A follow up to this post.
Bogle: "Tyranny of Compounding Costs"
In the 1983 Berkshire Hathaway Annual (BRKa) Shareholder Letter, Warren Buffett wrote the following about frictional costs and their impact on returns:
"...consider a typical company earning, say, 12% on equity. Assume a very high turnover rate in its shares of 100% per year. If a purchase and sale of the stock each extract commissions of 1% (the rate may be much higher on low-priced stocks) and if the stock trades at book value, the owners of our
hypothetical company will pay, in aggregate, 2% of the company's net worth annually for the privilege of transferring ownership. This activity does nothing for the earnings of the business, and means that 1/6 of them are lost to the owners through the 'frictional' cost of transfer. (And this calculation does not count option trading, which would increase frictional costs still further.)
All that makes for a rather expensive game of musical chairs."
The costs of this expensive game ends up in the pocket of the croupier as participants trade stocks back and forth frenetically. Buffett also later added:
"These expensive activities may decide who eats the pie, but they don't enlarge it."
The source of the "frictional costs" in the specific example provided in that letter. Yet no matter what the source happens to be, Buffett's broader point is no less relevant. These days commissions are far lower so the possibility of reduced frictional costs for participants is theoretically easier than ever*.
The problem is the many new potential sources of frictional cost in the system. A bunch of comes from just the general trend toward trading hyperactivity or "short-termism" by market participants.
(A substantially reduced average holding period compared to historic norms whether the trading is done directly via stocks or indirectly via ETFs.)
In the same letter, Buffett parenthetically also added:
"...hyperactive equity markets subvert rational capital allocation and act as pie shrinkers. Adam Smith felt that all noncollusive acts in a free market were guided by an invisible hand that led an economy to maximum progress; our view is that casino-type markets and hair-trigger investment management act as an invisible foot that trips up and slows down a forward-moving economy."
All this additional trading hyperactivity has more than picked up the slack and kept frictional costs for the system as a whole very high. So the current way of doing business remains very costly for the average market participant, but those that avoid all this hyperactivity don't bear these costs.
In the prior post, I mentioned what John Bogle calls "the tyranny of compounding costs". Well, during a SmartMoney interview back in 2005, Bogle noted that in a ~13 percent market the average mutual fund earns something like 10 percent, while the average mutual fund investor earns just 6.5 percent.**
"People understand the magic of compounding returns. But few investors know about what I call the tyranny of compounding costs.... You put up 100% of the capital and take on all the risk, but you get only 20-something percent of the return. That's a system that is destined to fail. People will not be that dumb forever." - John Bogle in SmartMoney back in 2005
"The magic of compounding returns, it turns out, is simply overwhelmed by the tyranny of compounding costs at today's exorbitant levels." - John Bogle in The Wall Street Journal (unedited version of remarks)
Oh, and taxes only make it worse. In the above example, it seems like the average mutual fund investor will earn half as much as the overall market (13 percent versus 6.5 percent) but it's actually worse than that. When you take into account compounding effects, the average mutual fund investor actually ends up with more like a bit more than one fifth as much money over 25 years (and it, of course, just gets worse as the "tyranny" compounds in reverse). This huge gap is the result of all these frictional costs plus the tendency of investors to buy during the good times and sell during the not-so-good times.**
Pretty much the opposite of what successful investors need to do.
Also, consider that both Buffett, Bogle, and Grantham (in the prior post) are referring to frictional costs in their examples that are generally much less than what many hedge funds are known to charge.
Knowing all this, does it make sense to have a system where participants work feverishly to outsmart the other participants (to be on the "right side" of trades) with the net result being nothing of value in the aggregate being created?
Why wouldn't one instead designed to encourage the minimization of frictional costs at every level (and a longer holding period by the average participant) be the better way to go?
The productive assets themselves would still compound in value at the same rate with more of the gains remaining in the pockets of those who actually put capital at risk.
I know this won't happen anytime soon (and we all have to invest in the world as it is) but to me it seems a more than fair question. The good news is (and I mentioned this in the prior post) the individual investor can still choose to not participate in the folly even if the system remains the way it is, give or take, for a very long time.
(Yet, unfortunately, society still bears the cost of this mostly unproductive activity. Jeremy Grantham once made the point that frictional costs like this actually "raid the balance sheet" of investors.)
Those that work to minimize frictional costs, stay within their limits, buy with discipline (a plain discount to value), and generally own assets long-term that compound intrinsically at a high rate increase the probability of ending up well ahead of most investors. Other than that, it's often one's own temperament and various cognitive biases that get in the way of above average long-term returns.
Adam
* Even if someone is not buying stocks directly, quite a few low cost ETFs and traditional mutual funds exist now that could be bought and held long-term to keep expenses low. The problem is that the evidence suggests ETFs are traded rather excessively.
** The difference between the fund returns and what the investors get for returns comes down to investors attempting to buy and sell in order to increase returns and reduce risk. The intent is, of course, to improve results but the opposite is achieved. (i.e. Buying when stocks are expensive during what seems like clear economic skies; selling when stocks are cheap as dark economic clouds emerge.) Bogle provided another example that suggests the gap is even worse back in 2003. The problem stems more from how price compares to per share intrinsic value -- whether or not there is a sufficient margin of safety -- and less from timing. (Even if, at specific times, stock prices can be generally expensive or cheap. In 2000 many stocks sold at big premiums to value; in 2009 many were at big discounts to value. It's just that a focus on timing distracts from what really matters: price vs value.)
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Monday, July 30, 2012
Friday, July 27, 2012
Philip Morris International
Philip Morris International (PM) is facing plenty of currency headwinds these days. From Philip Morris International's 2012 Second-Quarter Results:
Reported diluted earnings per share of $1.36, up by 0.7%, or by 8.1% excluding currency, versus $1.35 in 2011...
Let's take a step back. In 2008 Altria (MO) spun off Philip Morris International.
The stock has done just fine since then but, more importantly, so has the business itself.
In 2007, the last full year prior to the spin-off, Philip Morris International earned $ 6 billion.
Five year later in 2011, the company earned roughly $ 8.6 billion.
That's 43 percent earnings growth. Not too bad.
Yet, because they've been doing some consistently smart buying back of their stock, it looks even better on a per share basis.
They've shrunk share count nearly 20% while mostly doing the buying when the shares were comfortably below intrinsic value. They've also been paying a very nice growing dividend and, of course, will likely continue to do so for a very long time.
As a result of this smart capital allocation, earnings should be more than $ 5.00 per share this year compared to the $ 2.86 per share they earned in 2007.
So more like 75 percent growth on a per share basis.
Unfortunately, at its current price the prospects are far less attractive near-term and, as long as the stock price remains somewhat elevated, the buybacks will have a more modest impact on long-term per share value.
Adam
Long position in MO and PM. Nearly all of my shares of MO were purchased many years ago (at, of course, much lower than recent prices) and my PM shares are mostly the result of the spin-off. No intention to buy any additional shares near the current market price of either stock (nor sell any of the shares I own). Basically, for me at least, PM and MO are shares I intend to own for a very very long time and ideally "forever". One can only hope that these stocks will eventually go lower so more shares could be accumulated at a plain discount to value and so the buybacks will work more effectively.
---
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.
Reported diluted earnings per share of $1.36, up by 0.7%, or by 8.1% excluding currency, versus $1.35 in 2011...
Let's take a step back. In 2008 Altria (MO) spun off Philip Morris International.
The stock has done just fine since then but, more importantly, so has the business itself.
In 2007, the last full year prior to the spin-off, Philip Morris International earned $ 6 billion.
Five year later in 2011, the company earned roughly $ 8.6 billion.
That's 43 percent earnings growth. Not too bad.
Yet, because they've been doing some consistently smart buying back of their stock, it looks even better on a per share basis.
They've shrunk share count nearly 20% while mostly doing the buying when the shares were comfortably below intrinsic value. They've also been paying a very nice growing dividend and, of course, will likely continue to do so for a very long time.
As a result of this smart capital allocation, earnings should be more than $ 5.00 per share this year compared to the $ 2.86 per share they earned in 2007.
So more like 75 percent growth on a per share basis.
Unfortunately, at its current price the prospects are far less attractive near-term and, as long as the stock price remains somewhat elevated, the buybacks will have a more modest impact on long-term per share value.
Adam
Long position in MO and PM. Nearly all of my shares of MO were purchased many years ago (at, of course, much lower than recent prices) and my PM shares are mostly the result of the spin-off. No intention to buy any additional shares near the current market price of either stock (nor sell any of the shares I own). Basically, for me at least, PM and MO are shares I intend to own for a very very long time and ideally "forever". One can only hope that these stocks will eventually go lower so more shares could be accumulated at a plain discount to value and so the buybacks will work more effectively.
---
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, July 25, 2012
Stock Returns & GDP Growth: Why There's Little Correlation
A follow up to this post:
Why Growth Matters Less Than Investors Think
Below is a specific example of higher GDP growth not leading to higher stock returns. This article by Brett Arends that I mentioned in the prior post points out the following:
Real GDP growth from 1958 to 2008
- Japan 4.5%
- Sweden 3%
There was much more growth in Japan over that time horizon, but it was the Swedish investors that enjoyed the better returns. In fact, returns were three percentage points higher on average each year over those fifty years. Naturally, with compounding effects, three percent ends up being quite a lot more money over fifty years. It also makes quite an impact over a somewhat shorter time horizon. Let's say over the next quarter century what you've saved as of today ends up growing to $ 1 million by achieving the Japan-like returns. With the same amount of money at risk, the Sweden-like returns would instead grow to more like ~ $ 2 million as a result of the extra three percent per year. So the real cost of that 3% gap left to compound would be $ 1 million in gains.
So in the case of Japan and Sweden, growth in GDP told you little about potential equity returns. The article by Arends points out that research firm MSCI Barra looked at many major markets over the same period of time. The firm found no major correlation between GDP growth and stock market performance among them.
Professor Jay Ritter at the University of Florida also found that the correlation between the GDP growth and stock returns was actually negative for the twentieth century.
So what's at least some of the reasons?
- Investors often overpay for the fast-growers. A good investment at one price becomes a lousy one at another. Where there's excitement, stocks that sell for high multiples of earnings (paying too much for promise) usually follow. It's tough to do well long-term paying more per share than something is intrinsically worth. Also, depending on just how pricey the shares are, buybacks are anywhere from less effective to downright dumb as far as continuing shareholder returns are concerned. Shares that sell consistently below intrinsic value, if bought back when cheap, can juice long-term returns substantially even in a modest economic growth environment.
- Booming economies and industries attract lots of capital that leads to more competition. This usually lowers return on capital at least until a clear leader emerges. Return on capital is all-important and, in the case of Japan, their great companies have not exactly been known for being focused upon achieving high returns for shareholders. Also, high growth sometimes requires more capital than a business might have at its disposal leading to capital raising and share dilution. Well, it's per share increases to earnings that matter for an investor...not just absolute increases.
- Many enterprises are global and derive much of their value creation from outside their home country. So high GDP growth inside their home country, even for a sustained period of time, means little to these companies.
When you buy shares of anything, it's ultimately a proportional claim on its future cash flows. It may or may not be an exciting growth story. That's of little relevance. I opened the prior post with this Buffett quote that's relevant here:
"Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive." - Warren Buffett in the 1992 Berkshire Hathaway (BRKa) Shareholder Letter
The primary drivers of long-term returns is the price that's paid relative to intrinsic value, return on capital (having the highest possible truly free cash flows relative to the ongoing capital requirements of an enterprise), and whether real durable advantages exist.
A good business needs little capital, can return excess capital to shareholders or use it to finance opportunities at an attractive long-term return, yet can maintain (better yet...grow) the size and strength of its economic moat. It also requires business leaders who do not choose growth for its own sake over returns for its shareholders.
To be fair, sometimes the pursuit of market share and a willingness to endure pain in the early stages is quite necessary and smart. It helps if one already has a truly unassailable and profitable franchise well-established in a different market. Many of the great global brands have such a situation. They can afford to invest long-term. The key difference is they are usually operating with huge advantages and predicting that they will have a successful future outcome is less difficult to do. It's more about patience. In these cases deferring profitability in order to build a durable leadership position in a new market is wise.
Otherwise, lots of competing capital tends to show up (financial and human) in a high growth country or industry with difficult to predict outcomes. In this kind of environment there will no shortage excitement, innovation, and rapid change. All that capital formation tends to fund and create capable competition. There will be big winners, big losers and, at least before the fact, it won't always be easy to distinguish between them.* Enough capital for a sustained period of time ends up producing lots of new competitors with unpredictable long-term economics. A business can go from having what seemed to be an unassailable moat to having none at all in a relatively short amount of time.
Once favorable economics for owners are no more.
Just keep in mind that certain companies, often the great global brands with difficult to replicate distribution**, earn consistently above average return on capital. These great franchises can remain persistently profitable without engaging in anti-competitive behavior. The simplistic idea that high profitability will attract capital (and vice versa) that leads to less profitability (the supposed inevitable closing of the profits gap) doesn't always work in the real world. That model of how competitive forces will generally play out among competitors over time is flawed or, at least, limited in scope. It is not difficult to provide real world examples.
The formation of new innovative companies is good for civilization but may or may not be good for shareholders. Sometimes it will be. Sometimes not. One has little to do with the other. Airlines are incredibly important but rarely have been good for shareholders. When high returns are expected it often invites capital that creates lots of tough competitors. Pricing power and/or cost advantages are either non-existent or transitory. They do not prove durable. Sometimes, growth is pursued in lieu of returns. With the best intentions market share is pursued with the idea that profits will comes later. Sometimes it even works out. Still, more often than not, you get lots of growth but a low return on capital affair for owners. Not good if the best possible risk-adjusted returns is what you are after.
Those able to consistently pick the big winners (some are very good at that sort of thing) in these kind of dynamic situations may even do very well. To be successful, that style of investor also had better be very good at not allowing the big losses to occur. Big winners and big losers often reside in the same neighborhood and the houses aren't easy to tell apart. It's amazing how much getting above average returns comes down to just avoiding losses. Well, the big losses are often the flip side of going after home runs.
Otherwise, that's why the boring stable modest growth industries can be a more attractive investment approach. They attract little in the way of new capital formation, offer less excitement, but future outcomes are easier to predict.
(Again, returns can turn out rather well in the long run if you just mitigate the possibility of big losses.)
Finally, as I mentioned above, just because a stock happens to be listed on a particular exchange, doesn't mean its future cash flows are tied to that country. There is no shortage of great franchises that derive a large proportion of their economics a great distance from the country of origin or listing.
Adam
Related posts:
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009
* Think search engines in the late 1990s. Anyone that truly could see Google (GOOG) was going to be the winner before it all played out the way it did deserves huge rewards. I say "truly" because I'm guessing at least some early investors in Google thought the young company had a great chance to succeed but did not really know it would work out so well.
** Though there are certainly other ways to create an enduring moat.
---
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.
Why Growth Matters Less Than Investors Think
Below is a specific example of higher GDP growth not leading to higher stock returns. This article by Brett Arends that I mentioned in the prior post points out the following:
Real GDP growth from 1958 to 2008
- Japan 4.5%
- Sweden 3%
There was much more growth in Japan over that time horizon, but it was the Swedish investors that enjoyed the better returns. In fact, returns were three percentage points higher on average each year over those fifty years. Naturally, with compounding effects, three percent ends up being quite a lot more money over fifty years. It also makes quite an impact over a somewhat shorter time horizon. Let's say over the next quarter century what you've saved as of today ends up growing to $ 1 million by achieving the Japan-like returns. With the same amount of money at risk, the Sweden-like returns would instead grow to more like ~ $ 2 million as a result of the extra three percent per year. So the real cost of that 3% gap left to compound would be $ 1 million in gains.
So in the case of Japan and Sweden, growth in GDP told you little about potential equity returns. The article by Arends points out that research firm MSCI Barra looked at many major markets over the same period of time. The firm found no major correlation between GDP growth and stock market performance among them.
Professor Jay Ritter at the University of Florida also found that the correlation between the GDP growth and stock returns was actually negative for the twentieth century.
So what's at least some of the reasons?
- Investors often overpay for the fast-growers. A good investment at one price becomes a lousy one at another. Where there's excitement, stocks that sell for high multiples of earnings (paying too much for promise) usually follow. It's tough to do well long-term paying more per share than something is intrinsically worth. Also, depending on just how pricey the shares are, buybacks are anywhere from less effective to downright dumb as far as continuing shareholder returns are concerned. Shares that sell consistently below intrinsic value, if bought back when cheap, can juice long-term returns substantially even in a modest economic growth environment.
- Booming economies and industries attract lots of capital that leads to more competition. This usually lowers return on capital at least until a clear leader emerges. Return on capital is all-important and, in the case of Japan, their great companies have not exactly been known for being focused upon achieving high returns for shareholders. Also, high growth sometimes requires more capital than a business might have at its disposal leading to capital raising and share dilution. Well, it's per share increases to earnings that matter for an investor...not just absolute increases.
- Many enterprises are global and derive much of their value creation from outside their home country. So high GDP growth inside their home country, even for a sustained period of time, means little to these companies.
When you buy shares of anything, it's ultimately a proportional claim on its future cash flows. It may or may not be an exciting growth story. That's of little relevance. I opened the prior post with this Buffett quote that's relevant here:
"Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive." - Warren Buffett in the 1992 Berkshire Hathaway (BRKa) Shareholder Letter
The primary drivers of long-term returns is the price that's paid relative to intrinsic value, return on capital (having the highest possible truly free cash flows relative to the ongoing capital requirements of an enterprise), and whether real durable advantages exist.
A good business needs little capital, can return excess capital to shareholders or use it to finance opportunities at an attractive long-term return, yet can maintain (better yet...grow) the size and strength of its economic moat. It also requires business leaders who do not choose growth for its own sake over returns for its shareholders.
To be fair, sometimes the pursuit of market share and a willingness to endure pain in the early stages is quite necessary and smart. It helps if one already has a truly unassailable and profitable franchise well-established in a different market. Many of the great global brands have such a situation. They can afford to invest long-term. The key difference is they are usually operating with huge advantages and predicting that they will have a successful future outcome is less difficult to do. It's more about patience. In these cases deferring profitability in order to build a durable leadership position in a new market is wise.
Otherwise, lots of competing capital tends to show up (financial and human) in a high growth country or industry with difficult to predict outcomes. In this kind of environment there will no shortage excitement, innovation, and rapid change. All that capital formation tends to fund and create capable competition. There will be big winners, big losers and, at least before the fact, it won't always be easy to distinguish between them.* Enough capital for a sustained period of time ends up producing lots of new competitors with unpredictable long-term economics. A business can go from having what seemed to be an unassailable moat to having none at all in a relatively short amount of time.
Once favorable economics for owners are no more.
Just keep in mind that certain companies, often the great global brands with difficult to replicate distribution**, earn consistently above average return on capital. These great franchises can remain persistently profitable without engaging in anti-competitive behavior. The simplistic idea that high profitability will attract capital (and vice versa) that leads to less profitability (the supposed inevitable closing of the profits gap) doesn't always work in the real world. That model of how competitive forces will generally play out among competitors over time is flawed or, at least, limited in scope. It is not difficult to provide real world examples.
The formation of new innovative companies is good for civilization but may or may not be good for shareholders. Sometimes it will be. Sometimes not. One has little to do with the other. Airlines are incredibly important but rarely have been good for shareholders. When high returns are expected it often invites capital that creates lots of tough competitors. Pricing power and/or cost advantages are either non-existent or transitory. They do not prove durable. Sometimes, growth is pursued in lieu of returns. With the best intentions market share is pursued with the idea that profits will comes later. Sometimes it even works out. Still, more often than not, you get lots of growth but a low return on capital affair for owners. Not good if the best possible risk-adjusted returns is what you are after.
Those able to consistently pick the big winners (some are very good at that sort of thing) in these kind of dynamic situations may even do very well. To be successful, that style of investor also had better be very good at not allowing the big losses to occur. Big winners and big losers often reside in the same neighborhood and the houses aren't easy to tell apart. It's amazing how much getting above average returns comes down to just avoiding losses. Well, the big losses are often the flip side of going after home runs.
Otherwise, that's why the boring stable modest growth industries can be a more attractive investment approach. They attract little in the way of new capital formation, offer less excitement, but future outcomes are easier to predict.
(Again, returns can turn out rather well in the long run if you just mitigate the possibility of big losses.)
Finally, as I mentioned above, just because a stock happens to be listed on a particular exchange, doesn't mean its future cash flows are tied to that country. There is no shortage of great franchises that derive a large proportion of their economics a great distance from the country of origin or listing.
Adam
Related posts:
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009
* Think search engines in the late 1990s. Anyone that truly could see Google (GOOG) was going to be the winner before it all played out the way it did deserves huge rewards. I say "truly" because I'm guessing at least some early investors in Google thought the young company had a great chance to succeed but did not really know it would work out so well.
** Though there are certainly other ways to create an enduring moat.
---
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, July 23, 2012
Driven to Trade
Here's a recent Wall Street Journal article by Jason Zweig.
Zweig explores how much short-term thinking is part of our brain's fundamental wiring and the impact this can have on trading/investing behavior.
Why We're Driven to Trade
From the article:
...in order to avoid trading your accounts to death, you must counteract some of the very tendencies that make Homo sapiens the most intelligent of all species.
It turns out, the frontopolar cortex, an advanced reasoning center of the brain (located directly behind the forehead), is well-suited for finding patterns (and relentlessly attempts to do so) even when there is none. It will attempt to find patterns within randomness and see patterns that don't exist. So, at least somewhat oddly, it is literally the more advanced aspects of human intelligence that can get investors and traders into trouble. A new study (published in the Journal of Neuroscience) actually shows that those with a healthy frontopolar cortex often tried to outsmart a system that is essentially random while those with a damaged frontopolar cortex did not!
Unlike the other control groups (those that had a healthy frontopolar cortex), those with damage to this crucial reasoning center didn't tend to overweight recent random outcomes* and also didn't attempt to find non-existent patterns. If decision-making is heavily influenced by randomness interpreted as something with meaning, it's hard to imagine big misjudgments not being made. The article provides a good overview of the new study and reveals the way this tendency can adversely impact decision-making. More from the article:
...the frontopolar cortex refuses to admit defeat. It draws on all your computational abilities to search for patterns in random data.
In the absence of real patterns, it will detect illusory ones. And it will prompt you to act on them.
No wonder so many investors find it hard to muster the willpower to buy and hold a handful of investments for years at a time.
Naturally, any trained response to this tendency necessarily starts with awareness, followed by procedures and routines that counteract the more adverse consequences, and plenty of ongoing discipline.
Check out the full article. It goes on to suggest some ways to deal with this potential costly weakness. (Zweig's suggestions explicitly do not include the use of a hammer to the forehead. Thankfully, there are many solutions available more practical than that.)
Mostly, I think this gets back to simply knowing and staying within one's own limits while not confusing the illusion of control with actual control.
Adam
* What did healthy participants do? According to the article, they seemed to extrapolate "...their most recent experience into the future and choosing predominantly on that basis," - Nathaniel Daw, neuroscience professor at NYU
---
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.
Zweig explores how much short-term thinking is part of our brain's fundamental wiring and the impact this can have on trading/investing behavior.
Why We're Driven to Trade
From the article:
...in order to avoid trading your accounts to death, you must counteract some of the very tendencies that make Homo sapiens the most intelligent of all species.
It turns out, the frontopolar cortex, an advanced reasoning center of the brain (located directly behind the forehead), is well-suited for finding patterns (and relentlessly attempts to do so) even when there is none. It will attempt to find patterns within randomness and see patterns that don't exist. So, at least somewhat oddly, it is literally the more advanced aspects of human intelligence that can get investors and traders into trouble. A new study (published in the Journal of Neuroscience) actually shows that those with a healthy frontopolar cortex often tried to outsmart a system that is essentially random while those with a damaged frontopolar cortex did not!
Unlike the other control groups (those that had a healthy frontopolar cortex), those with damage to this crucial reasoning center didn't tend to overweight recent random outcomes* and also didn't attempt to find non-existent patterns. If decision-making is heavily influenced by randomness interpreted as something with meaning, it's hard to imagine big misjudgments not being made. The article provides a good overview of the new study and reveals the way this tendency can adversely impact decision-making. More from the article:
...the frontopolar cortex refuses to admit defeat. It draws on all your computational abilities to search for patterns in random data.
In the absence of real patterns, it will detect illusory ones. And it will prompt you to act on them.
No wonder so many investors find it hard to muster the willpower to buy and hold a handful of investments for years at a time.
Naturally, any trained response to this tendency necessarily starts with awareness, followed by procedures and routines that counteract the more adverse consequences, and plenty of ongoing discipline.
Check out the full article. It goes on to suggest some ways to deal with this potential costly weakness. (Zweig's suggestions explicitly do not include the use of a hammer to the forehead. Thankfully, there are many solutions available more practical than that.)
Mostly, I think this gets back to simply knowing and staying within one's own limits while not confusing the illusion of control with actual control.
Adam
* What did healthy participants do? According to the article, they seemed to extrapolate "...their most recent experience into the future and choosing predominantly on that basis," - Nathaniel Daw, neuroscience professor at NYU
---
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, July 20, 2012
Negative Working-Capital Cycle
The excerpt below is from an interview in Barron's with Paul Isaac.
In the interview, Isaac says he wouldn't buy Amazon (AMZN) at even $ 100 per share. He also says the company's free cash flow is not well understood.
Some of his thoughts on Amazon from the interview:
Amazon generates a lot of cash from its negative working-capital cycle, which funds the build-out of physical facilities to support logistics and fulfillment. In a sense, it borrows short from customers and uses that money to fund long-lived capital assets.
Rapid sales growth masks this process. Broad-based stock-option compensation requires an appreciating stock...It dismounts from that treadmill at great risk to its model.
The stock currently sells at $ 226/share. Many fans of Amazon's business emphasize free cash flow over its relatively weak earnings. A focus on free cash flow usually makes sense if there's a large non-cash charge flowing through the income statement. Unfortunately, in this case, the main driver is their negative working-capital cycle.*
These are very useful sources of cheap funding (actually, zero cost funding if sufficient growth is sustained) but should not be viewed as higher quality operating free cash flow.
Check out the whole interview. In it, Isaac also explains why he likes Devon Energy (DVN)) and Greif Brothers (GEF.B) among others. I have no opinion on either stock.
As far as Amazon goes, my main problem has always been stock valuation and the amount of share dilution that has occurred over the years, not the potential long-term prospects of the business itself. To me, figuring out whether the company's per-share intrinsic value will increase over time in a way that -- relative to the current market price -- the investor will be compensated well is the tough part when it comes to Amazon.
Unlike many other businesses, estimating Amazon's current per-share value and, within a narrow enough range, how much that value is likely to increase over time is just a very difficult thing to do. The company will probably turn out to be worth quite a lot, but the range of valuations is too wide to figure out what price today represents an acceptable margin of safety. Well, at least I can't figure this out.
I'm just more comfortable with a business that has good long-term prospects and already makes a lot of money now; more comfortable with one that sells at a sensible multiple of what it has already plainly demonstrated it can earn. There are plenty that fit that description and quite a few of them have been available at more than reasonable valuations in recent years.
I have much respect for the way CEO Jeff Bezos seems to always be building Amazon's business with an eye toward the longer term.
I'm just not convinced that translates into great risk-adjusted returns.
With that said, I do pay attention to Amazon for at least the following reason:
They're one of a handful of companies with the potential to disrupt other good businesses if they decide to do so.
As an investor, you have to keep an eye on the company as one that can potentially damage or maybe even destroy the economic moat of another business.
Adam
No position in Amazon, Devon, or Greif Brothers
Related posts:
Amazon, Apple, and Margin of Safety
Amazing Amazon
Barron's on Bezos: Time to Reign in Amazon's CEO?
Amazon's Jeff Bezos On Inventing & Disrupting
Amazon Sells Kindle Fire Below Cost
Technology Stocks
* Amazon gets a nice boost of cheap funding each year from unearned revenue, accounts payable that's in excess of account receivable, etc.
Also, like many tech stocks, it's worth noting that adding back stock-based compensation (as is done in the Operating Activities section of the cash flow statement) boosts free cash flow but is potentially a material source of future dilution (much as it has been in the past) and likely quite expensive for continuing shareholders over the long haul. Yes, it's a non-cash expense but, unlike some other non-cash expenses, it shouldn't be ignored. One way to think of this is to calculate how much net cash would be needed to keep share count stable over time. Well, that incremental cash expended is a very real cost to shareholders and should be subtracted from free cash flow for a better understanding of the business economics. It's, at the very least, a rather big stretch to consider economically meaningful any free cash flow calculation that doesn't attempt to account for the cost of stock-based compensation. For certain companies -- those that make heavy use of stock for compensation -- the cost is very real even if difficult to estimate. The reality is that these potentially material costs are generally rather difficult to pin down with any precision. Unfortunately, with stock-based compensation, the best case that can usually be expected is an estimated range of costs (the economic costs...not the accounting costs). A bit messy? No doubt, but that messiness doesn't mean the costs can be ignored to make it seem more neat than it is. Not everything that matters economically can be precisely quantified. In fact, some of the most important things can't be quantified at all.
---
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.
In the interview, Isaac says he wouldn't buy Amazon (AMZN) at even $ 100 per share. He also says the company's free cash flow is not well understood.
Some of his thoughts on Amazon from the interview:
Amazon generates a lot of cash from its negative working-capital cycle, which funds the build-out of physical facilities to support logistics and fulfillment. In a sense, it borrows short from customers and uses that money to fund long-lived capital assets.
Rapid sales growth masks this process. Broad-based stock-option compensation requires an appreciating stock...It dismounts from that treadmill at great risk to its model.
The stock currently sells at $ 226/share. Many fans of Amazon's business emphasize free cash flow over its relatively weak earnings. A focus on free cash flow usually makes sense if there's a large non-cash charge flowing through the income statement. Unfortunately, in this case, the main driver is their negative working-capital cycle.*
These are very useful sources of cheap funding (actually, zero cost funding if sufficient growth is sustained) but should not be viewed as higher quality operating free cash flow.
Check out the whole interview. In it, Isaac also explains why he likes Devon Energy (DVN)) and Greif Brothers (GEF.B) among others. I have no opinion on either stock.
As far as Amazon goes, my main problem has always been stock valuation and the amount of share dilution that has occurred over the years, not the potential long-term prospects of the business itself. To me, figuring out whether the company's per-share intrinsic value will increase over time in a way that -- relative to the current market price -- the investor will be compensated well is the tough part when it comes to Amazon.
Unlike many other businesses, estimating Amazon's current per-share value and, within a narrow enough range, how much that value is likely to increase over time is just a very difficult thing to do. The company will probably turn out to be worth quite a lot, but the range of valuations is too wide to figure out what price today represents an acceptable margin of safety. Well, at least I can't figure this out.
I'm just more comfortable with a business that has good long-term prospects and already makes a lot of money now; more comfortable with one that sells at a sensible multiple of what it has already plainly demonstrated it can earn. There are plenty that fit that description and quite a few of them have been available at more than reasonable valuations in recent years.
I have much respect for the way CEO Jeff Bezos seems to always be building Amazon's business with an eye toward the longer term.
I'm just not convinced that translates into great risk-adjusted returns.
With that said, I do pay attention to Amazon for at least the following reason:
They're one of a handful of companies with the potential to disrupt other good businesses if they decide to do so.
As an investor, you have to keep an eye on the company as one that can potentially damage or maybe even destroy the economic moat of another business.
Adam
No position in Amazon, Devon, or Greif Brothers
Related posts:
Amazon, Apple, and Margin of Safety
Amazing Amazon
Barron's on Bezos: Time to Reign in Amazon's CEO?
Amazon's Jeff Bezos On Inventing & Disrupting
Amazon Sells Kindle Fire Below Cost
Technology Stocks
* Amazon gets a nice boost of cheap funding each year from unearned revenue, accounts payable that's in excess of account receivable, etc.
Also, like many tech stocks, it's worth noting that adding back stock-based compensation (as is done in the Operating Activities section of the cash flow statement) boosts free cash flow but is potentially a material source of future dilution (much as it has been in the past) and likely quite expensive for continuing shareholders over the long haul. Yes, it's a non-cash expense but, unlike some other non-cash expenses, it shouldn't be ignored. One way to think of this is to calculate how much net cash would be needed to keep share count stable over time. Well, that incremental cash expended is a very real cost to shareholders and should be subtracted from free cash flow for a better understanding of the business economics. It's, at the very least, a rather big stretch to consider economically meaningful any free cash flow calculation that doesn't attempt to account for the cost of stock-based compensation. For certain companies -- those that make heavy use of stock for compensation -- the cost is very real even if difficult to estimate. The reality is that these potentially material costs are generally rather difficult to pin down with any precision. Unfortunately, with stock-based compensation, the best case that can usually be expected is an estimated range of costs (the economic costs...not the accounting costs). A bit messy? No doubt, but that messiness doesn't mean the costs can be ignored to make it seem more neat than it is. Not everything that matters economically can be precisely quantified. In fact, some of the most important things can't be quantified at all.
---
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.
Wednesday, July 18, 2012
Bogle: "The Tyranny of Compounding Costs"
Apparently, hedge funds aren't doing so well this year. From this CNBC article on hedge fund performance:
They are supposed to be the smart money—the best of the best....
The article later adds...
Hedge funds as a group are badly underperforming this year, which could lead to a series of redemptions, closings and rethinking of the lofty fee structures the managers of these alternative vehicles enjoy.
Many know the magic of compound returns, but fewer seem to fully appreciate what John Bogle calls "the tyranny of compounding costs". In the aggregate fees, commissions, and other "frictional" costs can only subtract, too often substantially over the long haul, from total returns. There's no way around it.
Little or, well, nothing of real use is created and the costs aren't exactly immaterial.
An individual investor or professional manager may be outperform but the industry as a whole, after frictional costs are subtracted, can't be anything but a net drag on returns. Productive assets will produce a certain amount of value over time with or without some money manager acting as the middle man. So the fees charged by professional investment management simply subtract (and certainly cannot add). I know some may challenge this premise but, at a minimum, lots of talent wakes up every day engaged in activities that seem mostly non-productive or of little utility.
There are those that rationalize the benefits of all these frictional costs (improved capital allocation being one of them) but I'm mostly skeptical of the arguments that I've heard.
(My mind remains open to the possibility that there are other benefits I do not fully appreciate.)
I do think that investment professionals who stay with their investments for a long time and try to engage constructively in corporate governance issues can add some real value.
Higher quality management, better business strategies, improved capital and resource allocation among things can be the result.
Otherwise, these costs meaningfully subtracts from the long-term returns for investors overall. The fees paid may benefit an individual investor who happens to be investing with someone, through luck or skill (or maybe a little of both), produces above average results. So, for that individual investor, it works at a micro-level. The best professionals can outperform by enough on a consistent basis to even justify their fees. I'm not arguing otherwise. This doesn't alter the arithmetic reality that all the salaries, fees, bonuses paid to money managers subtracts from returns of investors as a whole.
"If we [the investment industry] raise our fees from 0.5 percent to 1 percent, we actually raid the balance sheet. We take 0.5 per cent from what would have been savings and investment and turn it into income and GDP. In other words, you're taking money that would have become capital and chewing it up as bankers' bonuses." - Jeremy Grantham
Jeremy Grantham: 'We Add Nothing But Costs'
So it's the conversion of capital to income. Think of the compensation that's paid to investment management professionals (sometimes what seems an endless parade of these professional managers appear on business news each day). Some (maybe even many) are very capable and work very hard for their clients no doubt, but there's no getting around that their rather substantial compensation is literally savings and investment being converted to income.
It's simple arithmetic. Allow the "tyranny of compounding costs" to play out for many years and we're talking some real money when it is all said and done.
These flaws are costly even if all the costs aren't necessarily measurable. To improve the system overall, reducing frictional costs and increasing the average holding period ought to be among the top priorities. Of course, if and when that might happen isn't knowable. So, until then, the individual investor can still choose to not participate in the folly (even if society still bears the costs, unfortunately).
More in a follow up post.
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.
They are supposed to be the smart money—the best of the best....
The article later adds...
Hedge funds as a group are badly underperforming this year, which could lead to a series of redemptions, closings and rethinking of the lofty fee structures the managers of these alternative vehicles enjoy.
Many know the magic of compound returns, but fewer seem to fully appreciate what John Bogle calls "the tyranny of compounding costs". In the aggregate fees, commissions, and other "frictional" costs can only subtract, too often substantially over the long haul, from total returns. There's no way around it.
Little or, well, nothing of real use is created and the costs aren't exactly immaterial.
An individual investor or professional manager may be outperform but the industry as a whole, after frictional costs are subtracted, can't be anything but a net drag on returns. Productive assets will produce a certain amount of value over time with or without some money manager acting as the middle man. So the fees charged by professional investment management simply subtract (and certainly cannot add). I know some may challenge this premise but, at a minimum, lots of talent wakes up every day engaged in activities that seem mostly non-productive or of little utility.
There are those that rationalize the benefits of all these frictional costs (improved capital allocation being one of them) but I'm mostly skeptical of the arguments that I've heard.
(My mind remains open to the possibility that there are other benefits I do not fully appreciate.)
I do think that investment professionals who stay with their investments for a long time and try to engage constructively in corporate governance issues can add some real value.
Higher quality management, better business strategies, improved capital and resource allocation among things can be the result.
Otherwise, these costs meaningfully subtracts from the long-term returns for investors overall. The fees paid may benefit an individual investor who happens to be investing with someone, through luck or skill (or maybe a little of both), produces above average results. So, for that individual investor, it works at a micro-level. The best professionals can outperform by enough on a consistent basis to even justify their fees. I'm not arguing otherwise. This doesn't alter the arithmetic reality that all the salaries, fees, bonuses paid to money managers subtracts from returns of investors as a whole.
"If we [the investment industry] raise our fees from 0.5 percent to 1 percent, we actually raid the balance sheet. We take 0.5 per cent from what would have been savings and investment and turn it into income and GDP. In other words, you're taking money that would have become capital and chewing it up as bankers' bonuses." - Jeremy Grantham
Jeremy Grantham: 'We Add Nothing But Costs'
So it's the conversion of capital to income. Think of the compensation that's paid to investment management professionals (sometimes what seems an endless parade of these professional managers appear on business news each day). Some (maybe even many) are very capable and work very hard for their clients no doubt, but there's no getting around that their rather substantial compensation is literally savings and investment being converted to income.
It's simple arithmetic. Allow the "tyranny of compounding costs" to play out for many years and we're talking some real money when it is all said and done.
These flaws are costly even if all the costs aren't necessarily measurable. To improve the system overall, reducing frictional costs and increasing the average holding period ought to be among the top priorities. Of course, if and when that might happen isn't knowable. So, until then, the individual investor can still choose to not participate in the folly (even if society still bears the costs, unfortunately).
More in a follow up post.
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, July 16, 2012
Why Growth May Matter Less Than Investors Think
"Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive." - Warren Buffett in the 1992 Berkshire Hathaway (BRKa) Shareholder Letter
In the long run, investor returns are not primarily driven by growth.
They are, instead, mostly driven by long run return on capital and the price paid relative to intrinsic value. Here's a recent article by Brett Arends that does a good job of explaining why the returns for investors often have little to do with GDP growth. From the article:
"Wall Street's obsession with these things is institutional, not rational."
I've covered variations of the "growth myth" in previous posts. I realize some take it as a given that something like above average GDP growth should lead to better than average returns for investors. As it turns out, there is actually rather little correlation.
"The fastest-growing countries should give you the highest return. They simply don't. But, there's only four of us— that— that believe that story. Everyone else in the world believes that if you grow fast like China, you'll outperform in the stock market." - Jeremy Grantham on CNBC
At the very least, real evidence to support that accepted dogma is rather weak. When something counterintuitive comes along, it's usually worthwhile to give it real consideration instead of just treating it as some strange anomaly. The most useful insights are sometimes not far from what at first seems contradictory, paradoxical, or counterintuitive.
It's at least a good habit to explore what's against conventional wisdom. Of course economies with high levels of growth will generally have more desirable investment outcomes, right? As it turns out, not really.
Oh, and it's not just GDP growth. Fast-growing industries and businesses have a whole range of possible investor outcomes with above average returns far from being probable.
"...business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth." - Warren Buffett in the 1992 Berkshire Hathway Shareholder Letter
It'd be easy to conclude it applies to only something as historically troubled as airlines, but any industry or business that required sustained low return on capital investments to compete will result in subpar returns for investors over the long haul.
Unfortunately, sometimes it's the fastest growing, most promising, dynamic, and exciting areas of opportunity that will produce modest (or worse) returns and a wide range of outcomes for the typical investor.
Growth usually attracts (or often requires) lots of capital. All that supply of capital ends up financing plenty of new capable competition. It's the new competitors that leads to the lower return on capital (less pricing power, a supply glut etc.) and reduced long run investor returns (even though the overall opportunity may, in fact, remain rather large). It's the newly raised capital that might dilute per share returns. There's plenty of growth to go around but, for the investor, big winners and losers. If certain investors can actually pick the winners and avoid the losers consistently, then it might work out. That's usually easier to do in theory though some can clearly do it well. Those that try to need a realistic assessment of their capabilities and limits.
"A money manager with an IQ of 160 and thinks it's 180 will kill you," he said. "Going with a money manager with an IQ of 130 who thinks it's 125 could serve you well." - Charlie Munger in San Francisco Business Times
So lots of innovation and change is often very good for society, but not necessarily good for per share investor returns. Extreme change can mean that today's apparent leader is anything but further down the road with adverse consequences for investors. The result may be dramatic and hard to foresee differences in the core economics of the business even though today the business seems just fine.
(Consider Research in Motion: RIMM five years ago versus now. They seem an easy target now, but not too long ago they were highly profitable and viewed as a strong player.)
Where there's less industry growth and change, there's less fresh capital financing capable new competitors, and a narrower range of investment outcomes for the typical investor. If an established leader with sound economics in that industry has emerged, investor returns can end up being more predictably between good and better if an appropriate price is paid. So the typical investor may do just fine.*
Less downside, less upside, and naturally less excitement. In my book investing is not about the adrenaline rush, it's about getting above average results at the lowest possible risk.
I'll cover this subject more -- why high growth and high returns often have little to no correlation -- in future posts.
Adam
Long position in BRKb established at lower prices
Related posts:
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009
* I just think it is better to adopt an approach that doesn't require exceptional ability just in case the individual investor overestimates his or her own ability. In other words, an approach where nothing good has to happen to get a nice result (then if something happens to surprise on the upside...no problem). Think of it as an insurance policy. We can't all be above average. Again, it is a realistic assessment of abilities and limits that counts most for an investor. Demosthenes said: "What a man wishes, he will believe." Well, remember the survey of drivers in Sweden as explained by Charlie Munger: "...in self appraisals of prospects and talents it is the norm, as Demosthenes predicted, for people to be ridiculously over-optimistic. For instance, a careful survey in Sweden showed that 90% of automobile drivers considered themselves above average. And people who are successfully selling something, as investment counselors do, make Swedish drivers sound like depressives. Virtually every investment expert's public assessment is that he is above average, no matter what is the evidence to the contrary." - Charlie Munger speaking to the Foundation Financial Officers Group in 1998
---
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.
In the long run, investor returns are not primarily driven by growth.
They are, instead, mostly driven by long run return on capital and the price paid relative to intrinsic value. Here's a recent article by Brett Arends that does a good job of explaining why the returns for investors often have little to do with GDP growth. From the article:
"Wall Street's obsession with these things is institutional, not rational."
I've covered variations of the "growth myth" in previous posts. I realize some take it as a given that something like above average GDP growth should lead to better than average returns for investors. As it turns out, there is actually rather little correlation.
"The fastest-growing countries should give you the highest return. They simply don't. But, there's only four of us— that— that believe that story. Everyone else in the world believes that if you grow fast like China, you'll outperform in the stock market." - Jeremy Grantham on CNBC
At the very least, real evidence to support that accepted dogma is rather weak. When something counterintuitive comes along, it's usually worthwhile to give it real consideration instead of just treating it as some strange anomaly. The most useful insights are sometimes not far from what at first seems contradictory, paradoxical, or counterintuitive.
It's at least a good habit to explore what's against conventional wisdom. Of course economies with high levels of growth will generally have more desirable investment outcomes, right? As it turns out, not really.
Oh, and it's not just GDP growth. Fast-growing industries and businesses have a whole range of possible investor outcomes with above average returns far from being probable.
"...business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth." - Warren Buffett in the 1992 Berkshire Hathway Shareholder Letter
It'd be easy to conclude it applies to only something as historically troubled as airlines, but any industry or business that required sustained low return on capital investments to compete will result in subpar returns for investors over the long haul.
Unfortunately, sometimes it's the fastest growing, most promising, dynamic, and exciting areas of opportunity that will produce modest (or worse) returns and a wide range of outcomes for the typical investor.
Growth usually attracts (or often requires) lots of capital. All that supply of capital ends up financing plenty of new capable competition. It's the new competitors that leads to the lower return on capital (less pricing power, a supply glut etc.) and reduced long run investor returns (even though the overall opportunity may, in fact, remain rather large). It's the newly raised capital that might dilute per share returns. There's plenty of growth to go around but, for the investor, big winners and losers. If certain investors can actually pick the winners and avoid the losers consistently, then it might work out. That's usually easier to do in theory though some can clearly do it well. Those that try to need a realistic assessment of their capabilities and limits.
"A money manager with an IQ of 160 and thinks it's 180 will kill you," he said. "Going with a money manager with an IQ of 130 who thinks it's 125 could serve you well." - Charlie Munger in San Francisco Business Times
So lots of innovation and change is often very good for society, but not necessarily good for per share investor returns. Extreme change can mean that today's apparent leader is anything but further down the road with adverse consequences for investors. The result may be dramatic and hard to foresee differences in the core economics of the business even though today the business seems just fine.
(Consider Research in Motion: RIMM five years ago versus now. They seem an easy target now, but not too long ago they were highly profitable and viewed as a strong player.)
Where there's less industry growth and change, there's less fresh capital financing capable new competitors, and a narrower range of investment outcomes for the typical investor. If an established leader with sound economics in that industry has emerged, investor returns can end up being more predictably between good and better if an appropriate price is paid. So the typical investor may do just fine.*
Less downside, less upside, and naturally less excitement. In my book investing is not about the adrenaline rush, it's about getting above average results at the lowest possible risk.
I'll cover this subject more -- why high growth and high returns often have little to no correlation -- in future posts.
Adam
Long position in BRKb established at lower prices
Related posts:
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009
* I just think it is better to adopt an approach that doesn't require exceptional ability just in case the individual investor overestimates his or her own ability. In other words, an approach where nothing good has to happen to get a nice result (then if something happens to surprise on the upside...no problem). Think of it as an insurance policy. We can't all be above average. Again, it is a realistic assessment of abilities and limits that counts most for an investor. Demosthenes said: "What a man wishes, he will believe." Well, remember the survey of drivers in Sweden as explained by Charlie Munger: "...in self appraisals of prospects and talents it is the norm, as Demosthenes predicted, for people to be ridiculously over-optimistic. For instance, a careful survey in Sweden showed that 90% of automobile drivers considered themselves above average. And people who are successfully selling something, as investment counselors do, make Swedish drivers sound like depressives. Virtually every investment expert's public assessment is that he is above average, no matter what is the evidence to the contrary." - Charlie Munger speaking to the Foundation Financial Officers Group in 1998
---
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, July 13, 2012
Wells Fargo's 2nd Quarter 2012 Results
Wells Fargo's (WFC) second quarter results that were reported this morning seemed just fine. One quarter will not answer all the questions that need to be answered for any investment, of course, but you can still get some useful clues.
The results pretty much reinforce what seem to be some of Wells Fargo's strengths.
Pre-tax pre-provision profit for the quarter was $ 8.9 billion in the latest quarter compared to $ 7.9 billion in the same quarter one year ago. That's an important number because it is an indication of what Wells can currently absorb in losses each quarter before putting a dent into equity capital.
Mortgage banking is strong with noninterest income from that activity rising to $ 2.9 billion in the second quarter of 2012 from $ 1.6 billion in the second quarter of 2011. Overall, noninterest income grew to ~ $ 10.2 billion in the second quarter of 2012 from $ 9.7 billion in the second quarter of 2011.
Net interest income grew to $ 11.0 billion in the quarter compared to $ 10.7 billion in the same quarter last year. Nothing spectacular but in this environment seems pretty solid. Their net interest margin remains exceptional among the larger banks at 3.91%. As I've said in other posts, this provides both an offensive and defensive advantage for Wells. Not only does this potentially increase average profitability and return on equity over the full business cycle, it should make the bank more durable when credit losses begin to really kick in during a recession. It seems built to withstand more than many others. Wells Fargo's quarterly earnings continues to benefit from the release of loan-loss reserves ($ 400 million pre-tax). Unsurprising in the context of where we are in the credit cycle, but not exactly a source of earnings that warrants any enthusiasm. The good news is Wells Fargo has been relying much less on the release of reserves than most peers.
They also rely less on volatile investment banking and related activities. So there's far less dependence on opaque derivatives and trading gains in its mix.
Core deposits grew to $ 882 billion at the end of the latest quarter from $ 809 billion in the same quarter one year ago. So that desirable source of funding continues to increase nicely.
Loans grew to $ 775 billion at the end of the latest quarter from $ 752 billion in the same quarter one year ago.
Provision for credit losses is down slightly but whether all-important credit quality is healthy can't be really understood in an economic environment like this. Unfortunately, if a bank drops the ball in this regard it's not usually obvious until after the fact.
As far as I'm concerned Wells Fargo has plenty of equity capital no matter how one decides to measure it.
Otherwise, I'm not going to judge whether they "beat expectations" because I can't say I really care what those expectation were in the first place.
I'm guessing whether they did a few pennies more or less per share this quarter isn't going to matter all that much in 10 or 15 years.
Adam
Long position in WFC established at much lower than recent prices
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.
The results pretty much reinforce what seem to be some of Wells Fargo's strengths.
Pre-tax pre-provision profit for the quarter was $ 8.9 billion in the latest quarter compared to $ 7.9 billion in the same quarter one year ago. That's an important number because it is an indication of what Wells can currently absorb in losses each quarter before putting a dent into equity capital.
Mortgage banking is strong with noninterest income from that activity rising to $ 2.9 billion in the second quarter of 2012 from $ 1.6 billion in the second quarter of 2011. Overall, noninterest income grew to ~ $ 10.2 billion in the second quarter of 2012 from $ 9.7 billion in the second quarter of 2011.
Net interest income grew to $ 11.0 billion in the quarter compared to $ 10.7 billion in the same quarter last year. Nothing spectacular but in this environment seems pretty solid. Their net interest margin remains exceptional among the larger banks at 3.91%. As I've said in other posts, this provides both an offensive and defensive advantage for Wells. Not only does this potentially increase average profitability and return on equity over the full business cycle, it should make the bank more durable when credit losses begin to really kick in during a recession. It seems built to withstand more than many others. Wells Fargo's quarterly earnings continues to benefit from the release of loan-loss reserves ($ 400 million pre-tax). Unsurprising in the context of where we are in the credit cycle, but not exactly a source of earnings that warrants any enthusiasm. The good news is Wells Fargo has been relying much less on the release of reserves than most peers.
They also rely less on volatile investment banking and related activities. So there's far less dependence on opaque derivatives and trading gains in its mix.
Core deposits grew to $ 882 billion at the end of the latest quarter from $ 809 billion in the same quarter one year ago. So that desirable source of funding continues to increase nicely.
Loans grew to $ 775 billion at the end of the latest quarter from $ 752 billion in the same quarter one year ago.
Provision for credit losses is down slightly but whether all-important credit quality is healthy can't be really understood in an economic environment like this. Unfortunately, if a bank drops the ball in this regard it's not usually obvious until after the fact.
As far as I'm concerned Wells Fargo has plenty of equity capital no matter how one decides to measure it.
Otherwise, I'm not going to judge whether they "beat expectations" because I can't say I really care what those expectation were in the first place.
I'm guessing whether they did a few pennies more or less per share this quarter isn't going to matter all that much in 10 or 15 years.
Adam
Long position in WFC established at much lower than recent prices
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.
Thursday, July 12, 2012
Wells Fargo to Report Quarterly Earnings
Wells Fargo (WFC) will report its results for the 2nd quarter tomorrow morning.
In this previous post, I mentioned there were two articles that spoke favorably about the strengths of Wells Fargo among the larger banks.
Invest Long-term, Ignore the Coin Flips
While really not all that surprising, both articles focused more or less on the near term implications of what they perceived as Wells Fargo's strengths. As I've said, I'm not a big fan of attempting to judge how well a stock or a business will perform in such a short time frame. It's just not really where energy is all that well spent in my view.
What I am interested in (and hopeful for) when Wells Fargo reports is evidence that management is taking actions that will build real long-term intrinsic value. Also, since even the best bank is vulnerable to systemic shocks and instability, I'm interested in the ways they are enhancing the bank's ability to withstand the inevitable tougher economic times and potential systemic stresses brought on by crisis. That's always of some considerable interest with any large relatively complex financial institution. It goes beyond just having a strong capital position.
Have they funding themselves in a fundamentally stable and sound manner and especially with an eye toward withstanding times of economic and financial system strain? In the important ways, are they strengthening their franchise relative to competition? Are deposits among the lowest cost in the industry? How well are they squeezing out other non-productive costs? Do they have robust credit standards and a culture with incentives that reinforce those standards? Are they continuing to develop an increased level of depth to their customer relationships over time (Wells Fargo's cross-selling culture)?
Wells Fargo has a substantially higher net interest margin compared to the other big banks. That's not a small advantage when it comes to having both a greater ability to absorb losses during the tough times and to produce higher long run return on equity over a full business cycle.* Ultimately, that should lead to superior long-term shareholder returns at lower risk but says nothing about what the stock will do next week, month, year, or even longer. The economic tide will work both for them and against them from time to time but if they keep the cost of their money relatively low (and otherwise manage costs effectively), continue to mostly make intelligent loans to businesses and consumers, maintain/strengthen the balance sheet, and wisely allocate their excess capital, they'll create plenty of value over longer time frames.
Maintaining and increasing their competitive advantages will determine what Wells Fargo will be worth in 10 or 20 years. What's happening in next quarter or in the next several quarters reveals little in that regard.
Wells is a large bank that's less dependent on capital-markets-related revenue while the other larger banks generally do depend on capital markets activity as drivers of their core economics. More generally, Wells has a very strong domestic U.S. traditional banking franchise relative to its large peers (and does a rather small amount of investment banking business or proprietary trading).
So it's less of a casino and more trusted place for deposits and provider of credit to those that can use it and qualify for it. The kind of banking I'm thinking the world needs more of and needs it done well. All banks are vulnerable to systemic collapse but treating them if they are all the same is just an overly simplistic thing to do. Wells is still big and complex but how they primarily generate their revenues is very different from most of the other large banking franchises.
Banking seems difficult at best these days but the better run banks can use the current tough environment to increase the long run value of their franchise. Whether Wells beats earnings or revenue expectations this next quarter simply does not really matter that much.
I still wonder whether any bank is really worth the trouble for most investors considering the low valuations found among other investing alternatives. Sometimes what looks like a bargain bank stock is far from it. When it comes to investing in the common stock of banks, it's usually best to avoid what looks cheap. When it comes to the risk/reward profile, I'd favor the relatively understandable banks over the complex and opaque. In other words, banks primarily engaged in more traditional activities (being a trusted place for deposits and smart provider of credit...simpler, even if not exactly simple). Those with a strong balance sheet, smart expense management, low cost deposits, stable funding in most environments (insured deposits and long-term funding over short-term wholesale funding), who've proven they know how to intelligently provide credit to businesses and individuals that can handle it (rigorous credit risk management).
A bank with enough of the above characteristics will generally compound at a higher rate with lower risk than those that do not. They're sometimes worth what initially seems to be a premium valuation on a risk-adjusted return basis.
In contrast, those with a business model that depends heavily on capital markets and proprietary trading (stocks, bonds, currencies, commodities and their derivatives like credit default swaps etc.) to generate profits (and losses) are, to me, much less attractive than those who are providers of more traditional banking services. Most of these capital markets intensive institutions have -- all things being equal -- lower intrinsic value, more hard to gauge risks, and are deserving of what seems like a big discount.
As I said in the other post, Wells Fargo may or may not have great near-term business results. The stock may perform very well or horribly in the short run for all I know. I'll let others try to figure that out.
My thinking is that in the longer term the business and stock will do just fine.
Adam
Long position in Wells Fargo established at much lower than recent prices. No intention to add shares near the current valuation.
* Consider that Wells Fargo has typically had a roughly 1% (and at times even greater) net interest margin advantage compared to other big banks. That may not sound like much but consider this: If Wells Fargo's net interest margin was more like its competitors (something like 1% lower...2.91% instead of the 3.91% in the 1st quarter of 2012), the bank would earn $ 11.3 billion less pretax! Here's another way to look at it. On the same amount of earning assets, the 1% net interest margin advantage enables Wells Fargo to absorb an additional $ 11.3 billion per year of losses before putting a dent in their capital (actually, first it would hit loan loss reserves then equity capital) during times of economic and/or financial stress. So there's a defensive angle to this advantage as well. Some may look at a bank more statically and give less weight to this important dynamic.
Of course, the loans that go bad are accounted for with a provision for loan losses (a non-cash charge to earnings) that serves to build loan loss reserves on the balance sheet. Then, once a bank is convinced there's no hope of getting paid all or part of what is contractually obligated, loan charge-offs deplete the reserve. No matter how the accounting works, the important point here is that there is an additional $ 11.3 billion available per year to absorb losses on the same amount of earning assets. (Alternatively, a bank with a lower net interest margin needs to have more assets to generate the same amount of profit. Naturally, that means more loans that can go bad and must be absorbed.)
Finally, a bank can have above average net interest margins but, if it tends to make a lot of dumb loans, at some point this extra capacity to absorb won't be enough. A bank still has to know how to put their money to work intelligently and that means consistently providing credit to borrowers who can actually handle it.
---
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.
In this previous post, I mentioned there were two articles that spoke favorably about the strengths of Wells Fargo among the larger banks.
Invest Long-term, Ignore the Coin Flips
While really not all that surprising, both articles focused more or less on the near term implications of what they perceived as Wells Fargo's strengths. As I've said, I'm not a big fan of attempting to judge how well a stock or a business will perform in such a short time frame. It's just not really where energy is all that well spent in my view.
What I am interested in (and hopeful for) when Wells Fargo reports is evidence that management is taking actions that will build real long-term intrinsic value. Also, since even the best bank is vulnerable to systemic shocks and instability, I'm interested in the ways they are enhancing the bank's ability to withstand the inevitable tougher economic times and potential systemic stresses brought on by crisis. That's always of some considerable interest with any large relatively complex financial institution. It goes beyond just having a strong capital position.
Have they funding themselves in a fundamentally stable and sound manner and especially with an eye toward withstanding times of economic and financial system strain? In the important ways, are they strengthening their franchise relative to competition? Are deposits among the lowest cost in the industry? How well are they squeezing out other non-productive costs? Do they have robust credit standards and a culture with incentives that reinforce those standards? Are they continuing to develop an increased level of depth to their customer relationships over time (Wells Fargo's cross-selling culture)?
Wells Fargo has a substantially higher net interest margin compared to the other big banks. That's not a small advantage when it comes to having both a greater ability to absorb losses during the tough times and to produce higher long run return on equity over a full business cycle.* Ultimately, that should lead to superior long-term shareholder returns at lower risk but says nothing about what the stock will do next week, month, year, or even longer. The economic tide will work both for them and against them from time to time but if they keep the cost of their money relatively low (and otherwise manage costs effectively), continue to mostly make intelligent loans to businesses and consumers, maintain/strengthen the balance sheet, and wisely allocate their excess capital, they'll create plenty of value over longer time frames.
Maintaining and increasing their competitive advantages will determine what Wells Fargo will be worth in 10 or 20 years. What's happening in next quarter or in the next several quarters reveals little in that regard.
Wells is a large bank that's less dependent on capital-markets-related revenue while the other larger banks generally do depend on capital markets activity as drivers of their core economics. More generally, Wells has a very strong domestic U.S. traditional banking franchise relative to its large peers (and does a rather small amount of investment banking business or proprietary trading).
So it's less of a casino and more trusted place for deposits and provider of credit to those that can use it and qualify for it. The kind of banking I'm thinking the world needs more of and needs it done well. All banks are vulnerable to systemic collapse but treating them if they are all the same is just an overly simplistic thing to do. Wells is still big and complex but how they primarily generate their revenues is very different from most of the other large banking franchises.
Banking seems difficult at best these days but the better run banks can use the current tough environment to increase the long run value of their franchise. Whether Wells beats earnings or revenue expectations this next quarter simply does not really matter that much.
I still wonder whether any bank is really worth the trouble for most investors considering the low valuations found among other investing alternatives. Sometimes what looks like a bargain bank stock is far from it. When it comes to investing in the common stock of banks, it's usually best to avoid what looks cheap. When it comes to the risk/reward profile, I'd favor the relatively understandable banks over the complex and opaque. In other words, banks primarily engaged in more traditional activities (being a trusted place for deposits and smart provider of credit...simpler, even if not exactly simple). Those with a strong balance sheet, smart expense management, low cost deposits, stable funding in most environments (insured deposits and long-term funding over short-term wholesale funding), who've proven they know how to intelligently provide credit to businesses and individuals that can handle it (rigorous credit risk management).
A bank with enough of the above characteristics will generally compound at a higher rate with lower risk than those that do not. They're sometimes worth what initially seems to be a premium valuation on a risk-adjusted return basis.
In contrast, those with a business model that depends heavily on capital markets and proprietary trading (stocks, bonds, currencies, commodities and their derivatives like credit default swaps etc.) to generate profits (and losses) are, to me, much less attractive than those who are providers of more traditional banking services. Most of these capital markets intensive institutions have -- all things being equal -- lower intrinsic value, more hard to gauge risks, and are deserving of what seems like a big discount.
As I said in the other post, Wells Fargo may or may not have great near-term business results. The stock may perform very well or horribly in the short run for all I know. I'll let others try to figure that out.
My thinking is that in the longer term the business and stock will do just fine.
Adam
Long position in Wells Fargo established at much lower than recent prices. No intention to add shares near the current valuation.
* Consider that Wells Fargo has typically had a roughly 1% (and at times even greater) net interest margin advantage compared to other big banks. That may not sound like much but consider this: If Wells Fargo's net interest margin was more like its competitors (something like 1% lower...2.91% instead of the 3.91% in the 1st quarter of 2012), the bank would earn $ 11.3 billion less pretax! Here's another way to look at it. On the same amount of earning assets, the 1% net interest margin advantage enables Wells Fargo to absorb an additional $ 11.3 billion per year of losses before putting a dent in their capital (actually, first it would hit loan loss reserves then equity capital) during times of economic and/or financial stress. So there's a defensive angle to this advantage as well. Some may look at a bank more statically and give less weight to this important dynamic.
Of course, the loans that go bad are accounted for with a provision for loan losses (a non-cash charge to earnings) that serves to build loan loss reserves on the balance sheet. Then, once a bank is convinced there's no hope of getting paid all or part of what is contractually obligated, loan charge-offs deplete the reserve. No matter how the accounting works, the important point here is that there is an additional $ 11.3 billion available per year to absorb losses on the same amount of earning assets. (Alternatively, a bank with a lower net interest margin needs to have more assets to generate the same amount of profit. Naturally, that means more loans that can go bad and must be absorbed.)
Finally, a bank can have above average net interest margins but, if it tends to make a lot of dumb loans, at some point this extra capacity to absorb won't be enough. A bank still has to know how to put their money to work intelligently and that means consistently providing credit to borrowers who can actually handle it.
---
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, July 10, 2012
Invest Long-term, Ignore the Coin Flips
Here's a couple of articles on some of Wells Fargo's (WFC) strengths:
The Big Bank Set For The Strongest Quarter
WSJ's Deal Journal on Wells Fargo
In the first article, Credit Suisse cites strong mortgage-related banking activity as a key driver. In the other article, Jefferies mentions above average profitability, lack of investment banking, and the return of capital to shareholders. Both firms, not surprisingly, seem more focused on the near term implications of all this.
Now, as I've said on other occasions, attempting to judge how well a stock or a business will perform in such a short time frame isn't really where energy is all that well spent. Wells Fargo may or may not have great near-term business results. The stock may perform very well or horribly in the short run for all I know. I'll let others figure that out.
"Absent a lot of surprises, stocks are relatively predictable over twenty years. As to whether they're going to be higher or lower in two to three years, you might as well flip a coin to decide." - Peter Lynch
A long-term investor in any stock should expect terrible stock price action and real business difficulties from time to time. Yet, it is just not all that important if one has an investing horizon that is truly long-term. (If the money invested is needed in the next five years or less basically none of this applies. Equity investing just doesn't work over a time frame that short.) Even the best businesses (in banking or otherwise) run into tough times.
Business is inherently messy affair even when things go well and much more so when things do not. As long as a real and sustainable competitive advantage exists (or advantages) in the first place, that inherent messiness isn't the end of the world.*
The question is whether management deals with problems that may threaten key competitive advantages effectively (not just less than flattering headlines unless they do real damage to the brand). Protecting and strengthening the competitive advantages of a business (widening the moat) while remaining comfortably funded (via free cash flow and, if free cash flow is occasionally compromised, a rock solid balance sheet) under all economic conditions is what matters most. Near-term results do not.**
Unfortunately, some who opine on stocks have spent little time actually running businesses or at least dealing with some of the real world challenges of executing day to day. I'm just a bit dubious of those who lack that experience. Investors have varied backgrounds, of course, but I'd bet on those with at least some relevant senior operational experience running part of a business in any industry over those without it (also those accountable for buying and selling marketable securities over those who just provide their opinion about them). Operational responsibility provides the chance to make plenty of tough day-to-day judgment calls and decisions. What's more difficult, to provide an opinion or analysis of a business or actually being accountable for the results produced by a business? I believe you only learn the big lessons immersed in the thick of it. To me, nothing replaces having been there. Just reading some case study, building and analyzing a complex spreadsheet with tons of data, or talking to those with industry experience to form an opinion doesn't cut it. Those and things like it are important but insufficient. In other words, having had some responsibility/accountability for execution and dealing with resource and other constraints certainly can't hurt one's judgment of a business's strengths, challenges, opportunities, and threats. Mistakes get made. Personalities clash. Competitors do things you don't expect. Disruptive technologies come along. The culture of an acquired company's personnel turns out to not mesh with that of the parent company as well as hoped.
The list goes on.
I'll take someone who's dealt with it in the real world any day over someone who has not.
Opinion are all too easy to come by.
"I am a better investor because I am a businessman and a better businessman because I am an investor." - Warren Buffett
As a result, I'm always fascinated by someone who has never come close to running all or part of a business (of some complexity) telling those actually experienced at running rather complex business operations what they are doing wrong and how they should do it better.
Of course, while there are plenty of capable CEOs, there's certainly no shortage of mediocre or worse CEOs and other senior executives running corporations.
I realize there are some fine stock pickers/analysts who are lacking in operational experience but still are very effective.
There are exceptions, naturally, but I'm just arguing they could raise their game even further if they'd spent some time in their career, for example, running a factory versus just getting a walking tour through it with the CEO.
Adam
Long position in Wells Fargo established at much lower prices
* Still, the stock price action may not exactly be fun to watch. Loss aversion is always a powerful factor and many can't stand to look at that paper loss for an extended period. Even if someone can generally judge the value of a business well, the forceful influence of loss aversion may get in the way. An investor has to know their own limits and that includes the psychological and temperamental stuff. Otherwise, it's often best to ignore monthly statements and focus instead on getting good at judging value and how that value, even if imprecisely, is likely to change over time. (Consistently judging valuation to be meaningfully higher than it actually is can be rather expensive whether you have a strong awareness of the psychological factors, a cool investing temperament, and can ignore short-term price action or not.) Successful investing starts and ends with having sound judgment of value and disciplined buying at a discount.
** The best businesses (those with a real and sustainable economic moat) can remain solidly profitable in good times and the rougher times while having plenty of resources to invest in opportunities further down the road. Now, I happen to not like "paying too much for promise" but that's more a price versus value discipline. I'm happy if a business invests heavily in long-term prospects in lieu of maximizing near-term profits. The businesses to avoid are the ones who only seem to have a competitive advantage for a period of time but actually have no ability to defend their position long-term. Those that tend to reside in fast-changing industries with lots of technological change.
---
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 Bank Set For The Strongest Quarter
WSJ's Deal Journal on Wells Fargo
In the first article, Credit Suisse cites strong mortgage-related banking activity as a key driver. In the other article, Jefferies mentions above average profitability, lack of investment banking, and the return of capital to shareholders. Both firms, not surprisingly, seem more focused on the near term implications of all this.
Now, as I've said on other occasions, attempting to judge how well a stock or a business will perform in such a short time frame isn't really where energy is all that well spent. Wells Fargo may or may not have great near-term business results. The stock may perform very well or horribly in the short run for all I know. I'll let others figure that out.
"Absent a lot of surprises, stocks are relatively predictable over twenty years. As to whether they're going to be higher or lower in two to three years, you might as well flip a coin to decide." - Peter Lynch
A long-term investor in any stock should expect terrible stock price action and real business difficulties from time to time. Yet, it is just not all that important if one has an investing horizon that is truly long-term. (If the money invested is needed in the next five years or less basically none of this applies. Equity investing just doesn't work over a time frame that short.) Even the best businesses (in banking or otherwise) run into tough times.
Business is inherently messy affair even when things go well and much more so when things do not. As long as a real and sustainable competitive advantage exists (or advantages) in the first place, that inherent messiness isn't the end of the world.*
The question is whether management deals with problems that may threaten key competitive advantages effectively (not just less than flattering headlines unless they do real damage to the brand). Protecting and strengthening the competitive advantages of a business (widening the moat) while remaining comfortably funded (via free cash flow and, if free cash flow is occasionally compromised, a rock solid balance sheet) under all economic conditions is what matters most. Near-term results do not.**
Unfortunately, some who opine on stocks have spent little time actually running businesses or at least dealing with some of the real world challenges of executing day to day. I'm just a bit dubious of those who lack that experience. Investors have varied backgrounds, of course, but I'd bet on those with at least some relevant senior operational experience running part of a business in any industry over those without it (also those accountable for buying and selling marketable securities over those who just provide their opinion about them). Operational responsibility provides the chance to make plenty of tough day-to-day judgment calls and decisions. What's more difficult, to provide an opinion or analysis of a business or actually being accountable for the results produced by a business? I believe you only learn the big lessons immersed in the thick of it. To me, nothing replaces having been there. Just reading some case study, building and analyzing a complex spreadsheet with tons of data, or talking to those with industry experience to form an opinion doesn't cut it. Those and things like it are important but insufficient. In other words, having had some responsibility/accountability for execution and dealing with resource and other constraints certainly can't hurt one's judgment of a business's strengths, challenges, opportunities, and threats. Mistakes get made. Personalities clash. Competitors do things you don't expect. Disruptive technologies come along. The culture of an acquired company's personnel turns out to not mesh with that of the parent company as well as hoped.
The list goes on.
I'll take someone who's dealt with it in the real world any day over someone who has not.
Opinion are all too easy to come by.
"I am a better investor because I am a businessman and a better businessman because I am an investor." - Warren Buffett
As a result, I'm always fascinated by someone who has never come close to running all or part of a business (of some complexity) telling those actually experienced at running rather complex business operations what they are doing wrong and how they should do it better.
Of course, while there are plenty of capable CEOs, there's certainly no shortage of mediocre or worse CEOs and other senior executives running corporations.
I realize there are some fine stock pickers/analysts who are lacking in operational experience but still are very effective.
There are exceptions, naturally, but I'm just arguing they could raise their game even further if they'd spent some time in their career, for example, running a factory versus just getting a walking tour through it with the CEO.
Adam
Long position in Wells Fargo established at much lower prices
* Still, the stock price action may not exactly be fun to watch. Loss aversion is always a powerful factor and many can't stand to look at that paper loss for an extended period. Even if someone can generally judge the value of a business well, the forceful influence of loss aversion may get in the way. An investor has to know their own limits and that includes the psychological and temperamental stuff. Otherwise, it's often best to ignore monthly statements and focus instead on getting good at judging value and how that value, even if imprecisely, is likely to change over time. (Consistently judging valuation to be meaningfully higher than it actually is can be rather expensive whether you have a strong awareness of the psychological factors, a cool investing temperament, and can ignore short-term price action or not.) Successful investing starts and ends with having sound judgment of value and disciplined buying at a discount.
** The best businesses (those with a real and sustainable economic moat) can remain solidly profitable in good times and the rougher times while having plenty of resources to invest in opportunities further down the road. Now, I happen to not like "paying too much for promise" but that's more a price versus value discipline. I'm happy if a business invests heavily in long-term prospects in lieu of maximizing near-term profits. The businesses to avoid are the ones who only seem to have a competitive advantage for a period of time but actually have no ability to defend their position long-term. Those that tend to reside in fast-changing industries with lots of technological change.
---
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, July 6, 2012
Contango's Kenneth Peak on Low Costs, Value Creation, and Shareholder Wealth Per Share
As a follow up to yesterday's post on Contango Oil and Gas (MCF), here's a presentation that contains a summary of the company's core beliefs. Kenneth Peak,
the founder, CEO, and chairman of Contango, says that these core beliefs have been in place since the company's inception in the late 1990s.
Contango's Core Beliefs
- The only competitive advantage in the natural gas and oil business is to be among the LOWEST COST producers
- Virtually all the exploration and production industry's VALUE CREATION occurs through the drilling of successful exploration wells
- The whole point of a business is only and always to increase SHAREHOLDER WEALTH – PER SHARE…with conditions
Beliefs are optional, Results are mandatory and the only result that matters is long term – 3-5-10 year returns to shareholders
It's also worth noting Contango employs no hedges, has no debt, keeps plenty of cash on hand, and that 23 investors own 75 percent of the stock (Mr. Peak owns more than 15 percent).
"Investing is only and always about return on capital invested." - Kenneth Peak
In this Bloomberg interview, in addition to noting the importance of being low cost, Mr. Peak explains why you cannot lever up an exploration and production company saying that Houston is littered with the graveyards of enterprises that thought they could.
Contango generally drills in less than 200 ft of water in the Gulf of Mexico. Mr. Peak says that, in shale exploration, you may "never drill a dry hole", but that doesn't mean what you'll find will be economically sound (I guess he's saying that what's discovered too often produces a low return on capital). In contrast, he says that the types of wells you do find in the Gulf of Mexico tend to be economically sound.* In other words, when you find a productive well it's very profitable even though, in between, there may be some dry ones. Overall, he essentially argues that, if you know what you are doing, the cost of the dry wells are more than compensated for by the ones that end up not being productive.
In the Bloomberg interview, Peak says the payback on the investment is often 1 to 1.5 years for the kinds of wells he typically goes after.
Contango has few employees (ten or less) and just twelve wells offshore. So operationally it is a relatively uncomplicated and smaller company. According to this presentation back in 2010 (page 7), Contango's full cycle costs sit at roughly half the industry average which, if the case, sure seems rather impressive.
While Contango is a long distance from being my favorite kind of business, I think it's worthwhile noting when the person running the show seems such a competent capital allocator and, more generally, a capable operator. It wouldn't hurt to have more CEOs that think along these lines.
In any case, listening to what Mr. Peak has to say probably isn't a bad way to learn more about what's critical to business success in the energy industry.
Adam
No position in MCF
* At least in the shallower depths that he seems to favor. Kenneth Peak wrote a letter (excerpt can be found here) after the Deepwater Horizon oil spill in 2010. In the letter, he differentiates the kind of shallow water drilling Contango engages in from the deep water variety. He explains that shallow water drilling does not pose the same kind of operating challenges as deep water. For example, divers can be sent to the mud line of the well bore. Not so for deep water drilling.
---
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.
Contango's Core Beliefs
- The only competitive advantage in the natural gas and oil business is to be among the LOWEST COST producers
- Virtually all the exploration and production industry's VALUE CREATION occurs through the drilling of successful exploration wells
- The whole point of a business is only and always to increase SHAREHOLDER WEALTH – PER SHARE…with conditions
Beliefs are optional, Results are mandatory and the only result that matters is long term – 3-5-10 year returns to shareholders
It's also worth noting Contango employs no hedges, has no debt, keeps plenty of cash on hand, and that 23 investors own 75 percent of the stock (Mr. Peak owns more than 15 percent).
"Investing is only and always about return on capital invested." - Kenneth Peak
In this Bloomberg interview, in addition to noting the importance of being low cost, Mr. Peak explains why you cannot lever up an exploration and production company saying that Houston is littered with the graveyards of enterprises that thought they could.
Contango generally drills in less than 200 ft of water in the Gulf of Mexico. Mr. Peak says that, in shale exploration, you may "never drill a dry hole", but that doesn't mean what you'll find will be economically sound (I guess he's saying that what's discovered too often produces a low return on capital). In contrast, he says that the types of wells you do find in the Gulf of Mexico tend to be economically sound.* In other words, when you find a productive well it's very profitable even though, in between, there may be some dry ones. Overall, he essentially argues that, if you know what you are doing, the cost of the dry wells are more than compensated for by the ones that end up not being productive.
In the Bloomberg interview, Peak says the payback on the investment is often 1 to 1.5 years for the kinds of wells he typically goes after.
Contango has few employees (ten or less) and just twelve wells offshore. So operationally it is a relatively uncomplicated and smaller company. According to this presentation back in 2010 (page 7), Contango's full cycle costs sit at roughly half the industry average which, if the case, sure seems rather impressive.
While Contango is a long distance from being my favorite kind of business, I think it's worthwhile noting when the person running the show seems such a competent capital allocator and, more generally, a capable operator. It wouldn't hurt to have more CEOs that think along these lines.
In any case, listening to what Mr. Peak has to say probably isn't a bad way to learn more about what's critical to business success in the energy industry.
Adam
No position in MCF
* At least in the shallower depths that he seems to favor. Kenneth Peak wrote a letter (excerpt can be found here) after the Deepwater Horizon oil spill in 2010. In the letter, he differentiates the kind of shallow water drilling Contango engages in from the deep water variety. He explains that shallow water drilling does not pose the same kind of operating challenges as deep water. For example, divers can be sent to the mud line of the well bore. Not so for deep water drilling.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Thursday, July 5, 2012
Kenneth Peak on Bloomberg: Contango's CEO Discusses the Importance of Low Costs and Value Creation Per Share
Contango Oil and Gas (MCF) is a houston-based exploration and production business with a ~ $ 920 million market value. Kenneth Peak, the founder, CEO, and chairman of Contango, was recently interviewed on Bloomberg. In the interview, he talks about the importance of being among the lowest cost producers in the natural gas and oil exploration business.
Contango, in many ways, operates in what is an inherently tough environment.
Bloomberg Interviews Contango CEO
In a commodity business where (by definition) you have no control over price, being at or near the lowest cost becomes all-important. Being at least among the lowest cost producers is a crucial factor for survival during the bad times (low prices) and excess returns during the good times (high prices) for any commodity business.
(For banks it's similarly about having the lowest cost money.)
A durable low cost position, balance sheet strength, and management that allocates capital wisely is at or near the top of the list of those things an investor should attempt to gauge before putting capital at risk.
Well, at least that's what I'd look for before investing a penny in any commodity-based business.
Mr. Peak also explains why he chose to eliminate stock options at every level. He first eliminated his own stock options four years ago then later moved to do the same at the board level and for employees. He emphasizes the importance of value creation per share saying "there's no point in getting big, the object is to get rich". Stock options have a tendency to quietly dilute shareholders (and in some cases not so quietly...actually rather blatantly).
He makes the point that a buyback done just to offset dilution from options isn't really a buyback. In other words, the buying back of shares in order to offset that dilution is hardly a brilliant reason for a buyback (though some companies seem to behave as if it is).
Speaking generally, buybacks can make sense in my view if a business is financially strong, is comfortable in its competitive position, there's no clearly superior alternative use for the available funds, and the shares are selling at a plain discount to value.
So buybacks work well under the right set of very specific circumstances; inevitably the right course of action will be different for each business and industry.
It's worth noting that Contango doesn't bother to hedge, has plenty of cash, and no debt.
Contango may not be my favorite type of business but I do think some useful lessons can be learned from this interview.
Adam
No position in MCF
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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.
Contango, in many ways, operates in what is an inherently tough environment.
Bloomberg Interviews Contango CEO
In a commodity business where (by definition) you have no control over price, being at or near the lowest cost becomes all-important. Being at least among the lowest cost producers is a crucial factor for survival during the bad times (low prices) and excess returns during the good times (high prices) for any commodity business.
(For banks it's similarly about having the lowest cost money.)
A durable low cost position, balance sheet strength, and management that allocates capital wisely is at or near the top of the list of those things an investor should attempt to gauge before putting capital at risk.
Well, at least that's what I'd look for before investing a penny in any commodity-based business.
Mr. Peak also explains why he chose to eliminate stock options at every level. He first eliminated his own stock options four years ago then later moved to do the same at the board level and for employees. He emphasizes the importance of value creation per share saying "there's no point in getting big, the object is to get rich". Stock options have a tendency to quietly dilute shareholders (and in some cases not so quietly...actually rather blatantly).
He makes the point that a buyback done just to offset dilution from options isn't really a buyback. In other words, the buying back of shares in order to offset that dilution is hardly a brilliant reason for a buyback (though some companies seem to behave as if it is).
Speaking generally, buybacks can make sense in my view if a business is financially strong, is comfortable in its competitive position, there's no clearly superior alternative use for the available funds, and the shares are selling at a plain discount to value.
So buybacks work well under the right set of very specific circumstances; inevitably the right course of action will be different for each business and industry.
It's worth noting that Contango doesn't bother to hedge, has plenty of cash, and no debt.
Contango may not be my favorite type of business but I do think some useful lessons can be learned from this interview.
Adam
No position in MCF
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
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