A follow up to this previous post:
In this section of a 1994 speech by Charlie Munger at USC Business School, he gets beyond the "carrots" and talks more specifically about stocks and investing models.
Again, it's worth checking out the whole speech but below I've included some highlights:
Microeconomics
"Personally, I've gotten so that I now use a kind of two-track analysis. First, what are the factors that really govern the interests involved, rationally considered?
And second, what are the subconscious influences where the brain at a subconscious level is automatically doing these things which by and large are useful, but which often misfunction.
One approach is rationality the way you'd work out a bridge problem: by evaluating the real interests, the real probabilities and so forth. And the other is to evaluate the psychological factors that cause subconscious conclusions many of which are wrong.
Now we come to another somewhat less reliable form of human wisdom...microeconomics. And here, I find it quite useful to think of a free market economy or partly free market economy as sort of the equivalent of an ecosystem..."
"Just as in an ecosystem, people who narrowly specialize can get terribly good at occupying some little niche. Just as animals flourish in niches, similarly, people who specialize in the business world ‑ and get very good because they specialize frequently find good economics that they wouldn't get any other way.
And once we get into microeconomics, we get into the concept of advantages of scale. Now we're getting closer to investment analysis..."
Advantages of Scale
"Let's go through a list albeit an incomplete one of possible advantages of scale. Some come from simple geometry. If you're building a great spherical tank, obviously as you build it bigger, the amount of steel you use in the surface goes up with the square and the cubic volume goes up with the cube. So as you increase the dimensions, you can hold a lot more volume per unit area of steel.
And there are all kinds of things like that where the simple geometry—the simple reality—gives you an advantage of scale.
For example, you can get advantages of scale from TV advertising. When TV advertising first arrived when talking color pictures first came into our living rooms it was an unbelievably powerful thing. And in the early days, we had three networks that had whatever it was say 90% of the audience.
Well, if you were Procter & Gamble, you could afford to use this new method of advertising. You could afford the very expensive cost of network television because you were selling so many cans and bottles. Some little guy couldn't. And there was no way of buying it in part. Therefore, he couldn't use it. In effect, if you didn't have a big volume, you couldn't use network TV advertising which was the most effective technique."
"And your advantage of scale can be an informational advantage. If I go to some remote place, I may see Wrigley chewing gum alongside Glotz's chewing gum. Well, I know that Wrigley is a satisfactory product, whereas I don't know anything about Glotz's. So if one is 40 cents and the other is 30 cents, am I going to take something I don't know and put it in my mouth which is a pretty personal place, after all for a lousy dime?
So, in effect, Wrigley, simply by being so well known, has advantages of scale what you might call an informational advantage.
Another advantage of scale comes from psychology. The psychologists use the term 'social proof'. We are all influenced subconsciously and to some extent consciously by what we see others do and approve. Therefore, if everybody's buying something, we think it's better."
"The social proof phenomenon which comes right out of psychology gives huge advantages to scale ‑ for example, with very wide distribution, which of course is hard to get. One advantage of Coca-Cola is that it's available almost everywhere in the world.
Well, suppose you have a little soft drink. Exactly how do you make it available all over the Earth? The worldwide distribution setup which is slowly won by a big enterprise gets to be a huge advantage.... And if you think about it, once you get enough advantages of that type, it can become very hard for anybody to dislodge you."
"And these advantages of scale are so great, for example, that when Jack Welch came into General Electric, he just said, 'To hell with it. We're either going to be # 1 or #2 in every field we're in or we're going to be out. I don't care how many people I have to fire and what I have to sell. We're going to be #1 or #2 or out.'
That was a very tough‑minded thing to do, but I think it was a very correct decision if you're thinking about maximizing shareholder wealth. And I don't think it's a bad thing to do for a civilization either, because I think that General Electric is stronger for having Jack Welch there."
"On the subject of advantages of economies of scale, I find chain stores quite interesting. Just think about it. The concept of a chain store was a fascinating invention. You get this huge purchasing power which means that you have lower merchandise costs. You get a whole bunch of little laboratories out there in which you can conduct experiments. And you get specialization."
"If one little guy is trying to buy across 27 different merchandise categories influenced by traveling salesmen, he's going to make a lot of poor decisions. But if your buying is done in headquarters for a huge bunch of stores, you can get very bright people that know a lot about refrigerators and so forth to do the buying.
So there are huge purchasing advantages. And then there are the slick systems of forcing everyone to do what works. So a chain store can be a fantastic enterprise."
"And it makes sense to load up on the very few good insights you have instead of pretending to know everything about everything at all times. You're much more likely to do well if you start out to do something feasible instead of something that isn't feasible. Isn't that perfectly obvious?
How many of you have 56 brilliant ideas in which you have equal confidence? Raise your hands, please. How many of you have two or three insights that you have some confidence in? I rest my case.
I'd say that Berkshire Hathaway's system is adapting to the nature of the investment problem as it really is."
High Quality Businesses, Low Frictional Costs
"We've really made the money out of high quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money's been made in the high quality businesses. And most of the other people who've made a lot of money have done so in high quality businesses.
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."
"There are huge advantages for an individual to get into a position where you make a few great investments and just sit back and wait: You're paying less to brokers. You're listening to less nonsense. And if it works, the governmental tax system gives you an extra 1, 2 or 3 percentage points per annum compounded.
And you think that most of you are going to get that much advantage by hiring investment counselors and paying them 1% to run around, incurring a lot of taxes on your behalf? Lots of luck."
"Are there any dangers in this philosophy? Yes. Everything in life has dangers. Since it's so obvious that investing in great companies works, it gets horribly overdone from time to time. In the "Nifty-Fifty" days, everybody could tell which companies were the great ones. So they got up to 50, 60 and 70 times earnings. And just as IBM fell off the wave, other companies did, too. Thus, a large investment disaster resulted from too high prices. And you've got to be aware of that danger...
So there are risks. Nothing is automatic and easy. But if you can find some fairly-priced great company and buy it and sit, that tends to work out very, very well indeed especially for an individual."
Pricing Power
"Within the growth stock model, there's a sub-position: There are actually businesses, that you will find a few times in a lifetime, where any manager could raise the return enormously just by raising prices and yet they haven't done it. So they have huge untapped pricing power that they're not using. That is the ultimate no-brainer."
"You will get a few opportunities to profit from finding underpricing. There are actually people out there who don't price everything as high as the market will easily stand. And once you figure that out, it's like finding money in the street - ifyou have the courage of your convictions."
Newspapers
"If you look at Berkshire's investments where a lot of the money's been made and you look for the models, you can see that we twice bought into two newspaper towns which have since become one newspaper towns. So we made a bet to some extent...
In one of those The Washington Post we bought it at about 20% of the value to a private owner. So we bought it on a Ben Graham style basis at one fifth of obvious value and, in addition, we faced a situation where you had both the top hand in a game that was clearly going to end up with one winner and a management with a lot of integrity and intelligence. That one was a real dream. They're very high class people ‑ the Katharine Graham family. That's why it was a dream an absolute, damn dream.
Of course, that came about back in '73 - 74. And that was almost like 1932. That was probably a once-in-40-years type denouement in the markets. That investment's up about 50 times over our cost.
If I were you, I wouldn't count on getting any investment in your lifetime quite as good as The Washington Post was in '73 and '74.
But it doesn't have to be that good to take care of you."
Marketing & Technology Advantages
"Let me mention another model. Of course, Gillette and Coke make fairly low‑priced items and have a tremendous marketing advantage all over the world. And in Gillette's case, they keep surfing along new technology which is fairly simple by the standards of microchips. But it's hard for competitors to do.
So they've been able to stay constantly near the edge of improvements in shaving. There are whole countries where Gillette has more than 90% of the shaving market."
GEICO
"GEICO is a very interesting model. It's another one of the 100 or so models you ought to have in your head. I've had many friends in the sick business fix up game over a long lifetime. And they practically all use the following formula I call it the cancer surgery formula:
They look at this mess. And they figure out if there's anything sound left that can live on its own if they cut away everything else. And if they find anything sound, they just cut away everything else. Of course, if that doesn't work, they liquidate the business. But it frequently does work.
And GEICO had a perfectly magnificent business - submerged in a mess, but still working. Misled by success, GEICO had done some foolish things. They got to thinking that, because they were making a lot of money, they knew everything. And they suffered huge losses.
All they had to do was to cut out all the folly and go back to the perfectly wonderful business that was lying there. And when you think about it, that's a very simple model. And it's repeated over and over again.
And, in GEICO's case, think about all the money we passively made....It was a wonderful business combined with a bunch of foolishness that could easily be cut out. And people were coming in who were temperamentally and intellectually designed so they were going to cut it out. That is a model you want to look for.
And you may find one or two or three in a long lifetime that are very good. And you may find 20 or 30 that are good enough to be quite useful." - Charlie Munger
With so much focus on the many macro problems, it's easy to forget it is things like some of the above investing models that matter when it comes to successful stock picking.
By the way, if you look over the past century or so, there are relatively few periods when there were not serious macro challenges yet lots of money was made by owning shares of the quality businesses.
Adam
Munger on Elementary, Worldly Wisdom
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, August 28, 2009
Munger on Elementary, Worldly Wisdom
Below are some excerpts from a 1994 speech by Charlie Munger at the USC Business School. It's well worth reading the whole speech but below I've highlighted some noteworthy things:
Latticework of Models
"What is elementary, worldly wisdom? Well, the first rule is that you can't really know anything if you just remember isolated facts and try and bang 'em back. If the facts don't hang together on a latticework of theory, you don't have them in a usable form.
You've got to have models in your head. And you've got to array your experience both vicarious and direct on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and in life. You've got to hang experience on a latticework of models in your head.
What are the models? Well, the first rule is that you've got to have multiple models because if you just have one or two that you're using, the nature of human psychology is such that you'll torture reality..."
Elementary Mathematics
"...you've got to be able to handle numbers and quantities - basic arithmetic. And the great useful model, after compound interest, is the elementary math of permutations and combinations."
"At Harvard Business School, the great quantitative thing that bonds the first year class together is what they call decision tree theory. All they do is take high school algebra and apply it to real life problems. And the students love it. They're amazed to find that high school algebra works in life..."
"If you don't get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one‑legged man in an ass‑kicking contest. You're giving a huge advantage to everybody else."
Limitations of Accounting
"Obviously, you have to know accounting. It's the language of practical business life. It was a very useful thing to deliver to civilization. I've heard it came to civilization through Venice which of course was once the great commercial power in the Mediterranean. However, double-entry bookkeeping was a hell of an invention."
"But you have to know enough about it to understand its limitations - because although accounting is the starting place, it's only a crude approximation."
"In terms of the limitations of accounting, one of my favorite stories involves a very great businessman named Carl Braun who created the CF Braun Engineering Company. It designed and built oil refineries ‑ which is very hard to do. And Braun would get them to come in on time and not blow up and have efficiencies and so forth. This is a major art.
And Braun, being the thorough Teutonic type that he was, had a number of quirks. And one of them was that he took a look at standard accounting and the way it was applied to building oil refineries and he said, 'This is asinine.'
So he threw all of his accountants out and he took his engineers and said, "Now, we'll devise our own system of accounting to handle this process. "And in due time, accounting adopted a lot of Carl Braun's notions. So he was a formidably willful and talented man who demonstrated both the importance of accounting and the importance of knowing its limitations."
Most Reliable Models
"Which models are the most reliable? Well, obviously, the models that come from hard science and engineering are the most reliable models on this Earth."
"I don't think it's necessary for most people to be terribly facile in statistics. For example, I'm not sure that I can even pronounce the Poisson distribution. But I know what a Gaussian or normal distribution looks like and I know that events and huge aspects of reality end up distributed that way. So I can do a rough calculation.
But if you ask me to work out something involving a Gaussian distribution to ten decimal points, I can't sit down and do the math. I'm like a poker player who's learned to play pretty well without mastering Pascal.
And by the way, that works well enough. But you have to understand that bell‑shaped curve at least roughly as well as I do.
And, of course, the engineering idea of a backup system is a very powerful idea. The engineering idea of breakpoints that's a very powerful model, too. The notion of a critical mass that comes out of physics is a very powerful model."
"I suppose the next most reliable models are from biology/ physiology because, after all, all of us are programmed by our genetic makeup to be much the same."
Psychology and the Limitations of Cognitive Apparatus
"And then when you get into psychology, of course, it gets very much more complicated. But it's an ungodly important subject if you're going to have any worldly wisdom.
And you can demonstrate that point quite simply: There's not a person in this room viewing the work of a very ordinary professional magician who doesn't see a lot of things happening that aren't happening and not see a lot of things happening that are happening.
And the reason why is that the perceptual apparatus of man has shortcuts in it. The brain cannot have unlimited circuitry. So someone who knows how to take advantage of those shortcuts and cause the brain to miscalculate in certain ways can cause you to see things that aren't there.
Now you get into the cognitive function as distinguished from the perceptual function. And there, you are equally...more than equally in fact...likely to be misled. Again, your brain has a shortage of circuitry and so forth and it's taking all kinds of little automatic shortcuts."
"And so just as a man working with a tool has to know its limitations, a man working with his cognitive apparatus has to know its limitations."
"So the most useful and practical part of psychology which I personally think can be taught to any intelligent person in a week is ungodly important. And nobody taught it to me by the way. I had to learn it later in life, one piece at a time. And it was fairly laborious. It's so elementary though that, when it was all over, I felt like a fool.
And yeah, I'd been educated at Cal Tech and the Harvard Law School and so forth. So very eminent places mis-educated people like you and me.
The elementary part of psychology - the psychology of misjudgment, as I call it is a terribly important thing to learn. There are about 20 little principles. And they interact, so it gets slightly complicated. But the guts of it is unbelievably important.
Terribly smart people make totally bonkers mistakes by failing to pay heed to it. In fact, I've done it several times during the last two or three years in a very important way. You never get totally over making silly mistakes." - Charlie Munger
Later in the talk, Munger gets more specific about stocks and investing models. I'll follow up on this in a separate post.
Adam
Munger on Elementary, Worldly Wisdom - Part II
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Latticework of Models
"What is elementary, worldly wisdom? Well, the first rule is that you can't really know anything if you just remember isolated facts and try and bang 'em back. If the facts don't hang together on a latticework of theory, you don't have them in a usable form.
You've got to have models in your head. And you've got to array your experience both vicarious and direct on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and in life. You've got to hang experience on a latticework of models in your head.
What are the models? Well, the first rule is that you've got to have multiple models because if you just have one or two that you're using, the nature of human psychology is such that you'll torture reality..."
Elementary Mathematics
"...you've got to be able to handle numbers and quantities - basic arithmetic. And the great useful model, after compound interest, is the elementary math of permutations and combinations."
"At Harvard Business School, the great quantitative thing that bonds the first year class together is what they call decision tree theory. All they do is take high school algebra and apply it to real life problems. And the students love it. They're amazed to find that high school algebra works in life..."
"If you don't get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one‑legged man in an ass‑kicking contest. You're giving a huge advantage to everybody else."
Limitations of Accounting
"Obviously, you have to know accounting. It's the language of practical business life. It was a very useful thing to deliver to civilization. I've heard it came to civilization through Venice which of course was once the great commercial power in the Mediterranean. However, double-entry bookkeeping was a hell of an invention."
"But you have to know enough about it to understand its limitations - because although accounting is the starting place, it's only a crude approximation."
"In terms of the limitations of accounting, one of my favorite stories involves a very great businessman named Carl Braun who created the CF Braun Engineering Company. It designed and built oil refineries ‑ which is very hard to do. And Braun would get them to come in on time and not blow up and have efficiencies and so forth. This is a major art.
And Braun, being the thorough Teutonic type that he was, had a number of quirks. And one of them was that he took a look at standard accounting and the way it was applied to building oil refineries and he said, 'This is asinine.'
So he threw all of his accountants out and he took his engineers and said, "Now, we'll devise our own system of accounting to handle this process. "And in due time, accounting adopted a lot of Carl Braun's notions. So he was a formidably willful and talented man who demonstrated both the importance of accounting and the importance of knowing its limitations."
Most Reliable Models
"Which models are the most reliable? Well, obviously, the models that come from hard science and engineering are the most reliable models on this Earth."
"I don't think it's necessary for most people to be terribly facile in statistics. For example, I'm not sure that I can even pronounce the Poisson distribution. But I know what a Gaussian or normal distribution looks like and I know that events and huge aspects of reality end up distributed that way. So I can do a rough calculation.
But if you ask me to work out something involving a Gaussian distribution to ten decimal points, I can't sit down and do the math. I'm like a poker player who's learned to play pretty well without mastering Pascal.
And by the way, that works well enough. But you have to understand that bell‑shaped curve at least roughly as well as I do.
And, of course, the engineering idea of a backup system is a very powerful idea. The engineering idea of breakpoints that's a very powerful model, too. The notion of a critical mass that comes out of physics is a very powerful model."
"I suppose the next most reliable models are from biology/ physiology because, after all, all of us are programmed by our genetic makeup to be much the same."
Psychology and the Limitations of Cognitive Apparatus
"And then when you get into psychology, of course, it gets very much more complicated. But it's an ungodly important subject if you're going to have any worldly wisdom.
And you can demonstrate that point quite simply: There's not a person in this room viewing the work of a very ordinary professional magician who doesn't see a lot of things happening that aren't happening and not see a lot of things happening that are happening.
And the reason why is that the perceptual apparatus of man has shortcuts in it. The brain cannot have unlimited circuitry. So someone who knows how to take advantage of those shortcuts and cause the brain to miscalculate in certain ways can cause you to see things that aren't there.
Now you get into the cognitive function as distinguished from the perceptual function. And there, you are equally...more than equally in fact...likely to be misled. Again, your brain has a shortage of circuitry and so forth and it's taking all kinds of little automatic shortcuts."
"And so just as a man working with a tool has to know its limitations, a man working with his cognitive apparatus has to know its limitations."
"So the most useful and practical part of psychology which I personally think can be taught to any intelligent person in a week is ungodly important. And nobody taught it to me by the way. I had to learn it later in life, one piece at a time. And it was fairly laborious. It's so elementary though that, when it was all over, I felt like a fool.
And yeah, I'd been educated at Cal Tech and the Harvard Law School and so forth. So very eminent places mis-educated people like you and me.
The elementary part of psychology - the psychology of misjudgment, as I call it is a terribly important thing to learn. There are about 20 little principles. And they interact, so it gets slightly complicated. But the guts of it is unbelievably important.
Terribly smart people make totally bonkers mistakes by failing to pay heed to it. In fact, I've done it several times during the last two or three years in a very important way. You never get totally over making silly mistakes." - Charlie Munger
Later in the talk, Munger gets more specific about stocks and investing models. I'll follow up on this in a separate post.
Adam
Munger on Elementary, Worldly Wisdom - Part II
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Thursday, August 27, 2009
World's Safest Banks 2009
For 18 years Global Finance has been publishing its "World's 50 Safest Banks" list.
The new list was just published on August 25th. Five of the fifty banks on the list are located in the US:
Bank of New York Mellon # 32
JP Morgan Chase # 39
Wells Fargo # 42
U.S. Bancorp # 47
Northern Trust # 49
According to the list the safest bank in the world is KfW in Germany.
Adam
Long Wells Fargo and U.S. Bancorp
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 new list was just published on August 25th. Five of the fifty banks on the list are located in the US:
Bank of New York Mellon # 32
JP Morgan Chase # 39
Wells Fargo # 42
U.S. Bancorp # 47
Northern Trust # 49
According to the list the safest bank in the world is KfW in Germany.
Adam
Long Wells Fargo and U.S. Bancorp
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Wednesday, August 26, 2009
An Interview with Charlie Munger
Some excerpts from this interview with Charlie Munger:
Munger: "Interest rate swaps have enormous dangers given their size and the accounting that has been allowed. But credit default derivatives took that danger to new levels of excess—from something that was already gross and wrong. In the '20s we had the 'bucket shop.' The term bucket shop was a term of derision, because it described a gambling parlor. The bucket shop didn’t buy any securities. It just enabled people to make bets against the house and the house furnished little statements of how the bets came out. It was like the off-track betting system."
"Derivatives trading, with no central clearing, brought back the bucket shop, because you could make bets without having any interest in the basic security, and people did make such bets in the billions and billions of dollars. Some of the most admired people in finance—including Alan Greenspan—argued that derivatives trading, substituting for the old bucket shop, was a great contribution to modern economic civilization. There's another word for this: bonkers. It is not a credit to academic economics that Greenspan's view was so common."
"I would argue that the economists have not been all that good at working concepts of good and evil into their profession. Nor do they understand, at all well, the economic consequences of bad accounting."
"They say it's not economics if you think about the consequences of good and evil, and good and bad business accounting. I think what we’re learning is that when you don’t understand these consequences, you don't have an adequately skilled profession. You have big gaps in what you need. You have a profession that's like the man that Nietzsche ridiculed because he had a lame leg and was very proud of it. The economics profession has been proud of its lame leg."
"If you totally divorce economics from psychology, you've gone a long way toward divorcing it from reality."
Munger: "We may be forced into much desirable change. If there aren't a lot of new jobs in derivative trading, maybe the engineers will have to do more engineering. If you look at the history of Berkshire Hathaway, you will find that time after time we did something that I describe as turning lemons into lemonade. Part of my Berkshire Hathaway holdings came from a dumb investment."
Interviewer: "I didn't realize you made dumb investments."
Munger: "I certainly did. I think it's part of a life lived right that you learn how to make some lemonade out of your lemons."
The complete interview can be found here.
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.
Munger: "Interest rate swaps have enormous dangers given their size and the accounting that has been allowed. But credit default derivatives took that danger to new levels of excess—from something that was already gross and wrong. In the '20s we had the 'bucket shop.' The term bucket shop was a term of derision, because it described a gambling parlor. The bucket shop didn’t buy any securities. It just enabled people to make bets against the house and the house furnished little statements of how the bets came out. It was like the off-track betting system."
"Derivatives trading, with no central clearing, brought back the bucket shop, because you could make bets without having any interest in the basic security, and people did make such bets in the billions and billions of dollars. Some of the most admired people in finance—including Alan Greenspan—argued that derivatives trading, substituting for the old bucket shop, was a great contribution to modern economic civilization. There's another word for this: bonkers. It is not a credit to academic economics that Greenspan's view was so common."
"I would argue that the economists have not been all that good at working concepts of good and evil into their profession. Nor do they understand, at all well, the economic consequences of bad accounting."
"They say it's not economics if you think about the consequences of good and evil, and good and bad business accounting. I think what we’re learning is that when you don’t understand these consequences, you don't have an adequately skilled profession. You have big gaps in what you need. You have a profession that's like the man that Nietzsche ridiculed because he had a lame leg and was very proud of it. The economics profession has been proud of its lame leg."
"If you totally divorce economics from psychology, you've gone a long way toward divorcing it from reality."
Munger: "We may be forced into much desirable change. If there aren't a lot of new jobs in derivative trading, maybe the engineers will have to do more engineering. If you look at the history of Berkshire Hathaway, you will find that time after time we did something that I describe as turning lemons into lemonade. Part of my Berkshire Hathaway holdings came from a dumb investment."
Interviewer: "I didn't realize you made dumb investments."
Munger: "I certainly did. I think it's part of a life lived right that you learn how to make some lemonade out of your lemons."
The complete interview can be found here.
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, August 24, 2009
Bespoke on the Bull
Generally, I do not spend any time thinking about markets -- bull, bear, or whatever. My focus is on buying shares of great businesses at the right price. To allow growth in intrinsic value of the businesses themselves over time to do the heavy lifting instead of some special ability to trade or time the market.
I've always found Ben Graham's Mr. Market allegory to be useful. To me, it's as relevant as ever.
Ben's Mr. Market allegory may seem out-of-date in today's investment world, in which 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
It's a simple but useful idea. Mr. Market experiences extreme mood swings and, as a result, often wants to sell or buy businesses well above or below intrinsic value.
"The market is a psychotic, drunk, manic-depressive selling 4,000 companies every day. In one year, the high will double the low. These businesses are no more volatile than a farm or an apartment block [whose values do not swing so wildly]." - Warren Buffett at Wharton*
So not a new idea but still just as useful today as ever if you are a long-term investor. Certainly more useful than the myriad technical approaches that are so popular (traders probably have a different view...I can't speak to that).
Having said that, Bespoke Investment Group does provide some great statistics on markets for those that are more interested in this stuff than I. Here is one of their posts from this morning comparing the current bull market to past ones going back to the 1920's.
Adam
* Based upon notes that were taken at a 2006 Wharton meeting.
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've always found Ben Graham's Mr. Market allegory to be useful. To me, it's as relevant as ever.
Ben's Mr. Market allegory may seem out-of-date in today's investment world, in which 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
It's a simple but useful idea. Mr. Market experiences extreme mood swings and, as a result, often wants to sell or buy businesses well above or below intrinsic value.
So not a new idea but still just as useful today as ever if you are a long-term investor. Certainly more useful than the myriad technical approaches that are so popular (traders probably have a different view...I can't speak to that).
Having said that, Bespoke Investment Group does provide some great statistics on markets for those that are more interested in this stuff than I. Here is one of their posts from this morning comparing the current bull market to past ones going back to the 1920's.
Adam
* Based upon notes that were taken at a 2006 Wharton meeting.
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.
Stocks to Watch
Here is an update of stocks I like* for my own portfolio at the right price.
The maximum price I'd pay takes into account an acceptable margin of safety** and differs for each company. In other words, I believe these are intrinsically worth quite a bit more than the max price I've indicated in this post and in the prior Stocks to Watch posts. I also believe most of these companies generally have favorable long-term economics (i.e. the best of them have high and durable ROC) and, as a result, intrinsic values will grow over time. Of course, I may be wrong about the core economics and that margin of safety could provide insufficient protection against a loss. Still, a year from now I would expect to be willing to pay more for many of these based upon each company's intrinsic value growth over that time frame.
After last week's rally more than half of the stocks below are selling at prices above what I'd be willing to pay (under the dashed line in the list below). Mr. Market is in a bit too good of a mood right now for my taste.
So they're less cheap now but still excellent businesses at the right price. In contrast, back in February, almost all of the stocks on this list were below (in some cases well below) the highest price I'd be willing to pay.
The stocks in bold have two things in common. They are:
1) currently owned by Berkshire Hathaway (as of 6/30/09) and,
2) selling below the price that Warren Buffett paid in the past few years.
There are several other Berkshire Hathaway holdings on this list but they don't have the 2nd thing going for them.
These are all intended to be long-term investments. A ten year horizon or longer. No trades here.
Stock/Max Price I'd Pay/Recent Price
JNJ/65.00/61.03 - Buffett paid approx $ 62/share
COP/50.00/44.20 - Buffett paid approx $ 82/share...ouch
KFT/30.00/28.34 - Buffett paid approx $ 33/share
USB/24.00/20.41 - Buffett paid approx $ 31/share
WFC/28.00/27.94 - Buffett paid approx $ 32/share
KO/55.00/49.91
PG/60.00/53.58
AXP/35.00/32.85
PEP/60.00/57.49
---------------------
BNI/80.00/84.77 - Buffett paid approx $ 75/share
ADP/37.00/39.07
DEO/60.00/63.81
PM/45.00/46.87
BRKb/3000/3329
MO/16.00/18.04
LOW/19.00/21.16
MHK/30.00/47.45
HANS/25.00/33.09
PKX/80.00/95.63
RMCF/6.00/8.06
(Splits, spinoffs, and similar actions inevitably will occur going forward. Will adjust as necessary to make meaningful comparisons.)
Tactically these might all be getting more difficult to buy considering the extent of the recent rally.
Many stocks have rallied enough that the risk of paying more than necessary in the short-term is certainly there.
Yet, another risk, of course, is missing a stock entirely because it continues to rally. There is no perfect answer to this. The risk of missing something you like when a fair price is available (error of omission) can be more costly than suffering a short-term paper loss.
Here are some thoughts on errors of omission by Warren Buffett from an article in The Motley Fool.
And also...
"During 2008 I did some dumb things in investments. I made at least one major mistake of commission and several lesser ones that also hurt... Furthermore, I made some errors of omission, sucking my thumb when new facts came in." - Warren Buffett's 2008 Annual Letter to Shareholders
In other words, not buying what's still attractively valued to avoid short-term paper losses is far from perfect with your best long-term investment ideas.
To me, if an investment is initially bought at a fair price, and is likely to increase substantially in intrinsic value over 20 years, it makes no sense to be bothered by a temporary paper loss. Of course, make a misjudgment on the quality of a business and that paper loss becomes real (error of commission).
Bottom line: when highly confident that a great business is available at a fair price it's important to accumulate enough while the window of opportunity exists. Sometimes ignoring the risk of short-term losses is necessary to make sure a meaningful stake is acquired.
Ending up with just the quantity of "an eyedropper" when I'd like a full glass is not much fun.
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 are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to remain long the above stocks (at least those that at some point became cheap enough to buy) unless market prices become significantly higher than intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
** The required margin of safety is naturally larger for a bank than for something like KO. When I make a mistake and misjudge a company's economics in a major way, the margin of safety may still not be sufficient. Judging the durability of the economics correctly matters most. If the economics remain intact but the stock goes down that is a very good thing in the long run.
The maximum price I'd pay takes into account an acceptable margin of safety** and differs for each company. In other words, I believe these are intrinsically worth quite a bit more than the max price I've indicated in this post and in the prior Stocks to Watch posts. I also believe most of these companies generally have favorable long-term economics (i.e. the best of them have high and durable ROC) and, as a result, intrinsic values will grow over time. Of course, I may be wrong about the core economics and that margin of safety could provide insufficient protection against a loss. Still, a year from now I would expect to be willing to pay more for many of these based upon each company's intrinsic value growth over that time frame.
After last week's rally more than half of the stocks below are selling at prices above what I'd be willing to pay (under the dashed line in the list below). Mr. Market is in a bit too good of a mood right now for my taste.
So they're less cheap now but still excellent businesses at the right price. In contrast, back in February, almost all of the stocks on this list were below (in some cases well below) the highest price I'd be willing to pay.
The stocks in bold have two things in common. They are:
1) currently owned by Berkshire Hathaway (as of 6/30/09) and,
2) selling below the price that Warren Buffett paid in the past few years.
There are several other Berkshire Hathaway holdings on this list but they don't have the 2nd thing going for them.
These are all intended to be long-term investments. A ten year horizon or longer. No trades here.
Stock/Max Price I'd Pay/Recent Price
JNJ/65.00/61.03 - Buffett paid approx $ 62/share
COP/50.00/44.20 - Buffett paid approx $ 82/share...ouch
KFT/30.00/28.34 - Buffett paid approx $ 33/share
USB/24.00/20.41 - Buffett paid approx $ 31/share
WFC/28.00/27.94 - Buffett paid approx $ 32/share
KO/55.00/49.91
PG/60.00/53.58
AXP/35.00/32.85
PEP/60.00/57.49
---------------------
BNI/80.00/84.77 - Buffett paid approx $ 75/share
ADP/37.00/39.07
DEO/60.00/63.81
PM/45.00/46.87
BRKb/3000/3329
MO/16.00/18.04
LOW/19.00/21.16
MHK/30.00/47.45
HANS/25.00/33.09
PKX/80.00/95.63
RMCF/6.00/8.06
(Splits, spinoffs, and similar actions inevitably will occur going forward. Will adjust as necessary to make meaningful comparisons.)
Tactically these might all be getting more difficult to buy considering the extent of the recent rally.
Many stocks have rallied enough that the risk of paying more than necessary in the short-term is certainly there.
Yet, another risk, of course, is missing a stock entirely because it continues to rally. There is no perfect answer to this. The risk of missing something you like when a fair price is available (error of omission) can be more costly than suffering a short-term paper loss.
Here are some thoughts on errors of omission by Warren Buffett from an article in The Motley Fool.
And also...
"During 2008 I did some dumb things in investments. I made at least one major mistake of commission and several lesser ones that also hurt... Furthermore, I made some errors of omission, sucking my thumb when new facts came in." - Warren Buffett's 2008 Annual Letter to Shareholders
In other words, not buying what's still attractively valued to avoid short-term paper losses is far from perfect with your best long-term investment ideas.
To me, if an investment is initially bought at a fair price, and is likely to increase substantially in intrinsic value over 20 years, it makes no sense to be bothered by a temporary paper loss. Of course, make a misjudgment on the quality of a business and that paper loss becomes real (error of commission).
Bottom line: when highly confident that a great business is available at a fair price it's important to accumulate enough while the window of opportunity exists. Sometimes ignoring the risk of short-term losses is necessary to make sure a meaningful stake is acquired.
Ending up with just the quantity of "an eyedropper" when I'd like a full glass is not much fun.
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 are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to remain long the above stocks (at least those that at some point became cheap enough to buy) unless market prices become significantly higher than intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
** The required margin of safety is naturally larger for a bank than for something like KO. When I make a mistake and misjudge a company's economics in a major way, the margin of safety may still not be sufficient. Judging the durability of the economics correctly matters most. If the economics remain intact but the stock goes down that is a very good thing in the long run.
Thursday, August 20, 2009
Munger: The Hammer Syndrome
From this Charlie Munger speech at UC Santa Barbara:
"The big general objection to economics was the one early described by Alfred North Whitehead when he spoke of the fatal unconnectedness of academic disciplines, wherein each professor didn't even know the models of the other disciplines, much less try to synthesize those disciplines with his own.
"The nature of this failure is that it creates what I always call, 'man with a hammer syndrome.' And that's taken from the folk saying: To the man with only a hammer, every problem looks pretty much like a nail. And that works marvelously to gum up all professions, and all departments of academia, and indeed most practical life. The only antidote for being an absolute klutz due to the presence of a man with a hammer syndrome is to have a full kit of tools.
A special version of this 'man with a hammer syndrome' is terrible, not only in economics but practically everywhere else, including business. It's really terrible in business. You've got a complex system and it spews out a lot of wonderful numbers that enable you to measure some factors. But there are other factors that are terribly important, [yet] there's no precise numbering you can put to these factors. You know they're important, but you don't have the numbers. Well practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that." - Charlie Munger
You can't quantify all the risks of an investment but those risks are there. In the footnote of yesterday's post regarding the capital asset pricing model (CAPM) I mentioned that:
My preference is to just discount using the U.S. Treasury rate then separately make a judgment on investment specific risks and uncertainties.
Plugging a risk premium into a formula and acting like that covers it is a sloppy way to deal with the responsibility of evaluating risk. It doesn't replace thinking through consequences of what Charlie calls "the hard-to-measure stuff".
Use of a higher discount rate to account for risk might give some false sense of comfort but that's about all.
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.
"The big general objection to economics was the one early described by Alfred North Whitehead when he spoke of the fatal unconnectedness of academic disciplines, wherein each professor didn't even know the models of the other disciplines, much less try to synthesize those disciplines with his own.
"The nature of this failure is that it creates what I always call, 'man with a hammer syndrome.' And that's taken from the folk saying: To the man with only a hammer, every problem looks pretty much like a nail. And that works marvelously to gum up all professions, and all departments of academia, and indeed most practical life. The only antidote for being an absolute klutz due to the presence of a man with a hammer syndrome is to have a full kit of tools.
A special version of this 'man with a hammer syndrome' is terrible, not only in economics but practically everywhere else, including business. It's really terrible in business. You've got a complex system and it spews out a lot of wonderful numbers that enable you to measure some factors. But there are other factors that are terribly important, [yet] there's no precise numbering you can put to these factors. You know they're important, but you don't have the numbers. Well practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that." - Charlie Munger
You can't quantify all the risks of an investment but those risks are there. In the footnote of yesterday's post regarding the capital asset pricing model (CAPM) I mentioned that:
My preference is to just discount using the U.S. Treasury rate then separately make a judgment on investment specific risks and uncertainties.
Plugging a risk premium into a formula and acting like that covers it is a sloppy way to deal with the responsibility of evaluating risk. It doesn't replace thinking through consequences of what Charlie calls "the hard-to-measure stuff".
Use of a higher discount rate to account for risk might give some false sense of comfort but that's about all.
Adam
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Wednesday, August 19, 2009
Discount Rate
In business school, many learn the risk-free rate (long-term Treasury rate) plus a risk premium should be used to determine the proper discount rate.
If there's more risk, the use of a higher discount rate should account for that risk. Sounds harmless enough so far, right? Here's where it becomes a bit less so. Somehow, a stock's volatility or beta (fluctuation compared to a benchmark) is supposed to be a proxy for risk. Well, at least it is based upon what seems a highly flawed model.
No doubt more than a few who went to business school have carried this way of thinking into their business and investing endeavors.
Yet Warren Buffett has said he believes none of this makes any sense. So what rate does he use to discount the future cash flows of an investment?
The long-term U.S. Treasury rate.*
"Don't worry about risk the way it is taught at Wharton. Risk is a go/no go signal... We don't discount the future cash flows at 9% or 10%; we use the U.S. Treasury rate. We try to deal with things about which we are quite certain. You can't compensate for risk by using a high discount rate." - Warren Buffett at the 1998 Berkshire Hathaway (BRKa) Shareholder Meeting
"In order to calculate intrinsic value, you take those cash flows that you expect to be generated and you discount them back to their present value - in our case, at the long-term Treasury rate. And that discount rate doesn't pay you as high a rate as it needs to. But you can use the resulting present value figure that you get by discounting your cash flows back at the long-term Treasury rate as a common yardstick just to have a standard of measurement across all businesses." - Warren Buffett at the 1998 Berkshire Hathaway Shareholder Meeting
"...we adjust by simply trying to buy it at a big discount from the present value calculated using the risk-free interest rate. So if interest rates are 7% and we discount it back at 7% (which Charlie says I never do anyway — which is correct), then we'd require a substantial discount from that present value figure in order to warrant buying it." - Warren Buffett at the 1997 Berkshire Hathaway Shareholder Meeting
To me, the Buffett way of thinking not only makes more sense, it's also less complex and more useful.
Complexity is fine if it's warranted; it's fine if it has some incremental utility.
So the idea is to use one discount rate to create a "common yardstick" across different investments, calculating present value using that discount rate, then buying at a substantial discount to that present value to create a margin of safety.
Note that there's no real attempt to quantify risk in the process.
There is no shortage of ideas, formulas, and theories that are more or less directly related to the efficient market hypothesis. The capital asset pricing model (CAPM)** is just one good example. Charlie Munger thinks the creation of such a model comes down to, at least in part, what he calls "physics envy":
"Well, Berkshire's whole record has been achieved without paying one ounce of attention to the efficient market theory in its hard form. And not one ounce of attention to the descendants of that idea, which came out of academic economics and went into corporate finance and morphed into such obscenities as the capital asset pricing model, which we also paid no attention to." - Charlie Munger Speech at UC Santa Barbara
Then, later in the speech, Munger talked about nine different categories of things wrong with economics. Here's what he says is the third weakness:
"The third weakness that I find in economics is what I call physics envy. And of course, that term has been borrowed from...one of the world's great idiots, Sigmund Freud. But he was very popular in his time, and the concept got a wide vogue.
One of the worst examples of what physics envy did to economics was cause adaptation and hard-form efficient market theory. And then when you logically derived consequences from this wrong theory, you would get conclusions such as: it can never be correct for any corporation to buy its own stock. Because the price by definition is totally efficient, there could never be any advantage. QED. And they taught this theory to some partner at McKinsey when he was at some school of business that had adopted this crazy line of reasoning from economics, and the partner became a paid consultant for the Washington Post. And Washington Post stock was selling at a fifth of what an orangutan could figure was the plain value per share by just counting up the values and dividing. But he so believed what he'd been taught in graduate school that he told the Washington Post they shouldn't buy their own stock. Well, fortunately, they put Warren Buffett on the Board, and he convinced them to buy back more than half of the outstanding stock, which enriched the remaining shareholders by much more than a billion dollars." - Charlie Munger Speech at UC Santa Barbara
CAPM adjusts the expected return based upon a stock's volatility or beta. The expected return minus the risk-free rate is the risk premium.
To me, this way of thinking about risk and return has major defects.
The end result of all this is a discount rate (or expected return) based upon a risk premium that gets added to the risk free rate. Now, some would view CAPM as insufficient for companies with debt because it doesn't take into account the capital structure. That leads, unfortunately, to things like weighted average cost of capital (WACC).
Well, feel free to explore how to calculate WACC.
The WACC formula attempts to take the capital structure of a business into account.
It's also, if not exactly useless, closer to being useless than not as far as I'm concerned.
So the rates calculated via formulas like this are intended to then be used for discounting whatever the expected cash flows of a business might be.
Unwarranted complexity that is more than just a bit less than satisfactory and adds little to zero insight.
Exchange Between Charlie Munger & Professor William Bratton
The following pretty well captures how Buffett and Munger think about cost of capital:
Buffett: Charlie and I don't know our cost of capital. It's taught a[t] business schools, but we're skeptical. We just look to do the most intelligent thing we can with the capital that we have. We measure everything against our alternatives. I've never seen a cost of capital calculation that made sense to me. Have you Charlie?
Munger: Never. If you take the best text in economics by Mankiw, he says intelligent people make decisions based on opportunity costs -- in other words, it's your alternatives that matter. That's how we make all of our decisions. The rest of the world has gone off on some kick -- there's even a cost of equity capital. A perfectly amazing mental malfunction. - From the 2003 Berkshire Hathaway Shareholder Meeting
I'm guessing one of the reasons these flawed ideas have remained popular for so long is simply because so many business executives and investors have been taught -- and continue to be taught -- this stuff in business school.
An investor can still decide to use a slightly higher discount rate than the U.S. Treasury rate in order to add a margin of safety. A higher rate may make sense if the investor views the current risk-free interest rate environment to be unusually low and unlikely to be sustainable. Buffett has said as much:
"We don't think we're any good at predicting interest rates. But in times of what seem like very low rates, we might use a little higher rate." - Warren Buffett at the 1996 Berkshire Hathaway Shareholder Meeting
Using a higher rate when somewhat less certain about the future stream of cash an asset will generate over time -- I say somewhat because there's a threshold of uncertainty about future cash flows above which no margin of safety will be sufficient -- can also make some sense. Buffett apparently even indicated that he does this on occasion at the 1994 shareholder meeting.***
"If we thought we were getting a stream of cash over the thirty years that we felt extremely certain about, we'd use a discount rate that would be somewhat less than if it were one where we expected surprises or where we thought there were a greater possibility of surprises." - Warren Buffett at the 1994 Berkshire Hathaway Shareholder Meeting
So there's more than one reasonable way to decide what the discount rate should be.
It's just that the higher discount rate need not be adjusted based upon beta, capital structure, or any similarly formulaic approach. The formulas may provide a false level of precision that likely means little if anything in terms of real risk and uncertainty.
My own preference is to have a "common yardstick" to compare investments at any point in time -- using, as a baseline only, likely long-term U.S. Treasury rates knowing that ultimately it is impossible to predict the inevitable and unknowable fluctuations -- then paying a price that provides enough margin of safety (i.e. something comfortably below my estimate of per share intrinsic value) based upon my best judgment of the specific risks and uncertainties of the investment.
(The yardstick to be used can be altered based on changes to likely future long-term U.S. Treasury rates, of course, but comparisons between alternatives at any point in time should be made with the same yardstick.)
In any case, it's likely unwise -- considering the range of interest rates over the past half century or so -- to assume prevailing interest rates will always remain low.
The process of estimating value is inherently and necessarily rather imprecise. It's highly unlikely that any two investors will come up with the same estimate of value. Some of the more formulaic approaches at least imply that precision can exist where it cannot.
Factors that are not easily quantifiable need to be considered carefully.
Eventually, an assessment of the risk and uncertainty should result in a go/no go decision. It should not result in the use of a higher discount rate to compensate for that risk and uncertainty.
At some point, no discount rate is high enough.
Buffett has said he does most calculations in his head and is wary of "false precision". As a result, with many investments, he doesn't rely on exact numbers. It's telling that Munger claims Buffett never actually does these calculations. It's also telling that Buffett agrees with him.
Charlie Munger (Berkshire Hathaway's vice chairman) said, "Warren talks about these discounted cash flows. I've never seen him do one."
"It's true," replied Buffett. "If (the value of a company) doesn't just scream out at you, it's too close." - from the 1996 shareholder meeting
No matter how one decides to calculate value it's best to keep it simple but meaningful. More importantly, accept that risk and uncertainty is not easily quantifiable.
The discount to estimated value should be quite large and obvious.
Sound qualitative judgments must be made.
Adam
Long BRKb
* I posted this fair value calculator on Tuesday. It's another convenient tool for calculating value that is, like all others, only as good as the assumptions used. The use of Treasury rates to calculate present value for stocks is not at all the widely accepted practice. The norm, more or less, would still be to add a risk premium into the equation. Well, unfortunately, risk just cannot be accounted for via a simple adjustment like this in my view. If only it were that straightforward.
** According to CAPM, expected return is supposed to come from multiplying beta by the difference between the expected return of the market and the risk free rate then adding that number to the risk free rate:
Ra = Rf + β(Rm-Rf)
Ra = Expected Return
Rf = Risk Free Rate
β = Beta of the Security
Rm = Expected Market Return
That, somehow, (well, if you buy this stuff) is supposed to produce the expected return on the asset. Well, at least that's the case when beta is actually available. Of course, in the real world -- for many investments -- there is no observable beta. In my experience this is, at best, mostly an interesting academic exercise. Usually, the discount rate that ends up being used is still a guess within a range depending on perceived risk. Ugh. It's simply calculated in a falsely precise manner. To me, it's a waste of time and energy. My preference is to just discount using the U.S. Treasury rate then separately make a judgment on investment specific risks and uncertainties.
*** The fact that Buffett may vary the discount rate based upon his level of certainty can possibly be a bit confusing, if not seemingly inconsistent, with his "common yardstick" and related comments. To me, he's still mostly saying a similar thing. That an investor can't account for risk simply by increasing the risk premium and there's no formulaic way to determine the right discount rate. A higher discount rate just creates some additional margin of safety when somewhat less certain. It's not a formulaic adjustment; it's instead, meant to be meaningful, rough, yet more or less subjective. It's also worth remembering that, unlike the shareholder letters, these are comments made on the fly at the shareholder meetings and may or may not be exact quotes. The comment from the 1994 meeting is still worth noting since it is not quite the same as comments he's made on the same subject at other times.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
If there's more risk, the use of a higher discount rate should account for that risk. Sounds harmless enough so far, right? Here's where it becomes a bit less so. Somehow, a stock's volatility or beta (fluctuation compared to a benchmark) is supposed to be a proxy for risk. Well, at least it is based upon what seems a highly flawed model.
No doubt more than a few who went to business school have carried this way of thinking into their business and investing endeavors.
Yet Warren Buffett has said he believes none of this makes any sense. So what rate does he use to discount the future cash flows of an investment?
The long-term U.S. Treasury rate.*
"Don't worry about risk the way it is taught at Wharton. Risk is a go/no go signal... We don't discount the future cash flows at 9% or 10%; we use the U.S. Treasury rate. We try to deal with things about which we are quite certain. You can't compensate for risk by using a high discount rate." - Warren Buffett at the 1998 Berkshire Hathaway (BRKa) Shareholder Meeting
"In order to calculate intrinsic value, you take those cash flows that you expect to be generated and you discount them back to their present value - in our case, at the long-term Treasury rate. And that discount rate doesn't pay you as high a rate as it needs to. But you can use the resulting present value figure that you get by discounting your cash flows back at the long-term Treasury rate as a common yardstick just to have a standard of measurement across all businesses." - Warren Buffett at the 1998 Berkshire Hathaway Shareholder Meeting
"...we adjust by simply trying to buy it at a big discount from the present value calculated using the risk-free interest rate. So if interest rates are 7% and we discount it back at 7% (which Charlie says I never do anyway — which is correct), then we'd require a substantial discount from that present value figure in order to warrant buying it." - Warren Buffett at the 1997 Berkshire Hathaway Shareholder Meeting
To me, the Buffett way of thinking not only makes more sense, it's also less complex and more useful.
Complexity is fine if it's warranted; it's fine if it has some incremental utility.
So the idea is to use one discount rate to create a "common yardstick" across different investments, calculating present value using that discount rate, then buying at a substantial discount to that present value to create a margin of safety.
Note that there's no real attempt to quantify risk in the process.
There is no shortage of ideas, formulas, and theories that are more or less directly related to the efficient market hypothesis. The capital asset pricing model (CAPM)** is just one good example. Charlie Munger thinks the creation of such a model comes down to, at least in part, what he calls "physics envy":
"Well, Berkshire's whole record has been achieved without paying one ounce of attention to the efficient market theory in its hard form. And not one ounce of attention to the descendants of that idea, which came out of academic economics and went into corporate finance and morphed into such obscenities as the capital asset pricing model, which we also paid no attention to." - Charlie Munger Speech at UC Santa Barbara
Then, later in the speech, Munger talked about nine different categories of things wrong with economics. Here's what he says is the third weakness:
"The third weakness that I find in economics is what I call physics envy. And of course, that term has been borrowed from...one of the world's great idiots, Sigmund Freud. But he was very popular in his time, and the concept got a wide vogue.
One of the worst examples of what physics envy did to economics was cause adaptation and hard-form efficient market theory. And then when you logically derived consequences from this wrong theory, you would get conclusions such as: it can never be correct for any corporation to buy its own stock. Because the price by definition is totally efficient, there could never be any advantage. QED. And they taught this theory to some partner at McKinsey when he was at some school of business that had adopted this crazy line of reasoning from economics, and the partner became a paid consultant for the Washington Post. And Washington Post stock was selling at a fifth of what an orangutan could figure was the plain value per share by just counting up the values and dividing. But he so believed what he'd been taught in graduate school that he told the Washington Post they shouldn't buy their own stock. Well, fortunately, they put Warren Buffett on the Board, and he convinced them to buy back more than half of the outstanding stock, which enriched the remaining shareholders by much more than a billion dollars." - Charlie Munger Speech at UC Santa Barbara
CAPM adjusts the expected return based upon a stock's volatility or beta. The expected return minus the risk-free rate is the risk premium.
To me, this way of thinking about risk and return has major defects.
The end result of all this is a discount rate (or expected return) based upon a risk premium that gets added to the risk free rate. Now, some would view CAPM as insufficient for companies with debt because it doesn't take into account the capital structure. That leads, unfortunately, to things like weighted average cost of capital (WACC).
Well, feel free to explore how to calculate WACC.
The WACC formula attempts to take the capital structure of a business into account.
It's also, if not exactly useless, closer to being useless than not as far as I'm concerned.
So the rates calculated via formulas like this are intended to then be used for discounting whatever the expected cash flows of a business might be.
Unwarranted complexity that is more than just a bit less than satisfactory and adds little to zero insight.
Exchange Between Charlie Munger & Professor William Bratton
The following pretty well captures how Buffett and Munger think about cost of capital:
Buffett: Charlie and I don't know our cost of capital. It's taught a[t] business schools, but we're skeptical. We just look to do the most intelligent thing we can with the capital that we have. We measure everything against our alternatives. I've never seen a cost of capital calculation that made sense to me. Have you Charlie?
Munger: Never. If you take the best text in economics by Mankiw, he says intelligent people make decisions based on opportunity costs -- in other words, it's your alternatives that matter. That's how we make all of our decisions. The rest of the world has gone off on some kick -- there's even a cost of equity capital. A perfectly amazing mental malfunction. - From the 2003 Berkshire Hathaway Shareholder Meeting
I'm guessing one of the reasons these flawed ideas have remained popular for so long is simply because so many business executives and investors have been taught -- and continue to be taught -- this stuff in business school.
An investor can still decide to use a slightly higher discount rate than the U.S. Treasury rate in order to add a margin of safety. A higher rate may make sense if the investor views the current risk-free interest rate environment to be unusually low and unlikely to be sustainable. Buffett has said as much:
"We don't think we're any good at predicting interest rates. But in times of what seem like very low rates, we might use a little higher rate." - Warren Buffett at the 1996 Berkshire Hathaway Shareholder Meeting
Using a higher rate when somewhat less certain about the future stream of cash an asset will generate over time -- I say somewhat because there's a threshold of uncertainty about future cash flows above which no margin of safety will be sufficient -- can also make some sense. Buffett apparently even indicated that he does this on occasion at the 1994 shareholder meeting.***
"If we thought we were getting a stream of cash over the thirty years that we felt extremely certain about, we'd use a discount rate that would be somewhat less than if it were one where we expected surprises or where we thought there were a greater possibility of surprises." - Warren Buffett at the 1994 Berkshire Hathaway Shareholder Meeting
So there's more than one reasonable way to decide what the discount rate should be.
It's just that the higher discount rate need not be adjusted based upon beta, capital structure, or any similarly formulaic approach. The formulas may provide a false level of precision that likely means little if anything in terms of real risk and uncertainty.
My own preference is to have a "common yardstick" to compare investments at any point in time -- using, as a baseline only, likely long-term U.S. Treasury rates knowing that ultimately it is impossible to predict the inevitable and unknowable fluctuations -- then paying a price that provides enough margin of safety (i.e. something comfortably below my estimate of per share intrinsic value) based upon my best judgment of the specific risks and uncertainties of the investment.
(The yardstick to be used can be altered based on changes to likely future long-term U.S. Treasury rates, of course, but comparisons between alternatives at any point in time should be made with the same yardstick.)
In any case, it's likely unwise -- considering the range of interest rates over the past half century or so -- to assume prevailing interest rates will always remain low.
The process of estimating value is inherently and necessarily rather imprecise. It's highly unlikely that any two investors will come up with the same estimate of value. Some of the more formulaic approaches at least imply that precision can exist where it cannot.
Factors that are not easily quantifiable need to be considered carefully.
Eventually, an assessment of the risk and uncertainty should result in a go/no go decision. It should not result in the use of a higher discount rate to compensate for that risk and uncertainty.
At some point, no discount rate is high enough.
Buffett has said he does most calculations in his head and is wary of "false precision". As a result, with many investments, he doesn't rely on exact numbers. It's telling that Munger claims Buffett never actually does these calculations. It's also telling that Buffett agrees with him.
Charlie Munger (Berkshire Hathaway's vice chairman) said, "Warren talks about these discounted cash flows. I've never seen him do one."
"It's true," replied Buffett. "If (the value of a company) doesn't just scream out at you, it's too close." - from the 1996 shareholder meeting
No matter how one decides to calculate value it's best to keep it simple but meaningful. More importantly, accept that risk and uncertainty is not easily quantifiable.
The discount to estimated value should be quite large and obvious.
Sound qualitative judgments must be made.
Adam
Long BRKb
* I posted this fair value calculator on Tuesday. It's another convenient tool for calculating value that is, like all others, only as good as the assumptions used. The use of Treasury rates to calculate present value for stocks is not at all the widely accepted practice. The norm, more or less, would still be to add a risk premium into the equation. Well, unfortunately, risk just cannot be accounted for via a simple adjustment like this in my view. If only it were that straightforward.
** According to CAPM, expected return is supposed to come from multiplying beta by the difference between the expected return of the market and the risk free rate then adding that number to the risk free rate:
Ra = Rf + β(Rm-Rf)
Ra = Expected Return
Rf = Risk Free Rate
β = Beta of the Security
Rm = Expected Market Return
That, somehow, (well, if you buy this stuff) is supposed to produce the expected return on the asset. Well, at least that's the case when beta is actually available. Of course, in the real world -- for many investments -- there is no observable beta. In my experience this is, at best, mostly an interesting academic exercise. Usually, the discount rate that ends up being used is still a guess within a range depending on perceived risk. Ugh. It's simply calculated in a falsely precise manner. To me, it's a waste of time and energy. My preference is to just discount using the U.S. Treasury rate then separately make a judgment on investment specific risks and uncertainties.
*** The fact that Buffett may vary the discount rate based upon his level of certainty can possibly be a bit confusing, if not seemingly inconsistent, with his "common yardstick" and related comments. To me, he's still mostly saying a similar thing. That an investor can't account for risk simply by increasing the risk premium and there's no formulaic way to determine the right discount rate. A higher discount rate just creates some additional margin of safety when somewhat less certain. It's not a formulaic adjustment; it's instead, meant to be meaningful, rough, yet more or less subjective. It's also worth remembering that, unlike the shareholder letters, these are comments made on the fly at the shareholder meetings and may or may not be exact quotes. The comment from the 1994 meeting is still worth noting since it is not quite the same as comments he's made on the same subject at other times.
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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.
Tuesday, August 18, 2009
Fair Value Calculator
Here is a simple tool to estimate the intrinsic value of a business. I don't consider any tools like this to be adequate (intangibles matter too much) but some can be useful as a starting point.
With this one, when someone types in the stock's symbol the tool automatically plugs in this year's expected earnings (which is convenient) and then makes assumptions on earnings growth rates, discount rate, etc. The user can then make changes to those assumptions to recalculate the business value.
The tool works better for companies with predictable earnings but is less useful for cyclical companies. In the case of cyclical businesses it makes sense to enter normalized earnings instead of using this year's earnings as a baseline. Otherwise, it will significantly undervalue businesses during recessions and overvalue during economic expansions.
For example, it automatically uses earnings of $ 1.36/share for AXP but I view conservative normalized earnings for AXP to be $ 3.00/share. Using $ 1.36 and a 12% discount rate it calculates a business value of $ 30.92/share while using normalized earnings of $ 3.oo produces a business value of $ 51.80/share. (By the way...the idea that fair value can be calculated that precisely is kinda silly. Also, I don't agree with using a 12% discount rate but that's for another post.)
Again, this is only a simplistic starting point for valuing a business. The ability to judge the sustainability of a company's core economics over time matters. A tool like this is worthless if you get that wrong.
GuruFocus: Fair Value Calculator
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 this one, when someone types in the stock's symbol the tool automatically plugs in this year's expected earnings (which is convenient) and then makes assumptions on earnings growth rates, discount rate, etc. The user can then make changes to those assumptions to recalculate the business value.
The tool works better for companies with predictable earnings but is less useful for cyclical companies. In the case of cyclical businesses it makes sense to enter normalized earnings instead of using this year's earnings as a baseline. Otherwise, it will significantly undervalue businesses during recessions and overvalue during economic expansions.
For example, it automatically uses earnings of $ 1.36/share for AXP but I view conservative normalized earnings for AXP to be $ 3.00/share. Using $ 1.36 and a 12% discount rate it calculates a business value of $ 30.92/share while using normalized earnings of $ 3.oo produces a business value of $ 51.80/share. (By the way...the idea that fair value can be calculated that precisely is kinda silly. Also, I don't agree with using a 12% discount rate but that's for another post.)
Again, this is only a simplistic starting point for valuing a business. The ability to judge the sustainability of a company's core economics over time matters. A tool like this is worthless if you get that wrong.
GuruFocus: Fair Value Calculator
Adam
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Wednesday, August 12, 2009
Buffett On Space Exploration: Berkshire Shareholder Letter Highlights
From Warren Buffett's 1996 Berkshire Hathaway (BRKa) shareholder letter:
Our portfolio shows little change: We continue to make more money when snoring than when active.
Inactivity strikes us as intelligent behavior. Neither we nor most business managers would dream of feverishly trading highly-profitable subsidiaries because a small move in the Federal Reserve's discount rate was predicted or because some Wall Street pundit had reversed his views on the market. Why, then, should we behave differently with our minority positions in wonderful businesses? The art of investing in public companies successfully is little different from the art of successfully acquiring subsidiaries. In each case you simply want to acquire, at a sensible price, a business with excellent economics and able, honest management. Thereafter, you need only monitor whether these qualities are being preserved.
He then adds...
In studying the investments we have made in both subsidiary companies and common stocks, you will see that we favor businesses and industries unlikely to experience major change. The reason for that is simple: Making either type of purchase, we are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek.
I should emphasize that, as citizens, Charlie [Munger] and I welcome change: Fresh ideas, new products, innovative processes and the like cause our country's standard of living to rise, and that's clearly good. As investors, however, our reaction to a fermenting industry is much like our attitude toward space exploration: We applaud the endeavor but prefer to skip the ride.
For Berkshire, it has been mostly about combining inactivity with ownership (partial or full) of easy to understand businesses that intrinsically produce attractive per share returns.
In general, these businesses will often reside in stable industries.
Adam
Long BRKb
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Our portfolio shows little change: We continue to make more money when snoring than when active.
Inactivity strikes us as intelligent behavior. Neither we nor most business managers would dream of feverishly trading highly-profitable subsidiaries because a small move in the Federal Reserve's discount rate was predicted or because some Wall Street pundit had reversed his views on the market. Why, then, should we behave differently with our minority positions in wonderful businesses? The art of investing in public companies successfully is little different from the art of successfully acquiring subsidiaries. In each case you simply want to acquire, at a sensible price, a business with excellent economics and able, honest management. Thereafter, you need only monitor whether these qualities are being preserved.
He then adds...
In studying the investments we have made in both subsidiary companies and common stocks, you will see that we favor businesses and industries unlikely to experience major change. The reason for that is simple: Making either type of purchase, we are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek.
I should emphasize that, as citizens, Charlie [Munger] and I welcome change: Fresh ideas, new products, innovative processes and the like cause our country's standard of living to rise, and that's clearly good. As investors, however, our reaction to a fermenting industry is much like our attitude toward space exploration: We applaud the endeavor but prefer to skip the ride.
For Berkshire, it has been mostly about combining inactivity with ownership (partial or full) of easy to understand businesses that intrinsically produce attractive per share returns.
In general, these businesses will often reside in stable industries.
Adam
Long BRKb
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Tuesday, August 11, 2009
Circle of Competence
Here's an interesting exchange between Warren Buffett and Charlie Munger:*
Munger: A foreign correspondent, after talking to me for a while, once said: "You don't seem smart enough to be so good at what you’re doing. Do you have an explanation?" [Laughter]
Buffett: Was he referring to me or you? [Laughter]
Munger: I said, "We know the edge of our competency better than most." That's a very worthwhile thing. It's not a competency if you don't know the edge of it.
Also, below are some additional miscellaneous quotes on knowing your circle of competence and the importance of staying within limits:
"There are two kinds of people who lose money. Those who know nothing, and those who know everything." - Henry Kaufman
"If you have competence, you know the edge. It wouldn't be a competence if you didn't know where the boundaries lie. It's a question that almost answers itself." - Charlie Munger
"...Warren and I don't feel like we have any great advantage in the high-tech sector. In fact, we feel like we're at a big disadvantage in trying to understand the nature of technical developments in software, computer chips or what have you. So we tend to avoid that stuff, based on our personal inadequacies.
Again, that is a very, very powerful idea. Every person is going to have a circle of competence. And it's going to be very hard to advance that circle. If I had to make my living as a musician.... I can't even think of a level low enough to describe where I would be sorted out to if music were the measuring standard of the civilization.
So you have to figure out what your own aptitudes are. If you play games where other people have the aptitudes and you don't, you're going to lose. And that's as close to certain as any prediction that you can make." - Charlie Munger
"...just as a man working with a tool has to know its limitations, a man working with his cognitive apparatus has to know its limitations." - Charlie Munger
"Organized common (or uncommon) sense — very basic knowledge — is an enormously powerful tool. There are huge dangers with computers. People calculate too much and think too little." - Charlie Munger
Part of [having uncommon sense] is...to tune out folly, as opposed to recognizing wisdom. If you bat away many things, you don't clutter yourself. - Charlie Munger
"In the corporate world, if you have analysts, due diligence, and no horse sense you've just described hell." - Charlie Munger
"If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter. Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter." - Warren Buffett
Much of the above seems straightforward enough but, at times, those who possess excessive confidence -- even those who are otherwise very smart and capable -- misjudge where the true edge of their competence resides.
Adam
* Some of these comments are from notes taken at Berkshire Hathaway shareholder meetings. So, in some cases, I've not included quotations because it isn't clear whether the notes reflect the exact words that were used at that meeting.
---
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: A foreign correspondent, after talking to me for a while, once said: "You don't seem smart enough to be so good at what you’re doing. Do you have an explanation?" [Laughter]
Buffett: Was he referring to me or you? [Laughter]
Munger: I said, "We know the edge of our competency better than most." That's a very worthwhile thing. It's not a competency if you don't know the edge of it.
Also, below are some additional miscellaneous quotes on knowing your circle of competence and the importance of staying within limits:
"There are two kinds of people who lose money. Those who know nothing, and those who know everything." - Henry Kaufman
"If you have competence, you know the edge. It wouldn't be a competence if you didn't know where the boundaries lie. It's a question that almost answers itself." - Charlie Munger
"...Warren and I don't feel like we have any great advantage in the high-tech sector. In fact, we feel like we're at a big disadvantage in trying to understand the nature of technical developments in software, computer chips or what have you. So we tend to avoid that stuff, based on our personal inadequacies.
Again, that is a very, very powerful idea. Every person is going to have a circle of competence. And it's going to be very hard to advance that circle. If I had to make my living as a musician.... I can't even think of a level low enough to describe where I would be sorted out to if music were the measuring standard of the civilization.
So you have to figure out what your own aptitudes are. If you play games where other people have the aptitudes and you don't, you're going to lose. And that's as close to certain as any prediction that you can make." - Charlie Munger
"...just as a man working with a tool has to know its limitations, a man working with his cognitive apparatus has to know its limitations." - Charlie Munger
"Organized common (or uncommon) sense — very basic knowledge — is an enormously powerful tool. There are huge dangers with computers. People calculate too much and think too little." - Charlie Munger
Part of [having uncommon sense] is...to tune out folly, as opposed to recognizing wisdom. If you bat away many things, you don't clutter yourself. - Charlie Munger
"In the corporate world, if you have analysts, due diligence, and no horse sense you've just described hell." - Charlie Munger
"If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter. Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter." - Warren Buffett
Much of the above seems straightforward enough but, at times, those who possess excessive confidence -- even those who are otherwise very smart and capable -- misjudge where the true edge of their competence resides.
Adam
* Some of these comments are from notes taken at Berkshire Hathaway shareholder meetings. So, in some cases, I've not included quotations because it isn't clear whether the notes reflect the exact words that were used at that meeting.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Wednesday, August 5, 2009
Six Stock Portfolio Update
Portfolio performance since mentioning on April 9, 2009 that I like these six stocks* as long-term investments if bought near prevailing prices at that time (or lower, of course).
While I never make stock recommendations each of these, at the right price, are what I consider attractive long-term investments for my own capital.
Stock|% Change**
WFC|+30.9%
DEO|+37.0%
PM |+21.5%
PEP |+8.1%
LOW|+11.5%
AXP|+60.8%
Total return for the six stocks combined is 28.3% (excluding dividends) since April 9th. S&P 500 SPDR ETF is up 17.1% since that date. This is a conservative calculation of returns based upon the average price of each security on the date mentioned. Better market prices were available in subsequent days so total returns could have been improved with some careful accumulation.
The purpose is not to measure returns over such a short time frame. It's just, in part, an easy to verify working example of Newton's 4th Law.
Many equity investors would get improved returns if they: 1) bought and held shares in 5-10 great businesses (if time permits stock research), 2) avoided the hyperactive trading that is so popular these days to minimize mistakes & frictional costs, and 3) sold shares in a business only if the core economics become impaired or opportunity costs are extremely high.
This portfolio certainly won't outperform in every period but in the long run it has a reasonable probability of beating the S&P 500. It's not likely outperform the very best portfolio managers but should do very well against most mutual funds over a period of 10 years or longer with lower risk.
There's no shortage of evidence that many actively managed equity mutual funds underperform the S&P 500. Also, DALBAR's Quantitative Analysis of Investor Behavior (QAIB) study released in March 2009 revealed that over the past 20 years investors in stock mutual funds have underperformed the S&P 500 by 6.5% a year (8.35% vs. 1.87%). Beyond the performance of the funds themselves, it shows that much of these poor returns come down to investor behavior. The tendency of investors to buy the hot mutual fund that has been going up while selling when the market is going down out of panic or fear (the same is true for stocks).
The professional money management business is lucrative whether the funds performs or not. Few (if any) industries pay so well for below par service. It may seem harsh but Charlie Munger refers to those who get paid fees to help manage money as febezzlers. A quote by him on this subject can be found in this post. The full talk that he gives on the subject can also be found here. He backs up his arguments pretty well.
In any case, this simple experiment is designed so it's easy for anyone to check the results. So if this six stock portfolio isn't performing well against the S&P 500 (it'll take a few years, at least, to meaningfully start judging performance) it will be obvious.
I don't think these are necessarily the six best businesses in the world, but I believe they are all very good businesses*** that were selling at reasonable prices on April 9th. At any moment, there is always something better to own in theory but I don't think you can't invest that way (as if stocks are baseball cards) and have consistent success.
I plan to occasionally (though rarely) add or switch some of the stocks in this portfolio but generally will make only minor changes.
Adam
Long position in DEO, AXP, PEP, PM, WFC, and LOW
* This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to be long the positions noted unless they sell significantly above intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
** As of 7/31/09.
*** There are certainly quite a few other shares in businesses that would be good alternatives to these six. The point is to get a handful of them at a fair price and then let time work.
While I never make stock recommendations each of these, at the right price, are what I consider attractive long-term investments for my own capital.
Stock|% Change**
WFC|+30.9%
DEO|+37.0%
PM |+21.5%
PEP |+8.1%
LOW|+11.5%
AXP|+60.8%
Total return for the six stocks combined is 28.3% (excluding dividends) since April 9th. S&P 500 SPDR ETF is up 17.1% since that date. This is a conservative calculation of returns based upon the average price of each security on the date mentioned. Better market prices were available in subsequent days so total returns could have been improved with some careful accumulation.
The purpose is not to measure returns over such a short time frame. It's just, in part, an easy to verify working example of Newton's 4th Law.
Many equity investors would get improved returns if they: 1) bought and held shares in 5-10 great businesses (if time permits stock research), 2) avoided the hyperactive trading that is so popular these days to minimize mistakes & frictional costs, and 3) sold shares in a business only if the core economics become impaired or opportunity costs are extremely high.
This portfolio certainly won't outperform in every period but in the long run it has a reasonable probability of beating the S&P 500. It's not likely outperform the very best portfolio managers but should do very well against most mutual funds over a period of 10 years or longer with lower risk.
There's no shortage of evidence that many actively managed equity mutual funds underperform the S&P 500. Also, DALBAR's Quantitative Analysis of Investor Behavior (QAIB) study released in March 2009 revealed that over the past 20 years investors in stock mutual funds have underperformed the S&P 500 by 6.5% a year (8.35% vs. 1.87%). Beyond the performance of the funds themselves, it shows that much of these poor returns come down to investor behavior. The tendency of investors to buy the hot mutual fund that has been going up while selling when the market is going down out of panic or fear (the same is true for stocks).
The professional money management business is lucrative whether the funds performs or not. Few (if any) industries pay so well for below par service. It may seem harsh but Charlie Munger refers to those who get paid fees to help manage money as febezzlers. A quote by him on this subject can be found in this post. The full talk that he gives on the subject can also be found here. He backs up his arguments pretty well.
In any case, this simple experiment is designed so it's easy for anyone to check the results. So if this six stock portfolio isn't performing well against the S&P 500 (it'll take a few years, at least, to meaningfully start judging performance) it will be obvious.
I don't think these are necessarily the six best businesses in the world, but I believe they are all very good businesses*** that were selling at reasonable prices on April 9th. At any moment, there is always something better to own in theory but I don't think you can't invest that way (as if stocks are baseball cards) and have consistent success.
I plan to occasionally (though rarely) add or switch some of the stocks in this portfolio but generally will make only minor changes.
Adam
Long position in DEO, AXP, PEP, PM, WFC, and LOW
* This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to be long the positions noted unless they sell significantly above intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
** As of 7/31/09.
*** There are certainly quite a few other shares in businesses that would be good alternatives to these six. The point is to get a handful of them at a fair price and then let time work.
Monday, August 3, 2009
China's Economic Stability
From Jeremy Grantham's July 2009 letter:
"My colleague, Edward Chancellor, strongly suspects that the Chinese economy is dangerously unbalanced and very likely to come unhinged in the next few quarters, surprising the pants off investors."
Stephen Roach, who has been optimistic on China for a while, is developing a similar point of view:
"China must redirect economic growth towards internal private consumption.
Unlike most, I have been a steadfast optimist on China. Yet I am starting to worry. A macro strategy that exacerbates worrying imbalances is ultimately a recipe for failure."
Something to keep an eye on.
Adam
Related post:
Jeremy Grantham's Latest Letter
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.
"My colleague, Edward Chancellor, strongly suspects that the Chinese economy is dangerously unbalanced and very likely to come unhinged in the next few quarters, surprising the pants off investors."
Stephen Roach, who has been optimistic on China for a while, is developing a similar point of view:
"China must redirect economic growth towards internal private consumption.
Unlike most, I have been a steadfast optimist on China. Yet I am starting to worry. A macro strategy that exacerbates worrying imbalances is ultimately a recipe for failure."
Something to keep an eye on.
Adam
Related post:
Jeremy Grantham's Latest Letter
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.
Stocks to Watch
Here is an update of stocks I like* for my own portfolio at the right price.
The max price noted below is the most I'd pay, but obviously I like to buy them well below, if possible.
After last week's rally half are now selling at prices that are above what I'd pay (that half is shown under the dashed line in the list below). I wouldn't buy them here but they are still excellent businesses at the right price. In contrast, back in February...almost all of the stocks on this list were below (in some cases well below) the highest price I'd be willing to pay.
The stocks in bold have two things in common. They are:
1) currently owned by Berkshire Hathaway (as of 3/31/09) and,
2) selling below the price that Warren Buffett paid in the past few years.
There are several other Berkshire Hathaway holdings on this list but they don't have the 2nd thing going for them.
These are all intended to be long-term investments. A ten year horizon or longer. No trades here.
Stock/Max Price I'd Pay/Recent Price**
JNJ/65.00/60.89 - Buffett paid approx $ 62/share
COP/50.00/43.71 - Buffett paid approx $ 82/share...ouch
KFT/30.00/28.34 - Buffett paid approx $ 33/share
USB/24.00/20.41 - Buffett paid approx $ 31/share
WFC/28.00/24.46 - Buffett paid approx $ 32/share
BNI/80.00/78.59 - Buffett paid approx $ 75/share
KO/55.00/49.84
PG/60.00/55.51
AXP/35.00/28.33
PEP/60.00/56.75
---------------------
ADP/37.00/37.25
DEO/60.00/62.38
PM/45.00/46.60
BRKb/3000/3180
MO/16.00/17.53
LOW/19.00/22.46
MHK/30.00/51.58
HANS/25.00/31.01
PKX/80.00/101.07
RMCF/6.00/8.10
(Splits, spinoffs, and similar actions inevitably will occur going forward. Will adjust as necessary to make meaningful comparisons.)
Tactically, the S&P 500 has moved from a recent low of 872 on 7/10/09 to 987 as of last Friday. Many of the stocks above have rallied 30% or more in the past few months. So 3-5 months ago it was easier to buy almost any of these.
Many stocks have rallied so the risk of paying more than necessary in the short-term is there.
Yet, another risk, of course, is missing a stock entirely because it continues to rally. There is no perfect answer to this. The risk of missing something you like when a fair price is available (error of omission) can be more costly than suffering a short-term paper loss.
Here are some thoughts on errors of omission by Warren Buffett from an article in The Motley Fool.
And also...
"During 2008 I did some dumb things in investments. I made at least one major mistake of commission and several lesser ones that also hurt... Furthermore, I made some errors of omission, sucking my thumb when new facts came in." - Warren Buffett's 2008 Annual Letter to Shareholders
In other words, not buying what's still attractively valued to avoid short-term paper losses is far from perfect with your best long-term investment ideas.
To me, if an investment is initially bought at a fair price, and is likely to increase substantially in intrinsic value over 20 years, it makes no sense to be bothered by a temporary paper loss. Of course, make a misjudgment on the quality of a business and that paper loss becomes real (error of commission).
Bottom line: when highly confident that a great business is available at a fair price it's important to accumulate enough while the window of opportunity exists. Sometimes ignoring the risk of short-term losses is necessary to make sure a meaningful stake is acquired.
Ending up with just the quantity of "an eyedropper" when I'd like a full glass is no fun.
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 are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to remain long the above stocks (at least those that at some point became cheap enough to buy) unless market prices become significantly higher than intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
** As of 7/31/09
The max price noted below is the most I'd pay, but obviously I like to buy them well below, if possible.
After last week's rally half are now selling at prices that are above what I'd pay (that half is shown under the dashed line in the list below). I wouldn't buy them here but they are still excellent businesses at the right price. In contrast, back in February...almost all of the stocks on this list were below (in some cases well below) the highest price I'd be willing to pay.
The stocks in bold have two things in common. They are:
1) currently owned by Berkshire Hathaway (as of 3/31/09) and,
2) selling below the price that Warren Buffett paid in the past few years.
There are several other Berkshire Hathaway holdings on this list but they don't have the 2nd thing going for them.
These are all intended to be long-term investments. A ten year horizon or longer. No trades here.
Stock/Max Price I'd Pay/Recent Price**
JNJ/65.00/60.89 - Buffett paid approx $ 62/share
COP/50.00/43.71 - Buffett paid approx $ 82/share...ouch
KFT/30.00/28.34 - Buffett paid approx $ 33/share
USB/24.00/20.41 - Buffett paid approx $ 31/share
WFC/28.00/24.46 - Buffett paid approx $ 32/share
BNI/80.00/78.59 - Buffett paid approx $ 75/share
KO/55.00/49.84
PG/60.00/55.51
AXP/35.00/28.33
PEP/60.00/56.75
---------------------
ADP/37.00/37.25
DEO/60.00/62.38
PM/45.00/46.60
BRKb/3000/3180
MO/16.00/17.53
LOW/19.00/22.46
MHK/30.00/51.58
HANS/25.00/31.01
PKX/80.00/101.07
RMCF/6.00/8.10
(Splits, spinoffs, and similar actions inevitably will occur going forward. Will adjust as necessary to make meaningful comparisons.)
Tactically, the S&P 500 has moved from a recent low of 872 on 7/10/09 to 987 as of last Friday. Many of the stocks above have rallied 30% or more in the past few months. So 3-5 months ago it was easier to buy almost any of these.
Many stocks have rallied so the risk of paying more than necessary in the short-term is there.
Yet, another risk, of course, is missing a stock entirely because it continues to rally. There is no perfect answer to this. The risk of missing something you like when a fair price is available (error of omission) can be more costly than suffering a short-term paper loss.
Here are some thoughts on errors of omission by Warren Buffett from an article in The Motley Fool.
And also...
"During 2008 I did some dumb things in investments. I made at least one major mistake of commission and several lesser ones that also hurt... Furthermore, I made some errors of omission, sucking my thumb when new facts came in." - Warren Buffett's 2008 Annual Letter to Shareholders
In other words, not buying what's still attractively valued to avoid short-term paper losses is far from perfect with your best long-term investment ideas.
To me, if an investment is initially bought at a fair price, and is likely to increase substantially in intrinsic value over 20 years, it makes no sense to be bothered by a temporary paper loss. Of course, make a misjudgment on the quality of a business and that paper loss becomes real (error of commission).
Bottom line: when highly confident that a great business is available at a fair price it's important to accumulate enough while the window of opportunity exists. Sometimes ignoring the risk of short-term losses is necessary to make sure a meaningful stake is acquired.
Ending up with just the quantity of "an eyedropper" when I'd like a full glass is no fun.
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 are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to remain long the above stocks (at least those that at some point became cheap enough to buy) unless market prices become significantly higher than intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
** As of 7/31/09
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