Even if the probabilities are somewhat better than what Bogle suggests, those numbers are pretty daunting to say the least. Not seriously considering the implications in the context of one's own investing approach seems unwise. Here's what Jack Meyer, who managed the endowment, pension, and other assets as President and CEO of the Harvard Management Company from 1990 to 2005, had to say:
"Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 percent to 90 percent of managers fail to match their benchmarks. Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value."
I do find it interesting that there are many professional money managers and traders (some of them frequently appearing on various business news media outlets) recommending various, sometimes rather complex, investing and trading strategies.
It's easy to imagine and expect with all the expertise on display that quite a few of them must seriously outperform. In particular, some might reasonably expect them to outperform a participant who just buys -- at a reasonable price -- and holds long-term the stocks of companies that make the stuff found in a typical cupboard, refrigerator, and medicine cabinet.
(Well, at least those participants who understand business economics, are able to identify sustainable competitive advantages, have a price versus value discipline, while controlling their emotions during inevitable market fluctuations. Not complicated but, based upon investor behavioral patterns revealed in studies, apparently not easy for many to accomplish either.)
Yet, the verifiable evidence at least suggests that many pros do not, over a long time horizon, beat high quality stocks (or the market as a whole) bought when prices are reasonable or better. Also, for those experts that do outperform, there's just no easy way to separate the future fund "winners" from the mediocre (or worse).
It's possible, I suppose, that there are many participants employing various highly "sophisticated" investing/trading strategies who do actually outperform but just happen to be those that cannot be easily verified via SEC filings or confirmed by studies like the above.
Count me as skeptical of this based upon the evidence.
By the way, there's a long list of pros who approach the business using sound investing principles and a number outperform their benchmark.
I don't think the job of a money manager is an easy one. First, they all have to overcome those fees and transaction costs to outperform. In addition, more than a few highly active professional managers ignore the wisdom of Newton's 4th law or are forced to focus on near-term results (in order to keep assets under management stable and, well, keep their jobs) possibly to the detriment of long-term mutual fund investors. Some of this comes down to what has become a hyperactive, casino-oriented, trading culture that now permeates the capital markets. Too many seem to dismiss (or ignore) the merits of what Warren Buffett and Charlie Munger have been saying and doing for a very long time (their ~ 20%/year annualized returns over five decades is no accident). In my view, no small number of professional money managers (and academics) still pick and choose what they like about the Berkshire approach while conveniently ignoring (or inconveniently if you're an investor in a fund) important aspects of their investing principles.
Attractive returns can be achieved (though, as Bogle rightly points out, aren't likely to be achieved by most) by just paying a fair price for 5-10 good businesses and holding them for a very long time. At least that is the case for those who are comfortable with, and capable of, picking individual marketable stocks. It's a simple approach but that doesn't make it an easy one. For some, even more diversification may be necessary but consider this:
"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." -Charlie Munger in a 1998 Speech to the Foundation Financial Officers Group
The quote at the beginning of this post makes it pretty clear that Buffett holds a similar view. For those with a long enough investing horizon but lack the background to effectively pick individual securities, something like an index fund, traded minimally, makes a whole lot of sense.
John Bogle has long been a proponent of passive investing over more active styles. He has been providing lots of very wise advice along these lines to investors for a very long time. Too few pay attention to it.***
Otherwise, when considering stocks, the hard part is not necessarily figuring out what to buy. The difficulty comes down to whether the individual has the discipline, temperament, and patience to buy -- and hold long-term -- with enough margin of safety what they understand while ignoring the daily price fluctuations. In fact, since bear markets are inevitable, ideally it's best to be buying/accumulating more shares of high quality businesses -- what the investor knows the best and likes the most -- whenever the news is rather terrible. It's easy to make the mistake of overestimating one's own ability to do this.
No matter what it is best to avoid an excessive amount of trading activity. The trades create not only frictional costs but also more chances to make costly mistakes.
(There's a tendency -- due to overconfidence and overestimation of abilities -- to overweight the upside possibilities of a trading decision and underweight the downside. The net result can be costly.)
So buying shares of good businesses at a discount doesn't assure long-term outperformance. Certainly not. It's just that the possibility of achieving good risk-adjusted results improves over the long haul if:
1) an investor knows how to figure out, within a range, what a good business is worth, and
2) if that investor routinely pays a nice discount to per share value for it.
It's the partial long-term ownership of high quality businesses, compounding intrinsically in value over time, while avoiding meaningful mistakes. Mistake avoidance, especially those that result in permanent loss of capital, is key to the success that comes from this style of investing.
What's more doable?
A) Correctly picking, buying, and holding the actively managed mutual funds that will be the long-term top performers among the thousands of funds.
(Finding needles in a haystack.)
B) Buying shares of 5-10 (or, for those who prefer or require more diversification, maybe somewhat more) of the great business franchises -- those that are understood well when available at a discount to value -- then holding them for 20 years and, ideally, even longer. The returns for investors come via per share intrinsic value growth of the businesses not trying to own the right stocks or sectors at just the right time. In other words, no unusual trading skills (in fact, minimal trading is a must) or capacity to time the market is required.
(Identifying the highest quality businesses, those with modest debt and great brands/strong distribution, seems more akin to finding needles in a stack of needles. Well, at least for an investor who feels comfortable enough in their ability to understand business economics. Otherwise, identifying the strongest producers of small-ticket consumer goods is not exactly tough to do. Now, having the patience and discipline that's required to only buy shares in meaningful amounts when they're selling at a nice discount can be very challenging.)
C) Accumulating the shares of an index fund that has very low expenses steadily over time.
Whether A, B, or C makes more sense comes down to individuals capabilities and circumstances. No one should be buying stocks if it's not in their own comfort zone. Investing effectively mostly involves realistically assessing one's own limits and staying well within those limits. Based upon the evidence, it seems quite likely that C makes sense for a whole bunch of investors.
There are many fine mutual funds and talented professional managers out there. Yet, it can be far from easy to differentiate between who'll deliver above average and subpar results prospectively.
The long-term strengths and merits of a company like Coca-Cola against its peers seems to me, by comparison, relatively straightforward. Well, at the very least, it happens to be in my own investing comfort zone even if it doesn't necessarily make sense otherwise. Bogle's advice ought to get heavy consideration before venturing into individual stocks. It certainly influences my approach though the fact that I'm buying individual stocks would seem to suggest that's not the case. Here's how it fits in rather nicely. My own view is that index funds, traded minimally, outperform mostly because 1) frictional costs are kept low, and 2) the driver of returns is the long run per share intrinsic value increases of the many businesses in the index.
Basically, investors are kept from being their own worst enemy and incurring excessive frictional costs.
Well, it's possible to also minimize frictional costs in a much more concentrated equity portfolio while similarly allowing the per share intrinsic business value, as it increases, to be the primary driver of returns. The main downside, at least in the view of some, is increased risk due to lack of diversification but, once again:
"We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it." - Warren Buffett in the 1993 Berkshire Hathaway Shareholder Letter
So I think the approach has more in common with what Bogle has often recommended than it may seem to at first glance. An index fund isn't really the only way to invest in a relatively passive manner (passive trading-wise not homework-wise). The diversification debate is a legitimate one, but it's possible to own a concentrated, though otherwise relatively passively managed, equity portfolio. The approach has similar benefits to indexation -- low frictional costs, fewer investor mistakes, returns primarily from increases to intrinsic business value over a very long time horizon. Well, at least that's the case for those who understand business economics and can identify durable advantages while consistently buying shares at a discount to conservatively estimated value. It's a passive approach because, while there's lots of work that goes into understanding and valuing the businesses themselves, there's little in the way of trading activity.
No matter what the right long-term investment vehicle(s) might be (it's necessarily different for each individual) the key is always to avoid the temptation to trade excessively.
Based upon experience, I don't expect to convince many market participants of this.
Adam
Long positions in BRKb, PG, PEP, KO, PM, and DEO
Related posts:
Staples vs Cyclicals
Best and Worst Performing DJIA Stock
Defensive Stocks?
* A 16 percent annualized total returns (incl. dividends) over 20 years will turn a $ 10,000 investment into just under $ 200,000. Each of these stocks produced returns, give or take, in that ballpark. Now, it's not as if anything like these kind of returns will occur over the next twenty years. For lots of reasons that seems extremely unlikely. The very best funds will almost certainly do better. It's just that the best of these types of businesses (those with durable and attractive returns on capital) have a good chance of doing very well over a 20-year time frame at comparably low risk, as long as trading activity is minimized, and they're bought at reasonable valuations. As mentioned above, my preference happens to be PM and DEO but think highly of, even if to a lesser extent, the other stocks I've established long positions in (as noted above) when bought at the right price. PM and DEO do lack a convenient way to check their 20-year historical performance since they've not been trading as separate marketable stocks long enough. That comparative lack of historical performance doesn't negate their durable advantages, sound core business economics, and generally favorable long-term prospects. It's worth noting that PM, DEO, and PEP are each part of the Six Stock Portfolio.
** These higher quality businesses don't need to always outperform (and likely will not) the top 20 funds over a twenty year period to be worthwhile. Even if shares of the higher quality businesses did not outperform over the long haul going forward (and they may not, of course), the sheer simplicity of the approach compared to alternatives needs to be considered. So does the reduced likelihood of permanent capital loss and more narrow range of outcomes. In fact, if the quality franchises produced merely market returns they'd still win in my book. The reason is that, if bought well, the same return will have been arguably achieved at less risk of permanent capital loss (not temporary paper losses). Now, anyone buying the higher quality stocks expecting them to outperform during the next bull market will likely be disappointed. Look elsewhere for exciting price action. That is, in part, how they have earned the reputation of being defensive. Yet, this reputation is verifiably incorrect when you look at the historic returns of these stocks over the longer haul (at least a business cycle or two). Otherwise, the fact that they've delivered attractive risk-adjusted returns, rather passively, seems like more than just merely an intriguing aberration. Here we have a case where unusual trading skills, market timing acumen, or awe-inspiring foresight is not required. In fact, quite the opposite. It's simply buying, when cheap, shares of enterprises that make the great small-ticket consumer products -- especially those with the strongest brands -- and avoiding the temptation to trade excessively. In particular, the companies with scale, dominant distribution, and, of course, sound financial health. Are the right analytical skills and other capabilities required to do this effectively? Of course. Yet, beyond that, it's mostly knowing when to utilize a simple but useful insight if it presents itself. Over much shorter time horizons -- five years or less -- just about anything can happen as far as relative performance goes. It's always useful to extend the time horizon to reduce the mistakes that come from reacting to shorter term noise. My definition of short-term here might seem more long-term by the standards of many market participants these days.
*** Index funds beat the vast majority of active money managers. Is it easy to imagine someone with modest medical training performing at the level of a highly skilled surgeon? Of course not. Yet the equivalent seems possible in the context of investing. Are extraordinary returns, quickly achieved, possible this way? No, not really, but investing comes down to judging what will produce the most attractive relative risk-adjusted returns. These approaches (buying shares of high quality businesses held long-term or indexation) will never produce "lottery tickets" but it sure beats the typical experience of investors as noted by the QAIB and other studies. So no fast money here. Besides, it's not like lottery tickets (and certain more aggressive investing strategies) don't have asymmetric risk of permanent capital loss compared to possible gains. During shorter time horizons it's more likely to find individual funds (And, of course, many individual stocks but the big winners often reside near the big losers.) that outperform index funds or shares of the higher quality franchises. Some may try to jump in and out of investments (whatever happens to be "hot") at just the right time to enhance returns. I don't doubt some even succeed with such an approach but, at least based upon the available evidence, it's an idea that mostly seems good in theory, less so in practice.
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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.
On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you." - Warren Buffett in the 1993 Berkshire Hathaway (BRKa) Shareholder Letter
There are many thousands of open-ended mutual funds -- as well as an increasing number of exchange-traded funds (ETFs) -- to choose from for a retail investor these days.
This article, from 2007, lists the 20 best-performing open-ended mutual funds over a 20-year period. The number one fund (Vanguard Healthcare: VGHCX) produced a 16.84% annualized 20-year return. A 20-year record like those listed in this article is certainly no small accomplishment for a money manager.
Having said that, with all the funds to choose from, it is unlikely that an investor would have a mutual fund portfolio that performs anywhere near this well in the real world. Why?
First, the probability that an investor would have chosen (and held onto through the ups and downs) one of these 20 among all available funds is low (of course, there are quite a few others that did very well compared to a benchmark that just did not quite make this list). The fact is many funds do not even keep up with the S&P 500 because of fees, taxes, too much trading activity, and, well, poor investment decision-making.
Second, mutual fund investors themselves can be their own worst enemy. There's plenty of evidence that investors tend to buy more during the good times and sell during the not-so-good times which erodes long-term returns. So what fund investors actually earn ends up being much lower than the funds themselves.
The reason is simple: Investors attempt to time their investments and redemptions, often unsuccessfully.
They buy when others are fearless....sell the opposite. Not good.
From this extract of DALBAR's Quantitative Analysis of Investor Behavior (QAIB) that looked at 20-year returns through 2007:
"The results have shown, to varying degrees, that the average investor earns significantly less than mutual fund performance reports suggest...Investment return is far more dependent on investor behavior than on fund performance. Mutual fund investors who hold their investments typically earn higher returns over time than those who time the market."
Here are the results from DALBAR's more recent QAIB. According to the latest QAIB, the S&P 500 returned 8.35% over the 20 years that ended in 2008 while, on average, equity fund investors earned just 1.87% (less than the inflation rate of 2.89%). From this DALBAR press release:
"The dramatic events that continue to plague our financial markets have provoked panic, which exacerbates the ongoing carnage," said Lou Harvey, president of DALBAR. "For 15 years, QAIB has shown that investor returns lag what performance reports and prospectuses would lead one to believe is achievable. While those returns are, in fact, theoretically achievable, the reality is that investors are not rational, and make buy and sell decisions at the worst possible moments," he said.
Now, consider that each of the following boring stocks -- those often described as "defensive" -- produced total returns (incl. dividends) competitive with or better than the 20 best-performing funds over the same 20-year period.
Procter & Gamble (PG)
Pepsi (PEP)
Coca-Cola (KO)
That's just three examples. There are certainly others. Also, this isn't the only longer time horizon (i.e. choose another ~ 20-year period) that the above stocks -- along with others that have similar business characteristics -- have performed just fine. In other words, it's not unusual to find more than solid performance in other similarly long time frames even if that, of course, guarantees nothing going forward.
Now, while many of these boring stocks seem rather unlikely to do as well going forward on an absolute basis, their relative merits -- especially the best of these -- remain not insignificant.
(I mean, it would seem more than a little unwise to view that particular 20-year period as being anything less than exceptional; better to have more conservative expectations built into the investment process. There'll be no complaints if it turns out that being more optimistic was warranted.)
These are not just defensive stocks, they are quality businesses with attractive and durable core long-term economics. My preference among so-called defensive stocks (though there are certainly some fine alternatives) happens to be Philip Morris International (PM), and Diageo (DEO) despite the fact that they lack easy to confirm 20-year historical performance.*
Again, just because something that seems to be a higher quality investment has done well in the past guarantees nothing. Still, it's likely a mistake to discount these results as being just some one time anomaly or random real world special case without, at least, digging into this a bit deeper.
There are exceptions, of course, but generally the companies like Coca-Cola -- those that make and distribute leading branded small-ticket consumer products on a big scale -- have attractive long-term economics. The best among them are compounding machines that need not be traded (in fact, it's the attempt at trading that will likely hurts returns) though, as always, buying with a margin of safety matters. That means, for example, they can't be bought blindly at a time like the bubble of the late 1990s (it wasn't just tech stocks that were expensive) or during the "Nifty Fifty" era of the early 1970s. In both cases, stocks like Coca-Cola were selling at extraordinarily high multiples of earnings (30, 40, 50 times earnings and even higher). An investor can't pay that much and expect a good long-term result no matter how fine the companies themselves may be.
Otherwise, it's just not all that complicated.
"...most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising 'Take two aspirins'." - Warren Buffett in the 1987 Berkshire Hathaway Shareholder Letter
"There seems to be some perverse human characteristic that likes to make easy things difficult." - Warren Buffett in the Superinvestors of Graham-and-Doddsville
The easy to confirm fact that shares of businesses with great brands and strong distribution have produced such attractive long run returns should be at least noteworthy and, for those curious, deserving of further investigation.**
Those producing the stuff typically found in a cupboard, refrigerator, and medicine cabinet have performed very well (with less risk I think it is safe to say when bought at an attractive valuation) long-term compared to alternatives because they have historically had favorable economics (attractive return on capital).
They've generally had and the best are likely to continue having difficult to disrupt durable competitive advantages.
Has something fundamentally changed their long-term core economics? If not, intrinsic business value should still increase at a satisfactory or better rate over time. A bit boring, maybe, but potentially attractive returns in the long run nonetheless.
My point, in part, is that there's a cost to complexity. When a relatively simple (not easy) approach is likely to produce results similar to (or better than) the more complex one, it's the more straightforward one that is preferable.
Now, it's true that a bunch of investors would do better relying on the skills of a capable money manager (as long as the fees are reasonably low and their own behavior doesn't get in the way of long-term performance). There are certainly some very talented money managers out there. The problem is that too many individual investors do not actually benefit from the expertise. Some of this comes down to investor behavior as pointed out in DALBAR's QAIB, but part of the problem is it's just not that easy to figure out which funds are likely to provide attractive risk-adjusted returns going forward.
Also, professional money managers certainly do, on average, underperform the S&P 500 index over the long haul. According to Vanguard founder John Bogle, from 1984 to 2002 the average stock mutual fund delivered a 9.3% annual return compared to the S&P 500's return of 12.2% a year.
"The reason for that lag is not very complicated: As the trained, experienced investment professionals employed by the industry's managers compete with one another to pick the best stocks, their results average out. Thus, the average mutual fund should earn the market's return—before costs. Since all-in fund costs can be estimated at something like 3% per year, the annual lag of 2.9% in after-cost return seems simply to confirm that eminently reasonable hypothesis." - John Bogle
It gets worse. During that same period the average fund investor, according to DALBAR, earned just 2.6% a year.
(Again, the average fund investor underperformance is largely due to ill-timed buy/sell decisions and fund selection. In other words, a timing penalty and a selection penalty. Bogle adds why he thinks the DALBAR study might actually overstate the annual returns. See his explanation under the Is the DALBAR Study Accurate? section for more details.)
So the sub-par returns were a combination of both fund performance and investor behavior. Also, it's not just that the average mutual fund does poorly compared to a broad-based index. It's quite a bit worse than that. Bogle wrote the following back in 2007:
"The percentage of managers outperformed by the broad market index is, well, time-dependent. On a given day, it's likely about 55%; over a year maybe 60-65%, over a decade perhaps 75-80%, and over 50 years...well, there's no data (yet!) on that!
But the probability statistics suggest that over a 50-year period, some 98% of managers will lose to the market index."
There's a good chart in Bogle's "Little Book" (page 124) that covers this.
Even if the probabilities are somewhat better than what Bogle suggests, those numbers are pretty daunting to say the least. Not seriously considering the implications in the context of one's own investing approach seems unwise. Here's what Jack Meyer, who managed the endowment, pension, and other assets as President and CEO of the Harvard Management Company from 1990 to 2005, had to say:
"Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 percent to 90 percent of managers fail to match their benchmarks. Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value."
I do find it interesting that there are many professional money managers and traders (some of them frequently appearing on various business news media outlets) recommending various, sometimes rather complex, investing and trading strategies.
It's easy to imagine and expect with all the expertise on display that quite a few of them must seriously outperform. In particular, some might reasonably expect them to outperform a participant who just buys -- at a reasonable price -- and holds long-term the stocks of companies that make the stuff found in a typical cupboard, refrigerator, and medicine cabinet.
(Well, at least those participants who understand business economics, are able to identify sustainable competitive advantages, have a price versus value discipline, while controlling their emotions during inevitable market fluctuations. Not complicated but, based upon investor behavioral patterns revealed in studies, apparently not easy for many to accomplish either.)
Yet, the verifiable evidence at least suggests that many pros do not, over a long time horizon, beat high quality stocks (or the market as a whole) bought when prices are reasonable or better. Also, for those experts that do outperform, there's just no easy way to separate the future fund "winners" from the mediocre (or worse).
It's possible, I suppose, that there are many participants employing various highly "sophisticated" investing/trading strategies who do actually outperform but just happen to be those that cannot be easily verified via SEC filings or confirmed by studies like the above.
Count me as skeptical of this based upon the evidence.
By the way, there's a long list of pros who approach the business using sound investing principles and a number outperform their benchmark.
I don't think the job of a money manager is an easy one. First, they all have to overcome those fees and transaction costs to outperform. In addition, more than a few highly active professional managers ignore the wisdom of Newton's 4th law or are forced to focus on near-term results (in order to keep assets under management stable and, well, keep their jobs) possibly to the detriment of long-term mutual fund investors. Some of this comes down to what has become a hyperactive, casino-oriented, trading culture that now permeates the capital markets. Too many seem to dismiss (or ignore) the merits of what Warren Buffett and Charlie Munger have been saying and doing for a very long time (their ~ 20%/year annualized returns over five decades is no accident). In my view, no small number of professional money managers (and academics) still pick and choose what they like about the Berkshire approach while conveniently ignoring (or inconveniently if you're an investor in a fund) important aspects of their investing principles.
Attractive returns can be achieved (though, as Bogle rightly points out, aren't likely to be achieved by most) by just paying a fair price for 5-10 good businesses and holding them for a very long time. At least that is the case for those who are comfortable with, and capable of, picking individual marketable stocks. It's a simple approach but that doesn't make it an easy one. For some, even more diversification may be necessary but consider this:
"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." -Charlie Munger in a 1998 Speech to the Foundation Financial Officers Group
The quote at the beginning of this post makes it pretty clear that Buffett holds a similar view. For those with a long enough investing horizon but lack the background to effectively pick individual securities, something like an index fund, traded minimally, makes a whole lot of sense.
John Bogle has long been a proponent of passive investing over more active styles. He has been providing lots of very wise advice along these lines to investors for a very long time. Too few pay attention to it.***
Otherwise, when considering stocks, the hard part is not necessarily figuring out what to buy. The difficulty comes down to whether the individual has the discipline, temperament, and patience to buy -- and hold long-term -- with enough margin of safety what they understand while ignoring the daily price fluctuations. In fact, since bear markets are inevitable, ideally it's best to be buying/accumulating more shares of high quality businesses -- what the investor knows the best and likes the most -- whenever the news is rather terrible. It's easy to make the mistake of overestimating one's own ability to do this.
No matter what it is best to avoid an excessive amount of trading activity. The trades create not only frictional costs but also more chances to make costly mistakes.
(There's a tendency -- due to overconfidence and overestimation of abilities -- to overweight the upside possibilities of a trading decision and underweight the downside. The net result can be costly.)
So buying shares of good businesses at a discount doesn't assure long-term outperformance. Certainly not. It's just that the possibility of achieving good risk-adjusted results improves over the long haul if:
1) an investor knows how to figure out, within a range, what a good business is worth, and
2) if that investor routinely pays a nice discount to per share value for it.
It's the partial long-term ownership of high quality businesses, compounding intrinsically in value over time, while avoiding meaningful mistakes. Mistake avoidance, especially those that result in permanent loss of capital, is key to the success that comes from this style of investing.
What's more doable?
A) Correctly picking, buying, and holding the actively managed mutual funds that will be the long-term top performers among the thousands of funds.
(Finding needles in a haystack.)
B) Buying shares of 5-10 (or, for those who prefer or require more diversification, maybe somewhat more) of the great business franchises -- those that are understood well when available at a discount to value -- then holding them for 20 years and, ideally, even longer. The returns for investors come via per share intrinsic value growth of the businesses not trying to own the right stocks or sectors at just the right time. In other words, no unusual trading skills (in fact, minimal trading is a must) or capacity to time the market is required.
(Identifying the highest quality businesses, those with modest debt and great brands/strong distribution, seems more akin to finding needles in a stack of needles. Well, at least for an investor who feels comfortable enough in their ability to understand business economics. Otherwise, identifying the strongest producers of small-ticket consumer goods is not exactly tough to do. Now, having the patience and discipline that's required to only buy shares in meaningful amounts when they're selling at a nice discount can be very challenging.)
C) Accumulating the shares of an index fund that has very low expenses steadily over time.
Whether A, B, or C makes more sense comes down to individuals capabilities and circumstances. No one should be buying stocks if it's not in their own comfort zone. Investing effectively mostly involves realistically assessing one's own limits and staying well within those limits. Based upon the evidence, it seems quite likely that C makes sense for a whole bunch of investors.
There are many fine mutual funds and talented professional managers out there. Yet, it can be far from easy to differentiate between who'll deliver above average and subpar results prospectively.
The long-term strengths and merits of a company like Coca-Cola against its peers seems to me, by comparison, relatively straightforward. Well, at the very least, it happens to be in my own investing comfort zone even if it doesn't necessarily make sense otherwise. Bogle's advice ought to get heavy consideration before venturing into individual stocks. It certainly influences my approach though the fact that I'm buying individual stocks would seem to suggest that's not the case. Here's how it fits in rather nicely. My own view is that index funds, traded minimally, outperform mostly because 1) frictional costs are kept low, and 2) the driver of returns is the long run per share intrinsic value increases of the many businesses in the index.
Basically, investors are kept from being their own worst enemy and incurring excessive frictional costs.
Well, it's possible to also minimize frictional costs in a much more concentrated equity portfolio while similarly allowing the per share intrinsic business value, as it increases, to be the primary driver of returns. The main downside, at least in the view of some, is increased risk due to lack of diversification but, once again:
"We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it." - Warren Buffett in the 1993 Berkshire Hathaway Shareholder Letter
So I think the approach has more in common with what Bogle has often recommended than it may seem to at first glance. An index fund isn't really the only way to invest in a relatively passive manner (passive trading-wise not homework-wise). The diversification debate is a legitimate one, but it's possible to own a concentrated, though otherwise relatively passively managed, equity portfolio. The approach has similar benefits to indexation -- low frictional costs, fewer investor mistakes, returns primarily from increases to intrinsic business value over a very long time horizon. Well, at least that's the case for those who understand business economics and can identify durable advantages while consistently buying shares at a discount to conservatively estimated value. It's a passive approach because, while there's lots of work that goes into understanding and valuing the businesses themselves, there's little in the way of trading activity.
No matter what the right long-term investment vehicle(s) might be (it's necessarily different for each individual) the key is always to avoid the temptation to trade excessively.
Based upon experience, I don't expect to convince many market participants of this.
Adam
Long positions in BRKb, PG, PEP, KO, PM, and DEO
Related posts:
Staples vs Cyclicals
Best and Worst Performing DJIA Stock
Defensive Stocks?
* A 16 percent annualized total returns (incl. dividends) over 20 years will turn a $ 10,000 investment into just under $ 200,000. Each of these stocks produced returns, give or take, in that ballpark. Now, it's not as if anything like these kind of returns will occur over the next twenty years. For lots of reasons that seems extremely unlikely. The very best funds will almost certainly do better. It's just that the best of these types of businesses (those with durable and attractive returns on capital) have a good chance of doing very well over a 20-year time frame at comparably low risk, as long as trading activity is minimized, and they're bought at reasonable valuations. As mentioned above, my preference happens to be PM and DEO but think highly of, even if to a lesser extent, the other stocks I've established long positions in (as noted above) when bought at the right price. PM and DEO do lack a convenient way to check their 20-year historical performance since they've not been trading as separate marketable stocks long enough. That comparative lack of historical performance doesn't negate their durable advantages, sound core business economics, and generally favorable long-term prospects. It's worth noting that PM, DEO, and PEP are each part of the Six Stock Portfolio.
** These higher quality businesses don't need to always outperform (and likely will not) the top 20 funds over a twenty year period to be worthwhile. Even if shares of the higher quality businesses did not outperform over the long haul going forward (and they may not, of course), the sheer simplicity of the approach compared to alternatives needs to be considered. So does the reduced likelihood of permanent capital loss and more narrow range of outcomes. In fact, if the quality franchises produced merely market returns they'd still win in my book. The reason is that, if bought well, the same return will have been arguably achieved at less risk of permanent capital loss (not temporary paper losses). Now, anyone buying the higher quality stocks expecting them to outperform during the next bull market will likely be disappointed. Look elsewhere for exciting price action. That is, in part, how they have earned the reputation of being defensive. Yet, this reputation is verifiably incorrect when you look at the historic returns of these stocks over the longer haul (at least a business cycle or two). Otherwise, the fact that they've delivered attractive risk-adjusted returns, rather passively, seems like more than just merely an intriguing aberration. Here we have a case where unusual trading skills, market timing acumen, or awe-inspiring foresight is not required. In fact, quite the opposite. It's simply buying, when cheap, shares of enterprises that make the great small-ticket consumer products -- especially those with the strongest brands -- and avoiding the temptation to trade excessively. In particular, the companies with scale, dominant distribution, and, of course, sound financial health. Are the right analytical skills and other capabilities required to do this effectively? Of course. Yet, beyond that, it's mostly knowing when to utilize a simple but useful insight if it presents itself. Over much shorter time horizons -- five years or less -- just about anything can happen as far as relative performance goes. It's always useful to extend the time horizon to reduce the mistakes that come from reacting to shorter term noise. My definition of short-term here might seem more long-term by the standards of many market participants these days.
*** Index funds beat the vast majority of active money managers. Is it easy to imagine someone with modest medical training performing at the level of a highly skilled surgeon? Of course not. Yet the equivalent seems possible in the context of investing. Are extraordinary returns, quickly achieved, possible this way? No, not really, but investing comes down to judging what will produce the most attractive relative risk-adjusted returns. These approaches (buying shares of high quality businesses held long-term or indexation) will never produce "lottery tickets" but it sure beats the typical experience of investors as noted by the QAIB and other studies. So no fast money here. Besides, it's not like lottery tickets (and certain more aggressive investing strategies) don't have asymmetric risk of permanent capital loss compared to possible gains. During shorter time horizons it's more likely to find individual funds (And, of course, many individual stocks but the big winners often reside near the big losers.) that outperform index funds or shares of the higher quality franchises. Some may try to jump in and out of investments (whatever happens to be "hot") at just the right time to enhance returns. I don't doubt some even succeed with such an approach but, at least based upon the available evidence, it's an idea that mostly seems good in theory, less so in practice.
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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.
Friday, May 22, 2009
Inactive Investing
Much of achieving attractive long-term results comes down to buying quality assets at a discount then keeping frictional costs down.
Easier said than done.
One effective way to manage risk and reward is to buy shares of businesses with high and durable returns on capital (ROC) at attractive prices (i.e. discount to a conservative estimate of value).
The heavy lifting so to speak -- as measured by total return -- comes from the high ROC of the businesses themselves, instead of some special talent for trading.
In other words, the core economics and resulting increases to per share intrinsic value primarily drive returns.
Of course, it's not as if future returns on capital can be perfectly measured or predicted. Yet, to at least increase the likelihood of a good outcome, look to those businesses with high and sustainable ROC; those that possess, even if to varying degrees, rather wide "economic moats": AXP, PG, PM, KO, JNJ and DEO among others, come to mind.
Each seems likely to remain high ROC, wide moat, businesses that happen to be selling at reasonable valuations these days. Still, even the very best businesses can have things go very wrong for shareholders from time to time.
Capital might be allocated poorly, for example.
Also, even if capital is allocated well, just about any business gets tested at some point.
That's where always buying with a margin of safety comes in.
Having said that, here's a good example of how high ROC combined with a stock that mostly remains cheap over time impacts long-term returns:
$ 10,000 invested in Philip Morris (now Altria: MO) in 1957 was worth over $ 80 million fifty years later (incl. reinvested dividends).
So the stock generated an annual return of nearly 20% during that time frame.
The magic of compounding.
In contrast, $ 10,000 invested in General Motors in 1957 was well on its way to becoming worth nothing fifty plus years later. (Also with dividends reinvested. In this case, the investor would do better to not reinvest the dividends or, better yet, not invest at all.)
That means a roughly 6x increase in value has been an average decade for MO. It also happens to be pretty much what Altria produced this past decade. Odds seem at least reasonably good that both Altria and the recently spun off Philip Morris International (PM) will continue to do just fine (though likely not nearly as spectacular as in the past) over the long haul.*
Declining volume pressures will likely continue to be a major challenge, but that's not exactly a new problem for the tobacco business.
The story is not pretty but it's the core economics and price versus value that matters.
A big part of the returns produced by Philip Morris/Altria came from dividends that were reinvested in a stock that was consistently inexpensive. This works, other than potentially different tax implications depending on the type of account, much the same way as share buybacks.
Excluding the tax differences, buybacks and dividend reinvestments -- implemented at reasonable or better valuation levels (i.e. discount to intrinsic value) -- similarly benefit long-term owners; the former reduces overall share count, while the latter increases the number of shares owned.
The fact that these stocks remained mostly inexpensive did not come down to just concerns about declining volumes. It was the threat of major legal liabilities, and the fact that some investors won't touch a tobacco stock, that also contributed to the shares of Philip Morris/Altria mostly being cheap for many years. So the stock will actually do better going forward if prices remain relatively low.
Consider that the next time you're inclined to cheer when a stock price goes up in the short run yet your investing horizon is long-term.
Choosing between GM and Philip Morris was quite a flip of the coin back in the late 1950's. I'm guessing most investors back then thought of GM as a juggernaut while the tobacco business was a company heading into a world of uncertain legal liabilities and, over time, reduced demand. Both businesses have had their fair share of challenges since then yet only one of them maintained attractive core economics despite its troubles.
It is interesting to note how well most of the high quality franchises (i.e. those that sell small-ticket consumer items, leading brands, and strong distribution capabilities) have performed in most every 20 year period (i.e. something like 1971-90, 1972-91, 1972-92, etc...) going back decades. Once again, the reason is durable high returns on capital.**
If bought well, sustainable competitive advantages and attractive core business economics pay off in the long run.
Growth rate matters less.
Easier said than done.
One effective way to manage risk and reward is to buy shares of businesses with high and durable returns on capital (ROC) at attractive prices (i.e. discount to a conservative estimate of value).
The heavy lifting so to speak -- as measured by total return -- comes from the high ROC of the businesses themselves, instead of some special talent for trading.
In other words, the core economics and resulting increases to per share intrinsic value primarily drive returns.
Of course, it's not as if future returns on capital can be perfectly measured or predicted. Yet, to at least increase the likelihood of a good outcome, look to those businesses with high and sustainable ROC; those that possess, even if to varying degrees, rather wide "economic moats": AXP, PG, PM, KO, JNJ and DEO among others, come to mind.
Each seems likely to remain high ROC, wide moat, businesses that happen to be selling at reasonable valuations these days. Still, even the very best businesses can have things go very wrong for shareholders from time to time.
Capital might be allocated poorly, for example.
Also, even if capital is allocated well, just about any business gets tested at some point.
That's where always buying with a margin of safety comes in.
Having said that, here's a good example of how high ROC combined with a stock that mostly remains cheap over time impacts long-term returns:
$ 10,000 invested in Philip Morris (now Altria: MO) in 1957 was worth over $ 80 million fifty years later (incl. reinvested dividends).
So the stock generated an annual return of nearly 20% during that time frame.
The magic of compounding.
In contrast, $ 10,000 invested in General Motors in 1957 was well on its way to becoming worth nothing fifty plus years later. (Also with dividends reinvested. In this case, the investor would do better to not reinvest the dividends or, better yet, not invest at all.)
That means a roughly 6x increase in value has been an average decade for MO. It also happens to be pretty much what Altria produced this past decade. Odds seem at least reasonably good that both Altria and the recently spun off Philip Morris International (PM) will continue to do just fine (though likely not nearly as spectacular as in the past) over the long haul.*
Declining volume pressures will likely continue to be a major challenge, but that's not exactly a new problem for the tobacco business.
The story is not pretty but it's the core economics and price versus value that matters.
A big part of the returns produced by Philip Morris/Altria came from dividends that were reinvested in a stock that was consistently inexpensive. This works, other than potentially different tax implications depending on the type of account, much the same way as share buybacks.
Excluding the tax differences, buybacks and dividend reinvestments -- implemented at reasonable or better valuation levels (i.e. discount to intrinsic value) -- similarly benefit long-term owners; the former reduces overall share count, while the latter increases the number of shares owned.
The fact that these stocks remained mostly inexpensive did not come down to just concerns about declining volumes. It was the threat of major legal liabilities, and the fact that some investors won't touch a tobacco stock, that also contributed to the shares of Philip Morris/Altria mostly being cheap for many years. So the stock will actually do better going forward if prices remain relatively low.
Consider that the next time you're inclined to cheer when a stock price goes up in the short run yet your investing horizon is long-term.
Choosing between GM and Philip Morris was quite a flip of the coin back in the late 1950's. I'm guessing most investors back then thought of GM as a juggernaut while the tobacco business was a company heading into a world of uncertain legal liabilities and, over time, reduced demand. Both businesses have had their fair share of challenges since then yet only one of them maintained attractive core economics despite its troubles.
It is interesting to note how well most of the high quality franchises (i.e. those that sell small-ticket consumer items, leading brands, and strong distribution capabilities) have performed in most every 20 year period (i.e. something like 1971-90, 1972-91, 1972-92, etc...) going back decades. Once again, the reason is durable high returns on capital.**
If bought well, sustainable competitive advantages and attractive core business economics pay off in the long run.
Growth rate matters less.
A company that can sustain a relatively high ROC, over the long haul, will tend to converge on that rate of return if you hold it long enough.
The hard part is knowing which businesses can sustain it.
So here's one way to think about it that may be useful. Think of good businesses as a kind of strange long-term certificate of deposit (CD).
For example, if a business has a sustainable ROC of approximately 15% it effectively becomes a kind of bizarre CD:
The hard part is knowing which businesses can sustain it.
So here's one way to think about it that may be useful. Think of good businesses as a kind of strange long-term certificate of deposit (CD).
For example, if a business has a sustainable ROC of approximately 15% it effectively becomes a kind of bizarre CD:
In a high ROC business: As you increase the time frame the range of possible annual returns gets narrower and converges on the higher ROC rate.
In a low ROC business: As you increase the time frame the range of possible annual returns gets narrower and converges on the lower ROC rate.
Take KO as an example of a high ROC business. The free cash flow that KO will generate this year can be used to pay dividends with the rest going into growth opportunities such as new brands...expanding distribution etc. The returns on these new investments tend to be very high and eventually get reflected in the company's intrinsic value. In the first 2-3 years those investments, the economic impact would not typically be obvious because they're small relative to KO's other assets and current earning power. The trick occurs when you compound the new investments made by KO each year over a 20 year horizon or longer. With mostly wise capital allocation (mostly, in this case, via the use of retained earnings) over a long time frame, it's possible for a tidal wave of intrinsic value to be created.
Better to pay a fair price for the wonderful businesses.
Low ROC businesses might work, if very mispriced, over shorter time horizons, but in the long run a 6% ROC business will have a tough time intrinsically doing much better than a 6% return.
"Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result." - Charlie Munger
In the early days, in fact, Buffett used to buy these so called "cigar butts" (Ben Graham style) and profit when the shares became at least a bit less mispriced.
So Buffett would look for "dollar bills" selling temporarily for 50 cents, then sell it when the market began to price it more appropriately. Eventually, he more or less moved away from the Ben Graham approach. See's Candies is a good example.
In a low ROC business: As you increase the time frame the range of possible annual returns gets narrower and converges on the lower ROC rate.
Take KO as an example of a high ROC business. The free cash flow that KO will generate this year can be used to pay dividends with the rest going into growth opportunities such as new brands...expanding distribution etc. The returns on these new investments tend to be very high and eventually get reflected in the company's intrinsic value. In the first 2-3 years those investments, the economic impact would not typically be obvious because they're small relative to KO's other assets and current earning power. The trick occurs when you compound the new investments made by KO each year over a 20 year horizon or longer. With mostly wise capital allocation (mostly, in this case, via the use of retained earnings) over a long time frame, it's possible for a tidal wave of intrinsic value to be created.
Better to pay a fair price for the wonderful businesses.
Low ROC businesses might work, if very mispriced, over shorter time horizons, but in the long run a 6% ROC business will have a tough time intrinsically doing much better than a 6% return.
"Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result." - Charlie Munger
In the early days, in fact, Buffett used to buy these so called "cigar butts" (Ben Graham style) and profit when the shares became at least a bit less mispriced.
So Buffett would look for "dollar bills" selling temporarily for 50 cents, then sell it when the market began to price it more appropriately. Eventually, he more or less moved away from the Ben Graham approach. See's Candies is a good example.
While it is unlikely for most of us to achieve the 20% per year long-term returns of Berkshire Hathaway, a sensible inactive approach has the potential to do rather well compared to professional active managers while, just as crucially, taking less risk. I emphasized the word active because it is the activity itself that adds frictional costs (taxes, commissions) and increases the likelihood of making mistakes that ultimately causes the reduced returns.
Newton's 4th Law.
Some might be impressed by a money manager that timed the market effectively during the most recent crash. In other words, whoever was "smart" enough to sell right before the crash must know what they are doing right? Well, attempting to time the market creates new risks even if you happen to get it right from time to time. What about making the mistake of being out when the chance to buy at great prices slowly disappears? This can permanently reduce long term returns.***
It's understandable that many focus on temporary paper losses in the short run.
That doesn't make it wise. Investing means focusing on price versus value and long-term effects.
This means that learning to ignore near-term price action is very important.
In other words, why be bothered by a temporary paper loss of 30-40%, for example, if you buy businesses -- at a plain discount to value -- with favorable economics that should create an attractive outcome over the next twenty years? If the risk and reward balance seems favorable, the temporary losses simply become an opportunity or something to ignore. An asymmetrical dislike of losses compared to the satisfaction from gains at least explains some of this. Most focus on the risk of loss but few put enough emphasis on the risk of missing gains. This bias is costly in investing. If you own quality businesses, the long-term compounding effects should trump what happens in the market.
(Even if a crash occurs which, by the way, should be considered -- at least occasionally -- certain to happen from time to time.)
Some of Buffett's biggest long-term gains came on investments that initially dropped in price by half or so.
Newton's 4th Law.
Some might be impressed by a money manager that timed the market effectively during the most recent crash. In other words, whoever was "smart" enough to sell right before the crash must know what they are doing right? Well, attempting to time the market creates new risks even if you happen to get it right from time to time. What about making the mistake of being out when the chance to buy at great prices slowly disappears? This can permanently reduce long term returns.***
It's understandable that many focus on temporary paper losses in the short run.
That doesn't make it wise. Investing means focusing on price versus value and long-term effects.
This means that learning to ignore near-term price action is very important.
In other words, why be bothered by a temporary paper loss of 30-40%, for example, if you buy businesses -- at a plain discount to value -- with favorable economics that should create an attractive outcome over the next twenty years? If the risk and reward balance seems favorable, the temporary losses simply become an opportunity or something to ignore. An asymmetrical dislike of losses compared to the satisfaction from gains at least explains some of this. Most focus on the risk of loss but few put enough emphasis on the risk of missing gains. This bias is costly in investing. If you own quality businesses, the long-term compounding effects should trump what happens in the market.
(Even if a crash occurs which, by the way, should be considered -- at least occasionally -- certain to happen from time to time.)
Some of Buffett's biggest long-term gains came on investments that initially dropped in price by half or so.
So instead of actively trading, use the spare time you have to do important things like evaluating whether the businesses you own are about to have their "economic moat" reduced or eliminated.
(The newspaper business being a good recent example.)
This is a simple (but not easy) approach that helps eliminate the casino-oriented thinking that has become so prevalent among market participants.
Adam
Long AXP, PG, PM, KO, JNJ, DEO, and MO
* As always, I am talking about growth in the intrinsic value of the business not the stock price. In the short run stock prices can be all over the map but in the long run stock prices will tend to track intrinsic value growth.
** The best of these franchises have attractive risk and reward characteristics if bought at the right price. Yet it seems unwise to expect nearly as attractive returns going forward.
*** Buffett and Munger have sold or not owned stocks at times when valuations were not attractive to them. These were not decisions based upon market timing; they were decisions based upon price versus value.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
(The newspaper business being a good recent example.)
This is a simple (but not easy) approach that helps eliminate the casino-oriented thinking that has become so prevalent among market participants.
Adam
Long AXP, PG, PM, KO, JNJ, DEO, and MO
* As always, I am talking about growth in the intrinsic value of the business not the stock price. In the short run stock prices can be all over the map but in the long run stock prices will tend to track intrinsic value growth.
** The best of these franchises have attractive risk and reward characteristics if bought at the right price. Yet it seems unwise to expect nearly as attractive returns going forward.
*** Buffett and Munger have sold or not owned stocks at times when valuations were not attractive to them. These were not decisions based upon market timing; they were decisions based upon price versus value.
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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.
Friday, May 15, 2009
Are Strong Currencies A Necessary Condition for Prosperity?
"...it is worth remembering that real wealth lies not in debt but in educated people, laws, and work ethic, as well as in the quality and quantity of fixed assets and the effectiveness of corporate organization. We...have just tripped on make-believe assets and we now have to deal with chronic deleveraging and bruised animal spirits. When we have dealt with this crisis, all of our assets will still be sitting around waiting to be fully used once again. It is helpful to consider that after the Depression, the U.S. GDP got back on its original trendline as if the Depression had never occurred." - Jeremy Grantham
With the above quote in mind, it's worth considering the somewhat surprising fact that the U.S. Dollar is down in value roughly 98% compared to gold ("yeah, that's right" as David Puddy from Seinfeld would say) over the past century while the standard of living has increased, give or take, sevenfold during that time. So the idea that the long-term strength of a currency is critical to the growth in a country's standard of living is clearly not correct. I say this because if you listen to many debates on currency, there is often an implied assumption that the drop in a currency's value will inevitably result in a drop in the standard of living for those that live in the country.
So what's going on here?
Take a place like Zimbabwe. When too much currency gets printed the value goes down but that's not the problem. What is the real problem? A lack of underlying assets (tangible and intangible) and growth in those assets to support the population. In contrast, our destruction of the dollar over the past century did not ruin us because we have grown the intrinsic value of our assets significantly during that time. The growth in a society's assets over time determine wealth and increases in the standard of living -- not the currency's strength.
As Buffett once said, in the long run it wouldn't matter if our currency was converted to shark's teeth.
"You know, if the dollar becomes way--worth way less, we will sell See's Candy for more money. I mean, it won't be more real dollars, but we--if somebody's willing to give up 15 minutes of their labor or half to buy a pound of this or to buy six cans of this, they'll do the same thing and it won't make any difference whether shark's teeth are being used for money, basically.
So the best--well, the best assets you can have during inflation is your abilities. I mean, because if you're the best doctor in town or the best lawyer in town or the best broadcaster in town or whatever it may be, you will always command a certain percentage of the resources of society. So your own talents are the most important thing. But if you don't have any talent like I do, you try to buy into other people's talents. And you know, this is the best candy. This is the best soft drink, as far as I'm concerned, and it will be that way 10 years from now. And whatever the value currency is, we'll get our share in that--in terms of that value at that time." - Warren Buffett
Someone sitting at some watering hole 100 years ago who was arguing that the U.S. currency would be debased 98% in the next century, would probably also have been arguing the U.S. was going to be a pretty terrible place economically as a result. Yet, we've had a significant increase in prosperity because the underlying assets have grown enormously. That's ultimately what matters. Fiat currencies must, of course, be relatively stable in the short-to-medium run but, in the long run, they will almost always lose value against things like good businesses, land, gold etc. Fiat currencies aren't good stores of value long-term and probably never will be.
It's just too easy to print more when times get tough.
So assume paper currency debasement is pretty much a given and will likely continue over the next 50 years and beyond. It just does not mean we won't also be prospering in a big way.
The best way to manage this for an investor? In my view it is owning shares in good businesses. This both protects against wealth erosion caused by inflation (i.e. devalued paper money) and provides a way to capture a portion of the growth in the intrinsic value of society's underlying assets.
Adam
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
With the above quote in mind, it's worth considering the somewhat surprising fact that the U.S. Dollar is down in value roughly 98% compared to gold ("yeah, that's right" as David Puddy from Seinfeld would say) over the past century while the standard of living has increased, give or take, sevenfold during that time. So the idea that the long-term strength of a currency is critical to the growth in a country's standard of living is clearly not correct. I say this because if you listen to many debates on currency, there is often an implied assumption that the drop in a currency's value will inevitably result in a drop in the standard of living for those that live in the country.
So what's going on here?
Take a place like Zimbabwe. When too much currency gets printed the value goes down but that's not the problem. What is the real problem? A lack of underlying assets (tangible and intangible) and growth in those assets to support the population. In contrast, our destruction of the dollar over the past century did not ruin us because we have grown the intrinsic value of our assets significantly during that time. The growth in a society's assets over time determine wealth and increases in the standard of living -- not the currency's strength.
As Buffett once said, in the long run it wouldn't matter if our currency was converted to shark's teeth.
"You know, if the dollar becomes way--worth way less, we will sell See's Candy for more money. I mean, it won't be more real dollars, but we--if somebody's willing to give up 15 minutes of their labor or half to buy a pound of this or to buy six cans of this, they'll do the same thing and it won't make any difference whether shark's teeth are being used for money, basically.
So the best--well, the best assets you can have during inflation is your abilities. I mean, because if you're the best doctor in town or the best lawyer in town or the best broadcaster in town or whatever it may be, you will always command a certain percentage of the resources of society. So your own talents are the most important thing. But if you don't have any talent like I do, you try to buy into other people's talents. And you know, this is the best candy. This is the best soft drink, as far as I'm concerned, and it will be that way 10 years from now. And whatever the value currency is, we'll get our share in that--in terms of that value at that time." - Warren Buffett
Someone sitting at some watering hole 100 years ago who was arguing that the U.S. currency would be debased 98% in the next century, would probably also have been arguing the U.S. was going to be a pretty terrible place economically as a result. Yet, we've had a significant increase in prosperity because the underlying assets have grown enormously. That's ultimately what matters. Fiat currencies must, of course, be relatively stable in the short-to-medium run but, in the long run, they will almost always lose value against things like good businesses, land, gold etc. Fiat currencies aren't good stores of value long-term and probably never will be.
It's just too easy to print more when times get tough.
So assume paper currency debasement is pretty much a given and will likely continue over the next 50 years and beyond. It just does not mean we won't also be prospering in a big way.
The best way to manage this for an investor? In my view it is owning shares in good businesses. This both protects against wealth erosion caused by inflation (i.e. devalued paper money) and provides a way to capture a portion of the growth in the intrinsic value of society's underlying assets.
Adam
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Monday, May 11, 2009
Wesco Shareholder Meeting 2009
Below are some of Charlie Munger's thoughts from this year's Wesco shareholder meeting.
From these The Motley Fool notes:
Charlie Munger's Thoughts on Just About Everything
"Anyone with an engineering frame of mind will look at [accounting standards] and want to throw up in the aisle. And go ahead if you want to. It will be a memorable moment for all of us."
"I remember the $0.05 hamburger and a $0.40-per-hour minimum wage, so I've seen a tremendous amount of inflation in my lifetime. Did it ruin the investment climate? I think not."
"If I were in charge, I'd take away everything from banks that wasn't boring. Completely shut down [credit default swaps] 100%. What's the harm in this? The world worked just fine without them. We don't need an economy that resembles a vast poker tournament."
Check out some of Charlie Munger's other thoughts.
Adam
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
From these The Motley Fool notes:
Charlie Munger's Thoughts on Just About Everything
"Anyone with an engineering frame of mind will look at [accounting standards] and want to throw up in the aisle. And go ahead if you want to. It will be a memorable moment for all of us."
"A man does not deserve huge amounts of pay for creating tiny spreads on huge amounts of money. Any idiot can do it. And, as a matter of fact, many idiots do it."
"I remember the $0.05 hamburger and a $0.40-per-hour minimum wage, so I've seen a tremendous amount of inflation in my lifetime. Did it ruin the investment climate? I think not."
"If I were in charge, I'd take away everything from banks that wasn't boring. Completely shut down [credit default swaps] 100%. What's the harm in this? The world worked just fine without them. We don't need an economy that resembles a vast poker tournament."
Check out some of Charlie Munger's other thoughts.
Adam
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Saturday, May 9, 2009
Wells Fargo Raises Capital
Wells Fargo raised capital on Friday at $ 22/share with the stock closing at $ 28.18/share.
The rest of the capital will apparently be built up the old fashioned way. My expectation was for the regulators to push for much more capital and greater dilution (even though I think time will reveal they did not need it).
Some things to keep in mind:
Adam
Long position in Wells Fargo
* Wells initially paid $ 13.8 billion in stock and subsequently raised $ 12.6 billion. If you add the most recent $ 8.6 billion together the total amount of stock was $ 35 billion. Wells will get an estimated $ 19 billion tax benefit from the deal. I subtracted that tax benefit from the $ 35 billion to get the $ 16 billion. This is not meant to have false precision but it does give a more meaningful estimate of what the actual net cost to Wells shareholders have been for the deal.
While Wells did not pay all that money to Wachovia shareholders the total cost of gaining control includes the subsequent capital raises and tax benefits.
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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.
The rest of the capital will apparently be built up the old fashioned way. My expectation was for the regulators to push for much more capital and greater dilution (even though I think time will reveal they did not need it).
Some things to keep in mind:
- The post-dilution market cap of Wells is roughly $ 130 billion and will likely have an $18 billion growing income stream once the economy recovers. That makes the normalized P/E of what is probably the best banking franchise in the US equal to $130 billion/$ 18 billion = 7x earnings at friday's closing price. So Wells Fargo is by no means expensive today as a long-term investment but it was easier to buy back when I first mentioned it on April 9th. Its average share price on that day was $ 18.69 and it has been available at prices as low as $ 16.14 since then.
- Wells Fargo more than doubled its assets when it acquired Wachovia without raising much capital. After absorbing the Wachovia balance sheet, Wells ended up having capital ratios on the lower end of the spectrum. Since Wells can build capital faster than others through its exceptional earnings power those ratios are not a concern to me.
- Yesterday's capital raise effectively increased the net price Wells paid for Wachovia (in stock net of the tax benefits) from ~$ 7 billion to ~$16 billion*.
- I estimate that the Wachovia part of Wells Fargo will have normalized earnings of over $ 8 billion/year once Wells integrates it and the economy starts to recover. Here's the bottom line: Wells paid only $ 16 billion (again...in stock net of tax benefits) for an $ 8 billion growing stream of income (cash). ~2x earnings. So this so-called dilution is completely reasonable.
Adam
Long position in Wells Fargo
* Wells initially paid $ 13.8 billion in stock and subsequently raised $ 12.6 billion. If you add the most recent $ 8.6 billion together the total amount of stock was $ 35 billion. Wells will get an estimated $ 19 billion tax benefit from the deal. I subtracted that tax benefit from the $ 35 billion to get the $ 16 billion. This is not meant to have false precision but it does give a more meaningful estimate of what the actual net cost to Wells shareholders have been for the deal.
While Wells did not pay all that money to Wachovia shareholders the total cost of gaining control includes the subsequent capital raises and tax benefits.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Monday, May 4, 2009
Wells Fargo
Wells Fargo will apparently be required to raise some capital.
While Wells regulatory capital ratios were fine before Wachovia, the size and scope of that troubled bank reduced the regulatory capital ratios of the combined Wells-Wachovia to the low end.
Wells is a very good banking franchise in my view. The franchise value will become more obvious over time as the superior economics of the Wells model kicks into gear.
I think Warren Buffett's view is the correct one but regulators don't look at the economics the same way he does. Buffett added the following:
"I can tell you that US Bancorp and Wells Fargo are extremely strong banks," Buffett said Monday in an interview with CNBC. "They have terrific earning power, and earning power is enormously important in what happens to a business in the future. And you couldn't have two better banks virtually positioned than those two for future earnings."
But Buffett said the stress test results might not fully reflect the banks' strength. A company with low production costs but lots of debt might survive a recession but flunk the test, while a company with high production costs and no debt might ace the test but could not survive price declines, he said.
Buffett said Wells Fargo has the lowest cost of production of any of the big banks.
In any case, the impact of dilution should not end up being significant so the long-term investment thesis remains roughly the same.
Adam
Long position in U.S. Bancorp and Wells Fargo
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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.
While Wells regulatory capital ratios were fine before Wachovia, the size and scope of that troubled bank reduced the regulatory capital ratios of the combined Wells-Wachovia to the low end.
Wells is a very good banking franchise in my view. The franchise value will become more obvious over time as the superior economics of the Wells model kicks into gear.
I think Warren Buffett's view is the correct one but regulators don't look at the economics the same way he does. Buffett added the following:
"I can tell you that US Bancorp and Wells Fargo are extremely strong banks," Buffett said Monday in an interview with CNBC. "They have terrific earning power, and earning power is enormously important in what happens to a business in the future. And you couldn't have two better banks virtually positioned than those two for future earnings."
But Buffett said the stress test results might not fully reflect the banks' strength. A company with low production costs but lots of debt might survive a recession but flunk the test, while a company with high production costs and no debt might ace the test but could not survive price declines, he said.
Buffett said Wells Fargo has the lowest cost of production of any of the big banks.
In any case, the impact of dilution should not end up being significant so the long-term investment thesis remains roughly the same.
Adam
Long position in U.S. Bancorp and Wells Fargo
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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.
Munger on Banks
Charlie Munger believes that...
"Evil and folly have crept into our system at steadily increasing amounts. And finally it helped create a catastrophe for everyone, created the biggest economic threat since 1930s." - Charlie Munger
...and would like a 100% ban on credit-default swaps.
"It isn't as though the economic world didn’t function quite well without it, and it isn't as though what has happened has been so wonderfully desirable that we should logically want more of it." - Charlie Munger
When Munger speaks he's usually rather direct.
Adam
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
"Evil and folly have crept into our system at steadily increasing amounts. And finally it helped create a catastrophe for everyone, created the biggest economic threat since 1930s." - Charlie Munger
...and would like a 100% ban on credit-default swaps.
"It isn't as though the economic world didn’t function quite well without it, and it isn't as though what has happened has been so wonderfully desirable that we should logically want more of it." - Charlie Munger
When Munger speaks he's usually rather direct.
Adam
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Stress Tests
Later this week we will hear the stress test results. Even though Buffett has made it clear he doesn't think Wells needs capital...the regulators will almost certainly require them to raise some.
The capital raise is not likely enough to cause major dilution so long-term I still view it as the best bank to own. If they do raise capital it is possible that the government's CAP conversion price ($ 16.78/share) will anchor the stock. That is why I have targeted buying new shares slightly below at $ 14/share for now. Once the amount of possible shareholder dilution is more clear I may increase that price.
Assuming only minor dilution from the stress tests I still view the intrinsic value of Wells to be $45-55/share within 3 years as I said on April 8th.
Adam
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Assuming only minor dilution from the stress tests I still view the intrinsic value of Wells to be $45-55/share within 3 years as I said on April 8th.
Adam
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Sunday, May 3, 2009
Buffett Dismisses Stress Tests
According to this Bloomberg article, here's what Warren Buffett had to say about the bank stocks he likes before the annual shareholder meeting:
I think I know their future, frankly, better than somebody that comes in to take a look..."
Regulators, "may be using more of a checklist-type approach."
Dynamism Matters
Buffett said he judges banks by their "dynamism" and their ability to attract deposits, and singled out San Francisco-based Wells Fargo as a "fabulous" company.
"If you look at Coca-Cola today, for example, and just looked at a balance sheet, it wouldn't tell you anything at all about Coca-Cola...It's what the product is."
Low Cost of Funding
U.S. banks can't be viewed indiscriminately, Buffett said, citing "real differences," such as varying costs of funding, that separate strong lenders from their weaker rivals.
Low cost money is crucial in banking. It's not much different than a mining company with lower cost of extraction. If loan are in general intelligently made, then low cost money increases return on equity and provides more capacity to absorb losses in an economic downturn.
Adam
Long Wells Fargo and Coca-Cola
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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.
I think I know their future, frankly, better than somebody that comes in to take a look..."
Regulators, "may be using more of a checklist-type approach."
Dynamism Matters
Buffett said he judges banks by their "dynamism" and their ability to attract deposits, and singled out San Francisco-based Wells Fargo as a "fabulous" company.
"If you look at Coca-Cola today, for example, and just looked at a balance sheet, it wouldn't tell you anything at all about Coca-Cola...It's what the product is."
Low Cost of Funding
U.S. banks can't be viewed indiscriminately, Buffett said, citing "real differences," such as varying costs of funding, that separate strong lenders from their weaker rivals.
Low cost money is crucial in banking. It's not much different than a mining company with lower cost of extraction. If loan are in general intelligently made, then low cost money increases return on equity and provides more capacity to absorb losses in an economic downturn.
Adam
Long Wells Fargo and Coca-Cola
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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.
Warren Buffett: "I Apply My Own Stress Test"
From a recent CNBC interview:
BUFFETT: I can tell you, I apply my own stress test and they passed it with flying colors.
BECKY QUICK: You apply your own stress test to Wells Fargo? How do you do that?
BUFFETT: Sure. Well, I do it by looking at the details of their operation. Wells Fargo obtains their money, which is the raw material, they obtain their money cheaper than anybody else. You can look at the figures for every bank and you would be startled at the trillion dollars, roughly, that Wells Fargo gets from depositors, and to some extent from debt -- how much more cheap, how cheap that is compared to most of the other big banks. If you're a copper producer, and copper is selling for two dollars a pound, and you want to measure the stress of copper going to $1.30, for a guy whose production cost is $1.50, you know, he's got problems. If his cost is a dollar, he doesn't have problems. And Wells, in terms of its raw material costs, is better situated than any large bank, by some margin. So, it's built to sustain a lot.
The comments above are related to a core investing concept of Warren Buffett's that is worth repeating. What produces excess rates of return?
According to Buffett it is...
...a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.
Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price. Consumer franchises are a prime source of economic Goodwill. Other sources include governmental franchises not subject to profit regulation, such as television stations, and an enduring position as the low cost producer in an industry. - 1983 Berkshire Hathaway (BRKa) Shareholder Letter
The better banks produce excess returns by a) having a solid consumer franchise and b) a durable low cost position (i.e. an ability to obtain cheaper deposits than competitors).
The capitalized value of these excess returns is economic Goodwill.
While you will not find this type of Goodwill on a balance sheet, it is very real in an economic sense. You certainly will never find it in TCE (Tangible Common Equity) which is why that measure cannot possibly tell you the health of a bank.*
- When value of the product to the purchaser is the major determinant of selling price...excess returns can occur (Examples: Coca-Cola: KO, Wrigley, and See's Candies)
- When a company is the durable low cost producer in an industry...excess returns can also occur (Examples: Wells Fargo: WFC, and GEICO)
The better businesses have economic Goodwill but many businesses do not. By the way, a lot of complex math is not required. While you have to know how to interpret financial statements most of the important work is qualitative (strength of brands, products, distribution, culture, management etc).
Berkshire's stock did not go up over 90,000% since 1977 by carefully timing stock trades, sector rotation strategies, complex quantitative analysis etc. It was done by owning the right businesses then allowing the power of compounding do the heavy lifting. Keep in mind, almost ten of those 32 years was the so-called lost past decade for stocks. Also, Buffett's investment returns in the 20+ years he invested prior to 1977 are equally impressive so we are talking about a 50+ year track record.
$10k invested Berkshire in 1977 is worth over $ 9 million today
$10k invested in the S&P 500 in 1977 is worth just over $ 70k today
The difference? Berkshire has always owned stocks or businesses with tons of economic Goodwill while the S&P 500 has many businesses in it that do not have such economics working for them.
A satisfactory or better outcome accomplished with minimal trading activity.
It's buying great businesses at the right price and allowing Newton's 4th Law to work.
Adam
Long Berkshire, and Coca-Cola, and Wells Fargo
* Regulators, of course, have to operate under existing accounting rules and other regs while I am strictly looking at this from an economic point of view. Banks may be forced to raise capital for many technical or even political reasons. That does not mean it necessarily makes economic sense for each individual bank. There are some banks that do need capital but it's not because of low TCE. It will be because they lack earning power relative to the quality of their assets.
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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.
BUFFETT: I can tell you, I apply my own stress test and they passed it with flying colors.
BECKY QUICK: You apply your own stress test to Wells Fargo? How do you do that?
BUFFETT: Sure. Well, I do it by looking at the details of their operation. Wells Fargo obtains their money, which is the raw material, they obtain their money cheaper than anybody else. You can look at the figures for every bank and you would be startled at the trillion dollars, roughly, that Wells Fargo gets from depositors, and to some extent from debt -- how much more cheap, how cheap that is compared to most of the other big banks. If you're a copper producer, and copper is selling for two dollars a pound, and you want to measure the stress of copper going to $1.30, for a guy whose production cost is $1.50, you know, he's got problems. If his cost is a dollar, he doesn't have problems. And Wells, in terms of its raw material costs, is better situated than any large bank, by some margin. So, it's built to sustain a lot.
The comments above are related to a core investing concept of Warren Buffett's that is worth repeating. What produces excess rates of return?
According to Buffett it is...
...a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.
Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price. Consumer franchises are a prime source of economic Goodwill. Other sources include governmental franchises not subject to profit regulation, such as television stations, and an enduring position as the low cost producer in an industry. - 1983 Berkshire Hathaway (BRKa) Shareholder Letter
The better banks produce excess returns by a) having a solid consumer franchise and b) a durable low cost position (i.e. an ability to obtain cheaper deposits than competitors).
The capitalized value of these excess returns is economic Goodwill.
While you will not find this type of Goodwill on a balance sheet, it is very real in an economic sense. You certainly will never find it in TCE (Tangible Common Equity) which is why that measure cannot possibly tell you the health of a bank.*
- When value of the product to the purchaser is the major determinant of selling price...excess returns can occur (Examples: Coca-Cola: KO, Wrigley, and See's Candies)
- When a company is the durable low cost producer in an industry...excess returns can also occur (Examples: Wells Fargo: WFC, and GEICO)
The better businesses have economic Goodwill but many businesses do not. By the way, a lot of complex math is not required. While you have to know how to interpret financial statements most of the important work is qualitative (strength of brands, products, distribution, culture, management etc).
Berkshire's stock did not go up over 90,000% since 1977 by carefully timing stock trades, sector rotation strategies, complex quantitative analysis etc. It was done by owning the right businesses then allowing the power of compounding do the heavy lifting. Keep in mind, almost ten of those 32 years was the so-called lost past decade for stocks. Also, Buffett's investment returns in the 20+ years he invested prior to 1977 are equally impressive so we are talking about a 50+ year track record.
$10k invested Berkshire in 1977 is worth over $ 9 million today
$10k invested in the S&P 500 in 1977 is worth just over $ 70k today
The difference? Berkshire has always owned stocks or businesses with tons of economic Goodwill while the S&P 500 has many businesses in it that do not have such economics working for them.
A satisfactory or better outcome accomplished with minimal trading activity.
It's buying great businesses at the right price and allowing Newton's 4th Law to work.
Adam
Long Berkshire, and Coca-Cola, and Wells Fargo
* Regulators, of course, have to operate under existing accounting rules and other regs while I am strictly looking at this from an economic point of view. Banks may be forced to raise capital for many technical or even political reasons. That does not mean it necessarily makes economic sense for each individual bank. There are some banks that do need capital but it's not because of low TCE. It will be because they lack earning power relative to the quality of their assets.
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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.
Max Planck: Resistance of the Human Mind
According to this Wall Street Journal article, there's been a recurring theme of Warren Buffett and Charlie Munger at the latest Berkshire Hathaway meeting.
What's the theme?
...their complete disdain for modern portfolio theory and the use of higher-order mathematics in finance.
Buffett and Munger: Stay Away From Complex Math, Theories
In the same article, Buffett refers to something Max Planck once said:*
Mr. Buffett on the persistence of bad ideas in finance: "The famous physicist Max Planck was talking about the resistance of the human mind, even the bright human mind, to new ideas.... And he said science advances one funeral at a time, and I think there's a lot of truth to that and it's certainly been true in finance."
This is sort of along the same lines of this older Munger comment at the 2007 Berkshire Hathaway meeting:
"We'd argue that what's taught is at least 50% twaddle, but these people have high IQs. 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."
They are certainly no fan of the way finance and investing is taught in academia.
Adam
* "A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it." - Max Planck
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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.
What's the theme?
...their complete disdain for modern portfolio theory and the use of higher-order mathematics in finance.
Buffett and Munger: Stay Away From Complex Math, Theories
In the same article, Buffett refers to something Max Planck once said:*
Mr. Buffett on the persistence of bad ideas in finance: "The famous physicist Max Planck was talking about the resistance of the human mind, even the bright human mind, to new ideas.... And he said science advances one funeral at a time, and I think there's a lot of truth to that and it's certainly been true in finance."
This is sort of along the same lines of this older Munger comment at the 2007 Berkshire Hathaway meeting:
"We'd argue that what's taught is at least 50% twaddle, but these people have high IQs. 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."
They are certainly no fan of the way finance and investing is taught in academia.
Adam
* "A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it." - Max Planck
---
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.
Saturday, May 2, 2009
Free Cash Flow
Buffett said the following at today's Berkshire Shareholders meeting in response to a question about Free Cash Flow...
From CNBC
"Investing is about laying out cash to get more cash later. If you need a computer or calculation to figure it out you shouldn't buy it".
All the formulas, ratios, and detailed spreadsheets in the world will not help you understand many of the intangible qualities that matter far more in investing.
Adam
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
From CNBC
"Investing is about laying out cash to get more cash later. If you need a computer or calculation to figure it out you shouldn't buy it".
All the formulas, ratios, and detailed spreadsheets in the world will not help you understand many of the intangible qualities that matter far more in investing.
Adam
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Buffett Would like to Buy All of These 2 Banks...
...if he could.
Warren Buffett tells shareholders that "I would love to buy all of US Bancorp or I would love to buy all of Wells Fargo, if we were allowed to do it."
Buffett says they're making a lot of money and have strong earnings power, in contrast to a company like Chrysler.
Buffett again singled out Wells Fargo for particular praise, calling it a "fabulous" bank that "will be a lot better off in a couple of years than if none of this had happened."
Recalling that Wells shares fell below $9 earlier in the year, he said at that price, "If I had put all my net worth in one stock, that would be the stock."
Not all banks are created equal even if, in the short-to-intermediate run, the price action in the capital markets makes it seem that way. The problem becomes self-fulfilling when the better banks are forced to raise capital at prices that are far less than their per share intrinsic value.
As Clint Eastwood once said in the movie Unforgiven:
"Deserve's got nothin' to do with it."
The transfer of wealth represents real money whether it's fair or not.
Adam
Long U.S Bancorp and Wells Fargo
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.
Warren Buffett tells shareholders that "I would love to buy all of US Bancorp or I would love to buy all of Wells Fargo, if we were allowed to do it."
Buffett says they're making a lot of money and have strong earnings power, in contrast to a company like Chrysler.
Buffett again singled out Wells Fargo for particular praise, calling it a "fabulous" bank that "will be a lot better off in a couple of years than if none of this had happened."
Recalling that Wells shares fell below $9 earlier in the year, he said at that price, "If I had put all my net worth in one stock, that would be the stock."
Not all banks are created equal even if, in the short-to-intermediate run, the price action in the capital markets makes it seem that way. The problem becomes self-fulfilling when the better banks are forced to raise capital at prices that are far less than their per share intrinsic value.
As Clint Eastwood once said in the movie Unforgiven:
"Deserve's got nothin' to do with it."
The transfer of wealth represents real money whether it's fair or not.
Adam
Long U.S Bancorp and Wells Fargo
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, May 1, 2009
The Formula That Killed Wall Street
Good article on how formulas seem to work...
"Beware of geeks bearing formulas." - Warren Buffett
...until they don't.
Adam
HT: Mike Panizza
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.
"Beware of geeks bearing formulas." - Warren Buffett
...until they don't.
Adam
HT: Mike Panizza
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.
PetroChina
Below is something I wrote back in November 2007 to take a jab at what I thought was the general overvaluation of many stocks (especially those in emerging markets). So I picked on PetroChina and its $ 1 trillion market valuation. Unlike now, it was very difficult to buy inexpensive shares of good businesses at a fair price. The following was initially posted on November 7, 2007.
This blog didn't exist yet.
Club for Growth//Blog
______________________________________________
My view was that many stocks were selling at crazy valuations back in November 2007. I was also concerned about excessive leverage -- much of it, because of derivatives, not transparent enough to understand -- along with some of the other prevailing, rather dangerous, practices at some of the larger financial institutions. Yet I had no idea that we were within weeks of the peak in the stock market, and at the beginning of one vicious bear market.
Adam
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
This blog didn't exist yet.
Club for Growth//Blog
______________________________________________
What $1 Trillion Will Get You...
Posted on Nov. 7, 2007| 02:30 PM
Link to Article: http://www.clubforgrowth.org/perm/?postID=7762
______________________________________________
My pal Adam...just sent me and a few other guys the following email. In case you missed it, PetroChina went public on the Shanghai Exchange on Monday. The immediate valuation put the company's overall price tag at roughly $1 trillion.Link to Article: http://www.clubforgrowth.org/perm/?postID=7762
______________________________________________
I guess PetroChina is now worth $ 1 trillion. It got me to wondering. If we could pool together $ 1 trillion we could go on one hell of a shopping spree.
The combined value of all 17 of the companies listed below is less than $1 trillion so we could own all 17 of them instead of just owning PetroChina.
By the way, since we would still have $ 22 billion left over of play money we could then use that remaining dough to buy out all of Ferrari's production through 2030 or so....or just buy Ferrari the company itself. Whatever.
Of course, there may be some anti-trust issues owning the entire US Railroad Industry and both of Korea's major telecom companies. I don't think anyone will care about us owning both GM and Ford.
The number on the right is market value in billions.
Bank of America BAC 197.40 Altria MO 152.77 Verizon VZ 126.39 Pepsi PEP 117.4 American Express AXP 65.78 Home Depot HD 58.47 eBay EBAY 46.26 Lowe's LOW 36.23 Union Pacific UNP 32.86 Burlington Northern BNI 29.94 Korean Telecom SKM 20.52 Norfolk So. NSC 19.59 GM GM 19.52 CSX Corp. CSX 18.49 Ford F 17.66 KTC Corp. KTC 9.59 Expedia EXPE 9.32 TOTAL: 978.04 Billion
Permalink: http://www.clubforgrowth.org/perm/?postID=7762
My view was that many stocks were selling at crazy valuations back in November 2007. I was also concerned about excessive leverage -- much of it, because of derivatives, not transparent enough to understand -- along with some of the other prevailing, rather dangerous, practices at some of the larger financial institutions. Yet I had no idea that we were within weeks of the peak in the stock market, and at the beginning of one vicious bear market.
Adam
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
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