Munger on Efficient Markets, Indexing, & Stock Pickers

Charlie Munger said the following at the 2015 Daily Journal (DJCO) shareholder meeting:*

If all you had to do was figure out which companies were better than others, an idiot could make a lot of money. But they keep raising the prices to where the odds change.

I always knew that. They were teaching my colleagues that the stock market was so efficient that nobody could beat it....I knew it was bull. When I was young I never went near a business school so I didn't get polluted by the craziness.

[laughter]

I never believed it. I never believed there was a talking snake in the Garden of Eden. I had a gift for recognizing twaddle, and there's nothing remarkable about it. I don't have any wonderful insights that other people don't have. I just avoided idiocy slightly more consistently than others.

Other people are trying to be smart; all I'm trying to be is non-idiotic. I've found that's all you have to do to get ahead in life, be non-idiotic and live a long time. It's harder to be non-idiotic than most people think.

Later at the same meeting, he also had the following to say about indexing and stock pickers...

In the world as it is, indexing has gained a lot. It probably should have gained a lot, because it's quite rational. It's bad for a lot of people who would otherwise be earning money as stock pickers. It probably should have been bad for those people.

Money earned alongside investors isn't the problem. It's when, all too often, the money manager does well mostly from fees collected over time whether or not the average investor in a particular fund does well. Naturally, a money manager will do even better when the fund they manage performs well. So the incentives would seem aligned. Yet the range of outcomes for the investor putting money at risk, in most cases, is far different than that of a money manager. An equity investor generally has plenty of downside risk. With most fee arrangements that's just not the case for a money manager. Exceptions no doubt exist but the range of outcomes of a typical money manager -- often without the need to put their own capital at risk --  is usually good or better.

If you stop to think about it, civilized man has always had soothsayers, shamans, faith healers, and God knows what all. The stock picking industry is four or five percent super rational, disciplined people, and the rest of them are like faith healers or shamans.

And that's just the way it is, I'm afraid. It’s nice that they keep an image of being constructive, sensible people when they're really would-be faith healers. It keeps their self respect up.

Worse yet, it turns out many market participants don't even gauge their own performance objectively.

In fact, a study of investors showed that they overestimated "their returns by more than 11 percentage points per year. The average investor painfully lags an index fund and thinks he's Warren Buffett, basically."

Surprising? I certainly think so. That's why it likely deserves careful consideration:

"The thing that doesn't fit is the thing that's the most interesting, the part that doesn't go according to what you expected." - From The Pleasure of Finding Things Out by Nobel Prize winning physicist Richard Feynman

In other words, this particular bias -- like most -- may not be just someone else's problem.** So it's probably, at a minimum, not a bad idea to at least keep in mind. Simply being aware of the tendency is insufficient but it's a start. Deliberately taking steps to counteract such a bias can't hurt even if becoming completely immune may be difficult at best.

How's the portfolio objectively doing? Is all the extra complexity and effort actually yielding a clear benefit in terms of risk and reward? Am I ignoring certain things in order to feel better about all the effort that went into subpar results?

Choosing to avoid these kind of questions might prove costly in the long run.

Historically, the likelihood of doing well compared to index funds over the long run just hasn't been all that great. Some might think that's somehow going to change going forward but, at the very least, some skepticism seems warranted. The fact is too many who choose to pick individual stocks end up being overly optimistic about their abilities/prospects and, as a result, spend a lot of energy and time to little avail or worse.

Lots of unnecessary extra work.

Zero or even negative incremental reward.

The compounded long-term impact of frictional costs will always be a significant factor.

Reduce them wherever possible.

Adam

No position in DJCO

* From some excellent notes taken at the meeting earlier this year. Not a transcript.
** This has been covered, at least to some extent, in some earlier posts.
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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.

Competition & Moats - Part II

In a post a few months back I included the following Warren Buffett quote:

"We like to own castles with large moats filled with sharks and crocodiles that can fend off marauders -- the millions of people with capital that want to take our capital. We think in terms of moats that are impossible to cross, and tell our managers to widen their moat every year, even if profits do not increase every year."

Competition & Moats

Over the longer haul equity investing* mostly comes down to whether a business possesses durable advantages, has attractive economics, and can be bought -- outright or on a per-share basis -- at the right price.

Buffett once wrote:

"Severe change and exceptional returns usually don't mix. Most investors, of course, behave as if just the opposite were true. That is, they usually confer the highest price-earnings ratios on exotic-sounding businesses that hold out the promise of feverish change."

In fact, in enough cases to matter, businesses in rapidly changing/expanding industries -- usually with lots of growth potential -- cause investors to focus on the upside and, as a result, they tend pay a high multiple of earnings that, all risks considered, more than reflects the potential with too little consideration for lesser possibilities.

Never mind the worst possible outcomes.

The most dynamic industries might promise lots of growth but can also attract lots of competition, fresh capital, and have rules that are yet to be written. A new technology can naturally prove to be a great benefit for the world. Yet that's hardly a guarantee the capitalists involved will end up being justly rewarded. Look no further than the auto manufacturers and airlines for just two good examples. What's been better for the world those two industries or tobacco? What's generally been the better long-term investment?**

Some industries end up with multiple participants who build sustainable advantages. Others tend to have one big winner and lots of losers. For one it's a feast...for the rest it's famine. Worst of all some industries never seem to develop sound economics even for the so-called winners. With such unpredictability, identifying a sound investment beforehand -- with all risks and alternatives carefully considered -- without paying too much or making big misjudgments is easier said than done. This might makes things exciting but also inherently unpredictable with wide range of outcomes. Not exactly compatible with balancing risk and reward. In other words, lots of upside to be sure but also lots of downside.

Those who don't appropriately weigh the full range of outcomes tend to overpay for the privilege of ownership.

Insufficient margin of safety.

This is, at the very least, worthy of some consideration the next time an investment with exciting growth prospects comes along. Investing well is partly dependent on avoiding the big and costly errors.

It's worth emphasizing -- and I've covered variations of this in a number of prior posts -- growth is not the emphasis here. Growth can naturally be a fine thing under the right circumstances. Yet some seem will to assume that all growth is good growth. Well, at times, the importance of growth can be more than just a bit overrated.

There are certainly high growth businesses that end up building durable advantages over time.

Many examples of this exist from the past twenty years alone and, no doubt, there will be many more in the coming decades.

The tough part is figuring out how to reliably identify them beforehand and acquiring shares at an attractive enough price. That'd be attractive enough to own long-term and protect against misjudgments, the unknown, and the unknowable. In other words, that shares can be bought below what they're currently worth and produce a more than satisfactory long-term result. Also, if the shares do need to be sold a long time down the road (a "forever" holding period might be preferred but isn't always possible or even wise), a merely decent price compared to future -- much higher -- per share intrinsic value should be all that is required. Market participants who knowingly buy an expensive stock with the hope being to sell as it gets even more expensive have an entirely different emphasis. Market prices are not in a participants control. So it's unwise to be dependent on unusually high prices to achieve expected results. Buffett once said:

"Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results."

Now, it's not as if investing in something with exciting prospects can't work out extremely well.

For some investors -- due to their specific background and abilities -- investing in such things will be the appropriate place to risk their capital. It's just important to know when investing in such things doesn't really play to one's own strengths.

Those who build the next transformational business naturally deserve lots of respect. That doesn't necessarily mean it makes sense to invest in their efforts. Admiration from a distance can be, depending on circumstances and abilities, the right way to go.

An investment decision-making process must have enough discipline built in to prevent large and permanent losses of capital.

It's knowing what one knows as much as what one does not.

Some will choose to focus on identifying the next big winner.

Efforts to reduce costly errors often deserve more attention.

Once again...easier said than done.

Sometimes, rapidly changing competitive dynamics will result in serious damage to a business that once seemed like an invincible powerhouse with a fortress built around them.

Other times, even if not completely unaffected by the changing technological and competitive landscape, the business will adapt and continue to do just fine.

Figuring this out, at least for me, is what makes investing so challenging and worthwhile in the first place.

Some other things worth considering:

One or two big misjudgments can more than offset what's otherwise worked out well.

The relationship between risk and reward isn't as straightforward as some seem to think. Higher risk investments don't represent some kind of direct path to higher returns. Instead, they're more likely to be related to a wider range of outcomes.

A recipe for both large and unnecessary mistakes as well as possible big gains.

Risk and reward is not necessarily correlated in a positive manner.

Finding a business with rapid growth prospects -- along with core economics likely to remain sound for a very long time -- that can be bought at the right price (a plain discount to estimated value) isn't impossible but it's easy to underestimate what the worst possible outcomes could be.

Anyone can, after the fact, explain why something worked as an investment.

Only after the fact is it usually "obvious".

Cognitive and other biases -- in the context of investing -- are not necessarily just someone else's problem.

Adam

* The emphasis here NOT being on speculation. Instead, it's what an asset can produce over a very long time horizon. It's on whether something can be bought now and produce a satisfactory result primarily based on how intrinsic value changes over time. Those who try to guess what stock prices might do -- whether using fundamental analysis or not -- over the next few years or less are attempting to do something I have no view on whatsoever. There's nothing inherently wrong with speculation but it just doesn't have all that much in common with investment.
** This historical reality reveals little about the future: Different times, different competitive dynamics, different market prices....among other things. The point being that expecting what's good for the world to be directly correlated with future investment returns can be a big mistake.
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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.

Berkshire Hathaway 3rd Quarter 2015 13F-HR

The Berkshire Hathaway (BRKa) 3rd Quarter 13F-HR was released yesterday. Below is a summary of the changes that were made to the Berkshire equity portfolio during that quarter.
(For a convenient comparison, here's a post from last quarter that summarizes Berkshire's 2nd Quarter 13F-HR.)

There was plenty of buying and selling during the quarter. Here's a quick summary of the changes:*

Added to Existing Positions
IBM (IBM): 1.47 million shares (1% incr.); tot. stake $ 11.7 bil.
Phillips 66 (PSX): 31.8 mil. shares (107%); tot. stake $ 4.72 bil.
Charter (CHTR): 1.77 mil. shares (20%); tot. stake $ 1.81 bil.
General Motors (GM): 9.0 mil. shares (21%); tot. stake $ 1.50 bil.

I've included above only those positions worth at least $ 1 billion at the end of the 3rd quarter. In a portfolio this size -- more than $ 246 billion (equities, fixed income, cash, and other investments) as of the latest available filing with roughly half made up of common stocks** -- a position that's less than $ 1 billion doesn't really move the needle much.

Shares that were bought among positions worth less than $ 1 billion include Suncor (SU), Liberty Media (LMCK and LMCA), Axalta (AXTA), Liberty Global (LBTYA), and Twenty-First Century Fox (FOXA).

New Positions
Kraft Heinz (KHC): 326 mil. shares; total stake $ 23.0 bil.
AT&T (T): 59.3 mil. shares; total stake $ 1.93 bil.

A deal to combine Kraft and Heinz was announced earlier this year and closed on July 2nd, 2015. So, as a result, Berkshire now owns nearly 27% of the common stock in the combined Kraft Heinz Company. The stake is being accounted for using the equity method. See Note 7 in Berkshire's latest 10-Q for additional details. The investment now represents one of Berkshire's largest positions.

The new AT&T shares are a result of the deal to acquire DirecTV (DTV).

Berkshire also has very small new positions in Liberty LiLAC (LILA and LILAK) as a result of a distribution from Liberty Global (LBTYA and LBTYK).

It turns out that some Phillips 66 shares were actually purchased during the 2nd quarter but not disclosed until later.

Berkshire's 2nd Quarter 13F-HR filing had indicated some activity was being kept confidential. That filing said: "Confidential information has been omitted from the public Form 13F report and filed separately with the U.S. Securities and Exchange Commission."

We now know it was the Phillips 66 position that was omitted.
(Last quarter's 13F-HR made it appear as if Berkshire had sold its stake in Phillips 66. In fact, they were quietly adding to the position with SEC approval.)

This separate 13F-HR/A filing reveals the specific number of shares of Phillips 66 that were bought during that time.

Berkshire's latest 13F-HR filing did not indicate any activity was kept confidential.

Occasionally, the SEC allows Berkshire to keep certain moves in the portfolio confidential. The permission is granted by the SEC when a case can be made that the disclosure may cause buyers to drive up the price before Berkshire makes its additional purchases.

Reduced Positions
Wal-Mart (WMT): 4.20 million shares (6% decr.); tot. stake $ 3.64 bil.
Goldman Sachs (GS): 1.67 million shares (13%); tot. stake $ 1.90 bil.
Deere & Co. (DE): 258 thousand shares (1%); tot. stake $ 1.26 bil.

Warren Buffett told CNBC he sold the shares of Wal-Mart and Goldman Sachs to help fund the acquisition of Precision Castparts (PCP) deal, not because his of the two companies has become negative.

Shares that were sold among positions worth less than $ 1 billion include Bank of New York Mellon (BK), WABCO (WBC), Chicago Bridge & Iron (CBI), and Media General (MEG).

Sold Positions
Positions that show as sold outright include Viacom (VIAB), DirecTV (DTV), and Kraft (KRFT). DirecTV is, once again, the result of the deal with AT&T while the Kraft share are related to the deal to combine Kraft and Heinz.

Todd Combs and Ted Weschler are responsible for an increasingly large number of the moves in the Berkshire equity portfolio. These days, any changes involving smaller positions will generally be the work of the two portfolio managers.
(Though some of the holdings they're responsible for have become more substantial over time.)

Top Five Holdings
After the changes, Berkshire Hathaway's portfolio of equity securities remains mostly made up of financial, consumer and, to a lesser extent, technology stocks (mostly IBM).

1. Wells Fargo (WFC) = $ 24.1 bil.
2. Kraft Heinz (KHC) = $ 23.0 bil.
3. Coca-Cola (KO) = $ 16.0 bil.
4. IBM (IBM) = $ 11.7 bil.
5. American Express (AXP) = $ 11.2 bil.

As is almost always the case it's a very concentrated portfolio. The top five often represent 60-70 percent and, at times, even more of the equity portfolio. The large stake in Kraft Heinz has, in fact, simply made the portfolio even more concentrated. In addition, Berkshire owns equity securities listed on exchanges outside the U.S., plus fixed maturity securities, cash and cash equivalents, and other investments.

The portfolio excludes all the operating businesses that Berkshire owns outright with ~ 340,000 employees (25 being at headquarters) according to the latest letter.

Here are some examples of Berkshire's non-insurance businesses:

MidAmerican Energy, Burlington Northern Santa Fe, McLane Company, The Marmon Group, Shaw Industries, Benjamin Moore, Johns Manville, Acme Building, MiTek, Fruit of the Loom, Russell Athletic Apparel, NetJets, Nebraska Furniture Mart, See's Candies, Dairy Queen, The Pampered Chef, Business Wire, Iscar, Lubrizol, and Oriental Trading Company.
(Among others.)

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

See page 125 of the 2014 annual report for a full list of Berkshire's businesses.

Adam

Long positions in BRKb, WFC, KO, AXP, and PSX established at much lower than recent market prices. Also, long positions in WMT established at slightly lower than recent market prices and IBM established at higher than recent prices. (In each case compared to average cost basis.)

* All values shown are based upon the last trading day of the 3rd quarter.
** Berkshire Hathaway's holdings of ADRs are included in the 13F. What is not included are shares listed on exchanges outside the United States. The status of those shares, if a large enough position, are updated in the annual letter. So the only way any of the stocks listed on exchanges outside the U.S. will show up in the 13F is if Berkshire buys the ADR. Investments in things like preferred shares (and valuable warrants, where applicable, as explained in the recent letters) are also not included in the 13F.
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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.

Corporate Hocus-Pocus

Warren Buffett, earlier this year in his 2014 Berkshire Hathaway (BRKa) special letter*, offered the following perspective on conglomerates:

"Berkshire is now a sprawling conglomerate, constantly trying to sprawl further.

Conglomerates, it should be acknowledged, have a terrible reputation with investors. And they richly deserve it. Let me first explain why they are in the doghouse, and then I will go on to describe why the conglomerate form brings huge and enduring advantages to Berkshire.

Since I entered the business world, conglomerates have enjoyed several periods of extreme popularity, the silliest of which occurred in the late 1960s. The drill for conglomerate CEOs then was simple: By personality, promotion or dubious accounting – and often by all three – these managers drove a fledgling conglomerate's stock to, say, 20 times earnings and then issued shares as fast as possible to acquire another business selling at ten-or-so times earnings. They immediately applied 'pooling' accounting to the acquisition, which – with not a dime's worth of change in the underlying businesses – automatically increased per-share earnings, and used the rise as proof of managerial genius. They next explained to investors that this sort of talent justified the maintenance, or even the enhancement, of the acquirer's p/e multiple. And, finally, they promised to endlessly repeat this procedure and thereby create ever-increasing per-share earnings.

Wall Street's love affair with this hocus-pocus intensified as the 1960s rolled by. The Street's denizens are always ready to suspend disbelief when dubious maneuvers are used to manufacture rising per-share earnings, particularly if these acrobatics produce mergers that generate huge fees for investment bankers. Auditors willingly sprinkled their holy water on the conglomerates' accounting and sometimes even made suggestions as to how to further juice the numbers."

Why does this sort behavior happen in the first place? According to Buffett it's because, at least for some, "gushers of easy money washed away ethical sensitivities."

Buffett on Bold & Imaginative Accounting

Keep in mind that these earnings gains on a per share basis arose from "exploiting p/e differences" instead of any real value creation. Well, it's the quality of earnings increases over a long time horizon that should be the focus of investors.
(Speculators will no doubt look at this somewhat -- or, in fact, a whole lot -- differently.)

Efforts to inflate per-share earnings will be seen for what they are in the long run and valued accordingly. Those who get caught up in such things are exposed to more risk of permanent loss than they might otherwise realize.

The way that some choose to mostly ignore stock compensation expense seems a relevant example.

Learning how to separate the real thing from the questionable is an essential part of the investment process.

"The resulting firestorm of merger activity was fanned by an adoring press. Companies such as ITT, Litton Industries, Gulf & Western, and LTV were lionized, and their CEOs became celebrities. (These once-famous conglomerates are now long gone. As Yogi Berra said, 'Every Napoleon meets his Watergate.')"

Charlie Munger, earlier this year and even more recently, has compared one particular public company to ITT.

Here's how this Fortune article described ITT:

"Over a period of nine years, Harold Geneen used his company [ITT]...to make more than 350 acquisitions in over 80 countries around the world. Sales exploded from $765 million in 1961 to over $17 billion in 1970, before the wheels started to come off. The empire was eventually revealed to be little more than a giant accounting trick that covered up the losses from one acquisition with the paper profits of the next one."

Munger describes it the following way:

"It wasn't moral the first time. And the second time, it's not better. And people are enthusiastic about it. I'm holding my nose."

Accounting rules will naturally change** over time, but this won't end attempts to be less than conservative (or worse) with how the numbers are presented and even, somewhat strangely, how they're interpreted by those who ought to know better.

"It is difficult to get a man to understand something, when his salary depends upon his not understanding it!" - Upton Sinclair

Some of this behavior might also be explained, at least in part, by "career risk" and "the institutional imperative".

So why does the conglomerate structure work for Berkshire but not necessarily for others?

I'll cover that in a separate post and, at some point after that, look more closely at one of the conglomerates mentioned above.

Adam

Long position in BRKb established at much lower than recent market prices

Related posts:
Berkshire's Structure: Why It Works (follow-up)
Grantham & Buffett: "Career Risk" & "The Institutional Imperative"
Buffett on "The Institutional Imperative"
Buffett: A Portrait of Business Discipline
Buffett on Bold & Imaginative Accounting

* This is Buffett's special letter that was written for the 50th Anniversary of Berkshire. Munger also wrote a separate letter to recognize this Golden Anniversary. These can also be found at the end of the regular letter (page 24 and 39 respectively).
** The fact that 'pooling' is no longer allowed is but one example. 
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Buffett on Food Company Valuations

Earlier this year, Berkshire Hathaway (BRKa) and 3G Capital put togehter a large deal for what is now Kraft Heinz (KHC). Warren Buffett, after making some specific comments back in August about Kraft Heinz on CNBC, offered a more generalized view of larger food company market valuations.

He said that "most of the food companies sell at prices that it would be very hard for us to make a deal..."

This at least suggests future stock returns might be a whole lot less attractive if the existing price environment persists. In fact, those who likes one or more of these businesses as an investment for the longer haul (i.e. not as a speculative trade) should prefer that their shares underperform in the coming years.*

So, even if these businesses do perform reasonably well, equity return expectations should be tempered due to the fact that market prices aren't, in general, selling at a discount to per share intrinsic value.
(In fact, some to me now appear to be selling at a premium to value.)

The equity valuation environment was entirely a different one several years ago. Some of the consumer packaged goods makers remain terrific businesses in my view but, no matter how high quality something is, price matters.

Even the very best of these types of businesses certainly have not risen, on a per share basis, intrinsically in value as much as their stock prices have risen in recent years.
(Though some were selling at a nice discount to value back then so some of the gains since that time can be partly explained by having closed -- or more than closed -- that gap.)

It's when fear begins to dominate the psychology of markets that usually spells opportunity. Even very good businesses are far from immune to negative market price action.

That is -- or, at least, should be viewed as -- the good news.

"Long ago, Ben Graham taught me that 'Price is what you pay; value is what you get.' Whether we're talking about socks or stocks, I like buying quality merchandise when it is marked down." - Warren Buffett in his 1992 Berkshire Hathaway Shareholder Letter

Attractive prices rarely come along when the outlook is rosy. Most of the time -- short of a broad-based market decline -- there will be real and/or perceived legitimate questions about future prospects.**

A temporary, or even extended, drop in price can prove beneficial for investors.

A permanent drop in value is not.

High quality businesses tend to have durable advantages that allow intrinsic values to be persistent even in challenging economic environments while generally increasing -- even if unevenly -- over the longer haul.

Attempting to judge how intrinsic values might change and whether the price paid offers sufficient margin of safety ought to take priority over attempting to guess where prices are going near-term (or even intermediate-term).

Will these businesses still be able to deliver the kind of results they've been producing for a very long time?

A more challenging future doesn't necessarily mean the best of these have become -- or will become -- subpar businesses, but questions like this (and many others) still need to be carefully considered.

The world they're competing in is, as it likely always will be, changing in ways that might alter what have in the past been attractive core business economics.

Adam

Long position in BRKb established at much lower than recent market prices. No position in KHC. 

* To not only allow for the purchase/accumulation of more shares, but also so buybacks and dividend reinvestments are more effective. Some might wonder why Buffett wouldn't just sell now that market prices more fully reflect value. Well, he's made it clear they're in it for the long haul -- they're in it for what the business will be able to produce over a very long time horizon. So, in other words, he's likely satisfied with the price he paid against current value and the value that will be created over time. That doesn't mean current market prices make much sense.
** Few businesses, if any, are immune to difficulties from time to time. Part of investing well is learning how to differentiate the temporary but fixable setbacks from those that are more fundamental and value destroying in a permanent way.
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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.

Activists & the AmEx Buyback, Part II

A follow up to this post. Last month news broke that an activist hedge fund, ValueAct Capital Management, had taken a stake in American Express (AXP).

Well, not long after the ValueAct stake was announced, Warren Buffett had the following to say about buybacks and AmEx in an interview on CNBC:*

"People assume when we buy some stock we want it to go up. We don't want it to go up. Maybe, obviously, eventually... five or ten years from now [we'd like it]."

He added "we love the idea" of a business with an already cheap stock "buying its stock cheaper. I mean that's happened at American Express", and since they're "a regular repurchaser of shares", Berkshire Hathaway's (BRKa) stake increases more quickly "if the stock is down than if the stock is up."

Buffett was then asked whether he likes to see an activist like ValueAct come into the picture with AmEx.

Buffett's response was "No not particularly but...it is up to them what they do with their money. Actually it [sent the stock up] four or five points so the extent that American Express is repurchasing shares" it actually hurts AmEx long-term shareholders. He also said that "the cheaper the stock is the more shares American Express will be able to repurchase for a given amount of money and on balance...that helps us."

Each dollar used to buyback shares will have a smaller impact on share count. Plainly not a good thing for the long-term owner.

Fortunately the stock has come back down somewhat since Buffett said the above -- in part due to some of the market turmoil -- but, then again, maybe it would be down even more if there was no activist involvement.

The problem here is not at all specific to ValueAct. As I wrote in the prior post:

Naturally, this doesn't mean ValueAct won't ultimately end up having a positive effect [on AmEx].

They just may.

It's just that whatever effect on the business they end up having, it will potentially have to offset the negative impact -- at least from the standpoint of a long-term investor in AmEx -- of the higher prices making the buyback activity less effective (if the higher stock price proves persistent and is directly related to the hope an activist will eventually have a favorable influence).

Now, whether or not AmEx must adapt more effectively to a changing competitive and technological landscape is an important and fair debate. If an investor comes along -- one who's in it for the long haul -- can contribute to such a debate that certainly wouldn't be the worst thing that could happen.

More from last week's interview with Buffett:

"...People make buybacks very complicated. [A buyback] makes sense when you are buying your stock back below its intrinsic value and when you don't need that money for the needs of the business. And it makes no sense when you pay above intrinsic value and that's a very simple principle but it has been ignored by many managements over time."

I know it might seem odd to think of a stock rallying as bad news but, if a good business with some extra cash is buying back shares that sell nicely below per share intrinsic value, that's simply how the math works -- especially in the long run. Depending on for how long, and by how much, the stock remains below intrinsic the effect on future per share intrinsic value can be anywhere from negligible to quite substantial.

The reality is it makes little sense, no matter how counterintuitive, to hope shares of a good business rally in the near-term when the plan is to be an owner for decades. Of course, this won't work if the enterprise proves fundamentally flawed in some way. Otherwise, for those in a position to consistently buyback shares over time any near-term (or even intermediate-term) rally will only reduce returns. In other words, a stock that sells persistently below what it's intrinsically worth can increase investor returns, all else equal, at less risk.**

Naturally, for those who plan to sell next week it's a very different story.

During the interview Buffett points out that he can't buy more shares of AmEx. 

The reason? 

AmEx is a bank holding company and Berkshire already owns as much as is allowed.

Adam

Long position in AXP and BRKb established at much lower than recent prices

Related posts:
Activists & the AmEx Buyback, Part I
Altria: Price Matters
Multiple Expansion, Buybacks, & The P/E Illusion
The P/E Illusion
The Benefits of a Declining Stock
Buffett's Purchase of IBM Revisited
Buffett on Buybacks, Book Value, and Intrinsic Value
Buffett on Teledyne's Henry Singleton
Why Buffett Wants IBM's Shares "To Languish"
Buffett: When it's Advisable for a Company to Repurchase Shares
The Best Use of Corporate Cash
Buffett on Stock Buybacks - Part II
Buffett on Stock Buybacks
Buy a Stock...Hope the Price Drops?

* These quotes, in some cases, differ very slightly from CNBC's unofficial transcript.
** This can, depending on the circumstances, also work for dividend reinvestments.

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.

Behavioral Biases: How They Influence Investment Decisions

When a stock performs well -- and as just one example Amazon's (AMZN) stock, to say the least, certainly has over the long haul -- it's easy to become convinced, at times incorrectly, what ended up happening was obvious all along.

That's hindsight bias -- the belief, after the fact, that something was more predictable than it actually was -- and is just one among the many biases that impact investor behavior and results (and generally not in a good way).

Now, here's just some examples of those who, more or less, previously expressed a favorable view of Amazon as an investment.*

- Amazon 'Undervalued': Portfolio Manager

- Analysts Bullish on Amazon

- Ken Fisher Still Bullish on Amazon

And some from those with a less favorable point of view...

- Not Even Jeff Bezos Would Buy Amazon's Cash Flow

- Three Reasons Why Amazon's Cash Flow Is No Comfort

- Don't Be Fooled by Amazon's Cash Flow

There are, of course, many more examples of thoughtful but opposing views to be found. The same stock but very different views. For those with an open mind this can and should be a good thing. Unfortunately, it's easy to make the mistake of only seeking information that's consistent with one's own thinking.

Of course, investment decisions should never be based upon what someone else thinks. Ultimately, each investor needs to come to his/her own conclusions. Yet it's important to avoid making the mistake of only giving consideration to information that reinforces a particular view -- however flawed or biased it might be -- while mostly ignoring contrary facts and logic.

Keep in mind I'm simply using Amazon as an example. The same thing, in general, can be applied to other stocks though naturally the specific circumstances will always be unique.

Personally, I respect and admire Amazon and Jeff Bezos** but have never considered owning the stock for a simple reason:

I just don't know how to value it within a narrow enough range.

That doesn't necessarily mean I'll be surprised if the company proves to be very valuable over the long run.

In fact I won't be at all.

It simply means I don't understand it well enough especially when compared to alternatives; it means my estimate (within a range) of likely future returns can't be compared in a meaningful way to those things I think I do understand better; it means that if I can't value something with enough warranted confidence, it's by definition impossible to determine what price represents a sufficient margin of safety.

So, as a result, it has never made any sense for me to consider owning Amazon's stock. Behaving otherwise would likely be, at least in my case, a recipe for subpar results or worse in the long run.

Now, lets assume for some reason I had long ago decided to buy Amazon (again, I've always had -- and continue to have -- zero interest in doing so) and it happened to work out well for me. This result would have been mostly, if not entirely, due to pure luck. In other words, not being able recognize when good fortune more so than being right was the reason for the good result will likely lead to future costly mistakes and reduced results.
(Even though, due to luck, the results were favorably impacted by the Amazon investment my view is that the lack of discipline, ultimately, is likely to hurt results.)

It's about knowing and staying within limits.

Those who buy any stock without carefully considering the reasons why things may not go as well as hoped are potentially setting themselves up for permanent capital loss.

Beware of confirmation bias.

Beware of investor overconfidence.

These can prove expensive in the long run.

If not carefully managed these and other biases can lead to big and unnecessary mistakes.

The important thing to remember is that biases are -- in the context of investing -- not just someone else's problem.

For most of us -- if not all of us -- bias blind spot is a real factor.

It's easy to point to what worked well with the benefit of hindsight. For every Amazon -- at least in the real world -- there will be many that seem to have great potential but don't work out nearly so well.

That simply won't be obvious before the fact.

It will only become obvious when looking through the rear-view mirror.

Knowing what to avoid starts with buying only what you understand.

That means, inevitably, sometimes it's necessary to "miss" what after the fact proves to be an excellent opportunity.

Some investors no doubt were able to see Amazon's potential long ago and were rewarded for it.

Still, it's important to try and be objective about the reason something worked out well.

Easier said than done.

Sometimes, an investment might work out well due to brilliant insight and foresight.

Other times, good fortune might have played a significant role.

Knowing the difference can eliminate errors down the road.

Maybe some think Amazon's prospects and intrinsic business value have always been, and remain, plain to see; or maybe that's, at least in part, simply hindsight bias at work.

Adam

No position in AMZN

* Naturally, views such as these are not necessarily static, may have changed, or at some point may change.
** Some concerns and criticisms have also been previously highlighted.

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.

Bogle on Speculation

John "Jack" Bogle recently said the following on CNBC about volatility in the capital markets:

"It's just speculators not speculating on what they think is going to happen but what they think other speculators think is going to happen..."

So it's too much focus on trying to guess how other market participants might behave, along with other near-term events (fed action or inaction, earnings reports, GDP growth), instead of gauging the intrinsic values of businesses.

"This speculative binge that we're seeing here … has nothing to do with the fundamentals behind the long-term value of equities in particular, which are created by the values of corporations, earnings and dividends, and reinvestment in the business."

Estimating intrinsic business values is challenging enough; guessing what the market -- or any individual security -- is going to do is if not impossible, for most of us at least, a fool's game.

The idea that since a little speculation in markets is a good thing then unlimited amounts must become a wonderful thing is a fallacy. The petrol engine in my car likes roughly the right amount of air relative to fuel in order for the combustion process to work. So that means, at some point, too much -- or too little -- air compared to fuel will actually hinder performance.

It's about optimization. The same is true for capital markets. I'd argue there's way too much activity geared toward what's going to happen in the next minute, hour, day, week, month -- and even a year or two. Too much air; not enough fuel.

All of those time frames are way too short to be considered investment activity. It's speculation and even pure gambling (there's a difference between the two) over investment.

There are important reasons for the capital markets to exist and the focus should be mostly on what's the optimal way to makes sure it serves the real economy instead of itself.

Adam

Related posts:
Zero-Sum Games
On Speculation and Investment
Bogle on the Financial System
Graham on Investment: "Most Intelligent When It Is Most Businesslike"
John Bogle on Speculation & Capitalism's "Pathological Mutation"
Bogle: Back to the Basics - Speculation Dwarfing Investment
Buffett on Gambling and Speculation
Buffett on Speculation and Investment - Part II
Buffett on Speculation and Investment - Part I

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 Value vs Growth

Warren Buffett, in an interview on CNBC back in March of this year, said the following:

"I always say if you aren't investing for value, what are you investing for? And the idea that value and growth are two different things makes no sense. I mean, growth is part of the value equation and a company that grows and uses little capital in doing it...is obviously worth more money than one that doesn't grow. That doesn't make the one that doesn't grow valueless though." - Warren Buffett on CNBC

Growth can be a good thing if the price is right (i.e. price paid comfortably less than est. per share intrinsic value). Unfortunately, exciting growth prospects sometimes attracts more than its fair share of attention leading to market prices more than reflecting intrinsic value.

Too little margin of safety if future business performance disappoints.

In fact, growth isn't necessarily even always a good thing:

"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

Some seem to treat all growth as good growth. Well, that's just not the case.

"...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 Letter

What matters is buying a good business -- whether it happens to have growth prospects or not -- at a discount and warranted confidence that the core business economics are attractive and will remain so.

Some businesses produce high returns on existing capital but can't do the same on incremental capital. These can still prove to be sound investments (again, at the right price) but growth prospects -- at least the kind of growth that produces satisfactory or better returns -- will usually be modest. The fact is putting incremental capital to work in such a business can actually end up hurting investors. So excess capital needs to be intelligently allocated elsewhere* (outside the business) or, otherwise, returned to shareholders.

One problem that sometimes arises with higher growth businesses is simply that investors pay too much for the privilege of ownership. In other words, due to the excitement about the upside potential, what could go wrong doesn't get fair consideration. The end result being investors pay a price that doesn't protect them sufficiently if things don't go quite as well as hoped.

A price biased toward things going well can increase the risk of permanent capital loss. In fact, an optimistic price might lead to insufficient rewards even if things do go well.

More risk.

Less reward.

Adam

Long position in BRKb established at much lower than recent prices

Related posts:
High Returns on Capital vs High Returns on Incremental Capital - Jan 2015
Altria: Timing Isn't Everything, Part II - Jul 2014
Aesop's Investment Axiom Revisited - Jul 2014
Altria: Timing Isn't Everything - Jul 2014
Asset Growth and Stock Returns, Part II - Mar 2014
Asset Growth and Stock Returns - Feb 2014
Buffett and Munger on See's Candies, Part II - Jun 2013
Buffett and Munger on See's Candies - Jun 2013
Aesop's Investment Axiom - Feb 2013
Grantham: Investing in a Low-Growth World - Feb 2013
Buffett: Stocks, Bonds, and Coupons - Jan 2013
Maximizing Per-Share Value - Oct 2012
Death of Equities Greatly Exaggerated - Aug 2012
Stock Returns & GDP Growth - Jul 2012
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
Technology Stocks - May 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

* Berkshire has the luxury of being able to move excess capital from where it can't produce high returns to where it can.
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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.

Competition & Moats

At the 2014 Daily Journal (DJCO) shareholder meeting Charlie Munger said:*

How many big companies stay totally on top forever? Maybe Wrigley's Gum.

Then later added...

It's a competitive world out there. Somebody is always starting something. Even for the branded goods makers, who looked so invincible for forty years. The natural course of competition is that it gets tough. It's the people who expect everything to just keep going wonderfully who are nuts.

So at least some of these businesses are not quite as bulletproof as they used to be. Part of the challenge, at least in certain cases, is coming from private-label alternatives.

Munger, back in 2013 (see pages 26-27), specifically mentioned Costco's (COST) private-label offering, Kirkland toothpaste, as an example of one threat.

Costco got one of the major toothpaste manufacturers of the world to make their toothpaste in Costco's tube at a very low price.

He also mentions the threat of Amazon (AMZN).

It's also possible for a new entrant to reach customers in an economically viable way that didn't really exist a couple decades ago. So enough scale to reach a big audience becomes less of an advantage.

What makes the situation even more challenging these days for investors is market valuation levels (even after the recent capital markets turmoil). Many of the consumer packaged goods businesses have gone from having reasonable equity valuations several years ago to fully valued and, in some cases, even expensive.**

That also doesn't mean they've, in general, suddenly become terrible businesses. Hardly. Some continue to have some very wide and likely rather sustainable moats. The very best of the small ticket branded goods makers appear to still have very sound businesses even if somewhat less so than the past several decades. Yet, like anything else, the price paid matters and right now few, if any, seem to be selling at a meaningful discount to per share intrinsic value.

I think Charlie Munger's point, more generally, is an essential one for just about any investor. No matter how good a business has been in the past, it's necessary to carefully consider how competition, technology, regulations, and customer behavior (among other things) could end up altering the core economics of a business over time.

The competitive position of any business -- and how it might be changing -- is an all-important consideration for equity investors. Most of what matters won't necessarily -- well, at least not early enough to be useful -- show up in the numbers. So financial statements and complex spreadsheets likely won't offer much insight. Sometimes, what matters most can't be measured in a meaningful way. It ends up being more about the qualitative factors.

In other words, an investor mostly won't be able effectively anticipate changes by simply looking at what can be quantified precisely.

What was once a wide moat can become much reduced, or even disappear altogether, over time. Sometimes it happens quickly; other times it's more of a slow degradation. The key is finding those businesses with very substantial and sustainable moats run by managers focused on making those moats more formidable.

Warren Buffett once said:

"We like to own castles with large moats filled with sharks and crocodiles that can fend off marauders -- the millions of people with capital that want to take our capital. We think in terms of moats that are impossible to cross, and tell our managers to widen their moat every year, even if profits do not increase every year."

Notice that moat widening is given priority over near-term profits.

It's NOT necessarily about growth unless that growth happens to be the high return variety over the longer run.***

It's buying, at the right price, shares of businesses with high returns on capital that will likely prove sustainable.

It's NOT just about returns.

It's finding sensible ways to reduce the risk of permanent capital loss.

Adam

No position in DJCO, COST, or AMZN

* From some excellent notes that were taken at the meeting. These notes, presented in four parts, are well worth reading. Not a transcript.
** Warren Buffett recently talked about valuation levels, speaking specifically about the larger food companies, while on CNBC. He clearly doesn't see them as inexpensive these days. Of course, the fact that they may be not at all cheap reveals little or nothing about what the near or intermediate term price action might be.
*** Not all growth is good growth for investors. Growth is but one component of value that -- while sometimes a positive -- is not necessarily a positive, though some seem to assume that's the case. There are slow growth businesses that produce attractive investment results and fast growth businesses that do not. Some of this comes down to the price paid upfront but that's only part of the story.
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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.