Howard Marks: The Two Main Risks in the Investment World

From this memo to clients written by Howard Marks:

Howard Marks: Warning Flags

"...there are two main risks in the investment world: the risk of losing money and the risk of missing opportunity. You can completely avoid one or the other, or you can compromise between the two, but you can't eliminate both. One of the prominent features of investor psychology is that few people are able to (a) always balance the two risks or (b) emphasize the right one at the right time. Rather, at the extremes they usually obsess about the wrong one...and in so doing make the other the one deserving attention. 

During bull markets, when asset prices are elevated, there's great risk of losing money. And in bear markets, when everything's at rock bottom, the real risk consists of missing opportunity. Everyone knows these things. But bull markets develop for the simple reason that most people are buying – ignoring the risk of loss in order to keep from missing opportunity – just when elevated prices imply losses later. Likewise, markets reach their lows because most people are selling, trying to avoid further losses and ignoring the bargains that are everywhere." - Howard Marks

During bull markets, more often than not, it's the potential returns and missed opportunities that grab the headlines and capture the imagination.

In a bear markets risk of loss is front of mind.

It's best to not fall prey to these tendencies.

In good times, potential returns will always get more play than the risk of loss. It is not difficult to understand why this is the case. The simple fact is that risks are almost always hard to quantify and frequently invisible whereas returns are easy to reveal in black and white.

So naturally many investors flock to the highest (easily verifiable) returns without looking at it in the context of risks that may or may not have been taken. A mistake in my view that only becomes plainly obvious over the long haul.

There are always very real risks that in one or several instances happen to not materialize in a meaningful way (often leading to overconfidence when none is warranted). Crossing a canyon on a barrier free one lane bridge at 150 MPH may have worked out the last time but repeat that behavior enough and I'm certain performance will eventually suffer just a bit. Unfortunately, the risks in most investments are usually not nearly as plain. In fact, the many adverse things that can happen in the future are unknowable or at least hard to foresee.

In other words, that the latent risk did not happen to materialize in a particular instance make it no less real.

Investors that become good at managing the risks that can lead to permanent capital loss from a portfolio have a huge advantage.

"..Warren and I are better at tuning out the standard stupidities. We've left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error." - Charlie Munger

Business executives and investors (professional or not) often do not think about this carefully enough and end up paying for it. There are few subjects more important than this but it gets little attention. Why?

People see big returns and their eyes light up. Talk about risk and they fall asleep.

So what's the easiest way to manage investment risks leading to permanent loss of capital when many of the risk in the future are nearly impossible to anticipate?

Price.

"In the same way that expanded risk tolerance accompanies appreciated asset prices and contributes to the risk of loss, so does risk aversion tend to rise in times of depressed prices, increasing the risk of missed opportunity. When people refuse to buy assets regardless of their low prices, they miss out on the best, lowest-risk returns of the cycle." - Howard Marks

Howard Marks: Warning Flags

A business selling at a price that is a substantial discount to value (conservatively calculated) protects the investor from unforeseen and the unforeseeable risks.

A quality business bought at a substantial premium to value can actually be more risky than a troubled business selling at what is a plain discount.

So it's price that often dictates the risks that an investor is takes. That doesn't mean one shouldn't think carefully about all the risks involved in an investment. It's just humble recognition that you cannot anticipate everything and the only thing there to protect you is a really low price compared to likely future value.

Adam

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

Buffett on Widening the Moat

Warren Buffett wrote the following in the 2005 Berkshire Hathaway (BRKa) shareholder letter:

"Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous. 

When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as 'widening the moat.' And doing that is essential if we are to have the kind of business we want a decade or two from now. We always, of course, hope to earn more money in the short-term. But when short-term and long-term conflict, widening the moat must take precedence. If a management makes bad decisions in order to hit short-term earnings targets, and consequently gets behind the eight-ball in terms of costs, customer satisfaction or brand strength, no amount of subsequent brilliance will overcome the damage that has been inflicted."

The primary responsibility of a business executive is to understand the risks and threats to a franchise then take proactive action to protect and build the competitive advantage(s). An executive management team in place that understands their moat widening responsibilities improves long-term returns. Here's how Buffett explained it at the 2000 Berkshire shareholder meeting:

"We think in terms of moats that are impossible to cross, and tell our managers to widen their moat every year, even if profits do not increase every year."

If done well, it ultimately reinforces or improves the core economics (return on capital) of the franchise leading to superior investor returns.

Unfortunately, separating those who get this from those who pay it lip service is not always easy to do.

Adam

Long position in 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.

High Frequency Trading: Tail That Wags The Dog, Part II

A follow up to this previous post.

High Frequency Trading: Tail That Wags The Dog

Hedge fund manager, Leon Cooperman, thinks regulators should go after high-frequency trading. In this CNBC article, he said there's no reason markets should go up and down by such large percentages each day. He also said:

"Credit default swaps are also adding instability to the marketplace, and they should only be permitted to be traded in by those institutions and individuals that own the underlying bonds," Cooperman explained.

Charlie Munger, often bluntly critical of the financial sector, said* the following about derivatives like credit default swaps:

"Unlimited leverage comes automatically with an option exchange. Then, next, derivative trading made the option exchange look like a benign event. So just one after another the very people who should have been preventing these asininities were instead allowing foolish departures from the corrective devices we'd put in the last time we had a big trouble—devices that worked quite well."

"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."

So these changes undermine control of financial leverage in the system. Munger makes the point that these changes essentially take away the Federal Reserve System's longtime control of margin credit.

More on high frequency trading. From this Minyanville article written by Jeffrey Saut:

So who's selling? I think it is the "machines," driven by high-frequency trading (HFT) and Exchange Traded Funds (ETFs)...Exacerbating the situation are ETFs that are leveraged 2:1, or even 3:1, which if bought on margin implies 4 to 6 times leverage. Moreover, when ETFs buy or sell, they do so across the spectrum of stocks within their universe with NO regard for the fundamentals of any individual stock. So yeah, I think it is the "Rise of the Machines" that has compounded the "selling stampede"...

It's likely that some or all of the many market "innovations" that have come about go a long way toward explaining this Bespoke Investment Group chart that I mentioned in the previous post.

Fancy computers are engaging in legalized front-running. The profits are clearly coming from the rest of us -- our college endowments and our pensions. Why is this legal? What the hell is the government thinking? It's like letting rats into a restaurant. - Charlie Munger

Charlie Munger on Accountants & High Speed Traders

If these new sources of liquidity and ways to make side bets via things like credit derivatives have added instability we'd be wise to fix it yesterday. It's just dumb to allow things to function so much like a casino considering the vital purpose that the capital markets serve.

Until that happens, an individual investor with a long horizon has to learn to buy shares with discipline, whenever prices get comfortably below intrinsic value, and have the temperament to hang on for an unnecessarily rough ride.

The good news is the long run value creation of a good business does not fluctuate nearly as much as market price action might otherwise seem to indicate.

Adam

* Munger also added the following about derivatives: "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." 
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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.

World's Safest Banks 2011

Here is the 20th Annual Ranking from Global Finance of the "World's 50 Safest Banks".

According to the list, most of the safest banks are not located in the United States. Here are the six from the U.S. that made the 2011 list:

• BNY Mellon (BK): 24th
• JPMorgan Chase (JPM): 34th
• Wells Fargo (WFC): 36th
• U.S. Bancorp (USB): 40th
• Northern Trust (NTRS): 44th
• Cobank, ACB: 45th

In 2010, four of the above banks made the list and were ranked as follows:

• BNY Mellon: 30th
• JPMorgan Chase: 40th
• Wells Fargo: 43rd
• U.S. Bancorp: 48th

Gobal Finance 19th annual list of Safest Banks

So once again none in the U.S. reside anywhere near the top of the list. Still, all the banks that were on last year's list improved their position.

The number 1 bank on the list is KfW located in Germany.

Banks from Germany held 4 of the top 10 positions.

The Netherlands had 3 of the top 10 positions.

Here are the rankings from from last year.

Adam

Long JPM, WFC, an USB

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

Berkshire Hathaway Invests $ 5 Billion in Bank of America (BAC, BRKa, GS, GE)

From this Bank of America Press Release:

"Bank of America is a strong, well-led company, and I called Brian to tell him I wanted to invest in it," said Berkshire Hathaway Chairman and Chief Executive Officer Warren Buffett. "I am impressed with the profit-generating abilities of this franchise, and that they are acting aggressively to put their challenges behind them. Bank of America is focused on their customers and on serving them well. That's what customers want, and that's the company's strategy."

Buffett didn't buy Bank of America's (BAC) common stock.

Berkshire Hathaway (BRKa) is getting 50,000 preferred shares at $ 100,000 per share with a 6% dividend that is redeemable at a 5% premium.

Berkshire will also receive warrants to purchase 700 million shares at an exercise price of $7.1428 per share. These warrants can be exercised at any time over a 10-year period.

So Buffett is certainly getting a very nice deal but nothing like the deals he got from Goldman Sachs (GS) and General Electric (GE) during the 2008 crisis. He explained to CNBC why Bank of America is getting better terms.

Buffett Tells CNBC 'This Isn't 2008'

This endorsement by Buffett stands in stark contrast to some of the more vocal Bank of America critics (Henry Blodget, Yves Smith, and others) who are convinced that Bank of America has an enormous capital hole to fill.

Henry Blodget vs Bank of America: "Rotted to the Core"

"I'm sorry if BOA thinks the market is stupid," Henry says. "We went through this in 2008; all the banks said 'we're perfectly capitalized, we're in great shape'; three months later they were revealed to be rotted to the core. The concern is that's what's going on here."

So which view, Buffett's or the vocal critics, is likely to be correct?

Who knows.

Buffett is certainly capable as are many of the analysts but I wouldn't bet against Buffett's six decades of investing experience when he's putting $ 5 billion on the line.

What I do know is banks are vital utilities built on confidence. At a minimum, if a headline grabber like "Rotted to the Core" (or similar) is used to describe a bank some quality analysis and a high degree of certainty ought to be behind it. I don't think that's too much to ask. For someone to opine publicly that a bank is in the kind of extreme trouble that headline suggests it seems reasonable.

We all know that some of this can become self-fulfilling if the lack of confidence ends up feeding on itself.

If someone said "Rotted to the Core" about an oil company or most other businesses the effect is not the same. Most businesses are not built on the trust and confidence of the public and its counterparties in the same manner that a bank is. I mean, there's never risk that there will be the equivalent of a bank run on an oil company.

Obviously, critics are entitled to their opinion. It's true that many of these banks did stupid things and that much of their troubles are self-inflicted. I'm just saying thoughtful analysis and more carefully chosen words is very much in need when it comes to criticizing any bank versus another type of business.

The threshold of what can be said and how it gets communicated by a professional providing an opinion on something as vital as a bank ought to be higher. Some circumspection couldn't hurt.

To me, the negative coverage on banks seems, at least at times, a little cavalier at best.

Whether what seems to at times become a frenzied negative feedback loop in the blogosphere against a particular bank actually ends up putting that bank under even more real world pressure is the key question. I happen to think most bank CEOs already have a tough enough job.

Oh, and forgive me if I'm not convinced that the short-term price action of a stock has some kind wisdom in it. Something like American Express (AXP) went from $ 40 to $ 10 to $ 40/share in just over a year yet its intrinsic value barely changed at all during that time. Tech stocks that had P/Es of 100 or so a decade ago now have P/Es near 7. Wisdom?

Most sick patients are given the benefit of time to heal. The same is true of a bank but not if what I'll call the repair-the-balance-sheet window* is taken away from it.

Why would we want to risk accelerating the demise of a bank that otherwise might heal on its own? If a bank's financial situation is truly terminal that will become obvious in due time.

This seems lost on some in the business of opining on banks.

Adam

*Balance sheet repair comes from using things like pre-tax pre-provision earning power, capital raising, asset sales, and other balance sheet adjustments to absorb losses and build the necessary capital over time.

Buffett on Mediocre to Disastrous Returns: Berkshire Shareholder Letter Highlights (BRKa)

From Warren Buffett's 2004 Berkshire Hathaway (BRKa) shareholder letter:

If you examine the 35 years since the 1960s ended, you will find that an investor's return, including dividends, from owning the S&P has averaged 11.2% annually (well above what we expect future returns to be). But if you look for years with returns anywhere close to that 11.2% – say, between 8% and 14% – you will find only one before 2004. In other words, last year's "normal" return is anything but.

Over the 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous.

There have been three primary causes: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.

For an example of this, consider what Joel Greenblatt said in this Forbes interview:

...in the decade of the 2000s, that ten year period, the top performing mutual fund was up 18% a year. The average investor in that fund lost 11% a year.

Why is that? It's because every time the fund underperformed, people left. Every time the market went down, people left. Every time it outperformed, people piled in right after the outperformance. Right after the market went up, people piled in. So with all the investor's market decisions, the average investor – the average dollar weighted investor in that fund over the last decade, the best fund – ended up losing 11% a year.

Whether investing in quality stocks or mutual funds a key thing is to keep the expenses low and to consistently be buy at a discount to intrinsic value. Shares of a good business (or basket of stocks via a fund) selling comfortably below intrinsic value is more likely to happen during periods of fear and uncertainty.

When it feels uncomfortable to buy it is often (not always) the best time to buy.

The last ten years or so was a tough period for stocks* but that's not because American business performed poorly. The problem was one of extreme valuation. Many good businesses spent the decade "catching up" to their year 2000 valuation. It was one of those times to be fearful since so many others were being greedy.

It seemed strangely similar to the way Garrison Keillor describes Lake Wobegon:

Welcome to Lake Wobegon, where all the women are strong, all the men are good-looking, and all the children are above average. - Garrison Keillor

Well around the year 2000, far too many participants were acting as though the stock market was a place where every stock was above average.

Today, if not at the other extreme, it's close enough to be building long-term positions in quality businesses or funds while keeping the frictional costs low. The market as a whole may not be particularly cheap but many individual securities are more than reasonably valued.

The key thing is to avoid the buy high, sell low trap that Greenblatt describes in the Forbes interview. It is that behavior that frequently damages returns.

Of course, most do not think they are susceptible to that kind of thing but study after study shows otherwise.

Awareness of that susceptibility is a step toward developing a trained response to the episodes where the market goes from depressed to euphoric extremes.

Adam

Long position in BRKb

* There were quite a few professional money managers who avoided the many bubble stocks and navigated that difficult period just fine producing excellent returns.
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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.

High Frequency Trading: Tail That Wags The Dog

From this Bespoke Investment Group post:

'All or Nothing' Days on the Rise

Whenever the market has a day where the net advance/decline (A/D) reading of the S&P 500 is greater than 400 or less then negative 400, we call it an 'all or nothing' day. 

The chart in the Bespoke Investment Group post says it all.

Check it out.

The chart shows that if you add up all the 'all or nothing' days that occurred in the entire 1990s decade, the total comes to 27.

That is nearly half than the amount we are now getting in a typical year. An objective look at what has changed to figure out what is causing something to behave so much differently is a good place to start.

From this CNBC article:

High frequency trading is a "major, major negative for the stock market" and the overall economy, legendary value investor Marvin Schwartz, managing director and senior portfolio manager at Neuberger Berman, told CNBC Thursday.

"These high frequency traders begin the day owning nothing and they end the day owning nothing in terms of common stocks. But during the day they're accounting for between 50 percent and 65 percent of the volume," said Schwartz.

"The liquidity that is added to the market is "useless," with "no lasting value," he added.

Well, it turns out the first big jump in annual number of 'all or nothing' days occurred four years ago. That, of course, may be just a coincidence.

Maybe.

Still, even if that is just a coincidence, it'd be wise to take a close look at each of the many market 'innovations' that have come about under the guise of liquidity and other specious justifications in recent years. This needs a dispassionate, unbiased look by someone with the right expertise.

High speed trading and other similar innovations may serve the participants involved just fine but market instability can do real damage to real economy.

If this turns out to be a case of self-inflicted instability via these so-called innovations, the regulators who ought to be policing these things need to alter how the game is being played.
(Something self-inflicted should be easier to fix than something caused by an external force.)

My gut is that at least some of the changes (created under what seems a fairly hollow pretense) may partly be contributing to the above Bespoke Investment Group chart.

Innovation in finance is more often than not just a clever new way to enhance the amount of leverage, speculation, and gambling within the system. This may benefit some market participants (civilization not so much) up to the point that the system becomes unstable.

If these frequently self-serving so-called enhancements go unchecked we all pay. From John Kenneth Galbraith's book, A Short History of Financial Euphoria:

"The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version."

The reality is that the role of capital markets is far too vital to ever allow them to become a casino in disguise.

Global capital markets are now excessively large and complex. Whether they are actually performing their primary useful functions effectively often seems an afterthought.

It should be smaller, simpler, and more focused.

Charlie Munger doesn't see much benefit to the massive amount of trading between computers that goes on. He also doesn't seem to think the energy expended and talent utilized writing algorithms (that ultimately the rest of us pay for) provides much social contribution.

"...why should we want to encourage our brightest minds to do what amounts to code-breaking and electronic trading? No I think the whole system is stark-raving mad. Why should we want 25% of our graduating engineers going into finance?" - Charlie Munger

Munger: Cut Banking Sector 80%

We need less energy put into leveraged speculation and gambling with more time spent helping capital get to a good idea.

It's a monster of our own making. All too frequently, the tail that's wagging the dog to a greater than necessary extent.

Some may be okay with that but the markets serve us, not vice versa, and those with oversight responsibility need to make adjustments when, for whatever reason, they are functioning this far below potential.

Adam

Related post: 
High Speed Trading: Tail That Wags The Dog, Part II (follow-up)

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

Buffett on Bank Reform: "Too Big To Fail Will Always Exist"

An excerpt from a recent Buffett interview with Charlie Rose. In this part of the interview, Charlie Rose asks Warren Buffett if he thinks Dodd-Frank was the appropriate reform for the financial system.

BUFFETT: I think there's two things that are needed to keep the financial system from going crazy. One is keeping some limits on leverage and we didn't do a very job of that last time. And incidentally...The second thing is having the proper incentives for people at the top of important financial institutions. We saw institution after institution go to the government and say we're too important to this society that you can't let us fail. So pour in the money, do whatever's necessary and I'm going go off and be rich. I'm the guy that screwed it up. I think you've got to have down side, really drastic down side for the people that run financial institutions, big ones that get into trouble. And we need those incentives and I don't think they've attacked that yet. That can be done through the board of directors.
ROSE: Too big to fail continues to exist.
BUFFETT: Too big to fail will always exist. There will always be institutions that are too big to fail. They're deciding over in Europe that Greece is too big to fail.
ROSE: Ok. But could they be broken up. I know that. Should those institutions be broken up?
BUFFETT: No, we decided the whole banking system was too big to fail when we put in the FDIC in effect. We can't exist without them. So we have to do something to change the behavior of people that are at the top of those institutions so they have huge downsides. They didn't have down side. I'm not going to name names but those people did not have down side. They had down side to their reputation but they walked away with tens of millions of dollars so you can't that have that situation exist and expect great behavior. And then you have to have some restrictions on leverage.
ROSE: But has that changed?
BUFFETT: The incentives have not changed very much. They say they've changed by paying them more stock and all that. But that isn't draconian enough for me. 

It seems like the financial-reform law that is Dodd-Frank, a 2000 plus page document, creates plenty of regulatory uncertainty (many new rules remain in flux) yet does little to address the most crucial systemic problems.

"There are 400 rules being made now, and there are things in there that are downright idiotic," - Jamie Dimon speaking before the Council of Institutional Investors

Dimon recently called the law "Dodd-Frankenstein".

It's not exactly surprising he'd criticize the law but Dimon's often pretty good about calling things as he sees them.

Reduce leverage, increase transparency on derivatives (expose hidden leverage and risk), and separate the speculative activities of "casino" banking from "utility" banking.

Previous post: The Banking Power Utility

Most importantly, as Buffett says above, make sure those running these institutions lose much more than their reputation when a financial institution is put on the brink of failure.

There is far less leverage in the banking system. That's certainly a good thing. Otherwise, it seems by all accounts that Dodd-Frank created plenty of unneeded uncertainty yet does little when it comes to solving the tough problems. We've essentially gone the route of not reforming what needs to be reformed the most while creating uncertainty.

No doubt this contributes to a less healthy credit creation and investment that's needed so badly right now in the economy. Check out the full interview.

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.

A Prescription for Profiting on Drug Stocks

When this Barron's article was first published, back in early July, most of the large drug stocks -- like most other sectors at that time -- were selling at higher prices.

So that means the recent market sell off has created a slightly larger margin of safety on some of the larger drug stocks.

Some of these businesses are doing a better job than others moving beyond traditional patented pharmaceuticals and developing franchises around consumer-products, generics, and vaccines.

In the article industry analyst Tim Anderson (Sanford Bernstein) made projections out to 2015 and 2020 for nine U.S. and European drug companies. Not many analyst project so far out into the future.

His conclusion?

GlaxoSmithKline (GSK), Novartis (NVS), Pfizer (PFE), Merck (MRK), Sanofi (SNY), and Roche (RHHBY) are best positioned long-term.

A table at the bottom of the article summarizes current and projected future price to earnings, and dividend yield -- among other things. Keep in mind most of the stocks are now selling at lower prices so appropriate adjustments need to be made.

Over the long run, these businesses have generally produced above average return on capital yet some difficult to answer questions remain:

Can the pipelines of these businesses be replenished at a high return on capital going forward as older drugs come off patent?

Will the consumer-products, generics, and vaccines businesses eventually add some predictability and robustness to these franchises?

Those questions will not be answered anytime soon so I think a larger margin of safety for most of these companies is warranted.

The valuations on some of these seem to mostly reflect the patent cliff and other concerns. Since these businesses are often at the mercy of unfavorable headlines , I generally prefer to buy the best of these when the headlines are at their worst. The underlying problems (related to those headlines) may in fact be serious, but even the best businesses runs into trouble from time to time. Is the problem fixable at a reasonable cost? That's what will matter in the long run. Well, that and whether it was bought at an attractive price. Ultimately, I still think the diversified platform of Johnson & Johnson (JNJ) -- even with its well-publicized recent missteps -- is worth the valuation premium.

The recent market sell off did not hit large pharmaceuticals nearly as much as some other sectors.

Still, the patent headwinds, weak R&D productivity, and the market sell off has created a chance to buy shares in large drug companies at what seems a decent discount to intrinsic value.

Even though I think better capital appreciation opportunities exist elsewhere, many of these businesses produce above average dividend yields that can easily be covered with free cash flow.

Yet, for most of these above average capital appreciation is only there if bought at a bigger discount than what is now available.

Adam

Long JNJ, GSK, PFE and SNY
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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.

Fairholme and Financials

One of the best equity funds over the past decade, Fairholme (FAIRX), is down more than 25 percent this year.

Most of this weak performance comes down to the fund having an extremely high percentage of its assets in financial stocks. The size of Fairholme's exposure to that sector has already received its fair share of coverage.

Well, as it turns out, they've not backed off that sector one bit. In fact, the fund recently disclosed it now has roughly a 90% (previously it was more like 75%) of its assets in financial stocks.

With the exception of Sears (SHLD), just about every non-financial stock in the fund was sold during the last reported quarter. A small amount of Vodafone (VOD) was purchased but it had less than 1/10 of a percent impact on the portfolio.

The top five holdings make up more than 50% of the portfolio. As always, much like Berkshire Hathaway (BRKa), the portfolio is a very concentrated one.

It's hard for me to imagine having more than 10-15% exposure to financials and even then it's the highest quality stuff like Wells Fargo (WFC), U.S. Bancorp (USB), and American Express (AXP).

Essentially, I keep a small percentage exposure to banks and other financial stocks because of the hard to quantify systemic risks. Much of that risk comes down to credit derivatives of various kinds. As long as those side bets can be made with too little oversight and weak disclosure the financial system will remain less robust than it should be.

From the 2002 Berkshire Hathaway shareholder letter:

...derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is running.

Even the best run bank (and, of course, the global economy) can be hurt badly when confidence in the system goes south.

Fairholme deserves some credit for being bold. Having said that, even if it worked out well in the long run, I'd have a tough time handling risk management with 90% exposure to financials.

Adam

Long BRKb, WFC, USB, and AXP

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

Buffett on Borrowing Money: Berkshire Shareholder Letter Highlights

Warren Buffett wrote the following in the 2003 Berkshire Hathaway (BRKa) shareholder letter:

You may wonder why we borrow money while sitting on a mountain of cash. It's because of our "every tub on its own bottom" philosophy. We believe that any subsidiary lending money should pay an appropriate rate for the funds needed to carry its receivables and should not be subsidized by its parent. Otherwise, having a rich daddy can lead to sloppy decisions. Meanwhile, the cash we accumulate at Berkshire is destined for business acquisitions or for the purchase of securities that offer opportunities for significant profit.

The source of that cash pile is fueled, in part, by underwriting profits and float. Here's how he explains it in the 2010 Berkshire letter:

At Berkshire, we have now operated at an underwriting profit for eight consecutive years, our total underwriting gain for the period having been $17 billion. I believe it likely that we will continue to underwrite profitably in most – though certainly not all – future years. If we accomplish that, our float will be better than cost-free. We will benefit just as we would if some party deposited $66 billion with us, paid us a fee for holding its money and then let us invest its funds for our own benefit.

Well the underwriting profit streak, effectively Berkshire getting paid to borrow money, will probably end in 2011.

In this Bloomberg Businessweek article, Warren Buffett said that Japan's earthquake may lead to Berkshire's first underwriting loss for the first time in nine years.

Berkshire May Have Underwriting Loss

Berkshire generally has a mountain of cash and lots of new cash coming in each year via free cash flow from operations and new sources of float from the insurance businesses*. Yet, with all those sources of funds he still prefers that the subsidiaries do their own borrowing to impose discipline.

Berkshire may not be a bank but its $ 66 billion of float plays the same role as deposits at a bank. Somehow over the years Berkshire has figured out a way to, at least most of the time in recent years, consistently get paid for holding other peoples money while investing those funds for the benefit of shareholders. I wouldn't count on that continuing but the cost of float will likely remain cheap.

This model is the equivalent of a depositor receiving a negative interest rate then having the bank (Berkshire) generate something like a low teens percentage return with that money (or, in many instances when it comes to Buffett's skills, much higher).

The businesses that Berkshire has acquired will return 13% pre-tax on what we paid for them, maybe more. - Charlie Munger at the 2001 Wesco Financial Annual Shareholder Meeting

A well run bank is usually pretty satisfied with a 4% spread between what a bank pays depositors and what they can earn on the loans they make with the funds. Yet, at Berkshire, the spread can easily end up 2 to 3 times higher.

Borrowing money for close to nothing and earning say 12% to 14% with the investments you make is a pretty good business.

Even if the streak ends this year Berkshire will continue, in many years, to have a large source of funds that is sometimes cost-free. In the long run Berkshire's float will likely end up costing a few percent but that is still a large and stable source of cheap funds for the company.

Adam

Long position in BRKb

* Warren Buffett in the 2009 Berkshire Hathaway shareholder letter: Insurers receive premiums upfront and pay claims later. In extreme cases, such as those arising from certain workers' compensation accidents, payments can stretch over decades. This collect-now, pay-later model leaves us holding large sums – money we call "float" – that will eventually go to others. Meanwhile, we get to invest this float for Berkshire's benefit. Though individual policies and claims come and go, the amount of float we hold remains remarkably stable in relation to premium volume. Consequently, as our business grows, so does our float.

If premiums exceed the total of expenses and eventual losses, we register an underwriting profit that adds to the investment income produced from the float. This combination allows us to enjoy the use of free money – and, better yet, get paid for holding it.
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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.

Stock Purchases By Executives & Directors Hit Highest Level Since 1998

Here's a CNBC article on what a widely-watched insider buying newsletter (Vickers Weekly Insider) had to say. As investors seemed to be fleeing a volatile market, there was apparently a 16-fold increase in buy transactions in the last three weeks.

The fact that senior executives and directors are buying is far from a reliable signal that a stock is cheap or that stocks in general are cheap but the sheer breadth and quantity of buying lately is, at least, noteworthy.

Fearless Front Office: Most Insider Buying Since 1998

So insiders seem to have turned very bullish. The article highlighted the insider buying of JP Morgan (JPM) and Kraft (KFT), along with several others.

Kraft has a very good business but I don't think it's necessarily a bargain at or near the current valuation.

JP Morgan is certainly not expensive at a little over 7x earnings but few banks are these days.

I'd never buy a stock because an insider happens to be buying. Yet, if I liked shares of a particular business I'd consider it a slight positive to see an executive or director buying some shares.
(An extremely large purchase, especially if it were substantial relative to the wealth of the individual buying, would be more impressive.)

So some incremental purchases is certainly not bad thing. The absence of selling in a stock is also important though that becomes hard to gauge with the use of stock options (and the inevitable options expiration) being so prevalent.

I happen to think the best case scenario is when a CEO, along with other key executives, have a substantial portion of their wealth tied up in the company and a demonstrated a willingness to keep it there over the long run.

That's essentially what has been the situation at Berkshire Hathaway (BRKa) for years. When just about all of your wealth is in the company (as is the case for Charlie Munger and Warren Buffett) it's hardly a negative if more shares aren't being purchased.

In enough cases, an insider buy turns out to be a short-to-intermediate-term trade by an executive or director or not enough capital at risk compared to total net worth to really matter.

There's nothing wrong with that but it's no reason to celebrate either.

Ultimately, you have to make a call on the judgment of individual buyer. Not an easy thing to do.

That many senior corporate executives and directors are talented and capable professionals hardly assures they're going to reliably make wise stock purchase decisions.

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.

Berkshire Hathaway 2nd Quarter 2011 13F-HR

The Berkshire Hathaway (BRKa) 2nd Quarter 2011 13F-HR was released yesterday.

Compared to the 1st Quarter 2011 13F-HR, where not much changed in the portfolio, Buffett added some new positions and continued to build upon several existing positions. There also was also just a bit of selling in the quarter.

Here is a post that summarizes changes made in the previous Berkshire Hathaway 13F-HR.

In 2Q 2011, there were at least some new purchase(or purchases) that were kept confidential. The filing says: "Confidential information has been omitted from the Form 13F and filed separately with the Commission."

From time to time, the SEC allows Berkshire Hathaway to keep certain moves in the portfolio confidential. The intention being to prevent buyers from driving up the price before Berkshire makes its future purchases.

Besides the mystery stock(s) that Berkshire has been purchasing, there were the following disclosed changes to the stock portfolio:

Equities Purchased
New positions:
Verisk (VRSK): Bought 2.1 million shares, ~$ 71 million*
Dollar General (DG): 1.5 million shares, ~$ 49 million

Added to Existing Positions:
Wells Fargo (WFC): Bought 9.7 million shares, ~$ 275 million (2.8% increase)
Mastercard (MA): 189,000 shares, ~$ 52 million (88% increase)

A look at the cash flow statement from the most recent 10-Q reveals that over $ 3.6 billion million of equity purchases were made in the 2nd quarter.

The total of the 4 above purchases equals only an estimated $ 447 million. That means roughly $ 3.15 billion of other new purchase(s) (ie. equities that sell on exchanges outside the U.S. or mystery purchases/confidential trades inside the U.S.) were transacted by Berkshire Hathaway during 2Q 2011 that have yet to be disclosed.

Unlike the above minor adjustments to the portfolio the mystery purchase(s) are relatively significant in size.

Equities Sold
Reduced Positions:
Approximately 5.7 million shares of (KFT) was sold or $ 190 million (a 5.5% decrease). It remains a top five position.

No positions were sold outright.

Portfolio Summary
After the changes, Berkshire Hathaway's stock portfolio** is made up of ~ 42% consumer goods, 39% financials, 6% consumer services, and 6% healthcare. The remainder is primarily spread across industrials and energy.

1. Coca-Cola (KO) = $ 13.6 billion
2. Wells Fargo (WFC) = $ 8.7 billion
3. American Express (AXP) = $ 6.8 billion
4. Procter and Gamble (PG) = $ 4.7 billion
5. Kraft (KFT) = $ 3.4 billion

As is almost always the case, it's a very concentrated portfolio with the top five often making up something like 60-70 percent and, at times, even more of the equity portfolio.

Some of these mystery purchase(s) could be, at least in part, those of Todd Combs. Initially, Combs is expected to manage just $ 2-3 billion of the entire Berkshire Hathaway portfolio.

As of the last 10-Q (the best view available until the annual report comes out), the combined value of the Berkshire portfolio including the above equities plus fixed maturity securities and other investments is roughly $ 118 billion (excluding cash).

That portfolio, of course, excludes all the operating businesses that Berkshire owns. ere are some examples of the non-insurance businesses: MidAmerican Energy, Burlington Northern Santa Fe, McLane Company, The Marmon Group, Shaw Industries, Benjamin Moore, Johns Manville, Acme Building, MiTek, Fruit of the Loom, Russell Athletic Apparel, NetJets, Nebraska Furniture Mart, See's Candies, Dairy Queen, The Pampered Chef, Business Wire, Iscar Metalworking among others.

In addition, the insurance businesses (BH Reinsurance, General Re, GEICO etc.) owned by Berkshire have naturally provided plenty of "float" for their investments over time and continue to do so.

See page 106 of the annual report for a full list of Berkshire's businesses.

The earning power of these combined businesses is north of $ 10 billion/year.

In addition, there was nearly $ 48 billion in cash at the end of 2Q 2011 although $ 9 billion will be needed for the Lubrizol purchase that should close in 3Q 2011. With that pile of growing easily at a rate of $ 10-15 billion/year there is no shortage of money to put to work at Berkshire.

Adam

Long positions in BRKb, KO, WFC, AXP, PG, and KFT established at lower than recent market prices.

* Using the mid-point of each stocks trading range last quarter.
** Berkshire Hathaway's holdings of ADRs are included in the 13F-HR. What is not included are the shares listed on exchanges outside of the United States. The status of those shares (BYD, POSCO, Sanofi, Tesco etc.) are updated in the annual letter.
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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.

Google Buys Motorola Mobility for $ 12.5 Billion

It looks like Google (GOOG) will acquire Motorola Mobility (MMI) for $ 12.5 billion in cash or what is a 63% premium to Friday's closing price.

Press Release: Google to Acquire Motorola Mobility

Here's what CEO Larry Page had to say in this blog post:

In 2008, Motorola bet big on Android as the sole operating system across all of its smartphone devices. It was a smart bet and we're thrilled at the success they've achieved so far. We believe that their mobile business is on an upward trajectory and poised for explosive growth.

Motorola is also a market leader in the home devices and video solutions business. With the transition to Internet Protocol, we are excited to work together with Motorola and the industry to support our partners and cooperate with them to accelerate innovation in this space.

Motorola's total commitment to Android in mobile devices is one of many reasons that there is a natural fit between our two companies. Together, we will create amazing user experiences that supercharge the entire Android ecosystem for the benefit of consumers, partners and developers everywhere.

The patent battles between the largest players have been heating up. In the post, Larry Page said that Motorola Mobility strengthens Google's patent portfolio. According to Motorola, the company has 24,000+ patents and pending patent applications.

It's tough to gauge how valuable these patents will end up being for Google. Yet, it seems clear from recent comments and Google's attempt to shore up the patent portfolio via this acquisition that the company feels there's real threats from some of these ongoing patent battles. More from Page's blog post:

Our acquisition of Motorola will increase competition by strengthening Google's patent portfolio, which will enable us to better protect Android from anti-competitive threats from Microsoft, Apple and other companies.

For background, here's a relevant earlier post from the Official Google Blog: When Patents Attack Android

Patents are certainly not the greatest source of an economic moat (I'll take a good brand with wide distribution over just about any patent) but if you are in Google's position shoring up the intellectual property portfolio makes sense.

Here's some perspective on the size of Motorola's patent portfolio. From the Atlantic Wire:

Last month, a consortium of companies including Apple, Microsoft and Research in Motion beat Google in an auction and purchased Nortel's portfolio of 6,000 patents for $4.5 million. With 24,000 patents, Motorola Mobility's portfolio dwarfs that of Nortel's, and the $12.5 billion all cash price tag makes it seem like Google got a deal by comparison.

Of course, all patents are not created equal so there's no obvious answer to the question of which portfolio is actually of higher value.

Maybe the deal ends up being, at least in part, a chance to better integrate hardware and software product development in the way that Apple does but I'm guessing it's more about the patents.

On a price to earnings basis, the deal looks very expensive at nearly 30x forward estimated earnings (there's is a wide range of estimates so that multiple could easily be much lower or higher). Motorola Mobility does have over $ 3 billion in net cash so the price tag is actually more like $ 9.5 billion after adjusting for cash. No matter what, under most circumstances this certainly would have to be considered a pricey deal.

By itself, Motorola Mobility is not in a great business. It's in combination with Google's strengths that, at least in terms of defense, the assets of Motorola Mobility start to look valuable.

Whether this a good thing for Google's shareholders is tough to know because it seems, for the most part, to be a relatively expensive but important safeguard. I'm guessing the move is mostly about keeping Google's mobile strategy from being derailed not the value of Motorola Mobility's mediocre at best business.

So it's possible that the price paid may end up being more than justified considering what's at stake. Google seems to think it needs to fortify and enhance its advantages against what are extremely well-financed competitors like Microsoft (MSFT) and Apple (AAPL).

Combined, Microsoft and Apple are sitting on over $ 100 billion in net cash and have ~$ 45-50 billion in annualized free cash flow.

No matter what Motorola shareholders certainly are winners.

Google says they are committed to Android as an open platform and remains committed to the other device makers.

One of the questions is how will the other Android device makers respond. It looks like at least some of them view it favorably as the CEOs of HTC, Sony Ericsson, and LG have all already made public statements in support of this move by Google.

To date, 150 million Android devices have been activated worldwide with an additional 550,000 of the devices activated each day.

 Adam

Long positions in GOOG, MSFT, and AAPL

Related post:
Technology Stocks

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

Grantham: What to Buy?

An excerpt from Part II of Jeremy Grantham's latest quarterly letter with some commentary to follow:

-On a regular time horizon, I would continue to overweight quality stocks, which may well be on a roll. They are not priced to make a fortune, but they are priced to give approximately 4.5% to 5% real return, which I think is acceptable for low-risk assets. They have also delivered dependable downside – risk off – relative performance for several years, which is a characteristic generally in short supply.

Grantham's Quarterly Letter - Danger: Children At Play

Grantham and his team think that the S&P 500 is worth no more than 950.

Whether the S&P 500 is worth 950 or not there seem to be plenty of shares in individual businesses selling at a discount to value.

Most of them are, in fact, large and of the high quality variety.

Things like Berkshire Hathaway (BRKa), Pepsi (PEP), Johnson & Johnson (JNJ) along with large cap tech stocks like Microsoft (MSFT), among many others, are not at all expensive.

It almost seems routine now to see quality businesses selling at low teens or even single digit multiples of earnings. Yet, you only have to look back ten years or so to know the situation is far from routine.

A decade ago many of these businesses were selling anywhere from somewhat to massively overvalued.

The fact is most of these have been cheap for quite a while and most continue to get cheaper. That may seem like a bad thing (dead money or worse) but as a long-term holder of shares it's usually beneficial if the shares remain low or better yet, get cheaper, in the short-to-intermediate run:

1) It allows more shares of a good business to be accumulated by an investor over time at a fair or better price via dividend reinvestment or as new sources of cash become available.

2) Management can use the company's own free cash flow generation to buy more of the shares over time, whenever they are selling below intrinsic value, to the benefit of long-term holders of the stock.

The market weighing machine will in the long run reflect the cumulative effects of the buybacks and each businesses core economics on a per share basis.

So, as long as the favorable economics of these businesses remain in tact, hopefully prices remain low or even decline from here. With long-term returns as the focus that's precisely what investors should want.

Whether those favorable economics remains in tact is something far from certain that must be evaluated on a regular basis (especially for any technology business).

Now, I realize this approach flies in the face of the hyperactive trading ethos that is so popular these days. I'm sure there is one heck of an adrenaline rush for those involved in the trading game.

Those in the business of attempting to make a quick buck on a well timed trade will likely find the above somewhere between useless and uninteresting.

Yet, even if admittedly less exciting, it works when applied with discipline and sound judgment. I'll take the highest possible risk-adjusted forward rate of return in lieu of the adrenaline rush.

Adam

Related posts:
Defensive Stocks Revisited - March 2011
KO and JNJ: Defensive Stocks? - January 2011
Altria Outperforms...Again - October 2010
Grantham on Quality Stocks Revisited - July 2010
Friends & Romans - May 2010
Grantham on Quality Stocks - November 2009
Best Performing Mutual Funds - 20 Years - May 2009
Staples vs Cyclicals - April 2009
Best and Worst Performing DJIA Stock - April 2009
Defensive Stocks? - April 2009

Long BRKb, PEP, JNJ, and MSFT

* From the Grantham letter: The forecast provided above is based on the reasonable beliefs of GMO and is not a guarantee of future performance. Actual results may differ materially.
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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.

Cisco's Results & Outlook

Troubled Cisco (CSCO) reported some pretty solid quarterly results yesterday.

Reuters:
Cisco jumps as revenue outlook calms investors

Bloomberg:
Cisco Gains after Profit, Sales Tops Analysts' Estimates

Below are some financial highlights from the company's press release:

Cisco Reports 4th Quarter and Fiscal Year 2011 Results

-Cash flows from operations were $2.8 billion for the fourth quarter of fiscal 2011, compared with $3.0 billion for the third quarter of fiscal 2011, and compared with $3.2 billion for the fourth quarter of fiscal 2010. Cash flows from operations were $10.1 billion for fiscal 2011, compared with $10.2 billion for fiscal 2010.

-Cash and cash equivalents and investments were $44.6 billion at the end of fiscal 2011, compared with $43.4 billion at the end of the third quarter of fiscal 2011, and compared with $39.9 billion at the end of fiscal 2010.

-During the fourth quarter of fiscal 2011, Cisco repurchased 95 million shares of common stock under the stock repurchase program at an average price of $15.85 per share for an aggregate purchase price of $1.5 billion.

Subtract the $ 1.2 billion of capex from the $ 10.1 billion of cash flows from operations and you have a company that produced free cash flow of $ 8.9 billion in a tough transitional year.

Cisco has clearly made quite a few missteps. Yet, if you step back a bit it's a company selling at an enterprise value of $ 47.4 billion generating $ 8.9 billion of free cash flow. Not exactly expensive.

Shares Outstanding: 5.5 billion

Stock price at yesterday's close: 13.73/share

Market Cap: 5.5 billion*$13.73: $ 75.5 billion

Net Cash on the Balance Sheet*: $ 27.8 billion

Enterprise Value: $ 47.7 billion
Free Cash Flow: $ 8.9 billion

Enterprise Value/Free Cash Flow = 5.4x

Now, I happen to subtract stock based compensation when calculating the free cash flow of a company that uses lots of stock options to compensate employees.

Cisco is clearly one of those companies.

 This approach is meant to be conservative and add a margin of safety**.  Using my more conservative free cash flow numbers Cisco's enterprise value to earnings multiple is still just 6.5x.

Neither number is perfect but I think the 6.5x multiple uses cash flow that, while conservative, better approximates Cisco's economics.

"Proper accounting is like engineering. You need a margin of safety. Thank God we don't design bridges and airplanes the way we do accounting." - Charlie Munger

"...double-entry bookkeeping was a hell of an invention. And it's not that hard to understand. 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." - Charlie Munger

Munger on Accounting

Cisco's free cash flow would have to be shrinking rather quickly to justify either the 6.5x or 5.4x multiple.

I'm not a big fan of Cisco but at some point the price gets low enough that the risk/reward makes sense.

Now, if Cisco starts to grow consistently again returns for investors will likely be impressive. The good news is at the current multiple Cisco doesn't need to grow much to produce some nice longer term returns for investors.

Here's the only problem. Even if not quite as cheap, there are several fairly inexpensive large cap tech stocks (Microsoft: MSFT comes to mind as an example) with seemingly fewer difficulties than Cisco.

For investors, I would say that these are the kind of problems one wants.

Adam

Small long positions in CSCO and MSFT

* Cash and Cash Equivalents of $ 44.6 billion Minus debt of $ 16.8 billion.
** Since there's no easy perfect way to estimate what the real future cost of options to shareholders will be I go with this approach. It is admittedly a bit tough (i.e. conservative) but, not being a fan of companies that use lots of options for compensation in the first place, this is how I build in a bigger margin of safety. As an investor, I think of it as an excessive options use penalty.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Munger On Investment Banks, Economics, and More

More excerpts from the Charlie Munger interview in the Stanford Lawyer:

On Investment Banks
"The investment banks of yore, chastened by the '30s, were private partnerships, or near equivalents. The partners were dependent for their retirement on the prosperity of the firms they left behind and the customs and culture they left behind, and the places were much more responsible and honorable. That ethos, by the time the year 2006 came along, had pretty well disappeared. Our regulators allowed the proprietary trading departments at investment banks to become hedge funds in disguise, using the 'repo' system—one of the most extreme credit-granting systems ever devised. The amount of leverage was utterly awesome."

On Economic Collapses
"I think it is dangerous to have big disasters in a modern economy. I regard pre-World War I Germany as an advanced, decent civilization. After all, little Albert Einstein got a very good, subsidized primary education in German Catholic schools. But in its economic misery, Germany became dominated by Adolf Hitler. We've seen some god-awful people come to power in various miseries in various countries. Enough misery has huge dangers in a world where we have new pathogens, atomic bombs, and so forth. So we can't afford to have huge economic collapses."

On Economics & Psychology
"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."

On Eliminating Standard Error
"Warren and I have skills that could easily be taught to other people. One skill is knowing the edge of your own competency. It's not a competency if you don't know the edge of it. And Warren and I are better at tuning out the standard stupidities. We've left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error."

On Being Risk-Averse
"I think that many CEOs get carried away into folly. They haven't studied the past models of disaster enough and they’re not risk-averse enough. One of the very interesting things about Berkshire Hathaway is how chicken it is, how cautious, how low is its leverage. But Warren and I would not have been comfortable with more risk, entrusted with other people's net worths. There was no reason for our financial institutions to stretch as much as they did, with the leverage, the shady people and the compromises."

"I think the culture is simply going to have to learn to work more the way Berkshire Hathaway does, instead of the way Citigroup did."

"The culture of Goldman Sachs as a partnership was morally superior and better for the surrounding civilization than the culture that came after it went public."

On Resisting Reform
"...there are powerful forces intrinsic to the system that resist reform. But I have lived in my own life with responsible investment banking. When I was young, First Boston Company was an honorable and constructive firm and very much served the surrounding civilization. Investment banking at the height of this last folly was a disgrace to the surrounding civilization."

On Derivatives Trading
"If there aren't a lot of new jobs in derivative trading, maybe the engineers will have to do more engineering."

It's probably too much to ask but during attempts to fix some of what is broken in the financial system it would be nice if the merits of the above views were given some real consideration.

Adam

Related post:
Munger on Derivatives
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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.