Earlier this year, Apple (AAPL) expanded its share repurchase authorization to $ 60 billion.
Well, Carl Icahn is calling on the company to repurchase more like $ 150 billion in stock. From this recent Icahn letter to Tim Cook:
"We want to be very clear that we could not be more supportive of you, the existing management team, the culture at Apple and the innovative spirit it engenders. The criticism we have as shareholders has nothing to do with your management leadership or operational strategy. Our criticism relates to one thing only: the size and timeframe of Apple's buyback program. It is obvious to us that it should be much bigger and immediate."
Warren Buffett did recently say "I wish I had bought the stock many years ago" and also mentioned he had advised Apple on buying back their stock -- if they thought it to be undervalued -- a few years ago or so.
(At that time they did not.)
Buffett is no small fan of buybacks when they make sense yet said the following about the pressure on Apple to buyback even more of their stock than they are already doing:
"I think the Apple management and directors have done a pretty darn good job of running the company. My vote would be with them."
He then added this:
"I do not think that companies should be run primarily to please Wall Street and largely shareholders who are going to sell. I believe in running Berkshire for the shareholders who are going to stay and not the one's who are going to leave."
So they agree on how well the company is being run.
The important difference comes down to time horizon.
Buffett has always had a strong bias in favor of building and serving a base of shareholders who mostly are going to stick around for the long haul. With that in mind, he naturally has a preference that decisions are made, first and foremost, for long term owners. He's just not that enthusiastic about responding to pressure from someone who might not be around as a part owner for very long.
Pressure for change from those who intend to own shares for years to come -- under the right circumstances -- can be just fine; pressure from those with shorter time horizons is not.
So those who push for action to achieve a profitable near term outcome then move onto the next target should be considered of secondary importance to those in it for the long haul.
(What moves the stock up near-term may or may not also be favorable for long term owners.)
Still, what Carl Icahn usually does is hardly the equivalent of short term trading.
Agitating for fundamental change at the senior management and board level can be a very useful thing. No doubt more than a few companies need it. In fact, the investing world would benefit from more large shareholders who are willing to do so and are competent at it. The question is whether those who push for the change are willing -- alongside other owners -- to stick around for the long run repercussions of the change they helped facilitate.
Some will no doubt argue that the sticking around part isn't all that important as long as the right kind of change happens.*
Icahn wants Apple's board to move more aggressively and announce a $150 billion tender offer. He thinks it should be financed with debt or a mix of debt and balance sheet cash.
In the letter, Icahn does say "to invalidate any possible criticism that I would not stand by this thesis in terms of its long term benefit to shareholders, I hereby agree to withhold my shares from the proposed $150 Billion tender offer. There is nothing short term about my intentions here."
Of course, that definition of long term -- a willingness to withhold shares during the tender offer -- probably isn't exactly a time horizon that Buffett would consider long term.
Now, if someone like Carl Icahn can actually improve corporate governance more generally (and maybe improve/change the laws of consequence that can undermine long term oriented owners) that would be a very useful thing.
The quarterly results Apple released back in July revealed they've already been buying back a whole lot of stock. The company was also likely doing so, in a meaningful way, during the quarter that just ended.
One of Icahn's chief concerns seems to be that the window to buyback the stock when it is actually cheap will close sooner than later. That's certainly a legit concern. Now, the existing $ 60 billion buyback authorization is not exactly small but, the question is, how fast can it be executed. The company indicated back in April it expects the buyback to be completed by the end of 2015.
Well, if the buyback takes all of that time to complete and the stock price rises materially, it just won't be as effective as it could otherwise be. It may still have a favorable impact, of course, but a bit less so than if it were completed while the stock was selling for much less.**
It's also possible that the stock becomes truly expensive. In that case the buyback should naturally be halted. Buybacks generally only make sense when the share price represents a plain discount to per share intrinsic value, the company is comfortably financed, no superior alternative investment(s) exist, and all other important expenditures (including whatever solidifies/widens the moat) are covered.
Apple reports its quarterly results next week. At that time, it will become more clear just how much more stock they've been buying since they last reported.
The buyback activity may not be quite as much as some would like to see, but they still likely repurchased more than a few shares outstanding.
In any case, I'll still never really be all that comfortable with tech stocks as long-term investments.
They have, on occasion, become of mild interest (in small doses) when selling at a substantial discount to conservatively estimated per share intrinsic value.
That's about it.
Adam
Long position in AAPL established at much lower than recent prices
Related posts:
Apple's Buyback
Technology Stocks
* The following seems relevant here. Does the owner of an asset (e.g. a car), someone who intends to sell sooner than later, spend money on the things that will assure reliable performance many years from now or, instead, mostly just do those things that polish it up for sale? Time horizon impacts owner behavior. This naturally also applies to businesses. Crucial things must be often be done today to make sure a business remains competitive many years down the road. Those who are mostly (if not entirely) trying to get a near term result aren't likely to weigh those important long term considerations appropriately against their own near term objectives and interests. Sometimes there's no tension between near term and long term considerations; other times there is.
** One wonders how much of the recent rally in the stock can be attributed to Icahn's actions. In other words, how much has the higher than otherwise price inadvertently reduced Apple's buyback effectiveness. That may not be precisely knowable but it certainly matters. Around the more recent market prices, the buyback is already meaningfully less impactful than it would have been not long ago.
---
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.
Friday, October 25, 2013
Friday, October 18, 2013
Best Global Brands 2013
According to a report by Interbrand released late last month, Apple (AAPL) is now the most valuable global brand.
Coca-Cola (KO) had held the top spot for 13 straight years in prior Interbrand reports.
It now sits at number 3.
Top Ten Most Valuable Global Brands
1 Apple
2 Google (GOOG)
3 Coca-Cola
4 IBM (IBM)
5 Microsoft (MSFT)
6 General Electric (GE)
7 McDonald's (MCD)
8 Samsung (SSNLF)
9 Marlboro (INTC)
10 Toyota (TM)
Website: Best Global Brands 2013
Press Release: Interbrand's 14th Annual Best Global Brands Report
Report: Best Global Brands 2013
This top ten ranking of global brands has some similarities to the entirely separate ranking of global brands released earlier this year by Millward Brown.
Apple, Google, Coca-Cola, IBM, Microsoft, and McDonald's make the top ten on both lists. The specific value these two rankings place on each brand is in some cases, not surprisingly, very different (e.g. the study earlier this year puts Apple's brand value at $ 185 billion, the newer ranking places it at more like $ 98 billion).
Some of the are differences between the two rankings will naturally come down to methodology.
Interbrand's methodology is explained here. For inclusion in their rankings, a brand needs to have a "truly global" presence as defined by their methodology.
"In measurable terms, this requires that:
- At least 30 percent of revenues must come from outside the brand's home region
- It must have a presence in at least three major continents, as well as broad geographic coverage in emerging markets
- There must be sufficient publicly available data on the brand's financial performance
- Economic profit must be expected to be positive over the longer term, delivering a return above the brand’s operating and financing costs
- The brand must have a public profile and awareness above and beyond its own marketplace.
These requirements...lead to the exclusion of some well-known brands that might otherwise be expected to appear in the ranking. The Mars and BBC brands, for example, are privately held and do not have publicly available financial data. Walmart, although it does business in international markets, often does so under a variety of brands and, therefore, does not meet Interbrand's global requirements.
For similar reasons, brands in several sectors have been excluded."
These are:
Telecommunications - strong ties to their national markets but "awareness challenges" further away from home.
Airline industry - capital intensiveness and low margins result in brands that "struggle to achieve positive economic profits over the long term."
Pharmaceutical companies - consumer relationship is generally with the product brands (more so than the corporate brand owner) and "insufficient publicly disclosed financial data on pharmaceutical product brands."
Top 100 Global Brands
Among the top 100, Nokia's (NOK) brand, took the biggest hit in both absolute and percentage terms. Not exactly a surprise.
Google was the biggest gainer in absolute terms.
Facebook (FB) was the biggest gainer in percentage terms.
To me, it seems rather unlikely that brand value could ever be pinned down -- and I mentioned this in the post on Millward Brown's rankings -- as precisely as might be implied by these rankings.
Still, these studies are provide some indication which brands matter around the world and how -- in at least a rough sense -- their value might be changing.
Adam
Established long positions in AAPL, GOOG, KO, MSFT, and GE at much lower than recent prices. Recently added small new IBM position.
---
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.
Coca-Cola (KO) had held the top spot for 13 straight years in prior Interbrand reports.
It now sits at number 3.
Top Ten Most Valuable Global Brands
1 Apple
2 Google (GOOG)
3 Coca-Cola
4 IBM (IBM)
5 Microsoft (MSFT)
6 General Electric (GE)
7 McDonald's (MCD)
8 Samsung (SSNLF)
9 Marlboro (INTC)
10 Toyota (TM)
Website: Best Global Brands 2013
Press Release: Interbrand's 14th Annual Best Global Brands Report
Report: Best Global Brands 2013
This top ten ranking of global brands has some similarities to the entirely separate ranking of global brands released earlier this year by Millward Brown.
Apple, Google, Coca-Cola, IBM, Microsoft, and McDonald's make the top ten on both lists. The specific value these two rankings place on each brand is in some cases, not surprisingly, very different (e.g. the study earlier this year puts Apple's brand value at $ 185 billion, the newer ranking places it at more like $ 98 billion).
Some of the are differences between the two rankings will naturally come down to methodology.
Interbrand's methodology is explained here. For inclusion in their rankings, a brand needs to have a "truly global" presence as defined by their methodology.
"In measurable terms, this requires that:
- At least 30 percent of revenues must come from outside the brand's home region
- It must have a presence in at least three major continents, as well as broad geographic coverage in emerging markets
- There must be sufficient publicly available data on the brand's financial performance
- Economic profit must be expected to be positive over the longer term, delivering a return above the brand’s operating and financing costs
- The brand must have a public profile and awareness above and beyond its own marketplace.
These requirements...lead to the exclusion of some well-known brands that might otherwise be expected to appear in the ranking. The Mars and BBC brands, for example, are privately held and do not have publicly available financial data. Walmart, although it does business in international markets, often does so under a variety of brands and, therefore, does not meet Interbrand's global requirements.
For similar reasons, brands in several sectors have been excluded."
These are:
Telecommunications - strong ties to their national markets but "awareness challenges" further away from home.
Airline industry - capital intensiveness and low margins result in brands that "struggle to achieve positive economic profits over the long term."
Pharmaceutical companies - consumer relationship is generally with the product brands (more so than the corporate brand owner) and "insufficient publicly disclosed financial data on pharmaceutical product brands."
Top 100 Global Brands
Among the top 100, Nokia's (NOK) brand, took the biggest hit in both absolute and percentage terms. Not exactly a surprise.
Google was the biggest gainer in absolute terms.
Facebook (FB) was the biggest gainer in percentage terms.
To me, it seems rather unlikely that brand value could ever be pinned down -- and I mentioned this in the post on Millward Brown's rankings -- as precisely as might be implied by these rankings.
Still, these studies are provide some indication which brands matter around the world and how -- in at least a rough sense -- their value might be changing.
Adam
Established long positions in AAPL, GOOG, KO, MSFT, and GE at much lower than recent prices. Recently added small new IBM position.
---
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, October 11, 2013
Buffett's Purchase of IBM Revisited
In November of 2011, Warren Buffett revealed on CNBC for the first time that he had been buying shares of International Business Machines (IBM).
Buffett on IBM: Berkshire Buys Big Blue
He apparently began buying in the first quarter of that year and some will rightly note that the stock hasn't done much since then.
Certainly not, for example, compared to the S&P 500.
Berkshire Hathaway's (BRKa) cost basis in the stock is something like a little over $ 171 per share.
As I write this it is selling at roughly $ 185 per share (though, fortunately, earlier this week it went even lower).
So has it been a good investment for Berkshire?
It is, in fact, a very large and likely long-term position for the company. The stock hasn't done much but, as I'll get to below, earnings per share sure has.
Why Buffett Wants IBM's Shares "To Languish"
Here's how Buffett explained how he looks at IBM -- a company that's been repurchasing shares at a good clip for some time -- in the 2011 Berkshire Hathaway shareholder letter:
"When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well."
IBM has, in fact, been consistently repurchasing stock for quite some time.
If shares are selling at a plain discount to value, a temporarily even lower share price just increases the effectiveness of future repurchases for continuing shareholders.*
Buffett goes on to explain his thinking on IBM and their share repurchases this way:
"....what happens to the company's earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period?
I won't keep you in suspense. We should wish for IBM's stock price to languish throughout the five years."
This mostly comes down to the power of well executed share repurchases. They can work extremely well over the long haul when shares are bought nicely below intrinsic value, business prospects are at least solid (i.e. moat reinforcement/strengthening is not being neglected) and the company is in a comfortable financial position (a healthy balance sheet, lots of liquidity sources, along with robust even if fluctuating somewhat free cash flow).
Buffett walks through the math in the letter to further explain why he wants IBM's stock to "languish".**
The bulk of the IBM position for Berkshire was established in the 2nd and 3rd quarter of 2011. Buffett would have been able to see that IBM had earned $ 11.52 per share in its, at that time, most recently reported full fiscal year (2010).
Let's compare that to now. For 2013, earnings per share should come in at ~ $ 16.00 per share. That's obviously not such a bad increase in per share earnings power especially for what is a rather large company. Of course, there's certainly no guarantee that this earnings power will be persistent. That's only one of the many important judgments -- some easily quantifiable, many that are not -- any investor has to make.
Businesses -- even those that are, at least in my view, very much superior to IBM -- inevitably run into difficulties from time to time. The question becomes whether a particular business possesses -- and can further build -- enough advantages to produce attractive earnings over the longer haul.
The price paid should always represent a clear discount to the present value of conservatively estimated future earnings. There's some real ambiguity about what should be considered, within a range, IBM's normalized future earnings power. So the price paid should more than reflect such ambiguity. Otherwise, when a stock that's purchased at a plain discount to value temporarily goes to an even lower price -- especially if "temporarily" proves to be an extended period of time -- it's not at all a bad thing for the long-term owner.
(As long as the enterprise maintains an ongoing financial capacity to buyback shares.)
Berkshire has also been receiving a growing but still just decent annual dividend that now sits at roughly 2%; a nearly 50% increase in the dividend payment since early 2011.
Make some conservative assumptions on dividend growth (along with the impact of buybacks) going forward and that now modest payment seems likely to be rather a whole lot less modest 7-10 years out. Shares repurchased at attractive prices should, all else equal, eventually fuel earnings per share and, ultimately, dividends per share over the longer run. Over many years, especially if the stock remains low and the business performs at least reasonably well, the compounded impact of the share repurchases should be not inconsequential.
"The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day's supply.
Charlie and I don't expect to win many of you over to our way of thinking – we've observed enough human behavior to know the futility of that – but we do want you to be aware of our personal calculus."
So the key is the price compared to value and whether one thinks business prospects are likely to remain attractive (even if, as in the case of IBM, maybe a bit unexciting). The current valuation just doesn't demand spectacular business performance to achieve satisfactory risk-adjusted returns. Instead, it simply demands merely solid business performance and continued smart financial management. Price paid and, as Buffett points out in his 2011 letter, earnings performance "for a long time to come" will ultimately influence long-term investment results.
(Though not necessarily earnings performance in any given year or even over somewhat longer time frames. This is especially relevant when a business is going through some kind of transition or when macro factors come into play.)
Unfortunately, with some public companies, share repurchases are done at unattractive valuations and for the wrong reasons (e.g. to prop up the stock or to offset dilution from stock options).
It's when a stock sells for a plain discount to conservatively estimated per share intrinsic value, and the company can comfortably afford it, that a buyback makes sense.
I don't doubt that market participants primarily in the business of betting on price action will maintain this was not such a great investment. That view may even prove correct. Those looking for quick speculative gains will likely find IBM to be a mostly uninteresting place to put their money at risk. If nothing else, IBM is the sort of investment that's almost certain to not make someone quick and substantial returns.
Some will correctly point out the lack of revenue growth prospects; IBM's organic revenue growth has been pretty much nonexistent (or worse) for some time.
That's likely to continue.
While revenue growth can be a fine thing, it can't be viewed in a vacuum; not all incremental revenue is of the high return variety. Some opportunities produce growth without producing attractive returns on capital.
Excess capital should be returned to shareholders when it can't be put to good use elsewhere (i.e. when only subpar or worse investment alternatives exist). Well, in too many cases, that's just not what happens.
Of course, some might view IBM's share repurchases as just an attempt to prop up earnings. No doubt some companies do just that. I happen to think this doesn't apply to IBM when you consider how they've handled their financial management responsibilities over time.
(Buffett does highlight the quality of IBM's financial management in the 2011 letter.)
The specific context matters when it comes to share repurchases.
Among other things:
- How price paid compares to a conservative estimate of intrinsic value
- The attractiveness of investment alternatives
- The durability of the core business franchise
- Inherent capital intensiveness
- Financial health (balance sheet and free cash flow)
IBM is ultimately a technology business.
That's the bad news.
For that reason alone the company's stock will never be a favorite.
Naturally not all technology and technology-related businesses possess similar inherent risks; some new tech startup, for example, has very different specific risks associated with it compared to IBM. Up to a point it's true that the price paid can minimize the risk of permanent capital loss, but only up to a point.
Sometimes the risks of a business are so difficult to gauge that no price is low enough to provide sufficient margin of safety.
At some point the right answer is to just avoid.
For me, that's often the right answer with shares of technology businesses.***
From earlier in the 2011 letter:
"The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another."
There are certainly far better businesses out there but, once the inherent risks and opportunities are understood well enough that it gets beyond the go/no go decision, the investment process always comes down to price.
Adam
Long position in BRKb established long ago at much lower than recent prices. Recently added a small IBM position for the first time at somewhat lower than current prices.
Related posts:
Buffett on Buybacks, Book Value, and Intrinsic Value
Buffett on Teledyne's Henry Singleton
Why Buffett Wants IBM's Shares "To Languish"
Buffett on IBM: Berkshire Buys Big Blue
Buffett: When it's Advisable for a Company to Repurchase Shares
The Best Use of Corporate Cash
Technology Stocks
Buffett on Stock Buybacks - Part II
Buffett on Stock Buybacks
Buy a Stock...Hope the Price Drops?
* Share repurchases may happen going forward but will only make sense if the shares remain cheap enough. In other words, nicely below per share intrinsic value. Repurchases that are executed above approximate per share intrinsic value is generally poor use of capital. Since estimated per share value is best case an imprecise range, there should be a plain margin of safety. The discount to value should be obvious. Share count reduction needs to accomplished in am economically sound manner. This should be something an investor can count on but, unfortunately, that's not the case.
** In the letter, Buffett explains the relatively simple yet important repurchase math. Essentially, he points out that if IBM's stock price were to average something like $ 200 during a given period the company would acquire 250 million shares for its $ 50 billion. If the stock instead sold for $ 300 on average during the five-year period IBM will acquire only 167 million shares. He says that, over the five years, Berkshire's share of those earnings would be a full $ 100 million more in this "'disappointing' scenario". Also, if the stock were to fluctuate near current prices -- which are now even lower than the "'disappointing' scenario" -- it would work out even better. In the very long run the "weighing machine" will reflect roughly the additional per share value of those incremental earnings.
*** I realize some others may feel more comfortable with tech stocks but, with investments, buying only what one knows well is essential. That is necessarily unique to each investor. Gauging the future prospects of most tech businesses is tricky at best. At least it is for me.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Buffett on IBM: Berkshire Buys Big Blue
He apparently began buying in the first quarter of that year and some will rightly note that the stock hasn't done much since then.
Certainly not, for example, compared to the S&P 500.
Berkshire Hathaway's (BRKa) cost basis in the stock is something like a little over $ 171 per share.
As I write this it is selling at roughly $ 185 per share (though, fortunately, earlier this week it went even lower).
So has it been a good investment for Berkshire?
It is, in fact, a very large and likely long-term position for the company. The stock hasn't done much but, as I'll get to below, earnings per share sure has.
Why Buffett Wants IBM's Shares "To Languish"
Here's how Buffett explained how he looks at IBM -- a company that's been repurchasing shares at a good clip for some time -- in the 2011 Berkshire Hathaway shareholder letter:
"When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well."
IBM has, in fact, been consistently repurchasing stock for quite some time.
If shares are selling at a plain discount to value, a temporarily even lower share price just increases the effectiveness of future repurchases for continuing shareholders.*
Buffett goes on to explain his thinking on IBM and their share repurchases this way:
"....what happens to the company's earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period?
I won't keep you in suspense. We should wish for IBM's stock price to languish throughout the five years."
This mostly comes down to the power of well executed share repurchases. They can work extremely well over the long haul when shares are bought nicely below intrinsic value, business prospects are at least solid (i.e. moat reinforcement/strengthening is not being neglected) and the company is in a comfortable financial position (a healthy balance sheet, lots of liquidity sources, along with robust even if fluctuating somewhat free cash flow).
Buffett walks through the math in the letter to further explain why he wants IBM's stock to "languish".**
The bulk of the IBM position for Berkshire was established in the 2nd and 3rd quarter of 2011. Buffett would have been able to see that IBM had earned $ 11.52 per share in its, at that time, most recently reported full fiscal year (2010).
Let's compare that to now. For 2013, earnings per share should come in at ~ $ 16.00 per share. That's obviously not such a bad increase in per share earnings power especially for what is a rather large company. Of course, there's certainly no guarantee that this earnings power will be persistent. That's only one of the many important judgments -- some easily quantifiable, many that are not -- any investor has to make.
Businesses -- even those that are, at least in my view, very much superior to IBM -- inevitably run into difficulties from time to time. The question becomes whether a particular business possesses -- and can further build -- enough advantages to produce attractive earnings over the longer haul.
The price paid should always represent a clear discount to the present value of conservatively estimated future earnings. There's some real ambiguity about what should be considered, within a range, IBM's normalized future earnings power. So the price paid should more than reflect such ambiguity. Otherwise, when a stock that's purchased at a plain discount to value temporarily goes to an even lower price -- especially if "temporarily" proves to be an extended period of time -- it's not at all a bad thing for the long-term owner.
(As long as the enterprise maintains an ongoing financial capacity to buyback shares.)
Berkshire has also been receiving a growing but still just decent annual dividend that now sits at roughly 2%; a nearly 50% increase in the dividend payment since early 2011.
Make some conservative assumptions on dividend growth (along with the impact of buybacks) going forward and that now modest payment seems likely to be rather a whole lot less modest 7-10 years out. Shares repurchased at attractive prices should, all else equal, eventually fuel earnings per share and, ultimately, dividends per share over the longer run. Over many years, especially if the stock remains low and the business performs at least reasonably well, the compounded impact of the share repurchases should be not inconsequential.
"The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day's supply.
Charlie and I don't expect to win many of you over to our way of thinking – we've observed enough human behavior to know the futility of that – but we do want you to be aware of our personal calculus."
So the key is the price compared to value and whether one thinks business prospects are likely to remain attractive (even if, as in the case of IBM, maybe a bit unexciting). The current valuation just doesn't demand spectacular business performance to achieve satisfactory risk-adjusted returns. Instead, it simply demands merely solid business performance and continued smart financial management. Price paid and, as Buffett points out in his 2011 letter, earnings performance "for a long time to come" will ultimately influence long-term investment results.
(Though not necessarily earnings performance in any given year or even over somewhat longer time frames. This is especially relevant when a business is going through some kind of transition or when macro factors come into play.)
Unfortunately, with some public companies, share repurchases are done at unattractive valuations and for the wrong reasons (e.g. to prop up the stock or to offset dilution from stock options).
It's when a stock sells for a plain discount to conservatively estimated per share intrinsic value, and the company can comfortably afford it, that a buyback makes sense.
I don't doubt that market participants primarily in the business of betting on price action will maintain this was not such a great investment. That view may even prove correct. Those looking for quick speculative gains will likely find IBM to be a mostly uninteresting place to put their money at risk. If nothing else, IBM is the sort of investment that's almost certain to not make someone quick and substantial returns.
That's likely to continue.
While revenue growth can be a fine thing, it can't be viewed in a vacuum; not all incremental revenue is of the high return variety. Some opportunities produce growth without producing attractive returns on capital.
Excess capital should be returned to shareholders when it can't be put to good use elsewhere (i.e. when only subpar or worse investment alternatives exist). Well, in too many cases, that's just not what happens.
Of course, some might view IBM's share repurchases as just an attempt to prop up earnings. No doubt some companies do just that. I happen to think this doesn't apply to IBM when you consider how they've handled their financial management responsibilities over time.
(Buffett does highlight the quality of IBM's financial management in the 2011 letter.)
The specific context matters when it comes to share repurchases.
Among other things:
- How price paid compares to a conservative estimate of intrinsic value
- The attractiveness of investment alternatives
- The durability of the core business franchise
- Inherent capital intensiveness
- Financial health (balance sheet and free cash flow)
IBM is ultimately a technology business.
That's the bad news.
For that reason alone the company's stock will never be a favorite.
Naturally not all technology and technology-related businesses possess similar inherent risks; some new tech startup, for example, has very different specific risks associated with it compared to IBM. Up to a point it's true that the price paid can minimize the risk of permanent capital loss, but only up to a point.
Sometimes the risks of a business are so difficult to gauge that no price is low enough to provide sufficient margin of safety.
At some point the right answer is to just avoid.
For me, that's often the right answer with shares of technology businesses.***
From earlier in the 2011 letter:
"The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another."
There are certainly far better businesses out there but, once the inherent risks and opportunities are understood well enough that it gets beyond the go/no go decision, the investment process always comes down to price.
Adam
Long position in BRKb established long ago at much lower than recent prices. Recently added a small IBM position for the first time at somewhat lower than current prices.
Related posts:
Buffett on Buybacks, Book Value, and Intrinsic Value
Buffett on Teledyne's Henry Singleton
Why Buffett Wants IBM's Shares "To Languish"
Buffett on IBM: Berkshire Buys Big Blue
Buffett: When it's Advisable for a Company to Repurchase Shares
The Best Use of Corporate Cash
Technology Stocks
Buffett on Stock Buybacks - Part II
Buffett on Stock Buybacks
Buy a Stock...Hope the Price Drops?
* Share repurchases may happen going forward but will only make sense if the shares remain cheap enough. In other words, nicely below per share intrinsic value. Repurchases that are executed above approximate per share intrinsic value is generally poor use of capital. Since estimated per share value is best case an imprecise range, there should be a plain margin of safety. The discount to value should be obvious. Share count reduction needs to accomplished in am economically sound manner. This should be something an investor can count on but, unfortunately, that's not the case.
** In the letter, Buffett explains the relatively simple yet important repurchase math. Essentially, he points out that if IBM's stock price were to average something like $ 200 during a given period the company would acquire 250 million shares for its $ 50 billion. If the stock instead sold for $ 300 on average during the five-year period IBM will acquire only 167 million shares. He says that, over the five years, Berkshire's share of those earnings would be a full $ 100 million more in this "'disappointing' scenario". Also, if the stock were to fluctuate near current prices -- which are now even lower than the "'disappointing' scenario" -- it would work out even better. In the very long run the "weighing machine" will reflect roughly the additional per share value of those incremental earnings.
*** I realize some others may feel more comfortable with tech stocks but, with investments, buying only what one knows well is essential. That is necessarily unique to each investor. Gauging the future prospects of most tech businesses is tricky at best. At least it is for me.
---
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, October 4, 2013
Five Years After The Crisis...
It's been a little more than five years since the financial crisis really kicked into high gear.
With that in mind, I decided to re-read some of the things Warren Buffett and Charlie Munger were writing and saying -- well before the crisis began -- a decade or so ago. At the time both were becoming uneasy, I think it's fair to say, with the increasingly pervasive use of derivatives, combined with excessive leverage (often masked by the derivatives themselves), and the resulting rather complex -- nearly impossible to understand -- yet concentrated interconnectedness within the evolving financial system.
At the Berkshire shareholder meeting back in 2003, a bit more than five years before the financial crisis was to begin, Charlie Munger said the following:*
In engineering, people have a big margin of safety. But in the financial world, people don't give a damn about safety. They let it balloon and balloon and balloon. It's aided by false accounting. I'm more pessimistic than Warren. I'll be amazed if we don't have some kind of significant blowup in next 5-10 years.
So Charlie was clearly uncomfortable with the direction the financial world was going and, as it turned out, was all too right to be.
He was rightly concerned at the time and his relative pessimism to Warren Buffett was well-warranted.
Though Buffett was far from not concerned. He said the following at the same meeting:
Derivatives are advertised as shedding risk for the system, but they have long crossed the point of decreasing risk and now increase risk. The truth is that Coca Cola could handle risk [I think he was talking about currency exposure], but now with every company transferring risk to very few players, they are all hugely interdependent.
He also added:
When you start concentrating risk in institutions that are highly leveraged, [watch out].
We all now know how the toxic the combination of excessive leverage and, due to rampant use of increasingly complex derivatives, hugely interdependent financial institution would become. Yet, at the time, there was little more than a passing interest in their warnings.
Little to no proactive action was taken. I don't consider this particularly surprising but that's just the reality.
Buffett had already taken some time to more fully explain their views on derivatives in the 2002 Berkshire Hathaway shareholder letter. Below are some excerpts from the Derivatives section of the letter along with some comments:
Derivatives as time bombs
"Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system."
What reinsurance, derivatives, and hell have in common
"In fact, the reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit. In either industry, once you write a contract – which may require a large payment decades later – you are usually stuck with it. True, there are methods by which the risk can be laid off with others. But most strategies of that kind leave you with residual liability."
Errors of optimism
"Errors will usually be honest, reflecting only the human tendency to take an optimistic view of one's commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid (in whole or part) on 'earnings' calculated by mark-to-market accounting."
Unfortunately, as Buffett points out, many times there is no real functioning market for a particular derivatives contract. As a result "mark-to-model" is used.
He goes on to say:
"In extreme cases, mark-to-model degenerates into what I would call mark-to-myth."
Asymmetrical marking errors
"I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive 'earnings' (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham."
Buffett goes on to point out that derivatives can create a "pile-on effect" since some contracts, at what turns out to be an inopportune time, require collateral to immediately be posted for counterparties. Suddenly there is this huge unexpected need for cash that just isn't readily there.
This ultimately can lead to liquidity crisis.
"The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown."
We saw this during the financial crisis but Buffett was writing this long before what we now know had played out.
The 'linkage' problem
"In banking, the recognition of a 'linkage' problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain. When a 'chain reaction' threat exists within an industry, it pays to minimize links of any kind."
Micro vs Macro
"Many people argue that derivatives reduce systemic problems, in that participants who can't bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies.
Charlie and I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others."
One of the problems with many derivatives instruments is that they "make a joke of margin requirements." They allow leverage to build up in the system in ways that would not otherwise be possible.
"The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear."
Buffett closes by saying:
"Charlie and I believe Berkshire should be a fortress of financial strength – for the sake of our owners, creditors, policyholders and employees. We try to be alert to any sort of megacatastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."
The section on derivatives in Buffett's letter was released as an article in Fortune in March of 2003. The reason? Warren Buffett thought it important enough that it reach a wider audience.
I'd say that was a wise and well-intentioned thing to do even if those who could/should have paid attention chose to do otherwise. There was plenty of time for a course correction but those with the power to do so simply did not.
(That few considered carefully the warnings then changed their behavior is unsurprising when one considers the vast sums of money involved, the incentives and culture in place and, well, just human nature itself.)
It's still well worth reading what Warren Buffett had to say back then in its entirety. He had it just about right and Charlie Munger, if anything, even more so.
Of course, they were not exactly the only two people who were warning this all would end up very badly.
A number of others understood it well.
The reality is that severe overconfidence too often precedes -- or at least contributes to -- financial folly (LTCM comes to mind).
At times, overconfidence might merely hurt results but, at extremes, it can end up being a terribly destructive thing.
It may be only one of the many seeds of financial destruction, but sure ranks as an important one.**
Certainly more so than some might like to think.
Now, I happen to think it takes a special form of overconfidence -- and feel free to choose somewhat harsher words, where applicable, to describe this tendency -- to not consider carefully what the likes of Warren Buffett and Charlie Munger are saying.
(Especially when it comes to financial matters, though not necessarily limited to financial matters.)
I'm not at all suggesting that they're somehow never wrong.
It's just that they are so often very right.
Adam
Related posts:
Investor Overconfidence Revisited
Investor Overconfidence
Investors are Often Their Own Worst Enemies, Part II
Investors are Often Their Own Worst Enemies
Berkshire Hathaway's Derivatives Portfolio
Berkshire Hathaway: Earnings and the Derivatives Portfolio
The Illusion of Skill
The Illusion of Control
Buffett on Derivatives: The 'Chain Reaction' Threat
Munger on Derivatives
Charlie Munger on LTCM & Overconfidence
Buffett on Derivatives
When Genius Failed...Again
* From notes taken by Whitney Tilson.
** Some consider the tendency toward excessive confidence and optimism to be more pervasive and even destructive ("pervasive and potentially catastrophic" - Scott Plous, The Psychology of Judgment and Decision Making) compared to the many other cognitive biases.
Don't Blink! The Hazards of Confidence by Daniel Kahneman
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
With that in mind, I decided to re-read some of the things Warren Buffett and Charlie Munger were writing and saying -- well before the crisis began -- a decade or so ago. At the time both were becoming uneasy, I think it's fair to say, with the increasingly pervasive use of derivatives, combined with excessive leverage (often masked by the derivatives themselves), and the resulting rather complex -- nearly impossible to understand -- yet concentrated interconnectedness within the evolving financial system.
At the Berkshire shareholder meeting back in 2003, a bit more than five years before the financial crisis was to begin, Charlie Munger said the following:*
In engineering, people have a big margin of safety. But in the financial world, people don't give a damn about safety. They let it balloon and balloon and balloon. It's aided by false accounting. I'm more pessimistic than Warren. I'll be amazed if we don't have some kind of significant blowup in next 5-10 years.
So Charlie was clearly uncomfortable with the direction the financial world was going and, as it turned out, was all too right to be.
He was rightly concerned at the time and his relative pessimism to Warren Buffett was well-warranted.
Though Buffett was far from not concerned. He said the following at the same meeting:
Derivatives are advertised as shedding risk for the system, but they have long crossed the point of decreasing risk and now increase risk. The truth is that Coca Cola could handle risk [I think he was talking about currency exposure], but now with every company transferring risk to very few players, they are all hugely interdependent.
He also added:
When you start concentrating risk in institutions that are highly leveraged, [watch out].
We all now know how the toxic the combination of excessive leverage and, due to rampant use of increasingly complex derivatives, hugely interdependent financial institution would become. Yet, at the time, there was little more than a passing interest in their warnings.
Little to no proactive action was taken. I don't consider this particularly surprising but that's just the reality.
Buffett had already taken some time to more fully explain their views on derivatives in the 2002 Berkshire Hathaway shareholder letter. Below are some excerpts from the Derivatives section of the letter along with some comments:
Derivatives as time bombs
"Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system."
What reinsurance, derivatives, and hell have in common
"In fact, the reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit. In either industry, once you write a contract – which may require a large payment decades later – you are usually stuck with it. True, there are methods by which the risk can be laid off with others. But most strategies of that kind leave you with residual liability."
Errors of optimism
"Errors will usually be honest, reflecting only the human tendency to take an optimistic view of one's commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid (in whole or part) on 'earnings' calculated by mark-to-market accounting."
Unfortunately, as Buffett points out, many times there is no real functioning market for a particular derivatives contract. As a result "mark-to-model" is used.
He goes on to say:
"In extreme cases, mark-to-model degenerates into what I would call mark-to-myth."
Asymmetrical marking errors
"I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive 'earnings' (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham."
Buffett goes on to point out that derivatives can create a "pile-on effect" since some contracts, at what turns out to be an inopportune time, require collateral to immediately be posted for counterparties. Suddenly there is this huge unexpected need for cash that just isn't readily there.
This ultimately can lead to liquidity crisis.
"The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown."
We saw this during the financial crisis but Buffett was writing this long before what we now know had played out.
The 'linkage' problem
"In banking, the recognition of a 'linkage' problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain. When a 'chain reaction' threat exists within an industry, it pays to minimize links of any kind."
Micro vs Macro
"Many people argue that derivatives reduce systemic problems, in that participants who can't bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies.
Charlie and I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others."
One of the problems with many derivatives instruments is that they "make a joke of margin requirements." They allow leverage to build up in the system in ways that would not otherwise be possible.
"The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear."
Buffett closes by saying:
"Charlie and I believe Berkshire should be a fortress of financial strength – for the sake of our owners, creditors, policyholders and employees. We try to be alert to any sort of megacatastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."
The section on derivatives in Buffett's letter was released as an article in Fortune in March of 2003. The reason? Warren Buffett thought it important enough that it reach a wider audience.
I'd say that was a wise and well-intentioned thing to do even if those who could/should have paid attention chose to do otherwise. There was plenty of time for a course correction but those with the power to do so simply did not.
(That few considered carefully the warnings then changed their behavior is unsurprising when one considers the vast sums of money involved, the incentives and culture in place and, well, just human nature itself.)
It's still well worth reading what Warren Buffett had to say back then in its entirety. He had it just about right and Charlie Munger, if anything, even more so.
Of course, they were not exactly the only two people who were warning this all would end up very badly.
A number of others understood it well.
The reality is that severe overconfidence too often precedes -- or at least contributes to -- financial folly (LTCM comes to mind).
At times, overconfidence might merely hurt results but, at extremes, it can end up being a terribly destructive thing.
It may be only one of the many seeds of financial destruction, but sure ranks as an important one.**
Certainly more so than some might like to think.
Now, I happen to think it takes a special form of overconfidence -- and feel free to choose somewhat harsher words, where applicable, to describe this tendency -- to not consider carefully what the likes of Warren Buffett and Charlie Munger are saying.
(Especially when it comes to financial matters, though not necessarily limited to financial matters.)
I'm not at all suggesting that they're somehow never wrong.
It's just that they are so often very right.
Adam
Related posts:
Investor Overconfidence Revisited
Investor Overconfidence
Investors are Often Their Own Worst Enemies, Part II
Investors are Often Their Own Worst Enemies
Berkshire Hathaway's Derivatives Portfolio
Berkshire Hathaway: Earnings and the Derivatives Portfolio
The Illusion of Skill
The Illusion of Control
Buffett on Derivatives: The 'Chain Reaction' Threat
Munger on Derivatives
Charlie Munger on LTCM & Overconfidence
Buffett on Derivatives
When Genius Failed...Again
* From notes taken by Whitney Tilson.
** Some consider the tendency toward excessive confidence and optimism to be more pervasive and even destructive ("pervasive and potentially catastrophic" - Scott Plous, The Psychology of Judgment and Decision Making) compared to the many other cognitive biases.
Don't Blink! The Hazards of Confidence by Daniel Kahneman
---
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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