From the Berkshire Hathaway (BRKa) letter released earlier this year:
"...repurchases should be price-sensitive: Blindly buying an overpriced stock is value destructive, a fact lost on many promotional or ever-optimistic CEOs.
When a company says that it contemplates repurchases, it's vital that all shareholder-partners be given the
information they need to make an intelligent estimate of value. Providing that information is what Charlie and I try to
do in this report. We do not want a partner to sell shares back to the company because he or she has been misled or
inadequately informed.
Some sellers, however, may disagree with our calculation of value and others may have found investments
that they consider more attractive than Berkshire shares. Some of that second group will be right: There are
unquestionably many stocks that will deliver far greater gains than ours.
In addition, certain shareholders will simply decide it's time for them or their families to become net
consumers rather than continuing to build capital. Charlie and I have no current interest in joining that group. Perhaps
we will become big spenders in our old age."
Warren Buffett also said the following in an interview on CNBC back in May:
"...repurchases by the company are just like purchases to us, they're dumb a one price and smart at another price. And I like it when companies -- I like it when we're invested in companies where they understand that. Many companies just repurchase and repurchase, you know, it's the thing to do..."
What's an intelligent action at one price becomes stupid at some higher price. Any conversation over whether repurchasing shares makes sense should begin with whether or not the stock is in fact cheap.
Estimate per share intrinsic value, judge how that value is likely to change over time, then buy at a nice discount to that value.
Repurchases generally won't make sense when value -- within a range -- cannot be judged with enough confidence. Some businesses have inherent durable advantages while others have extremely difficult to understand prospects.
Beyond that it's assessing how such an action compares to existing well understood alternative uses of that capital.
For example, if internal investments critical to future competitiveness are neglected -- in order to buy what looks like an inexpensive stock -- long-term shareholders will likely not be served well.
Share repurchases work when truly excess capital is used to buy shares at a clear discount and when alternative uses are correctly judged inferior.
Seems obvious enough, at least at first, yet corporate repurchase behavior too often reinforces the impression that it's rather less than obvious.
Adam
Long position in BRKb
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Showing posts with label Berkshire Shareholder Letter Highlights: 2007-Present. Show all posts
Showing posts with label Berkshire Shareholder Letter Highlights: 2007-Present. Show all posts
Thursday, December 5, 2019
Monday, April 1, 2019
Buffett on Expenses
From the latest Berkshire Hathaway (BRKa) letter:
"...managements sometimes assert that their company's stock-based compensation shouldn't be counted as an expense. (What else could it be – a gift from shareholders?) And restructuring expenses? Well, maybe last year's exact rearrangement won't recur. But restructurings of one sort or another are common in business – Berkshire has gone down that road dozens of times, and our shareholders have always borne the costs of doing so.
Abraham Lincoln once posed the question: 'If you call a dog's tail a leg, how many legs does it have?' and then answered his own query: 'Four, because calling a tail a leg doesn't make it one.' Abe would have felt lonely on Wall Street.
Charlie and I do contend that our acquisition-related amortization expenses of $1.4 billion...are not a true economic cost. We add back such amortization 'costs' to GAAP earnings when we are evaluating both private businesses and marketable stocks.
In contrast, Berkshire's $8.4 billion depreciation charge understates our true economic cost. In fact, we need to spend more than this sum annually to simply remain competitive in our many operations. Beyond those 'maintenance' capital expenditures, we spend large sums in pursuit of growth. Overall, Berkshire invested a record $14.5 billion last year in plant, equipment and other fixed assets, with 89% of that spent in America.
The practice of ignoring real costs like stock-based compensation is the practice of deliberately making what's inherently challenging -- the investing process -- even more so.
Unfortunately it remains a not uncommon practice especially for businesses that rely heavily upon stock-based compensation.
Those who use earnings per share (reported or estimated) that exclude these real costs as a basis for calculating intrinsic value end up, all else equal, with an inflated assessment that value.
This conscious distortion may be a great way to feel better in the near term but it's an even better way to transfer wealth to strangers (the exiting shareholders) while, as a bonus I guess, taking on additional risk that need not be taken.
Now it's possible that, because a particular business has rapidly improving prospects, such a "gift" may be masked by the rapid increase to intrinsic business value. Yet the "gift" is still real even if buried inside the bigger story. It seems rather obvious that a more wise approach would be to admit a higher premium is being paid -- and in some cases no doubt a justifiable premium -- than to pretend the current earnings are higher than reality.
Premium prices built upon inflated earnings can, in fact, function as a gift to exiting shareholders.
Nothing wrong with generosity but I think it's fair to say there's better ways to go about being charitable.
Attempting to understand why what should be relatively informed individuals -- investors, analysts, and managements -- would accept such an alternative reality is worth the effort. There are, of course, underlying social and psychological factors at work here.
Those factors may not always be obvious or measurable but they're real and potent.
Adam
Long position in BRKb
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
"...managements sometimes assert that their company's stock-based compensation shouldn't be counted as an expense. (What else could it be – a gift from shareholders?) And restructuring expenses? Well, maybe last year's exact rearrangement won't recur. But restructurings of one sort or another are common in business – Berkshire has gone down that road dozens of times, and our shareholders have always borne the costs of doing so.
Abraham Lincoln once posed the question: 'If you call a dog's tail a leg, how many legs does it have?' and then answered his own query: 'Four, because calling a tail a leg doesn't make it one.' Abe would have felt lonely on Wall Street.
Charlie and I do contend that our acquisition-related amortization expenses of $1.4 billion...are not a true economic cost. We add back such amortization 'costs' to GAAP earnings when we are evaluating both private businesses and marketable stocks.
In contrast, Berkshire's $8.4 billion depreciation charge understates our true economic cost. In fact, we need to spend more than this sum annually to simply remain competitive in our many operations. Beyond those 'maintenance' capital expenditures, we spend large sums in pursuit of growth. Overall, Berkshire invested a record $14.5 billion last year in plant, equipment and other fixed assets, with 89% of that spent in America.
The practice of ignoring real costs like stock-based compensation is the practice of deliberately making what's inherently challenging -- the investing process -- even more so.
Unfortunately it remains a not uncommon practice especially for businesses that rely heavily upon stock-based compensation.
Those who use earnings per share (reported or estimated) that exclude these real costs as a basis for calculating intrinsic value end up, all else equal, with an inflated assessment that value.
This conscious distortion may be a great way to feel better in the near term but it's an even better way to transfer wealth to strangers (the exiting shareholders) while, as a bonus I guess, taking on additional risk that need not be taken.
Now it's possible that, because a particular business has rapidly improving prospects, such a "gift" may be masked by the rapid increase to intrinsic business value. Yet the "gift" is still real even if buried inside the bigger story. It seems rather obvious that a more wise approach would be to admit a higher premium is being paid -- and in some cases no doubt a justifiable premium -- than to pretend the current earnings are higher than reality.
Premium prices built upon inflated earnings can, in fact, function as a gift to exiting shareholders.
Nothing wrong with generosity but I think it's fair to say there's better ways to go about being charitable.
Attempting to understand why what should be relatively informed individuals -- investors, analysts, and managements -- would accept such an alternative reality is worth the effort. There are, of course, underlying social and psychological factors at work here.
Those factors may not always be obvious or measurable but they're real and potent.
Adam
Long position in BRKb
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Monday, April 23, 2018
When a Non-Random Rule & Random Fluctuations "Swamp the Truly Important"
From Warren Buffett's latest Berkshire Hathaway (BRKa) shareholder letter:
"...I would prefer to turn immediately to discussing Berkshire's operations. But...I must first tell you about a new accounting rule – a generally accepted accounting principle (GAAP) – that in future quarterly and annual reports will severely distort Berkshire's net income figures and very often mislead commentators and investors.
The new rule says that the net change in unrealized investment gains and losses in stocks we hold must be included in all net income figures we report to you. That requirement will produce some truly wild and capricious swings in our GAAP bottom-line. Berkshire owns $170 billion of marketable stocks (not including our shares of Kraft Heinz), and the value of these holdings can easily swing by $10 billion or more within a quarterly reporting period. Including gyrations of that magnitude in reported net income will swamp the truly important numbers that describe our operating performance. For analytical purposes, Berkshire's 'bottom-line' will be useless.
The new rule compounds the communication problems we have long had in dealing with the realized gains (or losses) that accounting rules compel us to include in our net income. In past quarterly and annual press releases, we have regularly warned you not to pay attention to these realized gains, because they – just like our unrealized gains – fluctuate randomly.
That's largely because we sell securities when that seems the intelligent thing to do, not because we are trying to influence earnings in any way. As a result, we sometimes have reported substantial realized gains for a period when our portfolio, overall, performed poorly (or the converse)."
Upon reading this it immediately reminded me of something Charlie Munger once said at a Wesco shareholder meeting:
"Anyone with an engineering frame of mind will look at [accounting standards] and want to throw up in the aisle. And go ahead if you want to. It will be a memorable moment for all of us."
Charlie's been pretty tough on the accounting profession in the past.
Here's a few additional examples.
Adam
Long position in BRKb established at much lower than recently prevailing market prices. No position in KHC.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
"...I would prefer to turn immediately to discussing Berkshire's operations. But...I must first tell you about a new accounting rule – a generally accepted accounting principle (GAAP) – that in future quarterly and annual reports will severely distort Berkshire's net income figures and very often mislead commentators and investors.
The new rule says that the net change in unrealized investment gains and losses in stocks we hold must be included in all net income figures we report to you. That requirement will produce some truly wild and capricious swings in our GAAP bottom-line. Berkshire owns $170 billion of marketable stocks (not including our shares of Kraft Heinz), and the value of these holdings can easily swing by $10 billion or more within a quarterly reporting period. Including gyrations of that magnitude in reported net income will swamp the truly important numbers that describe our operating performance. For analytical purposes, Berkshire's 'bottom-line' will be useless.
The new rule compounds the communication problems we have long had in dealing with the realized gains (or losses) that accounting rules compel us to include in our net income. In past quarterly and annual press releases, we have regularly warned you not to pay attention to these realized gains, because they – just like our unrealized gains – fluctuate randomly.
That's largely because we sell securities when that seems the intelligent thing to do, not because we are trying to influence earnings in any way. As a result, we sometimes have reported substantial realized gains for a period when our portfolio, overall, performed poorly (or the converse)."
Upon reading this it immediately reminded me of something Charlie Munger once said at a Wesco shareholder meeting:
"Anyone with an engineering frame of mind will look at [accounting standards] and want to throw up in the aisle. And go ahead if you want to. It will be a memorable moment for all of us."
Charlie's been pretty tough on the accounting profession in the past.
Here's a few additional examples.
Adam
Long position in BRKb established at much lower than recently prevailing market prices. No position in KHC.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Wednesday, March 22, 2017
Innovators, Imitators, & the Swarming Incompetents
From Warren Buffett's most recent Berkshire Hathaway (BRKa) shareholder letter:
"...the great majority of [investment] managers who attempt to over-perform will fail. The probability is also very high that the person soliciting your funds will not be the exception who does well. Bill Ruane – a truly wonderful human being and a man whom I identified 60 years ago as almost certain to deliver superior investment returns over the long haul – said it well: 'In investment management, the progression is from the innovators to the imitators to the swarming incompetents.'
Further complicating the search for the rare high-fee manager who is worth his or her pay is the fact that some investment professionals, just as some amateurs, will be lucky over short periods. If 1,000 managers make a market prediction at the beginning of a year, it's very likely that the calls of at least one will be correct for nine consecutive years. Of course, 1,000 monkeys would be just as likely to produce a seemingly all-wise prophet. But there would remain a difference: The lucky monkey would not find people standing in line to invest with him."
Buffett later adds:
"When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients."
What's an investor to do? According to Buffett, the vast majority of investors, large or small, would be better off owning index funds with reasonably low expenses.
(A view he's advocated previously including in the 2013 letter.)
Buffett, late last month on CNBC, further elaborated on his thinking on the high expenses investors often end up paying:
"The amount of money people wasted getting investment advice is just ridiculous in this country."
He then goes on to say:
"...it borders on obscene...I've known 10 or so people with modest amounts of money, I would bet a lot of money that they would do better than average. And I say that there are hundreds, maybe even thousands. But there's thousands, and thousands, and thousands and thousands of hedge fund managers charging two and twenty...And you don't get better because you charge a lot. I mean, that does not make you a better judge of securities or anything like that. And so the good salespeople, overwhelmingly, are the ones that attract the money, rather than the very few who are extraordinary at managing money."
Charlie Munger is, not surprisingly, included in that list of 10. Buffett says the people who he thought likely to do well in the investing business were not "the smartest guys necessarily in the world," but then added "although maybe Charlie is."
I find it very tough to argue with that.
Paying something like 1.5% per annum in incremental frictional costs -- or, incredibly, in some cases even more -- may not intuitively seem like a big deal but, on a compounded basis, the difference in long range outcomes is hardly insignificant.
Let's say a basket of investments increase in value -- before any fees -- at an annual rate of 5.0% for 25 years. Well, subtract those 1.5% in annual fees from the returns* over 25 years and you'll find that the gain takes a material haircut. In fact, after 25 years the investor ends up with only 60 cents on the dollar. So instead, for example, of having $ 100k in gains the investor instead keeps roughly $ 60k.**
It's the investor who puts capital at risk for many years yet a good chunk of the gains end up elsewhere.
What if the actual gains over 25 years end up being more modest?
Something like 1.5% annually before fees?
In that case, the gains to the investor would of course have to be zero since the 1.5% in fees exactly offset the returns. So, amazingly, the investment manager ends up with a positive, albeit reduced compared to the 5.0% scenario, result but the investor ends up breaking even.
Win-win...at least for the manager.
Once again, remember who actually put the capital at risk here.
Now, what if returns before fees end up being less than 1.5% over 25 years? Well, it will produce a net loss for the investor. Those fees still have to be covered somehow and if gains aren't sufficient the costs must be subtracted from the funds initially invested. This creates a scenario where, once again, the manager gets a positive, though admittedly more muted, result while the investor necessarily incurs a loss.
So 1.5% per year in fees sounds kind of harmless until considered in dollar terms over a proper long-term investing horizon.
What if during -- or, especially, toward the end of -- the 25 year period there's a big decline in market prices? Well, if the money is not needed by the investor (and emotions don't take over) during such an event this need not be the end of the world. Prices may normalize if whatever precipitated the decline mostly comes to an end. Yet it is the investor who has to ride it out or otherwise take the hit. In other words, the manager keeps all those fees paid out in prior years no matter what happens. Add a couple of zeros or more to the numbers above and it's not difficult to see why, as Buffett said in the letter, usually it's "the managers who reap outsized profits, not the clients."
Some managers, of course, suggest they have the capability to produce even greater returns than the examples I've used above and, well, a small number might even achieve such a result (without taking crazy risks). Yet picking a manager beforehand who will actually end up being worth something like 1.5% per annum in fees is easier said than done. During bull markets, when returns seem like they'll indefinitely be high, the high fees being charged will also seem like not terribly important background noise. Unfortunately, it's likely that with a long enough investment time horizon -- multiple market environments that inevitably include the good, the bad, and the ugly -- the importance of those fees will, ultimately, more or less become foreground noise.
Big declines in capital markets from time to time are unavoidable.
When it will happen and to what degree is neither knowable nor controllable.
Keeping expenses low is.
Seems straightforward enough but far too many investors still find it difficult to keep what are mostly avoidable costs at reasonable levels.
The result? A quiet, meaningful, but largely unnecessary wealth transfer.
Dumb ideas emerge from time to time in investing; keeping a close eye on the frictional costs likely won't prove to be one of them.
If expenses are kept in check the bulk of the gains mostly benefit whoever has actually put capital at risk. If not, much of the value that should compound and accumulate over time will, instead, end up in someone else's pocket.
Naturally, as equity prices rise to premium levels -- compared to per share intrinsic business values -- future returns eventually become anywhere from diminished to entirely insufficient while, at the same time, the possibility of permanent capital loss increases.
(Especially when the investment horizon is too short.)
As always, the price paid is paramount. Otherwise terrific asset(s) can be turned into lousy investment(s) if the price paid is too high.
Inadequate margin of safety.
Reduced potential reward.
Greater risk of loss.
Despite the popular view reward and risk need not always be positively correlated.
It's impossible to ignore where equity valuations are now compared to not all that long ago.
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
Bogle & Buffett on Frictional Costs
Buffett on Active Investing
John Bogle: Arithmetic Quants vs Algorithmic Quants
Hedge Funds: Balancing Risk & Reward?
Index Funds vs Actively Managed Funds
John Bogle on Investor Returns
Buffett's Hedge Fund Bet
John Bogle's "Relentless Rules of Humble Arithmetic", Part II
Index Fund Investing Revisited
Howard Marks on Risk
Charlie Munger on Complexity, Hedge Funds, and Pension Funds
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Risk and Reward Revisited
Newton's Fourth Law
Investor Overconfidence
Buffett on Risk and Reward
Margin of Safety & Mr. Market's Mood
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again
* Excluding tax considerations.
** If 4 times as much capital were invested but otherwise nothing changes in terms of performance, then the outcome over 25 years would of course be proportional (as far as returns and fees). At first this might seem fair enough. More money to manage...more fees, right? Yet, since we're still talking about the same 5% annualized return, those extra fees were generated simply because more assets were under management. Now, more assets no doubt will have some additional cost associated with them, but is 4 times more in fees really justified? Purchasing 4 times as many shares of a particular stock, for example, hardly increases the cost structure by four-fold. Does it really take 4 times the effort and skill to produce such a materially higher amount of fees? I think the question answers itself.
---
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.
(5)
"...the great majority of [investment] managers who attempt to over-perform will fail. The probability is also very high that the person soliciting your funds will not be the exception who does well. Bill Ruane – a truly wonderful human being and a man whom I identified 60 years ago as almost certain to deliver superior investment returns over the long haul – said it well: 'In investment management, the progression is from the innovators to the imitators to the swarming incompetents.'
Further complicating the search for the rare high-fee manager who is worth his or her pay is the fact that some investment professionals, just as some amateurs, will be lucky over short periods. If 1,000 managers make a market prediction at the beginning of a year, it's very likely that the calls of at least one will be correct for nine consecutive years. Of course, 1,000 monkeys would be just as likely to produce a seemingly all-wise prophet. But there would remain a difference: The lucky monkey would not find people standing in line to invest with him."
Buffett later adds:
"When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients."
What's an investor to do? According to Buffett, the vast majority of investors, large or small, would be better off owning index funds with reasonably low expenses.
(A view he's advocated previously including in the 2013 letter.)
Buffett, late last month on CNBC, further elaborated on his thinking on the high expenses investors often end up paying:
"The amount of money people wasted getting investment advice is just ridiculous in this country."
He then goes on to say:
"...it borders on obscene...I've known 10 or so people with modest amounts of money, I would bet a lot of money that they would do better than average. And I say that there are hundreds, maybe even thousands. But there's thousands, and thousands, and thousands and thousands of hedge fund managers charging two and twenty...And you don't get better because you charge a lot. I mean, that does not make you a better judge of securities or anything like that. And so the good salespeople, overwhelmingly, are the ones that attract the money, rather than the very few who are extraordinary at managing money."
Charlie Munger is, not surprisingly, included in that list of 10. Buffett says the people who he thought likely to do well in the investing business were not "the smartest guys necessarily in the world," but then added "although maybe Charlie is."
I find it very tough to argue with that.
Paying something like 1.5% per annum in incremental frictional costs -- or, incredibly, in some cases even more -- may not intuitively seem like a big deal but, on a compounded basis, the difference in long range outcomes is hardly insignificant.
Let's say a basket of investments increase in value -- before any fees -- at an annual rate of 5.0% for 25 years. Well, subtract those 1.5% in annual fees from the returns* over 25 years and you'll find that the gain takes a material haircut. In fact, after 25 years the investor ends up with only 60 cents on the dollar. So instead, for example, of having $ 100k in gains the investor instead keeps roughly $ 60k.**
What if the actual gains over 25 years end up being more modest?
Something like 1.5% annually before fees?
In that case, the gains to the investor would of course have to be zero since the 1.5% in fees exactly offset the returns. So, amazingly, the investment manager ends up with a positive, albeit reduced compared to the 5.0% scenario, result but the investor ends up breaking even.
Win-win...at least for the manager.
Once again, remember who actually put the capital at risk here.
Now, what if returns before fees end up being less than 1.5% over 25 years? Well, it will produce a net loss for the investor. Those fees still have to be covered somehow and if gains aren't sufficient the costs must be subtracted from the funds initially invested. This creates a scenario where, once again, the manager gets a positive, though admittedly more muted, result while the investor necessarily incurs a loss.
So 1.5% per year in fees sounds kind of harmless until considered in dollar terms over a proper long-term investing horizon.
What if during -- or, especially, toward the end of -- the 25 year period there's a big decline in market prices? Well, if the money is not needed by the investor (and emotions don't take over) during such an event this need not be the end of the world. Prices may normalize if whatever precipitated the decline mostly comes to an end. Yet it is the investor who has to ride it out or otherwise take the hit. In other words, the manager keeps all those fees paid out in prior years no matter what happens. Add a couple of zeros or more to the numbers above and it's not difficult to see why, as Buffett said in the letter, usually it's "the managers who reap outsized profits, not the clients."
Some managers, of course, suggest they have the capability to produce even greater returns than the examples I've used above and, well, a small number might even achieve such a result (without taking crazy risks). Yet picking a manager beforehand who will actually end up being worth something like 1.5% per annum in fees is easier said than done. During bull markets, when returns seem like they'll indefinitely be high, the high fees being charged will also seem like not terribly important background noise. Unfortunately, it's likely that with a long enough investment time horizon -- multiple market environments that inevitably include the good, the bad, and the ugly -- the importance of those fees will, ultimately, more or less become foreground noise.
Big declines in capital markets from time to time are unavoidable.
When it will happen and to what degree is neither knowable nor controllable.
Keeping expenses low is.
Seems straightforward enough but far too many investors still find it difficult to keep what are mostly avoidable costs at reasonable levels.
The result? A quiet, meaningful, but largely unnecessary wealth transfer.
Dumb ideas emerge from time to time in investing; keeping a close eye on the frictional costs likely won't prove to be one of them.
Naturally, as equity prices rise to premium levels -- compared to per share intrinsic business values -- future returns eventually become anywhere from diminished to entirely insufficient while, at the same time, the possibility of permanent capital loss increases.
(Especially when the investment horizon is too short.)
As always, the price paid is paramount. Otherwise terrific asset(s) can be turned into lousy investment(s) if the price paid is too high.
Inadequate margin of safety.
Reduced potential reward.
Greater risk of loss.
Despite the popular view reward and risk need not always be positively correlated.
It's impossible to ignore where equity valuations are now compared to not all that long ago.
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
Bogle & Buffett on Frictional Costs
Buffett on Active Investing
John Bogle: Arithmetic Quants vs Algorithmic Quants
Hedge Funds: Balancing Risk & Reward?
Index Funds vs Actively Managed Funds
John Bogle on Investor Returns
Buffett's Hedge Fund Bet
John Bogle's "Relentless Rules of Humble Arithmetic", Part II
Index Fund Investing Revisited
Howard Marks on Risk
Charlie Munger on Complexity, Hedge Funds, and Pension Funds
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Risk and Reward Revisited
Newton's Fourth Law
Investor Overconfidence
Buffett on Risk and Reward
Margin of Safety & Mr. Market's Mood
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again
* Excluding tax considerations.
** If 4 times as much capital were invested but otherwise nothing changes in terms of performance, then the outcome over 25 years would of course be proportional (as far as returns and fees). At first this might seem fair enough. More money to manage...more fees, right? Yet, since we're still talking about the same 5% annualized return, those extra fees were generated simply because more assets were under management. Now, more assets no doubt will have some additional cost associated with them, but is 4 times more in fees really justified? Purchasing 4 times as many shares of a particular stock, for example, hardly increases the cost structure by four-fold. Does it really take 4 times the effort and skill to produce such a materially higher amount of fees? I think the question answers itself.
---
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.
(5)
Friday, April 1, 2016
Flying Too Close To The Sun
Warren Buffett, in last year's Berkshire Hathaway (BRKa) special letter*, explained that conglomerates have been at times very popular but became especially so back in the 1960s:
"Since I entered the business world, conglomerates have enjoyed several periods of extreme popularity, the silliest of which occurred in the late 1960s."
This was covered, to an extent, in a post from late last year.
LTV -- a company once run by Jimmy Ling during that era -- is used as an example of a conglomerate structure that goes very wrong. From the letter:
"Through a lot of corporate razzle-dazzle, Ling had taken LTV from sales of only $36 million in 1965 to number 14 on the Fortune 500 list just two years later. Ling, it should be noted, had never displayed any managerial skills. But Charlie told me long ago to never underestimate the man who overestimates himself. And Ling had no peer in that respect.
Ling's strategy...was to buy a large company and then partially spin off its various divisions. In LTV’s 1966 annual report, he explained the magic that would follow: 'Most importantly, acquisitions must meet the test of the 2 plus 2 equals 5 (or 6) formula.' The press, the public and Wall Street loved this sort of talk.
In 1967 Ling bought Wilson & Co., a huge meatpacker that also had interests in golf equipment and pharmaceuticals. Soon after, he split the parent into three businesses, Wilson & Co. (meatpacking), Wilson Sporting Goods and Wilson Pharmaceuticals, each of which was to be partially spun off. These companies quickly became known on Wall Street as Meatball, Golf Ball and Goof Ball.
Soon thereafter, it became clear that, like Icarus, Ling had flown too close to the sun. By the early 1970s, Ling's empire was melting, and he himself had been spun off from LTV . . . that is, fired.
Periodically, financial markets will become divorced from reality – you can count on that. More Jimmy Lings will appear. They will look and sound authoritative. The press will hang on their every word. Bankers will fight for their business. What they are saying will recently have 'worked.' Their early followers will be feeling very clever. Our suggestion: Whatever their line, never forget that 2+2 will always equal 4. And when someone tells you how old-fashioned that math is --- zip up your wallet, take a vacation and come back in a few years to buy stocks at cheap prices."
So a bit of healthy skepticism comes in handy when some repackaged business strategy is being promoted aggressively (especially when bankers and the press fan the flames). This is especially true when questionable accounting and aggressive financing comes into play.
CEO behavior can have a huge impact on intrinsic business value especially over the very long haul. The good news is that plenty of extremely capable business executives are out there. Unfortunately, personality and salesmanship sometimes get in the way of making a sound judgment about a CEOs overall talents. For investors, it's vital to I.D. situations beforehand that lead to inflated perceived prospects and, at least for a time, a valuation that reflects the flawed perception.
The specifics may vary but it almost always is wise to avoid of investing in -- or, at times, alongside -- those who tend to overestimate themselves no matter how smart someone is (or seems to be).
"Smart, hard-working people aren't exempted from professional disasters from overconfidence. Often, they just go aground in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods." - Charlie Munger speech to the Foundation Financial Officers Group
"We recognized early on that very smart people do very dumb things, and we wanted to know why and who, so we could avoid them." - Charlie Munger at the 2007 Berkshire Hathaway Shareholder Meeting
"If you think your IQ is 160 but it's 150, you're a disaster. It's much better to have a 130 IQ and think it's 120." - Charlie Munger at the 2009 Berkshire Hathaway Shareholder Meeting
"If you have a 150 IQ, sell 30 points to someone else. You need to be smart, but not a genius. What's most important is inner peace; you have to be able to think for yourself. It's not a complicated game." - Warren Buffett at the 2009 Berkshire Hathaway Shareholder Meeting
Humility and knowing what you don't know can go a long way in investing.
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
Berkshire's Structure: Why It Works
Corporate Hocus-Pocus
Charlie Munger: Focus Investing and Fuzzy Concepts
Grantham & Buffett: "Career Risk" & "The Institutional Imperative"
Buffett on "The Institutional Imperative"
Buffett: A Portrait of Business Discipline
Buffett on Bold & Imaginative Accounting
Charlie Munger on LTCM & Overconfidence
When Genius Failed...Again
* 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).
---
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.
"Since I entered the business world, conglomerates have enjoyed several periods of extreme popularity, the silliest of which occurred in the late 1960s."
This was covered, to an extent, in a post from late last year.
LTV -- a company once run by Jimmy Ling during that era -- is used as an example of a conglomerate structure that goes very wrong. From the letter:
"Through a lot of corporate razzle-dazzle, Ling had taken LTV from sales of only $36 million in 1965 to number 14 on the Fortune 500 list just two years later. Ling, it should be noted, had never displayed any managerial skills. But Charlie told me long ago to never underestimate the man who overestimates himself. And Ling had no peer in that respect.
Ling's strategy...was to buy a large company and then partially spin off its various divisions. In LTV’s 1966 annual report, he explained the magic that would follow: 'Most importantly, acquisitions must meet the test of the 2 plus 2 equals 5 (or 6) formula.' The press, the public and Wall Street loved this sort of talk.
In 1967 Ling bought Wilson & Co., a huge meatpacker that also had interests in golf equipment and pharmaceuticals. Soon after, he split the parent into three businesses, Wilson & Co. (meatpacking), Wilson Sporting Goods and Wilson Pharmaceuticals, each of which was to be partially spun off. These companies quickly became known on Wall Street as Meatball, Golf Ball and Goof Ball.
Soon thereafter, it became clear that, like Icarus, Ling had flown too close to the sun. By the early 1970s, Ling's empire was melting, and he himself had been spun off from LTV . . . that is, fired.
Periodically, financial markets will become divorced from reality – you can count on that. More Jimmy Lings will appear. They will look and sound authoritative. The press will hang on their every word. Bankers will fight for their business. What they are saying will recently have 'worked.' Their early followers will be feeling very clever. Our suggestion: Whatever their line, never forget that 2+2 will always equal 4. And when someone tells you how old-fashioned that math is --- zip up your wallet, take a vacation and come back in a few years to buy stocks at cheap prices."
So a bit of healthy skepticism comes in handy when some repackaged business strategy is being promoted aggressively (especially when bankers and the press fan the flames). This is especially true when questionable accounting and aggressive financing comes into play.
CEO behavior can have a huge impact on intrinsic business value especially over the very long haul. The good news is that plenty of extremely capable business executives are out there. Unfortunately, personality and salesmanship sometimes get in the way of making a sound judgment about a CEOs overall talents. For investors, it's vital to I.D. situations beforehand that lead to inflated perceived prospects and, at least for a time, a valuation that reflects the flawed perception.
The specifics may vary but it almost always is wise to avoid of investing in -- or, at times, alongside -- those who tend to overestimate themselves no matter how smart someone is (or seems to be).
"Smart, hard-working people aren't exempted from professional disasters from overconfidence. Often, they just go aground in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods." - Charlie Munger speech to the Foundation Financial Officers Group
"We recognized early on that very smart people do very dumb things, and we wanted to know why and who, so we could avoid them." - Charlie Munger at the 2007 Berkshire Hathaway Shareholder Meeting
"If you think your IQ is 160 but it's 150, you're a disaster. It's much better to have a 130 IQ and think it's 120." - Charlie Munger at the 2009 Berkshire Hathaway Shareholder Meeting
"If you have a 150 IQ, sell 30 points to someone else. You need to be smart, but not a genius. What's most important is inner peace; you have to be able to think for yourself. It's not a complicated game." - Warren Buffett at the 2009 Berkshire Hathaway Shareholder Meeting
Humility and knowing what you don't know can go a long way in investing.
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
Berkshire's Structure: Why It Works
Corporate Hocus-Pocus
Charlie Munger: Focus Investing and Fuzzy Concepts
Grantham & Buffett: "Career Risk" & "The Institutional Imperative"
Buffett on "The Institutional Imperative"
Buffett: A Portrait of Business Discipline
Buffett on Bold & Imaginative Accounting
Charlie Munger on LTCM & Overconfidence
When Genius Failed...Again
* 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).
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Wednesday, March 9, 2016
Buffett on Stock-Based Compensation
From Warren Buffett's recently released 2015 Berkshire Hathaway (BRKa) shareholder letter:
"...it has become common for managers to tell their owners to ignore certain expense items that are all too real. 'Stock-based compensation' is the most egregious example. The very name says it all: 'compensation.' If compensation isn't an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?
Wall Street analysts often play their part in this charade, too, parroting the phony, compensation-ignoring 'earnings' figures fed them by managements. Maybe the offending analysts don’t know any better. Or maybe they fear losing 'access' to management. Or maybe they are cynical, telling themselves that since everyone else is playing the game, why shouldn’t they go along with it. Whatever their reasoning, these analysts are guilty of propagating misleading numbers that can deceive investors."
I've covered this subject to an extent in prior posts. Ignoring these very real costs -- especially when it comes to evaluating those businesses that happen to be highly dependent on stock-based compensation -- can lead to vastly different estimates of per share intrinsic value. It's possible that the tendency to ignore such expenses is at least in part related to what Jeremy Grantham has called "career risk" and Warren Buffett has described as "the institutional imperative".
The risk of permanent capital loss can to an extent be mitigated by using conservative assumptions about future business prospects. That way, if the least optimistic scenario -- or, worse yet, the supposed worst case turns out to be too optimistic -- is what plays out, the investor is at least somewhat protected.
(There'll obviously be no complaints if prospects prove to be surprisingly good.)
So estimate value conservatively then purchase shares when market price represents a nice discount to that estimate.
Ignoring a whole category of expenses such as stock-based compensation is hardly consistent with such a recipe.
Why there'd be a willingness to overlook -- by those who should be some of the most informed and knowledgeable no less -- what is, especially for certain tech stocks, too often a rather large expense is well worth understanding (for reasons that include but extend far beyond investing).
Estimating what'll end up being the true cost of stock-based compensation beforehand is not easy to do in a precise manner. Yet that reality doesn't justify pretending the costs don't exist at all. For investors, difficult to measure factors are often important to consider with stock-based compensation being just one of many. The correct response to this necessary imprecision is to make -- or at least attempt to make -- a rough but meaningful estimate. Existing accounting standards will always have their limitations, but at least can provide a useful starting point for the investor.
This ultimately gets back to the broader subject of risk. Investing competently starts with staying away from what's not well understood by the investor. No margin of safety should be considered large enough when outside one's comfort zone.
Sometimes it's necessary to avoid an investment with otherwise lots of potential upside because the worst case is intolerable. In other words, a known, if improbable, yet totally unacceptable outcome exists so no margin of safety seems large enough. Howard Marks has has said "I have no interest in being a skydiver who's successful 95% of the time."
That's a useful way to think about it. The outcome 5% of the time is just unacceptable no matter how good things go the other 95% of the time.
Some choose to treat volatility as a proxy for risk.
If risk analysis were only that straightforward.
It's just not and never will be.
Since, for investors, much of what matters can't be precisely quantified, it's the qualitative factors that end up deserving at least as much if not a whole lot more attention. As Charlie Munger once said:
"...practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that."
Just because something is tough to quantify doesn't necessarily reduce its significance.
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
Earnings Inflation
Howard Marks on Risk
Stock-based Compensation: Impact On Tech Stock P/E Ratios
Big Cap Tech: 10-Year Changes to Share Count
Grantham & Buffett: "Career Risk" & "The Institutional Imperative"
Buffett on "The Institutional Imperative"
Technology Stocks
Time for Dividends in Techland
Munger on Accounting
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.
"...it has become common for managers to tell their owners to ignore certain expense items that are all too real. 'Stock-based compensation' is the most egregious example. The very name says it all: 'compensation.' If compensation isn't an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?
Wall Street analysts often play their part in this charade, too, parroting the phony, compensation-ignoring 'earnings' figures fed them by managements. Maybe the offending analysts don’t know any better. Or maybe they fear losing 'access' to management. Or maybe they are cynical, telling themselves that since everyone else is playing the game, why shouldn’t they go along with it. Whatever their reasoning, these analysts are guilty of propagating misleading numbers that can deceive investors."
I've covered this subject to an extent in prior posts. Ignoring these very real costs -- especially when it comes to evaluating those businesses that happen to be highly dependent on stock-based compensation -- can lead to vastly different estimates of per share intrinsic value. It's possible that the tendency to ignore such expenses is at least in part related to what Jeremy Grantham has called "career risk" and Warren Buffett has described as "the institutional imperative".
The risk of permanent capital loss can to an extent be mitigated by using conservative assumptions about future business prospects. That way, if the least optimistic scenario -- or, worse yet, the supposed worst case turns out to be too optimistic -- is what plays out, the investor is at least somewhat protected.
(There'll obviously be no complaints if prospects prove to be surprisingly good.)
So estimate value conservatively then purchase shares when market price represents a nice discount to that estimate.
Ignoring a whole category of expenses such as stock-based compensation is hardly consistent with such a recipe.
Why there'd be a willingness to overlook -- by those who should be some of the most informed and knowledgeable no less -- what is, especially for certain tech stocks, too often a rather large expense is well worth understanding (for reasons that include but extend far beyond investing).
Estimating what'll end up being the true cost of stock-based compensation beforehand is not easy to do in a precise manner. Yet that reality doesn't justify pretending the costs don't exist at all. For investors, difficult to measure factors are often important to consider with stock-based compensation being just one of many. The correct response to this necessary imprecision is to make -- or at least attempt to make -- a rough but meaningful estimate. Existing accounting standards will always have their limitations, but at least can provide a useful starting point for the investor.
This ultimately gets back to the broader subject of risk. Investing competently starts with staying away from what's not well understood by the investor. No margin of safety should be considered large enough when outside one's comfort zone.
Sometimes it's necessary to avoid an investment with otherwise lots of potential upside because the worst case is intolerable. In other words, a known, if improbable, yet totally unacceptable outcome exists so no margin of safety seems large enough. Howard Marks has has said "I have no interest in being a skydiver who's successful 95% of the time."
That's a useful way to think about it. The outcome 5% of the time is just unacceptable no matter how good things go the other 95% of the time.
Some choose to treat volatility as a proxy for risk.
If risk analysis were only that straightforward.
It's just not and never will be.
Since, for investors, much of what matters can't be precisely quantified, it's the qualitative factors that end up deserving at least as much if not a whole lot more attention. As Charlie Munger once said:
"...practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that."
Just because something is tough to quantify doesn't necessarily reduce its significance.
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
Earnings Inflation
Howard Marks on Risk
Stock-based Compensation: Impact On Tech Stock P/E Ratios
Big Cap Tech: 10-Year Changes to Share Count
Grantham & Buffett: "Career Risk" & "The Institutional Imperative"
Buffett on "The Institutional Imperative"
Technology Stocks
Time for Dividends in Techland
Munger on Accounting
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Wednesday, January 27, 2016
Berkshire's Structure: Why It Works
Conglomerates, according to Warren Buffett, "have a terrible reputation with investors" that they "richly deserve".
I covered this, at least to an extent, in a post late last year.
So, if that's the case, why does the conglomerate structure work -- when it comes to maximizing the growth of capital over the long haul -- for Berkshire Hathaway (BRKa) but not some other companies?
It comes down to, at least in part, whether investors can generally count on the wise allocation of capital on a consistent basis (and, ideally, with many decades in mind).
Unfortunately, intelligent capital allocation in the real world is far from a given. Warren Buffett, in his 2014 Berkshire special letter*, uses the textile industry as one example:
"...capital withdrawals within the textile industry that should have been obvious were delayed for decades because of the vain hopes and self-interest of managements. Indeed, I myself delayed abandoning our obsolete textile mills for far too long."
He also points out that taxes and frictional costs are a big factor because "mouths with expensive tastes...clamor to be fed – among them investment bankers, accountants, consultants, lawyers and such capital-reallocators as leveraged buyout operators. Money-shufflers don't come cheap."
Now here's how Buffett goes on to explain Berkshire's advantages:
"...a conglomerate such as Berkshire is perfectly positioned to allocate capital rationally and at minimal cost. Of course, form itself is no guarantee of success: We have made plenty of mistakes, and we will make more. Our structural advantages, however, are formidable.
At Berkshire, we can – without incurring taxes or much in the way of other costs – move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise. Moreover, we are free of historical biases created by lifelong association with a given industry and are not subject to pressures from colleagues having a vested interest in maintaining the status quo. That's important: If horses had controlled investment decisions, there would have been no auto industry.
Another major advantage we possess is the ability to buy pieces of wonderful businesses – a.k.a. common stocks. That's not a course of action open to most managements. Over our history, this strategic alternative has proved to be very helpful; a broad range of options always sharpens decision-making. The businesses we are offered by the stock market every day – in small pieces, to be sure – are often far more attractive than the businesses we are concurrently being offered in their entirety. Additionally, the gains we've realized from marketable securities have helped us make certain large acquisitions that would otherwise have been beyond our financial capabilities.
In effect, the world is Berkshire's oyster – a world offering us a range of opportunities far beyond those realistically open to most companies. We are limited, of course, to businesses whose economic prospects we can evaluate. And that's a serious limitation: Charlie and I have no idea what a great many companies will look like ten years from now. But that limitation is much smaller than that borne by an executive whose experience has been confined to a single industry. On top of that, we can profitably scale to a far larger size than the many businesses that are constrained by the limited potential of the single industry in which they operate."
One of Berkshire's businesses, See's Candy, produces lots of earning power yet requires a rather small amount of capital. Unfortunately, it doesn't internally have many good uses for all the excess cash it produces. Buffett, using See's as an example of how excess capital can be moved from where it can't be put to good use to where it can be, explains it this way:
"We would have loved, of course, to intelligently use those funds to expand our candy operation. But our many attempts to do so were largely futile. So, without incurring tax inefficiencies or frictional costs, we have used the excess funds generated by See's to help purchase other businesses. If See's had remained a stand-alone company, its earnings would have had to be distributed to investors to redeploy, sometimes after being heavily depleted by large taxes and, almost always, by significant frictional and agency costs."
It seems like a structure like Berkshire should be more common but, well, it's just not. Another advantage Buffett covers is that Berkshire has become the "home of choice" for some great businesses. Berkshire is unique in that it offers a place where a "company's people and culture" has the best chance to remain in tact even if, inevitably, personnel changes will occur.
The compounded effect of wise capital allocation and low frictional costs is not small even if, due to its sheer size, Berkshire can longer compound at anywhere near as high a rate as it has in the past.
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
Corporate Hocus-Pocus
Charlie Munger: Focus Investing and Fuzzy Concepts
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. Charlie 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).
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
I covered this, at least to an extent, in a post late last year.
So, if that's the case, why does the conglomerate structure work -- when it comes to maximizing the growth of capital over the long haul -- for Berkshire Hathaway (BRKa) but not some other companies?
It comes down to, at least in part, whether investors can generally count on the wise allocation of capital on a consistent basis (and, ideally, with many decades in mind).
Unfortunately, intelligent capital allocation in the real world is far from a given. Warren Buffett, in his 2014 Berkshire special letter*, uses the textile industry as one example:
"...capital withdrawals within the textile industry that should have been obvious were delayed for decades because of the vain hopes and self-interest of managements. Indeed, I myself delayed abandoning our obsolete textile mills for far too long."
He also points out that taxes and frictional costs are a big factor because "mouths with expensive tastes...clamor to be fed – among them investment bankers, accountants, consultants, lawyers and such capital-reallocators as leveraged buyout operators. Money-shufflers don't come cheap."
Now here's how Buffett goes on to explain Berkshire's advantages:
"...a conglomerate such as Berkshire is perfectly positioned to allocate capital rationally and at minimal cost. Of course, form itself is no guarantee of success: We have made plenty of mistakes, and we will make more. Our structural advantages, however, are formidable.
At Berkshire, we can – without incurring taxes or much in the way of other costs – move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise. Moreover, we are free of historical biases created by lifelong association with a given industry and are not subject to pressures from colleagues having a vested interest in maintaining the status quo. That's important: If horses had controlled investment decisions, there would have been no auto industry.
Another major advantage we possess is the ability to buy pieces of wonderful businesses – a.k.a. common stocks. That's not a course of action open to most managements. Over our history, this strategic alternative has proved to be very helpful; a broad range of options always sharpens decision-making. The businesses we are offered by the stock market every day – in small pieces, to be sure – are often far more attractive than the businesses we are concurrently being offered in their entirety. Additionally, the gains we've realized from marketable securities have helped us make certain large acquisitions that would otherwise have been beyond our financial capabilities.
In effect, the world is Berkshire's oyster – a world offering us a range of opportunities far beyond those realistically open to most companies. We are limited, of course, to businesses whose economic prospects we can evaluate. And that's a serious limitation: Charlie and I have no idea what a great many companies will look like ten years from now. But that limitation is much smaller than that borne by an executive whose experience has been confined to a single industry. On top of that, we can profitably scale to a far larger size than the many businesses that are constrained by the limited potential of the single industry in which they operate."
One of Berkshire's businesses, See's Candy, produces lots of earning power yet requires a rather small amount of capital. Unfortunately, it doesn't internally have many good uses for all the excess cash it produces. Buffett, using See's as an example of how excess capital can be moved from where it can't be put to good use to where it can be, explains it this way:
"We would have loved, of course, to intelligently use those funds to expand our candy operation. But our many attempts to do so were largely futile. So, without incurring tax inefficiencies or frictional costs, we have used the excess funds generated by See's to help purchase other businesses. If See's had remained a stand-alone company, its earnings would have had to be distributed to investors to redeploy, sometimes after being heavily depleted by large taxes and, almost always, by significant frictional and agency costs."
It seems like a structure like Berkshire should be more common but, well, it's just not. Another advantage Buffett covers is that Berkshire has become the "home of choice" for some great businesses. Berkshire is unique in that it offers a place where a "company's people and culture" has the best chance to remain in tact even if, inevitably, personnel changes will occur.
The compounded effect of wise capital allocation and low frictional costs is not small even if, due to its sheer size, Berkshire can longer compound at anywhere near as high a rate as it has in the past.
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
Corporate Hocus-Pocus
Charlie Munger: Focus Investing and Fuzzy Concepts
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. Charlie 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).
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Tuesday, November 10, 2015
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.
---
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 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.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Wednesday, April 15, 2015
Berkshire's 'Big Four'
Warren Buffett, in his latest Berkshire Hathaway (BRKa) shareholder letter, wrote the following about what he calls the 'Big Four':
- American Express (AXP)
- Coca-Cola (KO)
- IBM (IBM)
- Wells Fargo (WFC)
"Berkshire increased its ownership interest last year in each of its 'Big Four' investments – American Express, Coca-Cola, IBM and Wells Fargo. We purchased additional shares of IBM (increasing our ownership to 7.8% versus 6.3% at yearend 2013). Meanwhile, stock repurchases at Coca-Cola, American Express and Wells Fargo raised our percentage ownership of each. Our equity in Coca-Cola grew from 9.1% to 9.2%, our interest in American Express increased from 14.2% to 14.8% and our ownership of Wells Fargo grew from 9.2% to 9.4%. And, if you think tenths of a percent aren't important, ponder this math: For the four companies in aggregate, each increase of one-tenth of a percent in our ownership raises Berkshire's portion of their annual earnings by $50 million."
It's worth noting that there's no attempt to bet on exceptional growth here. Some seem to think that high growth is a necessity to generate high returns. Well, consider the kind of businesses (whether through common stocks or outright purchases) Berkshire has owned over the past several decades. For the most part the returns have come from businesses that were not dependent on high growth over an extended period. Also, the returns generally have not come from businesses in industries that experience lots of change and require continuous product innovation. Instead, the emphasis has been on owning sound -- even if rather unexciting -- businesses that will be around for many decades. Ultimately, it's about increasing Berkshire's portion of what those businesses earn over time and the power of compounding effects.
So it's an emphasis on what the business can produce (in excess cash) over time. Those who, more or less, attempt to cleverly buy and sell stocks in order to profit from price action -- often with a rather not long time horizon in mind -- are engaged in a very different activity.
(This is the case whether or not the decisions are based upon business fundamentals. The fact that fundamentals are considered doesn't necessarily mean the activity isn't more speculation than investment.)
This approach works best if the business franchise remains competitive while real but manageable challenges keep the stock cheap for an extended period. A languishing stock can be a very good thing. In fact, the long-term investor in shares of a good business does not -- or, at least, should not -- logically want the share price to rise near-term or even intermediate-term.
Buffett recently said that some have a "misconception when we buy a stock we like it to go up. That's the last thing we want it to do."
For the investor who plans to be an owner for decades a rising stock price is not a good thing. What's much preferred is if the shares persistently sell at a discount to per-share intrinsic value.* When that happens -- at least for a business with sound long-term core economics -- future results improve as intrinsic value gets transferred from those who are impatient to those who are less so.**
"Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient." - From the 1991 Berkshire Letter
A rising stock simply makes buybacks less effective and makes it tougher to accumulate more shares over time via dividend reinvestments or incremental purchases at a proper discount.***
Why Buffett Wants IBM's Shares "To Languish"
Ultimately, it's about the discounted per-share value of the excess cash that's produced as long as the business can at least maintain or, better yet, improve its competitive position.
Buffett explains in the latest letter that Berkshire's portion of the 2014 earnings from these four businesses "amounted to $4.7 billion (compared to $3.3 billion only three years ago). In the earnings we report to you, however, we include only the dividends we receive – about $1.6 billion last year. (Again, three years ago the dividends were $862 million.) But make no mistake: The $3.1 billion of these companies' earnings we don't report are every bit as valuable to us as the portion Berkshire records."
That's just one of the reasons why Berkshire's price to earnings generally isn't a terribly useful thing to consider.
Adam
Long positions in AXP, KO, WFC, BRKb established at much lower than recent prices. Long position in IBM established at slightly higher than recent prices.
* Here's how Buffett explains intrinsic value in the Berkshire Hathaway owner's manual: "Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life."
** If a dollar of value is consistently bought back for 70 cents then the other 30 cents of value doesn't just disappear, it ends up being transferred to the continuing owners. So an intelligent buyback can lead to what is effectively an intrinsic value transfer from those too focused on near-term price action to those focused on per-share intrinsic value and long-term effects.
*** From the 2011 letter: "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."
---
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.
- American Express (AXP)
- Coca-Cola (KO)
- IBM (IBM)
- Wells Fargo (WFC)
"Berkshire increased its ownership interest last year in each of its 'Big Four' investments – American Express, Coca-Cola, IBM and Wells Fargo. We purchased additional shares of IBM (increasing our ownership to 7.8% versus 6.3% at yearend 2013). Meanwhile, stock repurchases at Coca-Cola, American Express and Wells Fargo raised our percentage ownership of each. Our equity in Coca-Cola grew from 9.1% to 9.2%, our interest in American Express increased from 14.2% to 14.8% and our ownership of Wells Fargo grew from 9.2% to 9.4%. And, if you think tenths of a percent aren't important, ponder this math: For the four companies in aggregate, each increase of one-tenth of a percent in our ownership raises Berkshire's portion of their annual earnings by $50 million."
It's worth noting that there's no attempt to bet on exceptional growth here. Some seem to think that high growth is a necessity to generate high returns. Well, consider the kind of businesses (whether through common stocks or outright purchases) Berkshire has owned over the past several decades. For the most part the returns have come from businesses that were not dependent on high growth over an extended period. Also, the returns generally have not come from businesses in industries that experience lots of change and require continuous product innovation. Instead, the emphasis has been on owning sound -- even if rather unexciting -- businesses that will be around for many decades. Ultimately, it's about increasing Berkshire's portion of what those businesses earn over time and the power of compounding effects.
So it's an emphasis on what the business can produce (in excess cash) over time. Those who, more or less, attempt to cleverly buy and sell stocks in order to profit from price action -- often with a rather not long time horizon in mind -- are engaged in a very different activity.
(This is the case whether or not the decisions are based upon business fundamentals. The fact that fundamentals are considered doesn't necessarily mean the activity isn't more speculation than investment.)
This approach works best if the business franchise remains competitive while real but manageable challenges keep the stock cheap for an extended period. A languishing stock can be a very good thing. In fact, the long-term investor in shares of a good business does not -- or, at least, should not -- logically want the share price to rise near-term or even intermediate-term.
Buffett recently said that some have a "misconception when we buy a stock we like it to go up. That's the last thing we want it to do."
For the investor who plans to be an owner for decades a rising stock price is not a good thing. What's much preferred is if the shares persistently sell at a discount to per-share intrinsic value.* When that happens -- at least for a business with sound long-term core economics -- future results improve as intrinsic value gets transferred from those who are impatient to those who are less so.**
"Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient." - From the 1991 Berkshire Letter
A rising stock simply makes buybacks less effective and makes it tougher to accumulate more shares over time via dividend reinvestments or incremental purchases at a proper discount.***
Why Buffett Wants IBM's Shares "To Languish"
Ultimately, it's about the discounted per-share value of the excess cash that's produced as long as the business can at least maintain or, better yet, improve its competitive position.
Buffett explains in the latest letter that Berkshire's portion of the 2014 earnings from these four businesses "amounted to $4.7 billion (compared to $3.3 billion only three years ago). In the earnings we report to you, however, we include only the dividends we receive – about $1.6 billion last year. (Again, three years ago the dividends were $862 million.) But make no mistake: The $3.1 billion of these companies' earnings we don't report are every bit as valuable to us as the portion Berkshire records."
That's just one of the reasons why Berkshire's price to earnings generally isn't a terribly useful thing to consider.
Adam
Long positions in AXP, KO, WFC, BRKb established at much lower than recent prices. Long position in IBM established at slightly higher than recent prices.
* Here's how Buffett explains intrinsic value in the Berkshire Hathaway owner's manual: "Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life."
** If a dollar of value is consistently bought back for 70 cents then the other 30 cents of value doesn't just disappear, it ends up being transferred to the continuing owners. So an intelligent buyback can lead to what is effectively an intrinsic value transfer from those too focused on near-term price action to those focused on per-share intrinsic value and long-term effects.
*** From the 2011 letter: "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."
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Wednesday, March 11, 2015
Investment Sins
"The fault, dear Brutus, is not in our stars, but in ourselves." - William Shakespeare in Julius Caesar
Warren Buffett, in his latest Berkshire Hathaway (BRKa) letter to shareholders*, explained the consequences of volatility being viewed, mistakenly, as a meaningful indication of risk.
In fact, he writes that such a view can "ironically" cause the investor to "end up doing some very risky things."
Buffett then adds to remember "the pundits who six years ago bemoaned fall stock prices and advised investing in 'safe' Treasury bills or bank certificates of deposit. People who heeded this sermon are now earning a pittance on sums they had previously expected would finance a pleasant retirement."
Since then the S&P 500 has roughly tripled. The extreme volatility that occurred during that time was more opportunity than risk.
So, unfortunately, due to the "fear of meaningless price volatility, these investors could have assured themselves of a good income for life by simply buying a very low-cost index fund whose dividends would trend upward over the years and whose principal would grow as well (with many ups and downs, to be sure).
Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to 'time' market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy."
Charlie Munger once pointed out that some of this comes down to temperament:
"A lot of people with high IQs are terrible investors because they've got terrible temperaments."
In the letter Buffett goes on to say:
"Anything can happen anytime in markets. And no advisor, economist, or TV commentator – and definitely not Charlie nor I – can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.
The commission of the investment sins listed above is not limited to 'the little guy.' Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades. A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool's game."
Some investment pros are naturally very capable but Buffett points out it's tough to know, at least in the near-term, "whether a great record is due to luck or talent."
He also says that professional advisors mostly "are far better at generating high fees than they are at generating high returns. In truth, their core competence is salesmanship. Rather than listen to their siren songs, investors – large and small – should instead read Jack Bogle's The Little Book of Common Sense Investing."
Buffett then refers to the Shakespeare quote included at the beginning of this post.
Those who trade frequently, try to be clever about market timing, diversify insufficiently (with the right amount being necessarily unique for each investor), incur lots of frictional costs, and use leverage to purchase equities shouldn't be surprised if they end up with a rather not so great outcome.
The ability to recognize where one's own behavior and limitations might get in the way of satisfactory (or better) returns can be a big advantage.
I'd add that choosing to make a specific investment based upon what someone else thinks is asking for trouble.
As Buffett says: "Anything can happen anytime..."
Well, if prices decline, it will be tough to hang in there (assuming hanging in there makes sense longer term) when an investment isn't truly well understood. Intrinsic worth, within a narrow range, has to be clear to the investor well before the market storm clouds arrive.
When price action goes south, who can maintain a justifiably positive view about something if it's been purchased based upon what someone else thinks? Real conviction in an investment comes from doing the necessary work then reaching one's own (hopefully sensible) conclusions. Listening to others is a recipe for inopportune selling.
Most investments -- even the one's that are very sound -- inevitably require that lots of warranted conviction will be needed from time to time.
Adam
Long position in BRKb established at much lower prices
Related posts:
Stocks and Risk
Munger on Focus Investing
Buffett on Risk and Reward
* The excerpts from the letter included in this post can be found on pages 18 and 19.
---
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.
Warren Buffett, in his latest Berkshire Hathaway (BRKa) letter to shareholders*, explained the consequences of volatility being viewed, mistakenly, as a meaningful indication of risk.
In fact, he writes that such a view can "ironically" cause the investor to "end up doing some very risky things."
Buffett then adds to remember "the pundits who six years ago bemoaned fall stock prices and advised investing in 'safe' Treasury bills or bank certificates of deposit. People who heeded this sermon are now earning a pittance on sums they had previously expected would finance a pleasant retirement."
Since then the S&P 500 has roughly tripled. The extreme volatility that occurred during that time was more opportunity than risk.
So, unfortunately, due to the "fear of meaningless price volatility, these investors could have assured themselves of a good income for life by simply buying a very low-cost index fund whose dividends would trend upward over the years and whose principal would grow as well (with many ups and downs, to be sure).
Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to 'time' market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy."
Charlie Munger once pointed out that some of this comes down to temperament:
"A lot of people with high IQs are terrible investors because they've got terrible temperaments."
In the letter Buffett goes on to say:
"Anything can happen anytime in markets. And no advisor, economist, or TV commentator – and definitely not Charlie nor I – can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.
The commission of the investment sins listed above is not limited to 'the little guy.' Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades. A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool's game."
Some investment pros are naturally very capable but Buffett points out it's tough to know, at least in the near-term, "whether a great record is due to luck or talent."
He also says that professional advisors mostly "are far better at generating high fees than they are at generating high returns. In truth, their core competence is salesmanship. Rather than listen to their siren songs, investors – large and small – should instead read Jack Bogle's The Little Book of Common Sense Investing."
Buffett then refers to the Shakespeare quote included at the beginning of this post.
Those who trade frequently, try to be clever about market timing, diversify insufficiently (with the right amount being necessarily unique for each investor), incur lots of frictional costs, and use leverage to purchase equities shouldn't be surprised if they end up with a rather not so great outcome.
The ability to recognize where one's own behavior and limitations might get in the way of satisfactory (or better) returns can be a big advantage.
I'd add that choosing to make a specific investment based upon what someone else thinks is asking for trouble.
As Buffett says: "Anything can happen anytime..."
Well, if prices decline, it will be tough to hang in there (assuming hanging in there makes sense longer term) when an investment isn't truly well understood. Intrinsic worth, within a narrow range, has to be clear to the investor well before the market storm clouds arrive.
When price action goes south, who can maintain a justifiably positive view about something if it's been purchased based upon what someone else thinks? Real conviction in an investment comes from doing the necessary work then reaching one's own (hopefully sensible) conclusions. Listening to others is a recipe for inopportune selling.
Most investments -- even the one's that are very sound -- inevitably require that lots of warranted conviction will be needed from time to time.
Adam
Long position in BRKb established at much lower prices
Related posts:
Stocks and Risk
Munger on Focus Investing
Buffett on Risk and Reward
* The excerpts from the letter included in this post can be found on pages 18 and 19.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Wednesday, March 4, 2015
Stocks and Risk
From Warren Buffett's most recent Berkshire Hathaway (BRKa) shareholder letter:*
"The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities – Treasuries, for example – whose values have been tied to American currency. That was also true in the preceding half-century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century.
Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.
It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing-power terms) than leaving funds in cash equivalents. That is relevant to certain investors – say, investment banks – whose viability can be threatened by declines in asset prices and which might be forced to sell securities during depressed markets. Additionally, any party that might have meaningful near-term needs for funds should keep appropriate sums in Treasuries or insured bank deposits.
For the great majority of investors, however, who can – and should – invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities."
This isn't simply a minor disagreement with modern finance theory. It's a major one. Modern theory considers the idea that stocks return more than other assets because they are more risky as some kind of fundamental truism.
Warren Buffett is saying that the exact opposite, in some circumstances, can be true in the long run. Consider this the next time someone says more risk must be taken to achieve greater returns and assumes there's always a positive correlation.
More risk = more rewards?
Not exactly.
The whole idea sounds reasonable enough but, well, it's flawed at best.
In fact, the real world provides us something a far more challenging when it comes time to understand risk and its relationship with investment returns.
Howard Marks offered this take in a memo last year:
Howard Marks on Risk
"We hear it all the time: 'Riskier investments produce higher returns' and 'If you want to make more money, take more risk.'
Both of these formulations are terrible. In brief, if riskier investments could be counted on to produce higher returns, they wouldn't be riskier."
A chart on page 6 of the memo by Marks presents risk and return the traditional way (with risk and return positively correlated). A second chart on the same page explains the relationship between risk and reward in a way that, to me, much more closely represents the world as it is. As far as I'm concerned it's a much more useful and correct depiction of risk and return.
How often do investors, whether it's explicit or not, assume incremental risk is required to generate incremental returns?
This assumption is a rather costly one for too many market participants. Near-term volatility -- as measured by beta -- just isn't very likely to reveal much about the long-term risks and potential returns of an investment (despite what finance theory suggests).** It'd be nice if understanding long-term investment risk came down to a single number. Unfortunately, making judgments about risk is necessarily imprecise and tough to quantify.
Those who choose to invest based upon some torched version of reality aren't likely to produce satisfactory investment outcomes.
Contending with all the illusions, biases, and fallacies -- among other things -- already makes investing well tough enough to do consistently well. So, wherever possible, it's essential to eliminate any distraction that might be caused by plainly flawed models.
Cash for near-term needs is essential. Funds needed in the next few years (and maybe even somewhat longer) should never be in stocks. Yet cash also has the lowest possible volatility -- so theory says it shouldn't be risky -- but the long-term risk ends up being not at all small.
A diversified basket of stocks bought with funds needed in the near-term and even intermediate-term is, of course, much riskier than cash.
Sometimes risk and reward must correlate in a positive manner.
It just need not necessarily be the case with a long enough time horizon.
Owning a portfolio of fine businesses long-term -- the only appropriate time horizon for equities -- allows risk to become much reduced.
Fortunately, many convenient low cost ways exist to obtain partial ownership of a diversified basket of businesses.
Whether mutual funds (incl. ETFs) or individual stocks is the right way to go naturally depends on the investor.
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
-Quality Stocks & the Risk-Return Tradeoff
-Howard Marks on Risk
-Grantham on Efficient Markets, Bubbles, and Ignoble Prizes
-Efficient Markets - Part II
-Risk and Reward Revisited
-Efficient Markets
-Modern Portfolio Theory, Efficient Markets, and the Flat Earth Revisited
-Buffett on Risk and Reward
-Buffett: Why Stocks Beat Bonds
-Beta, Risk, & the Inconvenient Real World Special Case
-Howard Marks: The Two Main Risks in the Investment World
-Black-Scholes and the Flat Earth Society
-Buffett: Indebted to Academics
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind
* See page 18.
** According to the capital asset pricing model (CAPM), for example, highly volatile stocks should produce higher returns than the less volatile stocks to compensate investors for the additional risk. CAPM is a one factor model. In this model beta is the measure of volatility and is supposed to (somehow) represent risk. Well, the estimation of risk is necessarily qualitative and can't be captured by a single factor like beta. The Fama and French three factor model adds two additional factors. Others might find this stuff useful. I find none of it to be. Pure distraction.
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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.
"The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities – Treasuries, for example – whose values have been tied to American currency. That was also true in the preceding half-century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century.
Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.
It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing-power terms) than leaving funds in cash equivalents. That is relevant to certain investors – say, investment banks – whose viability can be threatened by declines in asset prices and which might be forced to sell securities during depressed markets. Additionally, any party that might have meaningful near-term needs for funds should keep appropriate sums in Treasuries or insured bank deposits.
For the great majority of investors, however, who can – and should – invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities."
This isn't simply a minor disagreement with modern finance theory. It's a major one. Modern theory considers the idea that stocks return more than other assets because they are more risky as some kind of fundamental truism.
Warren Buffett is saying that the exact opposite, in some circumstances, can be true in the long run. Consider this the next time someone says more risk must be taken to achieve greater returns and assumes there's always a positive correlation.
More risk = more rewards?
Not exactly.
The whole idea sounds reasonable enough but, well, it's flawed at best.
Howard Marks offered this take in a memo last year:
Howard Marks on Risk
"We hear it all the time: 'Riskier investments produce higher returns' and 'If you want to make more money, take more risk.'
Both of these formulations are terrible. In brief, if riskier investments could be counted on to produce higher returns, they wouldn't be riskier."
A chart on page 6 of the memo by Marks presents risk and return the traditional way (with risk and return positively correlated). A second chart on the same page explains the relationship between risk and reward in a way that, to me, much more closely represents the world as it is. As far as I'm concerned it's a much more useful and correct depiction of risk and return.
How often do investors, whether it's explicit or not, assume incremental risk is required to generate incremental returns?
This assumption is a rather costly one for too many market participants. Near-term volatility -- as measured by beta -- just isn't very likely to reveal much about the long-term risks and potential returns of an investment (despite what finance theory suggests).** It'd be nice if understanding long-term investment risk came down to a single number. Unfortunately, making judgments about risk is necessarily imprecise and tough to quantify.
Those who choose to invest based upon some torched version of reality aren't likely to produce satisfactory investment outcomes.
Contending with all the illusions, biases, and fallacies -- among other things -- already makes investing well tough enough to do consistently well. So, wherever possible, it's essential to eliminate any distraction that might be caused by plainly flawed models.
Cash for near-term needs is essential. Funds needed in the next few years (and maybe even somewhat longer) should never be in stocks. Yet cash also has the lowest possible volatility -- so theory says it shouldn't be risky -- but the long-term risk ends up being not at all small.
A diversified basket of stocks bought with funds needed in the near-term and even intermediate-term is, of course, much riskier than cash.
Sometimes risk and reward must correlate in a positive manner.
It just need not necessarily be the case with a long enough time horizon.
Owning a portfolio of fine businesses long-term -- the only appropriate time horizon for equities -- allows risk to become much reduced.
Fortunately, many convenient low cost ways exist to obtain partial ownership of a diversified basket of businesses.
Whether mutual funds (incl. ETFs) or individual stocks is the right way to go naturally depends on the investor.
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
-Quality Stocks & the Risk-Return Tradeoff
-Howard Marks on Risk
-Grantham on Efficient Markets, Bubbles, and Ignoble Prizes
-Efficient Markets - Part II
-Risk and Reward Revisited
-Efficient Markets
-Modern Portfolio Theory, Efficient Markets, and the Flat Earth Revisited
-Buffett on Risk and Reward
-Buffett: Why Stocks Beat Bonds
-Beta, Risk, & the Inconvenient Real World Special Case
-Howard Marks: The Two Main Risks in the Investment World
-Black-Scholes and the Flat Earth Society
-Buffett: Indebted to Academics
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind
* See page 18.
** According to the capital asset pricing model (CAPM), for example, highly volatile stocks should produce higher returns than the less volatile stocks to compensate investors for the additional risk. CAPM is a one factor model. In this model beta is the measure of volatility and is supposed to (somehow) represent risk. Well, the estimation of risk is necessarily qualitative and can't be captured by a single factor like beta. The Fama and French three factor model adds two additional factors. Others might find this stuff useful. I find none of it to be. Pure distraction.
---
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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