From Jeremy Grantham's 3Q 2016 letter:
"We have been extremely spoiled in the last 30 years by experiencing 4 of perhaps the best 8 classic bubbles known to history. For me, the order of seniority is, from the top: Japanese land, Japanese stocks in 1989, US tech stocks in 2000, and US housing, which peaked in 2006..."
Grantham goes on to explain something each of these bubbles have in common. It essentially comes down to euphoria combined with widespread belief in the unbelievable. Things like:
- That "land under the Emperor’s Palace" should equal the combined value of all California real estate.
- That the Japanese stock market, at 65x earnings, was supposedly cheap.
(Apparently Solomon Brothers at the time thought that valuations should be more like 100x.)
- That U.S. tech stocks could also be considered cheap at 65x while Internet stocks had, at least in aggregate, negative earnings yet many sold at high multiples of their loss generating sales.
More from Grantham:
"...Greenspan (hiss) explained how the Internet would usher in a new golden age of growth, not the boom and bust of productivity that we actually experienced. And most institutional investment committees believed it or half believed it! And US house prices, said Bernanke in 2007, 'had never declined,' meaning they never would, and everyone believed him.
Indeed, the broad public during these four events, two in Japan and two in the US, appeared to believe most or all of it. As did the economic and financial establishments, especially for the two US bubbles. Certainly only mavericks spoke against them."
So how does the current environment compare? Well, according to Grantham, it just doesn't stack up.
"How does that level of euphoria, of wishful thinking, of general acceptance, compare to today’s stock market in the US? Not very well. The market lacks both the excellent fundamentals and the euphoria required to unreasonably extrapolate it."
This hardly makes for a wonderful investing environment. Grantham points out that the market these days economically and psychologically "is closer to an anti-bubble than a bubble. In every sense, that is, except one: Traditional measures of value score this market as extremely overpriced by historical standards."
He then adds...
"None of the usual economic or psychological conditions for an investment bubble are being met" though valuations are "almost on the statistical boundary of a bubble."
Investing well necessarily requires not only sufficient margin of safety to protect against unforeseeable outcomes (along with inevitable mistakes), it requires sufficient compensation considering ALL risks and understood alternatives.
High valuations make meeting these requirements nearly impossible.
During the financial crisis -- and actually for quite a long while after the crisis -- lots of equity bargains could be found.
These days...not so much.
Instead, in way to many instances, more than full valuations prevail these days even if there may naturally be the odd exception when it comes to such a generalization. Charlie Munger once said:
"Our system is to swim as competently as we can and sometimes the tide will be with us and sometimes it will be against us. But by and large we don't much bother with trying to predict the tides because we plan to play the game for a long time."
Unfortunately, valuation reveals little or nothing about what market prices might do in the near-term or even longer.
Judging how price compares to the intrinsic value of a business is a very different game than guessing how the "tides" might impact market prices.
The former is difficult yet not impossible while the latter activity is, at least for me, something destined to be ignored from the sidelines with great enthusiasm.
Adam
Related posts:
Isaac Newton, The Investor
Grantham om Bubbles
Charlie Munger: Snare and a Delusion
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 Grantham. Show all posts
Showing posts with label Grantham. Show all posts
Friday, December 30, 2016
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.
Tuesday, August 4, 2015
What's Gold Intrinsically Worth?
For roughly a decade, starting in 2001, gold prices performed extremely well.
So fans of the yellow stuff will rightly point to that fact.
I'll say upfront that I have just about zero interest in owning gold or any other nonproductive asset. Yet I'm certainly familiar with some of the arguments that are made for owning gold. As is often the case, Jim Grant is thoughtful on the subject of gold (and many other things related to finance and financial history) and worth paying attention to whether or not you happen to agree with him.
Grant points out that the dollar -- and this clearly applies to other paper currencies -- has "no intrinsic value" and is "faith-based."
Can't really argue with that but I think Jeremy Grantham makes a fair point when he says:
"...just as Jim Grant tells us (correctly) that we all have faith-based paper currencies backed by nothing, it is equally fair to say that gold is a faith-based metal. It pays no dividend, cannot be eaten, and is mostly used for nothing more useful than jewelry."
Grant does, in fact, think it makes sense to own gold recently calling it "an investment in financial and monetary disorder."
He also makes his case for a return to the gold standard.
"...the existing monetary arrangements are so precarious, so ill-founded and so destructive of the economic activity they are supposed to support and nurture, that they will be replaced by something better."
For Grant, that'd be a monetary system directly linked to the quantity of gold that can be dug up over time.
Those who share these views (and similar ones) may even prove to be right.
I certainly agree that a paper currency, even under the very best of circumstances, is likely -- if not certain -- to diminish in value over the longer haul. Inflation of some kind or another should erode the purchasing power of just about any currency over time whether or not there is a full-blown currency crisis.
The question is what to do about it.
I think that Grantham has it essentially just about right:
"I believe that resources in the ground, forestry, agriculture, common stocks, and even real estate are more certain to resist any inflation or paper currency crisis than is gold."
For me, the problem has been and remains estimating what gold is intrinsically worth.
Unlike a high quality business it doesn't produce any cash.
Gold's value is perceived, or maybe relative, but it's not intrinsic.
Jason Zweig explains it this way:
"...you will put lightning in a bottle before you figure out what gold is really worth."
WSJ: Let's Be Honest About Gold: It's a Pet Rock
Without a stream of free cash flow how can what something is intrinsically worth, if anything, be known within a narrow enough range?
Warren Buffett, much like Grantham, also suggests that productive assets* are the way to go: "Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor" to buy something like their favorite soda or candy.
Investing in a productive asset is very different than attempting to guess what someone else will be willing to pay for a lump of metal down the road. Here's what Buffett once said on CNBC:
"...it is an entirely different game to buy a lump of something and hope that somebody else pays you more for that lump two years from now than it is to buy something you expect to produce income for you over time."
Some may know (or think they know) where the price of gold is headed.
I have no idea and never will.
In fact, I'll never spend a moment trying to guess such a thing.
Zweig writes the following about those who are the truest believers -- the so-called "gold bugs" -- in the wisdom of gold ownership.
"Recognize...that gold bugs...often resemble the subjects of a laboratory experiment on the psychology of cognitive dissonance.
When you are in the grip of cognitive dissonance, anything that could be regarded as evidence that you might be wrong becomes proof that you must be right."
He then added this line:
"You don't want to be one of these people, spending years telling reality that it is wrong."
Zweig's article shows that for the past forty years or so the faith-based yellow metal has not generated much in terms or relative or absolute returns:
Avg Annual Return Since 1975 (after inflation)
- Gold: 0.8%
- Bonds: 5.0% ,
- Stocks: 8.3%
- Cash: 1.1%
Maybe the future will prove very different.
Personally, I'd be surprised if stocks or bonds do nearly as well going forward considering current valuations especially if (when?) interest rates normalize.
Gold?
No idea.
Few asset categories, broadly speaking, are plainly inexpensive though there's almost always some individual investment that's selling at a discount for situation specific reasons.
(The tough part being to find one you understand well enough to invest.)
Charlie Munger is, to say the least, usually rather forthright and has a unique way of getting to the point. Well, here's how he looks at gold:
"I don't have the slightest interest in gold. I like understanding what works and what doesn't in human systems. To me that's not optional; that's a moral obligation. If you're capable of understanding the world, you have a moral obligation to become rational. And I don't see how you become rational hoarding gold. Even if it works, you're a jerk."
And one final thought on gold from Jeremy Grantham...
"I hate gold. It does not pay a dividend, it has no value, and you can't work out what it should or shouldn't be worth...It is the last refuge of the desperate."
Of course, for all I know, gold will do very well in the future.
This is irrelevant for me since I have no way of valuing it.
For me it's simple:
If I don't know how to value something, I shouldn't own it.
Adam
Related posts:
-Buffett & Munger on Gold
-Buffett on Productive Assets
-Buffett: Why Stocks Beat Gold
-Buffett: Why Stocks Beat Bonds
-Buffett on Gold, Farms, and Businesses
-Edison on Gold: Fictitious Value & Superstition
-Munger on Buying Gold
-Thomas Edison on Gold
-Grantham on Gold: The "Faith-based Metal"
-Buffett: Forget Gold, Buy Stocks
-Gold vs Productive Assets
-Grantham: Gold is "Last Refuge of the Desperate"
-Why Buffett's Not a Big Fan of Gold
* Examples of what Buffett calls productive assets:
- Businesses (incl. partial ownership of businesses via marketable stocks)
- Farms
- Real Estate
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.
So fans of the yellow stuff will rightly point to that fact.
I'll say upfront that I have just about zero interest in owning gold or any other nonproductive asset. Yet I'm certainly familiar with some of the arguments that are made for owning gold. As is often the case, Jim Grant is thoughtful on the subject of gold (and many other things related to finance and financial history) and worth paying attention to whether or not you happen to agree with him.
Grant points out that the dollar -- and this clearly applies to other paper currencies -- has "no intrinsic value" and is "faith-based."
Can't really argue with that but I think Jeremy Grantham makes a fair point when he says:
"...just as Jim Grant tells us (correctly) that we all have faith-based paper currencies backed by nothing, it is equally fair to say that gold is a faith-based metal. It pays no dividend, cannot be eaten, and is mostly used for nothing more useful than jewelry."
Grant does, in fact, think it makes sense to own gold recently calling it "an investment in financial and monetary disorder."
He also makes his case for a return to the gold standard.
"...the existing monetary arrangements are so precarious, so ill-founded and so destructive of the economic activity they are supposed to support and nurture, that they will be replaced by something better."
For Grant, that'd be a monetary system directly linked to the quantity of gold that can be dug up over time.
Those who share these views (and similar ones) may even prove to be right.
I certainly agree that a paper currency, even under the very best of circumstances, is likely -- if not certain -- to diminish in value over the longer haul. Inflation of some kind or another should erode the purchasing power of just about any currency over time whether or not there is a full-blown currency crisis.
The question is what to do about it.
I think that Grantham has it essentially just about right:
"I believe that resources in the ground, forestry, agriculture, common stocks, and even real estate are more certain to resist any inflation or paper currency crisis than is gold."
For me, the problem has been and remains estimating what gold is intrinsically worth.
Unlike a high quality business it doesn't produce any cash.
Gold's value is perceived, or maybe relative, but it's not intrinsic.
Jason Zweig explains it this way:
"...you will put lightning in a bottle before you figure out what gold is really worth."
WSJ: Let's Be Honest About Gold: It's a Pet Rock
Without a stream of free cash flow how can what something is intrinsically worth, if anything, be known within a narrow enough range?
Warren Buffett, much like Grantham, also suggests that productive assets* are the way to go: "Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor" to buy something like their favorite soda or candy.
Investing in a productive asset is very different than attempting to guess what someone else will be willing to pay for a lump of metal down the road. Here's what Buffett once said on CNBC:
"...it is an entirely different game to buy a lump of something and hope that somebody else pays you more for that lump two years from now than it is to buy something you expect to produce income for you over time."
Some may know (or think they know) where the price of gold is headed.
I have no idea and never will.
In fact, I'll never spend a moment trying to guess such a thing.
Zweig writes the following about those who are the truest believers -- the so-called "gold bugs" -- in the wisdom of gold ownership.
"Recognize...that gold bugs...often resemble the subjects of a laboratory experiment on the psychology of cognitive dissonance.
When you are in the grip of cognitive dissonance, anything that could be regarded as evidence that you might be wrong becomes proof that you must be right."
He then added this line:
"You don't want to be one of these people, spending years telling reality that it is wrong."
Avg Annual Return Since 1975 (after inflation)
- Gold: 0.8%
- Bonds: 5.0% ,
- Stocks: 8.3%
- Cash: 1.1%
Maybe the future will prove very different.
Personally, I'd be surprised if stocks or bonds do nearly as well going forward considering current valuations especially if (when?) interest rates normalize.
Gold?
No idea.
Few asset categories, broadly speaking, are plainly inexpensive though there's almost always some individual investment that's selling at a discount for situation specific reasons.
(The tough part being to find one you understand well enough to invest.)
Charlie Munger is, to say the least, usually rather forthright and has a unique way of getting to the point. Well, here's how he looks at gold:
"I don't have the slightest interest in gold. I like understanding what works and what doesn't in human systems. To me that's not optional; that's a moral obligation. If you're capable of understanding the world, you have a moral obligation to become rational. And I don't see how you become rational hoarding gold. Even if it works, you're a jerk."
And one final thought on gold from Jeremy Grantham...
"I hate gold. It does not pay a dividend, it has no value, and you can't work out what it should or shouldn't be worth...It is the last refuge of the desperate."
Of course, for all I know, gold will do very well in the future.
This is irrelevant for me since I have no way of valuing it.
For me it's simple:
If I don't know how to value something, I shouldn't own it.
Adam
Related posts:
-Buffett & Munger on Gold
-Buffett on Productive Assets
-Buffett: Why Stocks Beat Gold
-Buffett: Why Stocks Beat Bonds
-Buffett on Gold, Farms, and Businesses
-Edison on Gold: Fictitious Value & Superstition
-Munger on Buying Gold
-Thomas Edison on Gold
-Grantham on Gold: The "Faith-based Metal"
-Buffett: Forget Gold, Buy Stocks
-Gold vs Productive Assets
-Grantham: Gold is "Last Refuge of the Desperate"
-Why Buffett's Not a Big Fan of Gold
* Examples of what Buffett calls productive assets:
- Businesses (incl. partial ownership of businesses via marketable stocks)
- Farms
- Real Estate
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Friday, October 31, 2014
Quality Stocks & the Risk-Return Tradeoff
Roughly five years ago, Jeremy Grantham said the following about what he calls "quality stocks".
"Quality stocks have outperformed the market since 1965 (when our quality data begins)..."
When Grantham talks about "quality stocks", he is referring to those that produce a "high and stable return".
He then adds:
"...Fama and French adopted a circular argument rather typical of finance academics in the 1970 to 2000 era: the market is efficient; P/B and small cap outperform, ergo they must be risk factors. That the result in this case happens to get to the right result is luck. The real behavioral market is perfectly happy not rewarding 'risk' when it feels like it, as is shown by the 70-year underperformance of high beta stocks. But this time it worked. Price-to-book, despite its low beta, is a risk factor because of its low fundamental quality and its vulnerability to failure in a depression. This is true with small cap as well. But what about 'Quality?' This factor has outperformed forever. (The S&P had a High Grade Index that started in 1925 and handsomely outperformed the S&P 500 to the end of 1965 when our data starts.) Since the market is efficient, to Fama and French quality must be a risk factor! So, by protecting you in the 1929 Crash and in 2008, and by having a low beta for that matter, Quality as represented by Coca-Cola and Johnson & Johnson must be a hidden risk factor. Oh, I know: 'The real world is merely an inconvenient special case!'"
The bad news is, unlike when Grantham wrote the above, quality stocks aren't at all cheap these days. Still, the above makes an important broader point about risk and return even if the stocks themselves -- at current prices -- are far less attractive.*
So let's start by looking at a rather conventional explanation of the tradeoff between risk and return.
From Investopedia:
"...potential return rises with an increase in risk. Low levels of uncertainty (low-risk) are associated with low potential returns, whereas high levels of uncertainty (high-risk) are associated with high potential returns."
So many assume that more risk must be taken to produce greater rewards. That might at first glance seem very reasonable but, well, it's just not.
Brett Arends explains it this way:
"Conventional wisdom will often tell you that the only way to earn higher returns than the overall stock market — the only way to 'beat the market' — is to take more risk.
This idea is at the heart of the 'modern portfolio theory' that is probably practiced by your investment manager. It sounds plausible. It sounds credible. Everyone can understand it, and it is a generally accepted assumption.
The only problem? It's wrong. New research has found that you could have earned higher returns than the market in the past while taking on lower risk. This isn't a minor detail. This turns conventional finance upside-down."
Howard Marks put forward two useful and relevant charts on risk and return (at the bottom of page 6 of this memo). The first presents risk and return the traditional way (with risk and return positively correlated).
The second chart explains the relationship between risk and reward in a way that, to me, much more closely represents the world as it is.
Here's how Howard Marks explains it:
"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."
Howard Marks on Risk
So risk and return need not be positively correlated.
It's simple, important, and too often ignored.
In the past I've referred to the following quote from the Superinvestors of Graham-and-Doddsville but it's worth repeating here:**
"Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, 'I have here a six-shooter and I have slipped one cartridge into it. Why don't you just spin it and pull it once? If you survive, I will give you $1 million.' I would decline -- perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice -- now that would be a positive correlation between risk and reward!
The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it's riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is."
The math is obviously pretty simple but let's quickly walk through this:
A dollar bill is found on the ground by two people.
It's probably real.
It might not be.
One person is willing to pay 60 cent (i.e. less than the face value because, if not real, it might be worth zero).
The second is willing to pay 40 cents.
Well, the first person can make 67% if the dollar bill is real and, of course, can lose the 60 cents if it's a fake.
The second person can make 150%, if real, and lose the 40 cents, if not.
Two-thirds the possible loss; more than twice the return. Reduced risk of permanent capital loss; greater reward. Things like the capital asset pricing model (CAPM) and the three factor model are not built for the possibility of a negative correlation between risk and reward. So the higher return produced at less risk ends up as alpha. Well, at least it does for those who buy into modern finance theory.
To me, this makes alpha the ultimate fudge factor because, in a scenario like the above, it masks what's really going on.
It masks the reality that, sometimes, risk and reward need not be positively correlated. This might seem harmless but I think the relationship between risk and reward as it is (whether positive or negative) should be explained in clear terms (i.e. instead of calling it an abnormal rate of return compared to what's predicted by an equilibrium model like CAPM).
So the assumption more risk must be taken to get more reward is an incorrect one. This idea is not exactly new -- considering that Buffett's comments, for example, were made roughly 30 years ago -- even if frequently ignored.
Somehow, that more risk must be taken to increase rewards remains at the core of modern finance to this day.
Adam
Related posts:
-Howard Marks on Risk
-Altria: Timing Isn't Everything, Part II
-Altria: Timing Isn't Everything
-Grantham on Efficient Markets, Bubbles, and Ignoble Prizes
-Efficient Markets - Part II
-Risk and Reward Revisited
-Boring Stocks
-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
-Defensive Stocks?
* The higher quality stocks mostly are not selling at a discount to value these days. At least that is my view. They're still good businesses but the shares just don't provide any protection against what might go wrong. It's, of course, impossible to predict when shares are going to sell at attractive prices. The risk of not owning a good stock at a fair price is a real one (error of omission) that sometimes doesn't get enough consideration. It's why buying what becomes cheap (for those comfortable buying individual stocks) when the opportunity arise is so important. It wasn't tough to buy shares in some of the highest quality businesses at a nice discount to per share intrinsic value several years ago. The situation is very different now. Unfortunately, it's just not possible to know if/when they'll be available at a discount in the future. So decisive action with an eye toward the long-term (i.e. that means mostly ignoring the near-term and even intermediate-term price action after purchase) is required whenever they happen to get cheap enough. The time to buy with a big margin of safety, at least for now, seems to have passed.
** See toward the end of the Superinvestors of Graham-and-Doddsville for more on risk and reward and why it need not be correlated in a positive manner. That more risk must be taken to achieve greater rewards, along with efficient markets and rational expectations, still somehow take center stage within much modern finance theory. They remain at the heart of modern financial and economic theory though, fortunately, some of these theories have taken a real hit. Their influence over time -- sometimes quietly, sometimes less so -- can do real world economic damage.
---
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.
"Quality stocks have outperformed the market since 1965 (when our quality data begins)..."
When Grantham talks about "quality stocks", he is referring to those that produce a "high and stable return".
He then adds:
"...Fama and French adopted a circular argument rather typical of finance academics in the 1970 to 2000 era: the market is efficient; P/B and small cap outperform, ergo they must be risk factors. That the result in this case happens to get to the right result is luck. The real behavioral market is perfectly happy not rewarding 'risk' when it feels like it, as is shown by the 70-year underperformance of high beta stocks. But this time it worked. Price-to-book, despite its low beta, is a risk factor because of its low fundamental quality and its vulnerability to failure in a depression. This is true with small cap as well. But what about 'Quality?' This factor has outperformed forever. (The S&P had a High Grade Index that started in 1925 and handsomely outperformed the S&P 500 to the end of 1965 when our data starts.) Since the market is efficient, to Fama and French quality must be a risk factor! So, by protecting you in the 1929 Crash and in 2008, and by having a low beta for that matter, Quality as represented by Coca-Cola and Johnson & Johnson must be a hidden risk factor. Oh, I know: 'The real world is merely an inconvenient special case!'"
The bad news is, unlike when Grantham wrote the above, quality stocks aren't at all cheap these days. Still, the above makes an important broader point about risk and return even if the stocks themselves -- at current prices -- are far less attractive.*
So let's start by looking at a rather conventional explanation of the tradeoff between risk and return.
From Investopedia:
"...potential return rises with an increase in risk. Low levels of uncertainty (low-risk) are associated with low potential returns, whereas high levels of uncertainty (high-risk) are associated with high potential returns."
So many assume that more risk must be taken to produce greater rewards. That might at first glance seem very reasonable but, well, it's just not.
Brett Arends explains it this way:
"Conventional wisdom will often tell you that the only way to earn higher returns than the overall stock market — the only way to 'beat the market' — is to take more risk.
This idea is at the heart of the 'modern portfolio theory' that is probably practiced by your investment manager. It sounds plausible. It sounds credible. Everyone can understand it, and it is a generally accepted assumption.
The only problem? It's wrong. New research has found that you could have earned higher returns than the market in the past while taking on lower risk. This isn't a minor detail. This turns conventional finance upside-down."
Howard Marks put forward two useful and relevant charts on risk and return (at the bottom of page 6 of this memo). The first presents risk and return the traditional way (with risk and return positively correlated).
The second chart explains the relationship between risk and reward in a way that, to me, much more closely represents the world as it is.
Here's how Howard Marks explains it:
"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."
Howard Marks on Risk
So risk and return need not be positively correlated.
It's simple, important, and too often ignored.
In the past I've referred to the following quote from the Superinvestors of Graham-and-Doddsville but it's worth repeating here:**
"Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, 'I have here a six-shooter and I have slipped one cartridge into it. Why don't you just spin it and pull it once? If you survive, I will give you $1 million.' I would decline -- perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice -- now that would be a positive correlation between risk and reward!
The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it's riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is."
The math is obviously pretty simple but let's quickly walk through this:
A dollar bill is found on the ground by two people.
It's probably real.
It might not be.
One person is willing to pay 60 cent (i.e. less than the face value because, if not real, it might be worth zero).
The second is willing to pay 40 cents.
Well, the first person can make 67% if the dollar bill is real and, of course, can lose the 60 cents if it's a fake.
The second person can make 150%, if real, and lose the 40 cents, if not.
Two-thirds the possible loss; more than twice the return. Reduced risk of permanent capital loss; greater reward. Things like the capital asset pricing model (CAPM) and the three factor model are not built for the possibility of a negative correlation between risk and reward. So the higher return produced at less risk ends up as alpha. Well, at least it does for those who buy into modern finance theory.
To me, this makes alpha the ultimate fudge factor because, in a scenario like the above, it masks what's really going on.
It masks the reality that, sometimes, risk and reward need not be positively correlated. This might seem harmless but I think the relationship between risk and reward as it is (whether positive or negative) should be explained in clear terms (i.e. instead of calling it an abnormal rate of return compared to what's predicted by an equilibrium model like CAPM).
So the assumption more risk must be taken to get more reward is an incorrect one. This idea is not exactly new -- considering that Buffett's comments, for example, were made roughly 30 years ago -- even if frequently ignored.
Somehow, that more risk must be taken to increase rewards remains at the core of modern finance to this day.
Adam
Related posts:
-Howard Marks on Risk
-Altria: Timing Isn't Everything, Part II
-Altria: Timing Isn't Everything
-Grantham on Efficient Markets, Bubbles, and Ignoble Prizes
-Efficient Markets - Part II
-Risk and Reward Revisited
-Boring Stocks
-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
-Defensive Stocks?
* The higher quality stocks mostly are not selling at a discount to value these days. At least that is my view. They're still good businesses but the shares just don't provide any protection against what might go wrong. It's, of course, impossible to predict when shares are going to sell at attractive prices. The risk of not owning a good stock at a fair price is a real one (error of omission) that sometimes doesn't get enough consideration. It's why buying what becomes cheap (for those comfortable buying individual stocks) when the opportunity arise is so important. It wasn't tough to buy shares in some of the highest quality businesses at a nice discount to per share intrinsic value several years ago. The situation is very different now. Unfortunately, it's just not possible to know if/when they'll be available at a discount in the future. So decisive action with an eye toward the long-term (i.e. that means mostly ignoring the near-term and even intermediate-term price action after purchase) is required whenever they happen to get cheap enough. The time to buy with a big margin of safety, at least for now, seems to have passed.
** See toward the end of the Superinvestors of Graham-and-Doddsville for more on risk and reward and why it need not be correlated in a positive manner. That more risk must be taken to achieve greater rewards, along with efficient markets and rational expectations, still somehow take center stage within much modern finance theory. They remain at the heart of modern financial and economic theory though, fortunately, some of these theories have taken a real hit. Their influence over time -- sometimes quietly, sometimes less so -- can do real world economic damage.
---
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, March 10, 2014
Buffett on "Asset Gathering" vs "Asset Managing"
During this CNBC interview, Warren Buffett and Becky Quick discussed the compensation of his two investment managers, Todd Combs and Ted Weschler:
BECKY: "Both of them were managing their own hedge funds before, and the compensation structure in Berkshire is very different than the two and 20 you would get if you were a hedge fund manager."
BUFFETT: "That's right. If they-- last year they started with about five billion each. If they'd put it under the mattress under the standard hedge fund arrangement they each would've made about $100 million. I mean, that shows you how nutty the arrangement is.
But they would have literally made $100 million by sticking it under the mattress. If they put it in an index fund, and gotten the two and 20, they each would've made over $300 million. All they had to do was buy the vanguard index. And they each would've made over $300 million. They also would've gotten more favorable tax treatment on it then they got by getting a salary from Berkshire.
So imagine I mean, you can retire forever on $300 million. So one year you go, you put the money in an index fund so it just shows that the-- it shows you amounts you get by asset gathering rather than asset managing. I mean even though a great many hedge funds in recent years have not delivered high performance, they've delivered high fees.
But our arrangement is that they get a salary and then they get which to most hedge fund guys would look like nothing, and then they get paid on the excess. They get ten percent of the excess over the S&P performance. But it's done over a three year staggered period. So they can't have just one up year and then another down year, or something of the sort."
Buffett then added...
"So, only if they do better than I can do by sticking the money in an S&P fund do they get paid a dime of performance. And it seems to me that's quite logical, but it's not something that the hedge fund community is out there pushing harder for."
(The above is from page 29-30 of the transcript.)
Berkshire has over $ 200 billion of stocks, bonds, and cash equivalents.
If two and twenty was the compensation structure used by Berkshire, the 2 percent alone would cost the company -- and, of course, the owners -- $ 4 billion per year.
Also, let's say, in a year there is a 10% portfolio return (a $ 20 billion gain). Well, using the traditional hedge fund arrangement, 20% of that gain would become compensation and cost the company an addition $ 4 billion. So that'd be $ 8 billion of additional compensation cost for Berkshire.
(Again, that's per year and, of course, quite a bit more if the portfolio were to perform exceptionally well in a particular year.)
So, those with this arrangement, by gathering enough assets, do more than just fine even with just subpar performance (they still get the 2% of assets under management) and really well in any year they generate some decent or better gains (20% of profits).*
If Berkshire had such an arrangement, this cost would hit the company year after year, dramatically lowering intrinsic value.
But, in my view, that's not all that's of significance here.
Consider the entire amount that Berkshire is spending these days on plant and equipment:
"Our subsidiaries spent a record $11 billion on plant and equipment during 2013, roughly twice our depreciation charge. About 89% of that money was spent in the United States. Though we invest abroad as well, the mother lode of opportunity resides in America." - From Buffett's latest Berkshire Hathaway (BRKa) Shareholder Letter (page 5)
So in a year that the portfolio produces a 10% return -- even if it simply equals the S&P 500 -- those typical hedge fund fees would consume $ 8 billion of the $ 11 billion (there are some accounting and tax considerations but no need to split hairs) of what is mostly rather useful infrastructure (railroads, utilities, and pipelines among other things) that, not only serves shareholders, likely improves the productive capacity of society more generally. That's a big hit to important capital investments year after year. Berkshire's capital expenditures cut across lots of different businesses, but a significant portion comes down to the following (from page 11-12 of the letter):
- BNSF Railway which "carries about 15%...of all inter-city freight, whether it is transported by truck, rail, water, air, or pipeline" in the United States.
"Indeed, we move more ton-miles of goods than anyone else, a fact establishing BNSF as the most important artery in our economy’s circulatory system."
- MidAmerican is made up of utilities that "serve regulated retail customers in eleven states" and includes a large amount of pipeline infrastructure.**
"...we are the leader in renewables: From a standing start nine years ago, MidAmerican now accounts for 7% of the country’s wind generation capacity, with more on the way. Our share in solar – most of which is still in construction – is even larger."
Buffett notes that, once completed, they'll have spent $ 15 billion on their renewables portfolio alone.
"We relish making such commitments as long as they promise reasonable returns."
The reinforcement and expansion of all this infrastructure would, instead, be undermined by the need to pay those hedge fund like fees.
"...society will forever need massive investments in both transportation and energy. It is in the self-interest of governments to treat capital providers in a manner that will ensure the continued flow of funds to essential projects. It is meanwhile in our self-interest to conduct our operations in a way that earns the approval of our regulators and the people they represent."
Well, if such fees can so materially reduce Berkshire's ability to make important investments -- and I think an $ 8 billion haircut out of $ 11 billion (73%) qualifies as a material hit -- it's not a stretch to suggest that this prevailing compensation system subtracts from the effectiveness of capital formation and allocation in a more general sense.
I mean, is the world really better off with so much capital being quietly siphoned in this way?
I've used this quote by Jeremy Grantham before, but it remains relevant:
"If we [the investment industry] raise our fees from 0.5 percent to 1 percent, we actually raid the balance sheet. We take 0.5 per cent from what would have been savings and investment and turn it into income and GDP. In other words, you're taking money that would have become capital and chewing it up as bankers' bonuses." - Jeremy Grantham
Jeremy Grantham: 'We Add Nothing But Costs'
Anyone who thinks the current system is serving the world anywhere near optimally is kidding themselves or, just maybe, suffers from some kind of self-serving bias.***
The negative compounded effect over time isn't small. Consider that these extreme fees do not only cut into today's capacity for capital expenditures; they also inhibit future increases to capex.
So that would mean Berkshire's capacity to make incremental purchases of plant and equipment -- let's say 10-20 years from now -- ends up a shadow of its potential.
According to this article, the hedge fund industry assets under management stands at $ 2 trillion.
This indicates it's a bit more.
Either way, it has increased substantially over the years. So the overall impact is certainly not getting smaller. The two and twenty arrangement (and similar) against a $ 2 trillion plus asset base doesn't exactly amount to spare change.
Some will argue that eventually at least a portion of all those fees will end up being put to work as capital in some form again. While that's true it is, to me, a terribly inefficient way to go about allocating funds to their most productive uses.
Frictional costs matter.
In the letter, Buffett mentions the "crumbling infrastructure" of the U.S. (though, as he points out, it doesn't apply to railroads). Well, maybe it'd be crumbling just a bit less if the Berkshire model was more the norm instead of the exception.
Berkshire's business prospects would necessarily be a lot different in twenty years if, as in the example above, 70-75% of its capital expenditures were diverted to fees instead of investing in useful and economically sound infrastructure enhancements.
I'm not suggesting the impact, on a compounded basis, is limited to infrastructure; these fees also impact investment more generally.
I'm also not suggesting these frictional costs could be eliminated entirely. There's a vital role to be played by effective investment management and related activities.
There'll always a certain necessary amount of frictional costs, yet I don't think it is hard to argue we are well beyond that amount.
I'm just suggesting, in it's current form and with current norms, these aren't just harmless defects and that obvious room for improvement exists (and it's not just the hedge funds); that a directional shift would be a very good thing should be obvious to all but those who are currently served well by the existing system.
This isn't to say that there are not some very capable hedge fund managers. There certainly are some very talented managers capable of delivering terrific long run results. It's just that the prevailing compensation system is too often a heads-I-win-tails-I-win-more system (for the investment managers, not the investors). Now, it seems pretty tough to blame anyone -- including those who might be somewhat (or even a whole lot) less talented than the very best -- for simply going where the money is. That's a perfectly legitimate and reasonable thing to do even if I happen to think, in its current form, the system doesn't serve its greater purpose nearly as well as it could.
Meaningful changes to behavior don't usually come about without real changes to the system itself.
Considering how lucrative the system is for those who benefit directly, don't expect the change to come from within or, as Buffett said during the interview, change is "not something that the hedge fund community is out there pushing harder for."
It's a fundamental overhaul that, among other things, would alter incentives (and ultimately even culture) but I won't even begin to suggest that there's an easy solution.
That a change is needed seems pretty clear. How to make it come about considering the forces at work is not at all obvious to me.
Still, it remains a big opportunity for someone wise and capable enough to fix some of the defects.
That's not going to happen soon. In the meantime, investors have no shortage of ways to avoid these costs and, well, just might want to act accordingly.
Adam
Long position in BRKb established at much lower than recent market prices
* Some will surely argue that you don't gather lots of assets unless the performance warrants it. While this no doubt is true in some cases, at times a somewhat different dynamic is at work. Brilliant performance over several years can attract lots of assets. Several years may seem a long time but, with investing, it's just generally not long enough. It's necessarily difficult to know what previous short and even intermediate performance tells you about future outcomes. Was it sound process or good fortune? Figuring out what previous returns reveal, if anything, to the investor about future outcomes is difficult enough, but judging how much risk was involved is even more so. That's just the nature of risk. Returns are relatively easy to measure; risks often not so much. A fund may seem to perform very well for years until the inherent weakness of an approach is revealed. It's sometimes not obvious that the apparent investment genius was merely a beneficiary of things like but certainly not limited to: random chance, a period that happened to be compatible with a particular approach, lots of leverage, and/or some other form excessive risk-taking that wasn't clear to investors before things went very badly south. Since, at these compensation levels one good year can make someone very rich indeed, the idea that this type of compensation system encourages, on a widespread basis, sound long-term capital allocation, with attractive returns, and smart risk management seems unlikely. Exceptions will always exist, but a well-designed system shouldn't be built around the exceptions. Even if it was broadly contributing to wise capital allocation, the huge frictional costs added to the system as a whole with little to no net benefit seems undeniable. The system will never be perfect; it could be much better.
** From the 2010 letter: "Our pipelines transport 8% of the country's natural gas. Obviously, many millions of Americans depend on us every day."
*** According to these notes, Charlie Munger said the following at USC Law School commencement back in 2007: Thinking that what's good for you is good for the wider civilization and rationalizing all these ridiculous conclusions based on this subconscious tendency to serve one's self is a terribly inaccurate way to think. Of course you want to drive that out of yourself because you want to be wise, not foolish. You also have to allow for the self-serving bias of everybody else because most people are not going to remove it all that successfully, the human condition being what it is. If you don't allow for self-serving bias in your conduct, again you're a fool.
---
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.
BECKY: "Both of them were managing their own hedge funds before, and the compensation structure in Berkshire is very different than the two and 20 you would get if you were a hedge fund manager."
BUFFETT: "That's right. If they-- last year they started with about five billion each. If they'd put it under the mattress under the standard hedge fund arrangement they each would've made about $100 million. I mean, that shows you how nutty the arrangement is.
But they would have literally made $100 million by sticking it under the mattress. If they put it in an index fund, and gotten the two and 20, they each would've made over $300 million. All they had to do was buy the vanguard index. And they each would've made over $300 million. They also would've gotten more favorable tax treatment on it then they got by getting a salary from Berkshire.
So imagine I mean, you can retire forever on $300 million. So one year you go, you put the money in an index fund so it just shows that the-- it shows you amounts you get by asset gathering rather than asset managing. I mean even though a great many hedge funds in recent years have not delivered high performance, they've delivered high fees.
But our arrangement is that they get a salary and then they get which to most hedge fund guys would look like nothing, and then they get paid on the excess. They get ten percent of the excess over the S&P performance. But it's done over a three year staggered period. So they can't have just one up year and then another down year, or something of the sort."
Buffett then added...
"So, only if they do better than I can do by sticking the money in an S&P fund do they get paid a dime of performance. And it seems to me that's quite logical, but it's not something that the hedge fund community is out there pushing harder for."
(The above is from page 29-30 of the transcript.)
Berkshire has over $ 200 billion of stocks, bonds, and cash equivalents.
If two and twenty was the compensation structure used by Berkshire, the 2 percent alone would cost the company -- and, of course, the owners -- $ 4 billion per year.
Also, let's say, in a year there is a 10% portfolio return (a $ 20 billion gain). Well, using the traditional hedge fund arrangement, 20% of that gain would become compensation and cost the company an addition $ 4 billion. So that'd be $ 8 billion of additional compensation cost for Berkshire.
(Again, that's per year and, of course, quite a bit more if the portfolio were to perform exceptionally well in a particular year.)
So, those with this arrangement, by gathering enough assets, do more than just fine even with just subpar performance (they still get the 2% of assets under management) and really well in any year they generate some decent or better gains (20% of profits).*
If Berkshire had such an arrangement, this cost would hit the company year after year, dramatically lowering intrinsic value.
But, in my view, that's not all that's of significance here.
Consider the entire amount that Berkshire is spending these days on plant and equipment:
"Our subsidiaries spent a record $11 billion on plant and equipment during 2013, roughly twice our depreciation charge. About 89% of that money was spent in the United States. Though we invest abroad as well, the mother lode of opportunity resides in America." - From Buffett's latest Berkshire Hathaway (BRKa) Shareholder Letter (page 5)
So in a year that the portfolio produces a 10% return -- even if it simply equals the S&P 500 -- those typical hedge fund fees would consume $ 8 billion of the $ 11 billion (there are some accounting and tax considerations but no need to split hairs) of what is mostly rather useful infrastructure (railroads, utilities, and pipelines among other things) that, not only serves shareholders, likely improves the productive capacity of society more generally. That's a big hit to important capital investments year after year. Berkshire's capital expenditures cut across lots of different businesses, but a significant portion comes down to the following (from page 11-12 of the letter):
- BNSF Railway which "carries about 15%...of all inter-city freight, whether it is transported by truck, rail, water, air, or pipeline" in the United States.
"Indeed, we move more ton-miles of goods than anyone else, a fact establishing BNSF as the most important artery in our economy’s circulatory system."
- MidAmerican is made up of utilities that "serve regulated retail customers in eleven states" and includes a large amount of pipeline infrastructure.**
"...we are the leader in renewables: From a standing start nine years ago, MidAmerican now accounts for 7% of the country’s wind generation capacity, with more on the way. Our share in solar – most of which is still in construction – is even larger."
Buffett notes that, once completed, they'll have spent $ 15 billion on their renewables portfolio alone.
"We relish making such commitments as long as they promise reasonable returns."
The reinforcement and expansion of all this infrastructure would, instead, be undermined by the need to pay those hedge fund like fees.
"...society will forever need massive investments in both transportation and energy. It is in the self-interest of governments to treat capital providers in a manner that will ensure the continued flow of funds to essential projects. It is meanwhile in our self-interest to conduct our operations in a way that earns the approval of our regulators and the people they represent."
Well, if such fees can so materially reduce Berkshire's ability to make important investments -- and I think an $ 8 billion haircut out of $ 11 billion (73%) qualifies as a material hit -- it's not a stretch to suggest that this prevailing compensation system subtracts from the effectiveness of capital formation and allocation in a more general sense.
I mean, is the world really better off with so much capital being quietly siphoned in this way?
I've used this quote by Jeremy Grantham before, but it remains relevant:
"If we [the investment industry] raise our fees from 0.5 percent to 1 percent, we actually raid the balance sheet. We take 0.5 per cent from what would have been savings and investment and turn it into income and GDP. In other words, you're taking money that would have become capital and chewing it up as bankers' bonuses." - Jeremy Grantham
Jeremy Grantham: 'We Add Nothing But Costs'
Anyone who thinks the current system is serving the world anywhere near optimally is kidding themselves or, just maybe, suffers from some kind of self-serving bias.***
The negative compounded effect over time isn't small. Consider that these extreme fees do not only cut into today's capacity for capital expenditures; they also inhibit future increases to capex.
So that would mean Berkshire's capacity to make incremental purchases of plant and equipment -- let's say 10-20 years from now -- ends up a shadow of its potential.
According to this article, the hedge fund industry assets under management stands at $ 2 trillion.
This indicates it's a bit more.
Either way, it has increased substantially over the years. So the overall impact is certainly not getting smaller. The two and twenty arrangement (and similar) against a $ 2 trillion plus asset base doesn't exactly amount to spare change.
Some will argue that eventually at least a portion of all those fees will end up being put to work as capital in some form again. While that's true it is, to me, a terribly inefficient way to go about allocating funds to their most productive uses.
Frictional costs matter.
In the letter, Buffett mentions the "crumbling infrastructure" of the U.S. (though, as he points out, it doesn't apply to railroads). Well, maybe it'd be crumbling just a bit less if the Berkshire model was more the norm instead of the exception.
Berkshire's business prospects would necessarily be a lot different in twenty years if, as in the example above, 70-75% of its capital expenditures were diverted to fees instead of investing in useful and economically sound infrastructure enhancements.
I'm not suggesting the impact, on a compounded basis, is limited to infrastructure; these fees also impact investment more generally.
I'm also not suggesting these frictional costs could be eliminated entirely. There's a vital role to be played by effective investment management and related activities.
There'll always a certain necessary amount of frictional costs, yet I don't think it is hard to argue we are well beyond that amount.
I'm just suggesting, in it's current form and with current norms, these aren't just harmless defects and that obvious room for improvement exists (and it's not just the hedge funds); that a directional shift would be a very good thing should be obvious to all but those who are currently served well by the existing system.
This isn't to say that there are not some very capable hedge fund managers. There certainly are some very talented managers capable of delivering terrific long run results. It's just that the prevailing compensation system is too often a heads-I-win-tails-I-win-more system (for the investment managers, not the investors). Now, it seems pretty tough to blame anyone -- including those who might be somewhat (or even a whole lot) less talented than the very best -- for simply going where the money is. That's a perfectly legitimate and reasonable thing to do even if I happen to think, in its current form, the system doesn't serve its greater purpose nearly as well as it could.
Meaningful changes to behavior don't usually come about without real changes to the system itself.
Considering how lucrative the system is for those who benefit directly, don't expect the change to come from within or, as Buffett said during the interview, change is "not something that the hedge fund community is out there pushing harder for."
It's a fundamental overhaul that, among other things, would alter incentives (and ultimately even culture) but I won't even begin to suggest that there's an easy solution.
That a change is needed seems pretty clear. How to make it come about considering the forces at work is not at all obvious to me.
Still, it remains a big opportunity for someone wise and capable enough to fix some of the defects.
That's not going to happen soon. In the meantime, investors have no shortage of ways to avoid these costs and, well, just might want to act accordingly.
Long position in BRKb established at much lower than recent market prices
* Some will surely argue that you don't gather lots of assets unless the performance warrants it. While this no doubt is true in some cases, at times a somewhat different dynamic is at work. Brilliant performance over several years can attract lots of assets. Several years may seem a long time but, with investing, it's just generally not long enough. It's necessarily difficult to know what previous short and even intermediate performance tells you about future outcomes. Was it sound process or good fortune? Figuring out what previous returns reveal, if anything, to the investor about future outcomes is difficult enough, but judging how much risk was involved is even more so. That's just the nature of risk. Returns are relatively easy to measure; risks often not so much. A fund may seem to perform very well for years until the inherent weakness of an approach is revealed. It's sometimes not obvious that the apparent investment genius was merely a beneficiary of things like but certainly not limited to: random chance, a period that happened to be compatible with a particular approach, lots of leverage, and/or some other form excessive risk-taking that wasn't clear to investors before things went very badly south. Since, at these compensation levels one good year can make someone very rich indeed, the idea that this type of compensation system encourages, on a widespread basis, sound long-term capital allocation, with attractive returns, and smart risk management seems unlikely. Exceptions will always exist, but a well-designed system shouldn't be built around the exceptions. Even if it was broadly contributing to wise capital allocation, the huge frictional costs added to the system as a whole with little to no net benefit seems undeniable. The system will never be perfect; it could be much better.
** From the 2010 letter: "Our pipelines transport 8% of the country's natural gas. Obviously, many millions of Americans depend on us every day."
*** According to these notes, Charlie Munger said the following at USC Law School commencement back in 2007: Thinking that what's good for you is good for the wider civilization and rationalizing all these ridiculous conclusions based on this subconscious tendency to serve one's self is a terribly inaccurate way to think. Of course you want to drive that out of yourself because you want to be wise, not foolish. You also have to allow for the self-serving bias of everybody else because most people are not going to remove it all that successfully, the human condition being what it is. If you don't allow for self-serving bias in your conduct, again you're a fool.
---
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 1, 2014
Quotes of 2013 - Part II
Some additional quotes from 2013 as a follow up to this recent post.
Quotes of 2013
Munger and Buffett: High-Frequency Trading and the Flash Crash
"I think the long term investor is not too much affected by things like the flash crash. That said, I think it is very stupid to allow a system to evolve where half of the trading is a bunch of short term people trying to get information one millionth of a nanosecond ahead of somebody else." - Charlie Munger
"I think it is basically evil and I don't think it should have ever been allowed to reach the size that it did. Why should all of us pay a little group of people to engage in legalized front-running of our orders?" - Charlie Munger
"...it [HFT] is not contributing anything to capitalism." - Warren Buffett
"The flash crash didn't hurt any investor. I mean, you know— you're sitting there with— with a stock. And, you know, and the next day...it's gone past. The frictional cost in...investing for somebody that does it in a real investing manner are really peanuts. I mean, they're far less than the cost in real estate or farms or all kinds of things. So it's— unless you turn it to your disadvantage by trying to do a lot of trading or something of the sort, it's a very, very inexpensive market to operate in...and all that noise should not bother you at all. Forget it." - Warren Buffett
Efficient Markets
"Our current problems are very confusing. If you aren't confused, you don't understand them very well." - Charlie Munger
Market Freezes Up
"Plainly, physics has made a different kind of contribution to human society than economics has. Then, again, physics is an easier nut to crack than economics. Electrons don't have feelings, as they say.
Progress in science is cumulative; we stand on the shoulders of giants. But progress in finance is cyclical; in money and banking, especially, we seem to keep making the same mistakes." - From Page 17-18 in Grant's Interest Rate Observer, Volume 31 Summer Break, August 23rd, 2013
Deadly Sins of Investing
"What happens in the fund business is the magic of compound returns is overwhelmed by the tyranny of compounding cost. It's a mathematical fact. There's no getting around it. The fact that we don't look at it, too bad for us." - John Bogle
John Bogle on "The Last Gatekeeper"
In this Morningstar interview, John Bogle points out that if you add together the money managed by the 25 largest firms in the mutual fund business, it represents something like 50% of the equity in America.
"A small handful of corporations, particularly the top five of them, control corporate America. And corporate America needs a lot of cleanup, a sweeping out. Executive compensation is a disgrace. Political contributions made by corporations are a disgrace..."
Bogle then later added...
"So when you look at the whole picture, really we're the last gatekeeper. Think about that for a minute; I have a chapter in the book about gatekeepers. We're the last gatekeeper. We, the mutual fund industry. The courts have failed us in terms of shareholder rights. The regulators have failed. The security analysts have failed. The money managers have failed. Right down, the press has in many respects failed with a few exceptions. The fund and corporate directors have both failed, and we're now down to the last line: the shareholders who own those companies. And if they don't speak, there's nobody left, and corporations should not be left to operate as private fiefdoms of their chief executives."
Grantham on Efficient Markets, Bubbles, and Ignoble Prizes
"Economics is a very soft science but it has delusions of hardness or what has been called physics envy. One of my few economic heroes, Kenneth Boulding, said that while mathematics had indeed introduced rigor into economics, it unfortunately also brought mortis. Later in his career he felt that economics had lost sight of its job to be useful to society, having lost its way in a maze of econometric formulas, which placed elegance over accuracy.
At the top of the list of economic theories based on clearly false assumptions is that of Rational Expectations, in which humans are assumed to be machines programmed with rational responses. Although we all know – even economists – that this assumption does not fi t the real world, it does allow for relatively simple conclusions, whereas the assumption of complicated, inconsistent, and emotional humanity does not. The folly of Rational Expectations resulted in five, six, or seven decades of economic mainstream work being largely thrown away. It did leave us, though, with perhaps the most laughable of all assumption-based theories, the Efficient Market Hypothesis (EMH).
We are told that investment bubbles have not occurred and, indeed, could never occur, by the iron law of the unproven assumptions used by the proponents of the EMH. Yet, in front of our eyes there have appeared in the last 25 years at least four of the great investment bubbles in all of investment history." - Jeremy Grantham
"So, economics has been more or less threadbare for 50 years. Pity then the plight of the Bank of Sweden with all that money to give away in honor of Alfred Nobel and in envy, perhaps, of the harder sciences." - Jeremy Grantham
Happy New Year,
Adam
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Quotes of 2013
Munger and Buffett: High-Frequency Trading and the Flash Crash
"I think the long term investor is not too much affected by things like the flash crash. That said, I think it is very stupid to allow a system to evolve where half of the trading is a bunch of short term people trying to get information one millionth of a nanosecond ahead of somebody else." - Charlie Munger
"I think it is basically evil and I don't think it should have ever been allowed to reach the size that it did. Why should all of us pay a little group of people to engage in legalized front-running of our orders?" - Charlie Munger
"...it [HFT] is not contributing anything to capitalism." - Warren Buffett
"The flash crash didn't hurt any investor. I mean, you know— you're sitting there with— with a stock. And, you know, and the next day...it's gone past. The frictional cost in...investing for somebody that does it in a real investing manner are really peanuts. I mean, they're far less than the cost in real estate or farms or all kinds of things. So it's— unless you turn it to your disadvantage by trying to do a lot of trading or something of the sort, it's a very, very inexpensive market to operate in...and all that noise should not bother you at all. Forget it." - Warren Buffett
Efficient Markets
"Our current problems are very confusing. If you aren't confused, you don't understand them very well." - Charlie Munger
Market Freezes Up
"Plainly, physics has made a different kind of contribution to human society than economics has. Then, again, physics is an easier nut to crack than economics. Electrons don't have feelings, as they say.
Progress in science is cumulative; we stand on the shoulders of giants. But progress in finance is cyclical; in money and banking, especially, we seem to keep making the same mistakes." - From Page 17-18 in Grant's Interest Rate Observer, Volume 31 Summer Break, August 23rd, 2013
Deadly Sins of Investing
"What happens in the fund business is the magic of compound returns is overwhelmed by the tyranny of compounding cost. It's a mathematical fact. There's no getting around it. The fact that we don't look at it, too bad for us." - John Bogle
John Bogle on "The Last Gatekeeper"
In this Morningstar interview, John Bogle points out that if you add together the money managed by the 25 largest firms in the mutual fund business, it represents something like 50% of the equity in America.
"A small handful of corporations, particularly the top five of them, control corporate America. And corporate America needs a lot of cleanup, a sweeping out. Executive compensation is a disgrace. Political contributions made by corporations are a disgrace..."
Bogle then later added...
"So when you look at the whole picture, really we're the last gatekeeper. Think about that for a minute; I have a chapter in the book about gatekeepers. We're the last gatekeeper. We, the mutual fund industry. The courts have failed us in terms of shareholder rights. The regulators have failed. The security analysts have failed. The money managers have failed. Right down, the press has in many respects failed with a few exceptions. The fund and corporate directors have both failed, and we're now down to the last line: the shareholders who own those companies. And if they don't speak, there's nobody left, and corporations should not be left to operate as private fiefdoms of their chief executives."
"Economics is a very soft science but it has delusions of hardness or what has been called physics envy. One of my few economic heroes, Kenneth Boulding, said that while mathematics had indeed introduced rigor into economics, it unfortunately also brought mortis. Later in his career he felt that economics had lost sight of its job to be useful to society, having lost its way in a maze of econometric formulas, which placed elegance over accuracy.
At the top of the list of economic theories based on clearly false assumptions is that of Rational Expectations, in which humans are assumed to be machines programmed with rational responses. Although we all know – even economists – that this assumption does not fi t the real world, it does allow for relatively simple conclusions, whereas the assumption of complicated, inconsistent, and emotional humanity does not. The folly of Rational Expectations resulted in five, six, or seven decades of economic mainstream work being largely thrown away. It did leave us, though, with perhaps the most laughable of all assumption-based theories, the Efficient Market Hypothesis (EMH).
We are told that investment bubbles have not occurred and, indeed, could never occur, by the iron law of the unproven assumptions used by the proponents of the EMH. Yet, in front of our eyes there have appeared in the last 25 years at least four of the great investment bubbles in all of investment history." - Jeremy Grantham
"So, economics has been more or less threadbare for 50 years. Pity then the plight of the Bank of Sweden with all that money to give away in honor of Alfred Nobel and in envy, perhaps, of the harder sciences." - Jeremy Grantham
Happy New Year,
Adam
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Friday, December 27, 2013
Quotes of 2013
A collection of quotes said or written at some point during this calendar year.
Grantham: Investing in a Low-Growth World
"All corporate growth has to funnel through return on equity. The problem with growth companies and growth countries is that they so often outrun the capital with which to grow and must raise more capital. Investors grow rich not on earnings growth, but on growth in earnings per share. There is almost no evidence that faster-growing countries have higher margins. In fact, it is slightly the reverse." - Jeremy Grantham
"The fact that growth companies historically have underperformed the market – probably because too much was expected of them and because they were more appealing to clients – was not accepted for decades, but by about the mid-1990s the historical data in favor of 'value' stocks began to overwhelm the earlier logically appealing idea that growth should win out. It was clear that 'value' or low growth stocks had won for the prior 50 years at least. This was unfortunate because the market's faulty intuition had made it very easy for value managers or contrarians to outperform. Ah, the good old days! But now the same faulty intuition applies to fast-growing countries. How appealing an assumption it is that they should beat the slow pokes. But it just ain't so." - Jeremy Grantham
Buffett on Berkshire's "Powerhouse Five" & "Big Four"
"At Berkshire we much prefer owning a non-controlling but substantial portion of a wonderful business to owning 100% of a so-so business. Our flexibility in capital allocation gives us a significant advantage over companies that limit themselves only to acquisitions they can operate." - Warren Buffett
Buffett on Berkshire's Float
"If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit is earned, we enjoy the use of free money – and, better yet, get paid for holding it. That's like your taking out a loan and having the bank pay you interest." - Warren Buffett
"...we have now operated at an underwriting profit for ten consecutive years, our pre-tax gain for the period having totaled $18.6 billion. Looking ahead, I believe we will continue to underwrite profitably in most years. If we do, our float will be better than free money." - Warren Buffett
"So how does our attractive float affect the calculations of intrinsic value? When Berkshire's book value is calculated, the full amount of our float is deducted as a liability, just as if we had to pay it out tomorrow and were unable to replenish it. But that's an incorrect way to look at float..." - Warren Buffett
"The value of our float is one reason – a huge reason – why we believe Berkshire's intrinsic business value substantially exceeds its book value." - Warren Buffett
Warren Buffett on "The Key to Investing"
"American business will do fine over time. And stocks will do well just as certainly, since their fate is tied to business performance. Periodic setbacks will occur, yes, but investors and managers are in a game that is heavily stacked in their favor. (The Dow Jones Industrials advanced from 66 to 11,497 in the 20th Century, a staggering 17,320% increase that materialized despite four costly wars, a Great Depression and many recessions. And don't forget that shareholders received substantial dividends throughout the century as well.)
Since the basic game is so favorable, Charlie and I believe it's a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of 'experts,' or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it." - Warren Buffett
Not Picking Stocks By The Numbers
An exchange between Warren Buffett and Charlie Munger as summarized by the Wall Street Journal's live blog:
"We are looking at businesses exactly like we are looking at them if somebody came in and asked us to buy the whole business," Buffett said. He said they then want to know how it will do in ten years.
Munger was even more forceful: "We don't know how to buy stocks by metrics ... We know that Burlington Northern will have a competitive advantage in years ... we don't know what the heck Apple will have. ... You really have to understand the company and its competitive positions. ... That's not disclosed by the math.
Buffett: "I don't know how I would manage money if I had to do it just on the numbers."
Munger, interupting, "You'd do it badly."
Buffett on Bonds and Productive Assets
"I bought a piece of real estate in New York in 1992, I have not had a quote on it since. I look to the performance of the assets. Maybe...my piece of real estate have had pull backs, but I don't even know about 'em. People pay way too— way too much attention to the short term. If you're getting your money's worth in a stock, buy it and forget it." - Warren Buffett
"...interest rates have a powerful effect on...all assets. Real estate, farms, oil, everything else...they're the cost of carrying other assets. They're the alternative. They're the yardstick." - Warren Buffett
"...the fact that there are troubles in Europe, and there are plenty of troubles, and they're not going go away fast, does not mean you don't buy stocks. We bought stocks when the United States was in trouble, in 2008 and— and it was in huge trouble and we spent 15 1/2 billion in three weeks in— between September 15th and October 10th. It wasn't because the news was good, it was because the prices were good." - Warren Buffett
"In terms of stocks, you know, stocks are reasonably priced. They were very cheap a few years ago. They're reasonably priced now. But stocks grow in value over time because they retain earnings..." - Warren Buffett
(Stocks prices were, of course, generally much lower when Buffett said this compared to now.)
"There could be conditions under which we...would own bonds. But— they're conditions far different than what exist now." - Warren Buffett
"I would have productive assets. I would favor those enormously over fixed dollars investments now, and I think it's silly — to have some ratio like 30 or 40 or 50% in bonds. They're terrible investments now." - Warren Buffett
"News is better now. Stocks are higher. They're still not— they're not ridiculously high at all, and bonds are priced artificially. You've got some guy buying $85 billion a month. (LAUGH) And— that will change at some point. And when it changes, people could lose a lot of money if they're in long-term bonds." - Warren Buffett
"...I bought a farm in 1985, I haven't had— had a quote on it since. But I know what it's produced every year. And I know it's worth more money now. You know, it— if I'd gotten a quote on it every day and somebody's said, "You know, maybe you oughta sell because there's, you know, there's clouds in the West," or something. (LAUGH) It's — it's crazy." - Warren Buffett
Charlie Munger: What Buying a House and Rabbit Hunting Have in Common
"Partly there was a time you felt foolish you didn't buy a house because you weren't making all the money everybody else was making, so it was a typical crazy boom. Now people have learned house prices can go down as well as up." - Charlie Munger
"It's like a fella who goes rabbit hunting and thoroughly enjoys himself. And then the rabbits haul out guns and start firing back. It would dim your enthusiasm for rabbit hunting, and that's what happened in the housing market." - Charlie Munger
More quotes in a follow-up.
Adam
Long position in Berkshire Hathaway (BRKb) established at much lower prices
Quotes of 2012
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.
"All corporate growth has to funnel through return on equity. The problem with growth companies and growth countries is that they so often outrun the capital with which to grow and must raise more capital. Investors grow rich not on earnings growth, but on growth in earnings per share. There is almost no evidence that faster-growing countries have higher margins. In fact, it is slightly the reverse." - Jeremy Grantham
"The fact that growth companies historically have underperformed the market – probably because too much was expected of them and because they were more appealing to clients – was not accepted for decades, but by about the mid-1990s the historical data in favor of 'value' stocks began to overwhelm the earlier logically appealing idea that growth should win out. It was clear that 'value' or low growth stocks had won for the prior 50 years at least. This was unfortunate because the market's faulty intuition had made it very easy for value managers or contrarians to outperform. Ah, the good old days! But now the same faulty intuition applies to fast-growing countries. How appealing an assumption it is that they should beat the slow pokes. But it just ain't so." - Jeremy Grantham
Buffett on Berkshire's "Powerhouse Five" & "Big Four"
"At Berkshire we much prefer owning a non-controlling but substantial portion of a wonderful business to owning 100% of a so-so business. Our flexibility in capital allocation gives us a significant advantage over companies that limit themselves only to acquisitions they can operate." - Warren Buffett
Buffett on Berkshire's Float
"If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit is earned, we enjoy the use of free money – and, better yet, get paid for holding it. That's like your taking out a loan and having the bank pay you interest." - Warren Buffett
"...we have now operated at an underwriting profit for ten consecutive years, our pre-tax gain for the period having totaled $18.6 billion. Looking ahead, I believe we will continue to underwrite profitably in most years. If we do, our float will be better than free money." - Warren Buffett
"So how does our attractive float affect the calculations of intrinsic value? When Berkshire's book value is calculated, the full amount of our float is deducted as a liability, just as if we had to pay it out tomorrow and were unable to replenish it. But that's an incorrect way to look at float..." - Warren Buffett
"The value of our float is one reason – a huge reason – why we believe Berkshire's intrinsic business value substantially exceeds its book value." - Warren Buffett
Warren Buffett on "The Key to Investing"
"American business will do fine over time. And stocks will do well just as certainly, since their fate is tied to business performance. Periodic setbacks will occur, yes, but investors and managers are in a game that is heavily stacked in their favor. (The Dow Jones Industrials advanced from 66 to 11,497 in the 20th Century, a staggering 17,320% increase that materialized despite four costly wars, a Great Depression and many recessions. And don't forget that shareholders received substantial dividends throughout the century as well.)
Since the basic game is so favorable, Charlie and I believe it's a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of 'experts,' or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it." - Warren Buffett
Not Picking Stocks By The Numbers
An exchange between Warren Buffett and Charlie Munger as summarized by the Wall Street Journal's live blog:
"We are looking at businesses exactly like we are looking at them if somebody came in and asked us to buy the whole business," Buffett said. He said they then want to know how it will do in ten years.
Munger was even more forceful: "We don't know how to buy stocks by metrics ... We know that Burlington Northern will have a competitive advantage in years ... we don't know what the heck Apple will have. ... You really have to understand the company and its competitive positions. ... That's not disclosed by the math.
Buffett: "I don't know how I would manage money if I had to do it just on the numbers."
Munger, interupting, "You'd do it badly."
Buffett on Bonds and Productive Assets
"I bought a piece of real estate in New York in 1992, I have not had a quote on it since. I look to the performance of the assets. Maybe...my piece of real estate have had pull backs, but I don't even know about 'em. People pay way too— way too much attention to the short term. If you're getting your money's worth in a stock, buy it and forget it." - Warren Buffett
"...interest rates have a powerful effect on...all assets. Real estate, farms, oil, everything else...they're the cost of carrying other assets. They're the alternative. They're the yardstick." - Warren Buffett
"...the fact that there are troubles in Europe, and there are plenty of troubles, and they're not going go away fast, does not mean you don't buy stocks. We bought stocks when the United States was in trouble, in 2008 and— and it was in huge trouble and we spent 15 1/2 billion in three weeks in— between September 15th and October 10th. It wasn't because the news was good, it was because the prices were good." - Warren Buffett
"In terms of stocks, you know, stocks are reasonably priced. They were very cheap a few years ago. They're reasonably priced now. But stocks grow in value over time because they retain earnings..." - Warren Buffett
(Stocks prices were, of course, generally much lower when Buffett said this compared to now.)
"There could be conditions under which we...would own bonds. But— they're conditions far different than what exist now." - Warren Buffett
"I would have productive assets. I would favor those enormously over fixed dollars investments now, and I think it's silly — to have some ratio like 30 or 40 or 50% in bonds. They're terrible investments now." - Warren Buffett
"News is better now. Stocks are higher. They're still not— they're not ridiculously high at all, and bonds are priced artificially. You've got some guy buying $85 billion a month. (LAUGH) And— that will change at some point. And when it changes, people could lose a lot of money if they're in long-term bonds." - Warren Buffett
"...I bought a farm in 1985, I haven't had— had a quote on it since. But I know what it's produced every year. And I know it's worth more money now. You know, it— if I'd gotten a quote on it every day and somebody's said, "You know, maybe you oughta sell because there's, you know, there's clouds in the West," or something. (LAUGH) It's — it's crazy." - Warren Buffett
Charlie Munger: What Buying a House and Rabbit Hunting Have in Common
"Partly there was a time you felt foolish you didn't buy a house because you weren't making all the money everybody else was making, so it was a typical crazy boom. Now people have learned house prices can go down as well as up." - Charlie Munger
"It's like a fella who goes rabbit hunting and thoroughly enjoys himself. And then the rabbits haul out guns and start firing back. It would dim your enthusiasm for rabbit hunting, and that's what happened in the housing market." - Charlie Munger
More quotes in a follow-up.
Adam
Long position in Berkshire Hathaway (BRKb) established at much lower prices
Quotes of 2012
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Friday, November 22, 2013
Grantham on Efficient Markets, Bubbles, and Ignoble Prizes
The latest GMO quarterly letter was recently released.*
Below, I've highlighted some of Jeremy Grantham's thoughts on efficient markets, bubbles, and the 2013 Nobel Prize in Economics from his section of the letter:
"Economics is a very soft science but it has delusions of hardness or what has been called physics envy. One of my few economic heroes, Kenneth Boulding, said that while mathematics had indeed introduced rigor into economics, it unfortunately also brought mortis. Later in his career he felt that economics had lost sight of its job to be useful to society, having lost its way in a maze of econometric formulas, which placed elegance over accuracy.
At the top of the list of economic theories based on clearly false assumptions is that of Rational Expectations, in which humans are assumed to be machines programmed with rational responses. Although we all know – even economists – that this assumption does not fit the real world, it does allow for relatively simple conclusions, whereas the assumption of complicated, inconsistent, and emotional humanity does not. The folly of Rational Expectations resulted in five, six, or seven decades of economic mainstream work being largely thrown away. It did leave us, though, with perhaps the most laughable of all assumption-based theories, the Efficient Market Hypothesis (EMH).
We are told that investment bubbles have not occurred and, indeed, could never occur, by the iron law of the unproven assumptions used by the proponents of the EMH. Yet, in front of our eyes there have appeared in the last 25 years at least four of the great investment bubbles in all of investment history."
To me, this latest letter is Grantham at his best.
(His section begins on page 6.)
Well worth reading in its entirety.
Grantham goes on to describe the four bubbles that, for many, will hardly be unfamiliar:
1) Japanese equity bubble - By 1989 stocks were selling at 65 times earnings (on what may be not so great accounting). Grantham points out, before that, stocks had never peaked at more than 25 times earnings. Japanese stocks would go on to fall 90%.
2) Japanese land bubble - This bubble peaked a couple of years later in 1991. Grantham describes it this way:
"This was probably the biggest bubble in history and was certainly far worse than the Tulip Bubble and the South Sea Bubble. And, yes, the land under the Emperor's Palace, valued at property prices in downtown Tokyo, really was equal to the value of the land in the state of California. Seems efficient to me..."
3) U.S. equity bubble in 2000 - This one peaked at 35 times earnings but that doesn't even begin to describe how expensive certain stocks had become. For perspective, earnings peaked at 21 times earnings in 1929.
4) U.S. housing bubble - According to Grantham this was the first bubble that was truly global.
Grantham notes that, according to EMH, these annoying real world occurrences should happen something like once every 10,000 years.
He also makes the point that "this efficient market nonsense" certainly didn't hurt value managers like himself.
"...so I should find time to thank all those involved for producing and passionately promoting the idea. During the 1970s and 1980s I am convinced it helped reduce the number of quantitatively-talented individuals entering the money management business."
Warren Buffett has previously made a similar point.
Max Planck understood well the resistance of the human mind, even among those who happen to be very smart, to new ideas. He understood how that tendency impacted scientific advancement.
Buffett has said the same applies to finance.
Well, one of the more disappointing -- even if unfortunately not exactly surprising -- aspects of what has happened over these past decades is this:
"...the proponents of the EMH not only promoted their theory, but via the academic establishment the high priests badgered academic researchers into leaving, resigning themselves to non-tenure, or getting religion, as it were."
Much later in the letter, Grantham talks more specifically about the 2013 Nobel Prize in Economic Sciences:
"So, economics has been more or less threadbare for 50 years. Pity then the plight of the Bank of Sweden with all that money to give away in honor of Alfred Nobel and in envy, perhaps, of the harder sciences. If you had $1.2 million to give away but few worthy recipients, what would you do? I would suggest making it a once-every-three-year event..."
His primary reason?
To make it more likely that only "the Real McCoys" win the prize and to prevent "so many ordinary soldiers" from getting it.
That's unlikely to happen anytime soon, but that doesn't make it any less unfortunate that the Bank of Sweden did the following:
"...to further prove how completely they have lost the plot, they gave two-thirds of the prize to two economists who attempted to prove market inefficiency and one-third to another who claimed it was efficient and seriously efficient at that. What a farce. And to read all these genteel descriptions, or rather rationalizations, as to why this made sense is to realize to what extent the establishment is respected, regardless of its competence level."
The economists he is referring to are Eugene Fama, Robert Shiller, and Lars Peter Hansen.
"Robert Shiller at least served society – Kenneth Boulding would have approved – by loudly warning us of impending doom from the Tech Bubble with his superbly timed book Irrational Exuberance in the spring of 2000. Not bad! He also warned us well in advance of the much more dangerous housing bubble..."
Grantham is, not surprisingly, not quite so complimentary of Fama:
"As for Fama, who conversely provided a rationale for all of us to walk off the cliff with confidence, the less said the better. For believers in market efficiency and all the assumptions that go along with it, the real world really is merely an annoying special case."
Grantham has mentioned this so-called "special case" before.
Now, to get an idea how Eugene Fama looks at bubbles, consider what he said when presented with the following back in 2010:
Interview With Eugene Fama
"Many people would argue that, in this case, the inefficiency was primarily in the credit markets, not the stock market—that there was a credit bubble that inflated and ultimately burst."
He responded this way:
"I don't even know what that means. People who get credit have to get it from somewhere. Does a credit bubble mean that people save too much during that period? I don't know what a credit bubble means. I don't even know what a bubble means. These words have become popular. I don't think they have any meaning."
That comment from Fama just might help begin to explain how such ideas and assumptions have been able to maintain their widespread -- some, including myself, would argue rather more than a little bit damaging -- influence for so long.
From later in the same interview:
"But you are skeptical about the claims about how irrationality affects market prices?"
Fama's response:
"It's a leap. I'm not saying you couldn't do it, but I'm an empiricist. It's got to be shown."**
Naturally, there's nothing inherently wrong with needing it "to be shown", but somehow, at least for Fama, these recent bubbles don't offer much evidence. Also, for certain things "to be shown", we'll probably need several more centuries of data (if not more) for sufficient empirical evidence to exist. In the meantime most of us have to make judgments lacking that evidence.
Other related articles:
-In praise of empiricism: a Nobel prize for everyday economics
-It's the Data, Stupid! Empiricists grab this year's Nobel Prizes.
-Eugene Fama, King of Predictable Markets**
Fama continues to think, more or less, that efficient markets made up of even-tempered and rational participants exist in the real world. This way of thinking at least implies that it's tough to distinguish between what's been mispriced and changes to risk.
Fama seems to generally view any variation in market price as being rational and the reward one gets for taking on risk. In other words, if the market price changes then it must necessarily be a reflection of changes in risk.
Shiller's view seems to be that, at least in the shorter run, less than rational psychological forces may take hold that leads to mispriced assets but, in the longer run, those mispricings tend to be corrected.
Fama does, in fact, seem to have an almost unflappable confidence in things like efficient markets.
Shiller, of course, does not.
Not long after their Nobel Prize was announced Shiller was interviewed on CNBC. In the interview, Shiller called Fama the "father" of efficient markets as a theory and most responsible for popularizing it over the years.
Shiller also said the following about Fama's rather consistent, if nothing else, view that markets are mostly quite efficient and rational:
"When you hatch a theory, you don't easily let go, that's where he [Fama) is. I think he's a -- he's a brilliant man...but he's rather involved in this theory."
CNBC Video: Robert Shiller on Eugene Fama
Maybe, just maybe, the reason Fama doesn't see the empirical evidence relates, in part, to Shiller's explanation.
That doesn't really seem a stretch at all.
Well, in any case, Fama, Shiller, and Hansen have won a big prize.
No doubt winning it involved lots of hard work by what are well-intentioned and smart people.
Still, consider me more than a little bit skeptical of thinking that's built upon the foundation of efficient markets and rational expectations. I happen to be rather convinced that the influence of these theories over time have not been a good thing at all for civilization.
To me, the sooner they lose influence the better.
Naturally, some very capable proponents of these theories (and the many related models) will offer a more favorable view.
In any case, the outcome of this debate has important consequences.
To me, the market isn't terribly efficient. Yet outperforming the market as a whole remains extremely difficult. Some use market efficiency as the explanation for this difficulty. Well, there's no reason why capital markets can't have some inefficiencies AND be difficult to outperform.
To me, these things coexist just fine.
For example, a relatively small proportion of participants might have certain capabilities (both temperamental and intellectual) to consistently benefit from mispricings while the great majority of participants overestimate their ability to do so.
The logical way to go, with this in mind, will continue to be index funds for most market participants.
Adam
Related posts:
-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
-Grantham on "The Greatest-Ever Failure of Economic Theory"
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind
* Also published in Barron's.
** Fama is described as "a careful empiricist" in the article.
---
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.
Below, I've highlighted some of Jeremy Grantham's thoughts on efficient markets, bubbles, and the 2013 Nobel Prize in Economics from his section of the letter:
"Economics is a very soft science but it has delusions of hardness or what has been called physics envy. One of my few economic heroes, Kenneth Boulding, said that while mathematics had indeed introduced rigor into economics, it unfortunately also brought mortis. Later in his career he felt that economics had lost sight of its job to be useful to society, having lost its way in a maze of econometric formulas, which placed elegance over accuracy.
At the top of the list of economic theories based on clearly false assumptions is that of Rational Expectations, in which humans are assumed to be machines programmed with rational responses. Although we all know – even economists – that this assumption does not fit the real world, it does allow for relatively simple conclusions, whereas the assumption of complicated, inconsistent, and emotional humanity does not. The folly of Rational Expectations resulted in five, six, or seven decades of economic mainstream work being largely thrown away. It did leave us, though, with perhaps the most laughable of all assumption-based theories, the Efficient Market Hypothesis (EMH).
We are told that investment bubbles have not occurred and, indeed, could never occur, by the iron law of the unproven assumptions used by the proponents of the EMH. Yet, in front of our eyes there have appeared in the last 25 years at least four of the great investment bubbles in all of investment history."
To me, this latest letter is Grantham at his best.
(His section begins on page 6.)
Well worth reading in its entirety.
Grantham goes on to describe the four bubbles that, for many, will hardly be unfamiliar:
1) Japanese equity bubble - By 1989 stocks were selling at 65 times earnings (on what may be not so great accounting). Grantham points out, before that, stocks had never peaked at more than 25 times earnings. Japanese stocks would go on to fall 90%.
2) Japanese land bubble - This bubble peaked a couple of years later in 1991. Grantham describes it this way:
"This was probably the biggest bubble in history and was certainly far worse than the Tulip Bubble and the South Sea Bubble. And, yes, the land under the Emperor's Palace, valued at property prices in downtown Tokyo, really was equal to the value of the land in the state of California. Seems efficient to me..."
3) U.S. equity bubble in 2000 - This one peaked at 35 times earnings but that doesn't even begin to describe how expensive certain stocks had become. For perspective, earnings peaked at 21 times earnings in 1929.
4) U.S. housing bubble - According to Grantham this was the first bubble that was truly global.
Grantham notes that, according to EMH, these annoying real world occurrences should happen something like once every 10,000 years.
He also makes the point that "this efficient market nonsense" certainly didn't hurt value managers like himself.
"...so I should find time to thank all those involved for producing and passionately promoting the idea. During the 1970s and 1980s I am convinced it helped reduce the number of quantitatively-talented individuals entering the money management business."
Warren Buffett has previously made a similar point.
Max Planck understood well the resistance of the human mind, even among those who happen to be very smart, to new ideas. He understood how that tendency impacted scientific advancement.
Buffett has said the same applies to finance.
Well, one of the more disappointing -- even if unfortunately not exactly surprising -- aspects of what has happened over these past decades is this:
"...the proponents of the EMH not only promoted their theory, but via the academic establishment the high priests badgered academic researchers into leaving, resigning themselves to non-tenure, or getting religion, as it were."
Much later in the letter, Grantham talks more specifically about the 2013 Nobel Prize in Economic Sciences:
"So, economics has been more or less threadbare for 50 years. Pity then the plight of the Bank of Sweden with all that money to give away in honor of Alfred Nobel and in envy, perhaps, of the harder sciences. If you had $1.2 million to give away but few worthy recipients, what would you do? I would suggest making it a once-every-three-year event..."
His primary reason?
To make it more likely that only "the Real McCoys" win the prize and to prevent "so many ordinary soldiers" from getting it.
That's unlikely to happen anytime soon, but that doesn't make it any less unfortunate that the Bank of Sweden did the following:
"...to further prove how completely they have lost the plot, they gave two-thirds of the prize to two economists who attempted to prove market inefficiency and one-third to another who claimed it was efficient and seriously efficient at that. What a farce. And to read all these genteel descriptions, or rather rationalizations, as to why this made sense is to realize to what extent the establishment is respected, regardless of its competence level."
The economists he is referring to are Eugene Fama, Robert Shiller, and Lars Peter Hansen.
"Robert Shiller at least served society – Kenneth Boulding would have approved – by loudly warning us of impending doom from the Tech Bubble with his superbly timed book Irrational Exuberance in the spring of 2000. Not bad! He also warned us well in advance of the much more dangerous housing bubble..."
Grantham is, not surprisingly, not quite so complimentary of Fama:
"As for Fama, who conversely provided a rationale for all of us to walk off the cliff with confidence, the less said the better. For believers in market efficiency and all the assumptions that go along with it, the real world really is merely an annoying special case."
Grantham has mentioned this so-called "special case" before.
Now, to get an idea how Eugene Fama looks at bubbles, consider what he said when presented with the following back in 2010:
Interview With Eugene Fama
"Many people would argue that, in this case, the inefficiency was primarily in the credit markets, not the stock market—that there was a credit bubble that inflated and ultimately burst."
He responded this way:
"I don't even know what that means. People who get credit have to get it from somewhere. Does a credit bubble mean that people save too much during that period? I don't know what a credit bubble means. I don't even know what a bubble means. These words have become popular. I don't think they have any meaning."
That comment from Fama just might help begin to explain how such ideas and assumptions have been able to maintain their widespread -- some, including myself, would argue rather more than a little bit damaging -- influence for so long.
From later in the same interview:
"But you are skeptical about the claims about how irrationality affects market prices?"
Fama's response:
"It's a leap. I'm not saying you couldn't do it, but I'm an empiricist. It's got to be shown."**
Naturally, there's nothing inherently wrong with needing it "to be shown", but somehow, at least for Fama, these recent bubbles don't offer much evidence. Also, for certain things "to be shown", we'll probably need several more centuries of data (if not more) for sufficient empirical evidence to exist. In the meantime most of us have to make judgments lacking that evidence.
Other related articles:
-In praise of empiricism: a Nobel prize for everyday economics
-It's the Data, Stupid! Empiricists grab this year's Nobel Prizes.
-Eugene Fama, King of Predictable Markets**
Fama continues to think, more or less, that efficient markets made up of even-tempered and rational participants exist in the real world. This way of thinking at least implies that it's tough to distinguish between what's been mispriced and changes to risk.
Fama seems to generally view any variation in market price as being rational and the reward one gets for taking on risk. In other words, if the market price changes then it must necessarily be a reflection of changes in risk.
Shiller's view seems to be that, at least in the shorter run, less than rational psychological forces may take hold that leads to mispriced assets but, in the longer run, those mispricings tend to be corrected.
Fama does, in fact, seem to have an almost unflappable confidence in things like efficient markets.
Shiller, of course, does not.
Not long after their Nobel Prize was announced Shiller was interviewed on CNBC. In the interview, Shiller called Fama the "father" of efficient markets as a theory and most responsible for popularizing it over the years.
Shiller also said the following about Fama's rather consistent, if nothing else, view that markets are mostly quite efficient and rational:
"When you hatch a theory, you don't easily let go, that's where he [Fama) is. I think he's a -- he's a brilliant man...but he's rather involved in this theory."
CNBC Video: Robert Shiller on Eugene Fama
Maybe, just maybe, the reason Fama doesn't see the empirical evidence relates, in part, to Shiller's explanation.
That doesn't really seem a stretch at all.
Well, in any case, Fama, Shiller, and Hansen have won a big prize.
No doubt winning it involved lots of hard work by what are well-intentioned and smart people.
Still, consider me more than a little bit skeptical of thinking that's built upon the foundation of efficient markets and rational expectations. I happen to be rather convinced that the influence of these theories over time have not been a good thing at all for civilization.
To me, the sooner they lose influence the better.
Naturally, some very capable proponents of these theories (and the many related models) will offer a more favorable view.
In any case, the outcome of this debate has important consequences.
To me, the market isn't terribly efficient. Yet outperforming the market as a whole remains extremely difficult. Some use market efficiency as the explanation for this difficulty. Well, there's no reason why capital markets can't have some inefficiencies AND be difficult to outperform.
To me, these things coexist just fine.
For example, a relatively small proportion of participants might have certain capabilities (both temperamental and intellectual) to consistently benefit from mispricings while the great majority of participants overestimate their ability to do so.
The logical way to go, with this in mind, will continue to be index funds for most market participants.
Adam
Related posts:
-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
-Grantham on "The Greatest-Ever Failure of Economic Theory"
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind
* Also published in Barron's.
** Fama is described as "a careful empiricist" in the article.
---
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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