From the Berkshire Hathaway (BRKa) letter released earlier this year:
"...repurchases should be price-sensitive: Blindly buying an overpriced stock is value destructive, a fact lost on many promotional or ever-optimistic CEOs.
When a company says that it contemplates repurchases, it's vital that all shareholder-partners be given the
information they need to make an intelligent estimate of value. Providing that information is what Charlie and I try to
do in this report. We do not want a partner to sell shares back to the company because he or she has been misled or
inadequately informed.
Some sellers, however, may disagree with our calculation of value and others may have found investments
that they consider more attractive than Berkshire shares. Some of that second group will be right: There are
unquestionably many stocks that will deliver far greater gains than ours.
In addition, certain shareholders will simply decide it's time for them or their families to become net
consumers rather than continuing to build capital. Charlie and I have no current interest in joining that group. Perhaps
we will become big spenders in our old age."
Warren Buffett also said the following in an interview on CNBC back in May:
"...repurchases by the company are just like purchases to us, they're dumb a one price and smart at another price. And I like it when companies -- I like it when we're invested in companies where they understand that. Many companies just repurchase and repurchase, you know, it's the thing to do..."
What's an intelligent action at one price becomes stupid at some higher price. Any conversation over whether repurchasing shares makes sense should begin with whether or not the stock is in fact cheap.
Estimate per share intrinsic value, judge how that value is likely to change over time, then buy at a nice discount to that value.
Repurchases generally won't make sense when value -- within a range -- cannot be judged with enough confidence. Some businesses have inherent durable advantages while others have extremely difficult to understand prospects.
Beyond that it's assessing how such an action compares to existing well understood alternative uses of that capital.
For example, if internal investments critical to future competitiveness are neglected -- in order to buy what looks like an inexpensive stock -- long-term shareholders will likely not be served well.
Share repurchases work when truly excess capital is used to buy shares at a clear discount and when alternative uses are correctly judged inferior.
Seems obvious enough, at least at first, yet corporate repurchase behavior too often reinforces the impression that it's rather less than obvious.
Adam
Long position in BRKb
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Showing posts with label Investing. Show all posts
Showing posts with label Investing. Show all posts
Thursday, December 5, 2019
Monday, April 1, 2019
Buffett on Expenses
From the latest Berkshire Hathaway (BRKa) letter:
"...managements sometimes assert that their company's stock-based compensation shouldn't be counted as an expense. (What else could it be – a gift from shareholders?) And restructuring expenses? Well, maybe last year's exact rearrangement won't recur. But restructurings of one sort or another are common in business – Berkshire has gone down that road dozens of times, and our shareholders have always borne the costs of doing so.
Abraham Lincoln once posed the question: 'If you call a dog's tail a leg, how many legs does it have?' and then answered his own query: 'Four, because calling a tail a leg doesn't make it one.' Abe would have felt lonely on Wall Street.
Charlie and I do contend that our acquisition-related amortization expenses of $1.4 billion...are not a true economic cost. We add back such amortization 'costs' to GAAP earnings when we are evaluating both private businesses and marketable stocks.
In contrast, Berkshire's $8.4 billion depreciation charge understates our true economic cost. In fact, we need to spend more than this sum annually to simply remain competitive in our many operations. Beyond those 'maintenance' capital expenditures, we spend large sums in pursuit of growth. Overall, Berkshire invested a record $14.5 billion last year in plant, equipment and other fixed assets, with 89% of that spent in America.
The practice of ignoring real costs like stock-based compensation is the practice of deliberately making what's inherently challenging -- the investing process -- even more so.
Unfortunately it remains a not uncommon practice especially for businesses that rely heavily upon stock-based compensation.
Those who use earnings per share (reported or estimated) that exclude these real costs as a basis for calculating intrinsic value end up, all else equal, with an inflated assessment that value.
This conscious distortion may be a great way to feel better in the near term but it's an even better way to transfer wealth to strangers (the exiting shareholders) while, as a bonus I guess, taking on additional risk that need not be taken.
Now it's possible that, because a particular business has rapidly improving prospects, such a "gift" may be masked by the rapid increase to intrinsic business value. Yet the "gift" is still real even if buried inside the bigger story. It seems rather obvious that a more wise approach would be to admit a higher premium is being paid -- and in some cases no doubt a justifiable premium -- than to pretend the current earnings are higher than reality.
Premium prices built upon inflated earnings can, in fact, function as a gift to exiting shareholders.
Nothing wrong with generosity but I think it's fair to say there's better ways to go about being charitable.
Attempting to understand why what should be relatively informed individuals -- investors, analysts, and managements -- would accept such an alternative reality is worth the effort. There are, of course, underlying social and psychological factors at work here.
Those factors may not always be obvious or measurable but they're real and potent.
Adam
Long position in BRKb
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
"...managements sometimes assert that their company's stock-based compensation shouldn't be counted as an expense. (What else could it be – a gift from shareholders?) And restructuring expenses? Well, maybe last year's exact rearrangement won't recur. But restructurings of one sort or another are common in business – Berkshire has gone down that road dozens of times, and our shareholders have always borne the costs of doing so.
Abraham Lincoln once posed the question: 'If you call a dog's tail a leg, how many legs does it have?' and then answered his own query: 'Four, because calling a tail a leg doesn't make it one.' Abe would have felt lonely on Wall Street.
Charlie and I do contend that our acquisition-related amortization expenses of $1.4 billion...are not a true economic cost. We add back such amortization 'costs' to GAAP earnings when we are evaluating both private businesses and marketable stocks.
In contrast, Berkshire's $8.4 billion depreciation charge understates our true economic cost. In fact, we need to spend more than this sum annually to simply remain competitive in our many operations. Beyond those 'maintenance' capital expenditures, we spend large sums in pursuit of growth. Overall, Berkshire invested a record $14.5 billion last year in plant, equipment and other fixed assets, with 89% of that spent in America.
The practice of ignoring real costs like stock-based compensation is the practice of deliberately making what's inherently challenging -- the investing process -- even more so.
Unfortunately it remains a not uncommon practice especially for businesses that rely heavily upon stock-based compensation.
Those who use earnings per share (reported or estimated) that exclude these real costs as a basis for calculating intrinsic value end up, all else equal, with an inflated assessment that value.
This conscious distortion may be a great way to feel better in the near term but it's an even better way to transfer wealth to strangers (the exiting shareholders) while, as a bonus I guess, taking on additional risk that need not be taken.
Now it's possible that, because a particular business has rapidly improving prospects, such a "gift" may be masked by the rapid increase to intrinsic business value. Yet the "gift" is still real even if buried inside the bigger story. It seems rather obvious that a more wise approach would be to admit a higher premium is being paid -- and in some cases no doubt a justifiable premium -- than to pretend the current earnings are higher than reality.
Premium prices built upon inflated earnings can, in fact, function as a gift to exiting shareholders.
Nothing wrong with generosity but I think it's fair to say there's better ways to go about being charitable.
Attempting to understand why what should be relatively informed individuals -- investors, analysts, and managements -- would accept such an alternative reality is worth the effort. There are, of course, underlying social and psychological factors at work here.
Those factors may not always be obvious or measurable but they're real and potent.
Adam
Long position in BRKb
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Saturday, June 30, 2018
Jeff Bezos on High Standards
From the most recent Amazon (AMZN) shareholder letter:
"High standards are contagious. Bring a new person onto a high standards team, and they'll quickly adapt. The opposite is also true. If low standards prevail, those too will quickly spread...I believe high standards are domain specific, and that you have to learn high standards separately in every arena of interest. When I started Amazon, I had high standards on inventing, on customer care, and (thankfully) on hiring. But I didn't have high standards on operational process: how to keep fixed problems fixed, how to eliminate defects at the root, how to inspect processes, and much more. I had to learn and develop high standards on all of that (my colleagues were my tutors).
Understanding this point is important because it keeps you humble. You can consider yourself a person of high standards in general and still have debilitating blind spots. There can be whole arenas of endeavor where you may not even know that your standards are low or non-existent, and certainly not world class. It's critical to be open to that likelihood."
A similar thing seems relevant to the world of investing.
I think it's fair to say that some seem more than willing to offer their views on just about every investment in every industry. Well, those willing to opine on most anything in the universe appear unaware of what Jeff Bezos is saying above. Such behavior, when on display, usually warrants a healthy dose of skepticism. The opinionator may use all the right terminology, have a solid understanding of the macro factors, and may even know quite a bit about lots of businesses across many industries.
At least enough to sound impressive.
Yet it doesn't necessarily follow that they'll sufficiently understand those businesses well enough to justify putting capital at risk. If someone, for example, were capable of evaluating the prospects of a particular technology business, it does not automatically mean they'll also understand how to capably judge the prospects of a steel producer.
Necessarily, there'll be different competitive dynamics, different industry-specific opportunities and challenges, and the things to consider and understand in depth just goes on and on.
Behaving otherwise lacks the kind of wise humility that Jeff Bezos refers to in his letter.
Low levels of humility can prove more than somewhat correlated with low returns (or worse). In fact, when combined with early investing success overconfidence may lead to increasingly spectacular and costly failures. In other words, for the overconfident investor, the longer a series of early wins happens to be likely means bigger more expensive mistakes at a later time.*
Hubris and investing don't mix.
The reality is that even very talented individuals often have "debilitating blind spots".
High levels of competence and prior accomplishment, however impressive, do not automatically provide an exemption.
Worse yet, there's a tendency to think blind spots are someone else's problem.
In fact, there's some evidence this may especially be applicable to highly capable individuals.
Those who think they have somehow developed some kind of blind spot immunity run the risk of being (or becoming) a latent or blatant liability.
That such a liability hasn't explicitly revealed itself just yet doesn't prove its nonexistence.
Adam
No position in AMZN
* It's worth noting here, as an aside, that the relationship between risk and reward is frequently misunderstood. The risk/reward relationship is vastly more confounding than the prevailing view -- that there inevitably must be a positive correlation between the two -- would suggest.
---
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.
"High standards are contagious. Bring a new person onto a high standards team, and they'll quickly adapt. The opposite is also true. If low standards prevail, those too will quickly spread...I believe high standards are domain specific, and that you have to learn high standards separately in every arena of interest. When I started Amazon, I had high standards on inventing, on customer care, and (thankfully) on hiring. But I didn't have high standards on operational process: how to keep fixed problems fixed, how to eliminate defects at the root, how to inspect processes, and much more. I had to learn and develop high standards on all of that (my colleagues were my tutors).
Understanding this point is important because it keeps you humble. You can consider yourself a person of high standards in general and still have debilitating blind spots. There can be whole arenas of endeavor where you may not even know that your standards are low or non-existent, and certainly not world class. It's critical to be open to that likelihood."
A similar thing seems relevant to the world of investing.
I think it's fair to say that some seem more than willing to offer their views on just about every investment in every industry. Well, those willing to opine on most anything in the universe appear unaware of what Jeff Bezos is saying above. Such behavior, when on display, usually warrants a healthy dose of skepticism. The opinionator may use all the right terminology, have a solid understanding of the macro factors, and may even know quite a bit about lots of businesses across many industries.
At least enough to sound impressive.
Yet it doesn't necessarily follow that they'll sufficiently understand those businesses well enough to justify putting capital at risk. If someone, for example, were capable of evaluating the prospects of a particular technology business, it does not automatically mean they'll also understand how to capably judge the prospects of a steel producer.
Necessarily, there'll be different competitive dynamics, different industry-specific opportunities and challenges, and the things to consider and understand in depth just goes on and on.
Behaving otherwise lacks the kind of wise humility that Jeff Bezos refers to in his letter.
Low levels of humility can prove more than somewhat correlated with low returns (or worse). In fact, when combined with early investing success overconfidence may lead to increasingly spectacular and costly failures. In other words, for the overconfident investor, the longer a series of early wins happens to be likely means bigger more expensive mistakes at a later time.*
Hubris and investing don't mix.
The reality is that even very talented individuals often have "debilitating blind spots".
High levels of competence and prior accomplishment, however impressive, do not automatically provide an exemption.
Worse yet, there's a tendency to think blind spots are someone else's problem.
In fact, there's some evidence this may especially be applicable to highly capable individuals.
Those who think they have somehow developed some kind of blind spot immunity run the risk of being (or becoming) a latent or blatant liability.
That such a liability hasn't explicitly revealed itself just yet doesn't prove its nonexistence.
Adam
No position in AMZN
* It's worth noting here, as an aside, that the relationship between risk and reward is frequently misunderstood. The risk/reward relationship is vastly more confounding than the prevailing view -- that there inevitably must be a positive correlation between the two -- would suggest.
---
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 26, 2018
Equity "Coupons"
What Warren Buffett had to say about bonds and stocks in an interview on CNBC late last month:
"...if you buy a 30-year government bond, it has a whole bunch of coupons attached...And the coupon says 3%, or whatever it may say. And you know that's what you're going to get between now and 30 years from now. And then they're going to give you the money back. What is a stock? A stock is the same sort of thing. It has a bunch of coupons. It's just they haven't printed the numbers on them yet. And it's your job as an investor to print those numbers on it. If those numbers say 10% and most American businesses earn over 10% on tangible equity. If they say 10%, that bond is worth a hell of a lot more money than a bond that says 3% on it. But if that government bond goes to 10%, it changes the value of this equity bond that, in effect, you're buying...when you buy an interest in...anything, you are buying something that, over time, is going to return cash to you...And those are the coupons. And it's...your job as an investor to decide what you think those coupons will be because that's what you're buying. And you're buying the discounted value. And the higher the yardstick goes, and the yardstick is government bonds, the less attractive these...look. That's just fundamental economics. So in 1982 or '83, when the long government bond got to 15%, a company that was earning 15% on equity was worth no more than book value under those circumstances because you could buy a 30-year strip of bonds and guarantee yourself for 15% a year. And a business that earned 12%, it was a sub-par business then. But a business that earns 12% when the government bond is 3% is one hell of a business now. And that's why they sell for very fancy prices."
An emphasis on stock prices -- how they'll change over short or even more extended time horizons -- is best thought of as speculation (if not pure gambling). There's nothing inherently wrong with speculation, of course, it just has less in common with investing than some seem to think.
If, instead, the emphasis is on what the "coupons" will look like long-term it's possible, if not easy, for a present valuation, within a narrow enough range, to be estimated. From there prevailing market prices can be compared to estimated value. Sensible investment decisions can then be made.
(Based upon, best case, inescapably imperfect but meaningful assumptions.)
Two or more informed investors will rarely agree, at least not in a precise way, on the intrinsic value of an investment. It's not about being right; it's about being right enough within an acceptable range.
Judging what the equity "coupons" are likely to be over a long time frame is challenging enough. Predicting interest rates is, if not impossible, nearly so. The discount paid to a conservative estimate of value can, only up to a point, protect the investor from errors, unknowns, and the unknowable.
Margin of safety always comes into play; deciding what it should be is necessarily investment specific.
Stretch assumptions and investing well just aren't compatible.
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.
"...if you buy a 30-year government bond, it has a whole bunch of coupons attached...And the coupon says 3%, or whatever it may say. And you know that's what you're going to get between now and 30 years from now. And then they're going to give you the money back. What is a stock? A stock is the same sort of thing. It has a bunch of coupons. It's just they haven't printed the numbers on them yet. And it's your job as an investor to print those numbers on it. If those numbers say 10% and most American businesses earn over 10% on tangible equity. If they say 10%, that bond is worth a hell of a lot more money than a bond that says 3% on it. But if that government bond goes to 10%, it changes the value of this equity bond that, in effect, you're buying...when you buy an interest in...anything, you are buying something that, over time, is going to return cash to you...And those are the coupons. And it's...your job as an investor to decide what you think those coupons will be because that's what you're buying. And you're buying the discounted value. And the higher the yardstick goes, and the yardstick is government bonds, the less attractive these...look. That's just fundamental economics. So in 1982 or '83, when the long government bond got to 15%, a company that was earning 15% on equity was worth no more than book value under those circumstances because you could buy a 30-year strip of bonds and guarantee yourself for 15% a year. And a business that earned 12%, it was a sub-par business then. But a business that earns 12% when the government bond is 3% is one hell of a business now. And that's why they sell for very fancy prices."
An emphasis on stock prices -- how they'll change over short or even more extended time horizons -- is best thought of as speculation (if not pure gambling). There's nothing inherently wrong with speculation, of course, it just has less in common with investing than some seem to think.
If, instead, the emphasis is on what the "coupons" will look like long-term it's possible, if not easy, for a present valuation, within a narrow enough range, to be estimated. From there prevailing market prices can be compared to estimated value. Sensible investment decisions can then be made.
(Based upon, best case, inescapably imperfect but meaningful assumptions.)
Two or more informed investors will rarely agree, at least not in a precise way, on the intrinsic value of an investment. It's not about being right; it's about being right enough within an acceptable range.
Judging what the equity "coupons" are likely to be over a long time frame is challenging enough. Predicting interest rates is, if not impossible, nearly so. The discount paid to a conservative estimate of value can, only up to a point, protect the investor from errors, unknowns, and the unknowable.
Margin of safety always comes into play; deciding what it should be is necessarily investment specific.
Stretch assumptions and investing well just aren't compatible.
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.
Thursday, October 13, 2016
Bogle & Buffett on Frictional Costs
John Bogle had the following to say in a speech earlier this year:
"Hedge funds (so-called; actually concentrated investment accounts which offer a wide variety of strategies) manage about $2.8 trillion of assets, at a cost equal to at least 3% of assets per year (300 basis points, an informed guess), generating some $84 billion in annual fees."
Vanguard manages roughly $3 trillion with roughly two thirds being index funds. Similar size but naturally much lower costs:
"The costs of supervising these index portfolios come to about $400 million annually, or 0.02% per year (two basis points)—less than 1% of the hedge fund rate. Administering the index funds and handling the accounts of some 15 million index shareholders costs another $1.2 billion, adding 0.06% (six basis points) to bring the aggregate expense ratio to eight basis points."
The ~ 300 basis point "informed guess" is primarily driven by the 2 and 20 compensation structure that is common to hedge funds. The above comments are not unlike those made by Warren Buffett -- in reference to his bet that a low-cost S&P 500 index fund would outperform a basket of hedge funds chosen by experts -- at the Berkshire Hathaway (BRKa) shareholder meeting earlier this year:
"The result is that after eight years and several hundred hedge fund managers being involved, the totally unmanaged fund by Vanguard with very minimal costs is now 40-something [percentage] points ahead of the group of hedge funds. It may sound like a terrible result for the hedge funds, but it's not a terrible result for the hedge fund managers."
Buffett also pointed out...
"We have two [investment] managers at Berkshire. They each manage $9 billion for us. They both ran hedge funds before. If they had a 2/20 arrangement with Berkshire, which is not uncommon in the hedge fund world, they would be getting $180 million annually each merely for breathing."
And then added:
"It's a compensation scheme that is unbelievable to me and that's one reason I made this bet."
So it comes down to this big difference in frictional costs to explain the results (so far) of Buffett's bet.
Investors in these high-cost funds are betting that, over many years, a capable manager can reliably outrun such a frictional cost headwind and that somehow those investors will be able to correctly pick beforehand who that manager is going to be. As Charlie Munger said at the same Berkshire meeting:
"There have been a few of these managers who've actually succeeded...But it's a tiny group of people...like looking for a needle in a haystack."
The likelihood that a manager will do well ends up much higher than the likelihood those who actually put their capital at risk will do well.
It seems rather obvious that the system would be vastly improved if the opposite were true.
Tortured logic is required to explain why those who are putting their capital at risk shouldn't first be compensated sufficiently before vast sums are drained from their balance sheet.
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
Buffett on Active Investing
John Bogle: Arithmetic Quants vs Algorithmic Quants
Hedge Funds: Balancing Risk & Reward?
Index Funds vs Actively Managed Funds
John Bogle on Investor Returns
Buffett's Hedge Fund Bet
John Bogle's "Relentless Rules of Humble Arithmetic", Part II
Index Fund Investing Revisited
Charlie Munger on Complexity, Hedge Funds, and Pension Funds
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again
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.
"Hedge funds (so-called; actually concentrated investment accounts which offer a wide variety of strategies) manage about $2.8 trillion of assets, at a cost equal to at least 3% of assets per year (300 basis points, an informed guess), generating some $84 billion in annual fees."
Vanguard manages roughly $3 trillion with roughly two thirds being index funds. Similar size but naturally much lower costs:
"The costs of supervising these index portfolios come to about $400 million annually, or 0.02% per year (two basis points)—less than 1% of the hedge fund rate. Administering the index funds and handling the accounts of some 15 million index shareholders costs another $1.2 billion, adding 0.06% (six basis points) to bring the aggregate expense ratio to eight basis points."
The ~ 300 basis point "informed guess" is primarily driven by the 2 and 20 compensation structure that is common to hedge funds. The above comments are not unlike those made by Warren Buffett -- in reference to his bet that a low-cost S&P 500 index fund would outperform a basket of hedge funds chosen by experts -- at the Berkshire Hathaway (BRKa) shareholder meeting earlier this year:
"The result is that after eight years and several hundred hedge fund managers being involved, the totally unmanaged fund by Vanguard with very minimal costs is now 40-something [percentage] points ahead of the group of hedge funds. It may sound like a terrible result for the hedge funds, but it's not a terrible result for the hedge fund managers."
Buffett also pointed out...
"We have two [investment] managers at Berkshire. They each manage $9 billion for us. They both ran hedge funds before. If they had a 2/20 arrangement with Berkshire, which is not uncommon in the hedge fund world, they would be getting $180 million annually each merely for breathing."
And then added:
"It's a compensation scheme that is unbelievable to me and that's one reason I made this bet."
So it comes down to this big difference in frictional costs to explain the results (so far) of Buffett's bet.
Investors in these high-cost funds are betting that, over many years, a capable manager can reliably outrun such a frictional cost headwind and that somehow those investors will be able to correctly pick beforehand who that manager is going to be. As Charlie Munger said at the same Berkshire meeting:
"There have been a few of these managers who've actually succeeded...But it's a tiny group of people...like looking for a needle in a haystack."
The likelihood that a manager will do well ends up much higher than the likelihood those who actually put their capital at risk will do well.
It seems rather obvious that the system would be vastly improved if the opposite were true.
Tortured logic is required to explain why those who are putting their capital at risk shouldn't first be compensated sufficiently before vast sums are drained from their balance sheet.
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
Buffett on Active Investing
John Bogle: Arithmetic Quants vs Algorithmic Quants
Hedge Funds: Balancing Risk & Reward?
Index Funds vs Actively Managed Funds
John Bogle on Investor Returns
Buffett's Hedge Fund Bet
John Bogle's "Relentless Rules of Humble Arithmetic", Part II
Index Fund Investing Revisited
Charlie Munger on Complexity, Hedge Funds, and Pension Funds
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again
Monday, September 12, 2016
Buffett on Active Investing
Warren Buffett said the following on CNBC back in May:
"Active investing as a whole is certain to lead to worse than average results."
He goes on to explain that those who are active, in aggregate, must by definition get an average result. Subtract all the fees and what happens is a below average result. John Bogle has previously made the point that it's tough to get around what he calls the "relentless rules of humble arithmetic".
Naturally some think they themselves will be able to outperform over the long haul or, alternatively, that they'll be able to reliably pick, beforehand, an active manager who will outperform.
This might prove possible for some but history shows it's much easier in theory than reality.
Buffett's bet with Protege Partners -- one that now goes back more than eight years -- was, from his point of view, meant to demonstrate that while many "smart people are involved in running hedge funds...to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors."
Naturally, Protege held the opposite view.
The results so far?*
Index Fund: 65.7%
Hedge Funds: 21.9%
Of course, one example doesn't necessarily prove anything but Buffett elaborated on his thinking during the 2016 Berkshire Hathaway (BRKa) shareholder meeting:
"Supposedly sophisticated people...hire consultants, and no consultant in the world is going to tell you 'just buy an S&P index fund and sit for the next 50 years.' You don't get to be a consultant that way. And you certainly don't get an annual fee that way. So the consultant has every motivation in the world to tell you, 'this year I think we should concentrate more on international stocks,' or 'this manager is particularly good on the short side,' and so they come in and they talk for hours, and you pay them a large fee, and they always suggest something other than just sitting on your rear end and participating in the American business without cost. And then those consultants, after they get their fees, they in turn recommend to you other people who charge fees, which... cumulatively eat up capital like crazy."
And, according to Buffett, it's not easy to change behavior:
"I've talked to huge pension funds, and I've taken them through the math, and when I leave, they go out and hire a bunch of consultants and pay them a lot of money. It's just unbelievable."
And guess who these consultants tend to recommend?
Hedge funds that typically get paid via something like a 2-and-20 or a similar compensation structure.
According to Buffett these consultants usually "have lots of charts and PowerPoint presentations and they recommend people who are in turn going to charge a lot of money and they say, 'well you can only get the best talent by paying 2-and-20,' or something of the sort, and the flow of money from the 'hyperactive' to what I call the 'helpers' is dramatic."
During the CNBC interview Buffett added the following:
"In...almost every field, the professional brings something to the party."
Yet, in contrast, Buffett points out that the world of professional investing as a whole produces "negative results to their clientele. And that's a very interesting phenomenon to live with, if you spend your life doing something where your expectancy is to hurt your customer. And yet that is the case for professional investors."
Naturally, some capable individual managers will outperform. Yet as Charlie Munger said at the Berkshire meeting:
"There have been a few of these managers who've actually succeeded...But it's a tiny group of people...like looking for a needle in a haystack."
Think about it this way: if 80% to 90% of actively managed funds tend to underperform, then that by definition means the purchaser of a low-cost index fund, with no skills whatsoever, should over the long-term outperform roughly 80% to 90% of the professional managers.**
Can you imagine such a product existing for other professions?
In other words, there's just no way to buy a product that will enable someone to perform better than, for example, 80% to 90% of doctors without the requisite expertise. The same would be mostly true for other professions (and, for that matter, this also applies to skilled trades).
Of course, one of the problems with this is investors tend to trade index funds too much -- the net reward for the incremental effort being reduced returns -- as well as the actively managed funds they own. Such behavior usually turns what should be inherently, at least on a relative basis, an advantageous approach into one that is less so.
It's tough to outperform picking individual stocks. Similarly, it's tough to pick the professional investors who, going forward and over the long-term, will not only outperform, but will outperform by enough to justify all the frictional costs and, possibly, the incremental risks they'll need to take.
Stocks, generally speaking, appear to be not all cheap these days. So it would seem to be rather unwise to expect market averages will produce more than modest results as long as such valuations persist. Of course, what look like high-ish valuations can for a time become even higher and, as far as near-term price action goes, almost anything can happen.***
Some will see such a situation for what it is and no doubt be tempted to find some creative ways to outperform.
An understandable response?
Possibly.
That doesn't necessarily make it the correct response.
The vast majority (I'd 80% to 90% qualifies) of active investors -- many who are smart, capable, and hardworking -- do worse than what a passive approach could achieve. So that means many market participants, if nothing else, must have a built in bias; they inherently overestimate their own likelihood of success. To them, it's always the other less prepared and less able participants who'll do worse than the average.
Certainly not themselves.
It's worth amplifying that all the extra effort involved isn't just producing no incremental benefit, it's producing a worse than passive outcome; a negative return on all the additional invested time and effort.
A subpar result for the investors though likely not for the managers.
Where else is so much time and talent put forth to achieve so little or, in fact, what is a net reduced outcome?
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
John Bogle: Arithmetic Quants vs Algorithmic Quants
Hedge Funds: Balancing Risk & Reward?
Index Funds vs Actively Managed Funds
John Bogle on Investor Returns
Buffett's Hedge Fund Bet
John Bogle's "Relentless Rules of Humble Arithmetic", Part II
Index Fund Investing Revisited
Charlie Munger on Complexity, Hedge Funds, and Pension Funds
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again
* Through December 31, 2015.
** Think of it this way: it's essentially a choice between a small chance of picking the manager who produces long-term outperformance versus near certainty of being at or near the top ~10% or 20% in terms of long-term market performance. Also, there's still some (usually rather modest) fees to consider in an index fund that might produce a lesser outcome.
*** As always, I have no view on what near-term market prices might be. I'll leave that sort of thing to those who attempt to profit betting on price action. The focus here is definitely not on speculation; it is always on investment -- judging what something is intrinsically worth, looking for reasonable (if not considerable) mispricings, then benefiting, in general, mostly from what's produced over the long run. Valuations right now do seem to be more on the high side than not for many stocks. Or, well, let's just say it seems wise to, considering where valuations are at the present time, use conservative assumptions and lower future return expectations. Of course, higher multiples in the near-term can naturally occur. Those higher multiples may even theoretically make those with a shorter horizon (who sell) better off -- or, at a minimum, will make some participants feel better off -- but, in fact, a meaningful drop in market prices would logically make life easier for the long-term investor. Those with a substantial investing time horizon who are hoping for market prices to continue higher near-term (or even intermediate-term) should keep this in mind. It is lower market prices that increase the possibility of making incremental purchases -- whether done directly by the shareholder or via buybacks using the company's excess cash -- at a nice discount to intrinsic value. The potential long-term compounded effects for continuing owners (i.e. not traders) need not be small. Buying shares at increasingly large discounts to conservatively estimated value over time should, all else equal, reduce risks/improve returns.
(Notice the sometimes overlooked inverse relationship here. Risk and reward is at times positively correlated, but some incorrectly assume they're always positively correlated. Well, the correlation is not always positive and is, as far as I'm concerned, too often a rather underutilized consideration.)
---
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.
"Active investing as a whole is certain to lead to worse than average results."
He goes on to explain that those who are active, in aggregate, must by definition get an average result. Subtract all the fees and what happens is a below average result. John Bogle has previously made the point that it's tough to get around what he calls the "relentless rules of humble arithmetic".
Naturally some think they themselves will be able to outperform over the long haul or, alternatively, that they'll be able to reliably pick, beforehand, an active manager who will outperform.
This might prove possible for some but history shows it's much easier in theory than reality.
Buffett's bet with Protege Partners -- one that now goes back more than eight years -- was, from his point of view, meant to demonstrate that while many "smart people are involved in running hedge funds...to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors."
Naturally, Protege held the opposite view.
The results so far?*
Index Fund: 65.7%
Hedge Funds: 21.9%
Of course, one example doesn't necessarily prove anything but Buffett elaborated on his thinking during the 2016 Berkshire Hathaway (BRKa) shareholder meeting:
"Supposedly sophisticated people...hire consultants, and no consultant in the world is going to tell you 'just buy an S&P index fund and sit for the next 50 years.' You don't get to be a consultant that way. And you certainly don't get an annual fee that way. So the consultant has every motivation in the world to tell you, 'this year I think we should concentrate more on international stocks,' or 'this manager is particularly good on the short side,' and so they come in and they talk for hours, and you pay them a large fee, and they always suggest something other than just sitting on your rear end and participating in the American business without cost. And then those consultants, after they get their fees, they in turn recommend to you other people who charge fees, which... cumulatively eat up capital like crazy."
And, according to Buffett, it's not easy to change behavior:
"I've talked to huge pension funds, and I've taken them through the math, and when I leave, they go out and hire a bunch of consultants and pay them a lot of money. It's just unbelievable."
And guess who these consultants tend to recommend?
Hedge funds that typically get paid via something like a 2-and-20 or a similar compensation structure.
According to Buffett these consultants usually "have lots of charts and PowerPoint presentations and they recommend people who are in turn going to charge a lot of money and they say, 'well you can only get the best talent by paying 2-and-20,' or something of the sort, and the flow of money from the 'hyperactive' to what I call the 'helpers' is dramatic."
During the CNBC interview Buffett added the following:
"In...almost every field, the professional brings something to the party."
Yet, in contrast, Buffett points out that the world of professional investing as a whole produces "negative results to their clientele. And that's a very interesting phenomenon to live with, if you spend your life doing something where your expectancy is to hurt your customer. And yet that is the case for professional investors."
Naturally, some capable individual managers will outperform. Yet as Charlie Munger said at the Berkshire meeting:
"There have been a few of these managers who've actually succeeded...But it's a tiny group of people...like looking for a needle in a haystack."
Think about it this way: if 80% to 90% of actively managed funds tend to underperform, then that by definition means the purchaser of a low-cost index fund, with no skills whatsoever, should over the long-term outperform roughly 80% to 90% of the professional managers.**
Can you imagine such a product existing for other professions?
In other words, there's just no way to buy a product that will enable someone to perform better than, for example, 80% to 90% of doctors without the requisite expertise. The same would be mostly true for other professions (and, for that matter, this also applies to skilled trades).
Of course, one of the problems with this is investors tend to trade index funds too much -- the net reward for the incremental effort being reduced returns -- as well as the actively managed funds they own. Such behavior usually turns what should be inherently, at least on a relative basis, an advantageous approach into one that is less so.
It's tough to outperform picking individual stocks. Similarly, it's tough to pick the professional investors who, going forward and over the long-term, will not only outperform, but will outperform by enough to justify all the frictional costs and, possibly, the incremental risks they'll need to take.
Stocks, generally speaking, appear to be not all cheap these days. So it would seem to be rather unwise to expect market averages will produce more than modest results as long as such valuations persist. Of course, what look like high-ish valuations can for a time become even higher and, as far as near-term price action goes, almost anything can happen.***
Some will see such a situation for what it is and no doubt be tempted to find some creative ways to outperform.
An understandable response?
Possibly.
That doesn't necessarily make it the correct response.
The vast majority (I'd 80% to 90% qualifies) of active investors -- many who are smart, capable, and hardworking -- do worse than what a passive approach could achieve. So that means many market participants, if nothing else, must have a built in bias; they inherently overestimate their own likelihood of success. To them, it's always the other less prepared and less able participants who'll do worse than the average.
Certainly not themselves.
It's worth amplifying that all the extra effort involved isn't just producing no incremental benefit, it's producing a worse than passive outcome; a negative return on all the additional invested time and effort.
A subpar result for the investors though likely not for the managers.
Where else is so much time and talent put forth to achieve so little or, in fact, what is a net reduced outcome?
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
John Bogle: Arithmetic Quants vs Algorithmic Quants
Hedge Funds: Balancing Risk & Reward?
Index Funds vs Actively Managed Funds
John Bogle on Investor Returns
Buffett's Hedge Fund Bet
John Bogle's "Relentless Rules of Humble Arithmetic", Part II
Index Fund Investing Revisited
Charlie Munger on Complexity, Hedge Funds, and Pension Funds
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again
* Through December 31, 2015.
** Think of it this way: it's essentially a choice between a small chance of picking the manager who produces long-term outperformance versus near certainty of being at or near the top ~10% or 20% in terms of long-term market performance. Also, there's still some (usually rather modest) fees to consider in an index fund that might produce a lesser outcome.
*** As always, I have no view on what near-term market prices might be. I'll leave that sort of thing to those who attempt to profit betting on price action. The focus here is definitely not on speculation; it is always on investment -- judging what something is intrinsically worth, looking for reasonable (if not considerable) mispricings, then benefiting, in general, mostly from what's produced over the long run. Valuations right now do seem to be more on the high side than not for many stocks. Or, well, let's just say it seems wise to, considering where valuations are at the present time, use conservative assumptions and lower future return expectations. Of course, higher multiples in the near-term can naturally occur. Those higher multiples may even theoretically make those with a shorter horizon (who sell) better off -- or, at a minimum, will make some participants feel better off -- but, in fact, a meaningful drop in market prices would logically make life easier for the long-term investor. Those with a substantial investing time horizon who are hoping for market prices to continue higher near-term (or even intermediate-term) should keep this in mind. It is lower market prices that increase the possibility of making incremental purchases -- whether done directly by the shareholder or via buybacks using the company's excess cash -- at a nice discount to intrinsic value. The potential long-term compounded effects for continuing owners (i.e. not traders) need not be small. Buying shares at increasingly large discounts to conservatively estimated value over time should, all else equal, reduce risks/improve returns.
(Notice the sometimes overlooked inverse relationship here. Risk and reward is at times positively correlated, but some incorrectly assume they're always positively correlated. Well, the correlation is not always positive and is, as far as I'm concerned, too often a rather underutilized consideration.)
---
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, June 29, 2016
Bogle: Arithmetic Quants vs Algorithmic Quants
From a recent speech by John Bogle:
"As I see it, the plain and simple, well-armed, lightly-dressed, unencumbered shepherd is the index fund, a portfolio holding all 500 stocks in the Standard & Poor’s 500 Index. The David approach to investing, then, is 'buy a diversified portfolio of stocks operated at rock-bottom costs, and hold it forever.' The index fund relies on simple arithmetic, a mathematical tautology that could be calculated by a second grader: gross return in the stock market, minus the frictional costs of investing, equals the net return that is shared by all investors as a group. Taking the lion's share of those costs out of the equation is the key to successful long-term investing.
In contrast, many (most?) Goliaths of academia and quantitative investing believe the contrary: the application of multiple complex equations—the language of science and technology, of engineering and mathematics (yes, STEM), developed with computers processing Big Data, and trading stocks at the speed of light—make our Goliaths far stronger and more powerful than are we indexing Davids. The question posed in my title is essentially, 'who wins?'—the arithmetic quants or the algorithmic quants."
In the early days, when the hedge fund Goliaths* were individually smaller in size and part of a much smaller industry (assets of $ 120 billion in 1997), annualized returns were impressive: 11.8 percent vs 7.2 percent for the S&P 500 from 1990 to 2008.
By 2008, the Goliaths had $ 1.4 trillion in assets that have now grown to roughly $ 2.8 trillion and their relative performance has suffered a bunch: 5.3 percent vs 13.5 percent for the S&P 500 from 2009 to 2016.
Will there prove to be, in the long run, any advantage to all this additional complexity? Is the additional size the main cause of the more recent underperformance? Is it the additional competition from capable individuals entering what is, if nothing else, a potentially rather lucrative profession? Or is it the addition of less capable managers entering the industry? For Bogle this all just reflects what is an inevitable reversion to the mean. The extra muscle and heavy armor -- in terms of industry assets -- has certainly led to huge compensation for the Goliaths.
(Bogle estimates ~$ 84 billion in annual fees while The New York Times reported that the top 25 managers alone were paid an average of $ 465 million in 2014.)
In any case, not unlike the classic battle, all that additional muscle and armor didn't make the Hedge Fund Goliaths a more formidable opponent to the indexing Davids; instead, it appears -- at least based upon the more recent results -- to have made them vulnerable to a much simpler and low cost approach.
Huge frictional costs -- roughly 3 percent per year or more according to Bogle -- are, of course, a meaningful factor but, with a greater than 8 percent annualized gap since 2009, it comes down to more than just those costs. Keep in mind that in the early days the drag of these heavy frictional costs also existed.
The range of outcomes is also a concern. Over the past 5 years, according to Bogle, individual hedge fund returns have been between -91 percent to 157 percent.
Yikes.
These Goliaths may perform much better in the future, of course. There's, as always, just no way to know. Yet I think it's fair to ask whether such long-term outcomes deserves so much time, talent, and capital especially when much less costly, simple, and effective alternatives exist.
If nothing else, over the long haul, the headwind coming from all the frictional costs is no small thing for most to overcome. Some exceptional managers no doubt will overcome those costs -- whether through pure chance or skill or a bit of both -- but that doesn't change the reality that a hedge fund with typical fees must outperform by ~3 percent each year just to keep up with the indexing Davids.
Adam
Related posts:
Hedge Funds: Balancing Risk & Reward?
Index Funds vs Actively Managed Funds
John Bogle on Investor Returns
Buffett's Hedge Fund Bet
John Bogle's "Relentless Rules of Humble Arithmetic", Part II
Index Fund Investing Revisited
Charlie Munger on Complexity, Hedge Funds, and Pension Funds
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again
* It's worth noting the wide variety of investment and trading strategies employed by hedge funds. Still, what most have in common is vastly greater complexity and cost.
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.
"As I see it, the plain and simple, well-armed, lightly-dressed, unencumbered shepherd is the index fund, a portfolio holding all 500 stocks in the Standard & Poor’s 500 Index. The David approach to investing, then, is 'buy a diversified portfolio of stocks operated at rock-bottom costs, and hold it forever.' The index fund relies on simple arithmetic, a mathematical tautology that could be calculated by a second grader: gross return in the stock market, minus the frictional costs of investing, equals the net return that is shared by all investors as a group. Taking the lion's share of those costs out of the equation is the key to successful long-term investing.
In contrast, many (most?) Goliaths of academia and quantitative investing believe the contrary: the application of multiple complex equations—the language of science and technology, of engineering and mathematics (yes, STEM), developed with computers processing Big Data, and trading stocks at the speed of light—make our Goliaths far stronger and more powerful than are we indexing Davids. The question posed in my title is essentially, 'who wins?'—the arithmetic quants or the algorithmic quants."
In the early days, when the hedge fund Goliaths* were individually smaller in size and part of a much smaller industry (assets of $ 120 billion in 1997), annualized returns were impressive: 11.8 percent vs 7.2 percent for the S&P 500 from 1990 to 2008.
By 2008, the Goliaths had $ 1.4 trillion in assets that have now grown to roughly $ 2.8 trillion and their relative performance has suffered a bunch: 5.3 percent vs 13.5 percent for the S&P 500 from 2009 to 2016.
Will there prove to be, in the long run, any advantage to all this additional complexity? Is the additional size the main cause of the more recent underperformance? Is it the additional competition from capable individuals entering what is, if nothing else, a potentially rather lucrative profession? Or is it the addition of less capable managers entering the industry? For Bogle this all just reflects what is an inevitable reversion to the mean. The extra muscle and heavy armor -- in terms of industry assets -- has certainly led to huge compensation for the Goliaths.
(Bogle estimates ~$ 84 billion in annual fees while The New York Times reported that the top 25 managers alone were paid an average of $ 465 million in 2014.)
In any case, not unlike the classic battle, all that additional muscle and armor didn't make the Hedge Fund Goliaths a more formidable opponent to the indexing Davids; instead, it appears -- at least based upon the more recent results -- to have made them vulnerable to a much simpler and low cost approach.
The range of outcomes is also a concern. Over the past 5 years, according to Bogle, individual hedge fund returns have been between -91 percent to 157 percent.
Yikes.
These Goliaths may perform much better in the future, of course. There's, as always, just no way to know. Yet I think it's fair to ask whether such long-term outcomes deserves so much time, talent, and capital especially when much less costly, simple, and effective alternatives exist.
If nothing else, over the long haul, the headwind coming from all the frictional costs is no small thing for most to overcome. Some exceptional managers no doubt will overcome those costs -- whether through pure chance or skill or a bit of both -- but that doesn't change the reality that a hedge fund with typical fees must outperform by ~3 percent each year just to keep up with the indexing Davids.
Adam
Related posts:
Hedge Funds: Balancing Risk & Reward?
Index Funds vs Actively Managed Funds
John Bogle on Investor Returns
Buffett's Hedge Fund Bet
John Bogle's "Relentless Rules of Humble Arithmetic", Part II
Index Fund Investing Revisited
Charlie Munger on Complexity, Hedge Funds, and Pension Funds
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again
* It's worth noting the wide variety of investment and trading strategies employed by hedge funds. Still, what most have in common is vastly greater complexity and cost.
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, May 10, 2016
Buffett: The "Double-Barrel Effect"
Here's what Warren Buffett and Charlie Munger had to say about the necessity to buy more capital-intensive businesses -- something that's at odds with what they mostly did in their early days -- at the most recent Berkshire Hathaway (BRKa) shareholder meeting:
"The ideal business is one that takes no capital but yet grows...if you have a business that grows, and gives you a lot of money every year, and...it [capital] isn't required in its growth, you get a double-barrel effect: from the earnings growth that occurs internally without the use of capital, and then you get the capital it produces to go and buy other businesses.
And See's Candy was a good example of that."
He later added:
"Increasing capital acts as an anchor on returns in many ways."
I'd place the emphasis on "in many ways". When a business needs to continuously absorb lots of capital the number of options available to management get reduced. These fewer options can be especially devastating during a tough business transition (whether brought on by micro or macro factors).
Over shorter time horizons -- and,in my book, a few years or less qualifies as a shorter time horizon when it comes to equity investment -- the impact on returns may not be all that obvious. Full business cycle core economics become masked. (Especially during periods of exceptional prosperity whether industry-specific or more general.) It's over longer time frames, when the impact on compounding becomes the dominant influence on total returns (instead of trading market price action), that the "anchor" becomes increasingly plain as day. This doesn't mean there aren't good capital-intensive businesses; this does mean the risk-reward profile is necessarily unique and unwise to ignore.
Buffett also mentions that Berkshire has a few businesses that earn 100 percent on capital (and this was covered to an extent in the Berkshire annual report) while their energy business produces more like 11-12 percent per year.
"And that's a very decent return, but it's a different sort of animal than the business with very low capital-intensity."
The problem isn't only that there aren't many high return on capital businesses available; it's whether the price is right and that they're large enough to matter considering Berkshire's scale.
It's also worth remembering that it's not just about judging if a business can produce high returns on capital now. What matters most is if that business will continue doing so for a very long time -- often far from easy to judge with enough warranted confidence.
Charlie Munger followed with this...
"...when our circumstances changed, we changed our minds. In the early days quite a few times, we bought a business that was soon producing 100 percent per annum on what we paid for it and didn't require much reinvestment. If we'd been able to continue doing that, we would have loved to do it. But when we couldn't we went to Plan B. And Plan B's working pretty well and in many ways, I've gotten so where I sort of prefer it."
I'm always a bit surprised just how often I'll see an analysis or opinion on a business that places little emphasis on the importance of this "double-barrel effect".
Making an investment without giving due consideration to returns on capital --along with how competitive dynamics and technology might reduce the advantages a business possesses in a way that drastically alters future returns on capital -- is, to me, just a misjudged investment in the making. I'd have no idea how to approach risking capital in such a way.
Return on capital is all-important yet, for some reason, other factors seem to get a great deal more attention instead by some market participants. All the energy that goes into how quarterly earnings and/or some new product might impact the near-term price action of a stock -- or, alternatively, how macro factors might influence the market as a whole -- comes to mind. This is, to me, attempting to consistently guess correctly what is nearly unguessable instead of focusing that energy more productively elsewhere.
In fact, just how infrequently returns on capital comes up when someone is making a case in favor of (or against) a particular equity investment is, to me, rather revealing.
A passing mention (or no mention at all) too often is the norm whether that case is being made in writing or otherwise.*
Now, return on capital certainly isn't the only thing that matters.
Equity investing will never be that straightforward.
It just needs to be given a proper weighting.
Every business and the industry will have many unique things to consider much of which will not be quantifiable.
Well, at the very least not in a precise manner.
There's much to think about with any investment and returns on capital is just one of many important considerations. That's why trying to understand every investment opportunity is usually a recipe for understanding nothing at all with sufficient depth.
It's inevitable that a potentially attractive investment opportunity will show up on someone's radar yet should be "missed" because it just happens to be outside that investor's comfort zone.
What to avoid is necessarily unique for each investor. Knowing what one doesn't know then buying only what's understandable -- at a plain discount, of course -- generally requires the right temperament, independent thinking, discipline, and an awareness of limits over pure genius.
Here's Buffett at the 2009 Berkshire meeting:
"If you have a 150 IQ, sell 30 points to someone else. You need to be smart, but not a genius. What's most important is inner peace; you have to be able to think for yourself. It's not a complicated game."
Those who do choose to extend beyond their comfort zone might find that justified conviction won't be there when it's needed most.
Adam
Long position in BRKb established at much lower than recent prices
Related posts:
High Returns on Capital vs High Returns on Incremental Capital
Not Picking Stocks By The Numbers
Buffett: Cigar Butts & Wonderful Businesses
Buffett: Severe Change, Exceptional Returns Don't Mix
Buffett: 57% Return on Equity Capital
Inexpensive Stock?
Circle of Competence
Inactive Investing
* I do not mean to paint with too broad a brush here. Obviously many capable investors give returns on capital the consideration it deserves.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
"The ideal business is one that takes no capital but yet grows...if you have a business that grows, and gives you a lot of money every year, and...it [capital] isn't required in its growth, you get a double-barrel effect: from the earnings growth that occurs internally without the use of capital, and then you get the capital it produces to go and buy other businesses.
And See's Candy was a good example of that."
He later added:
"Increasing capital acts as an anchor on returns in many ways."
I'd place the emphasis on "in many ways". When a business needs to continuously absorb lots of capital the number of options available to management get reduced. These fewer options can be especially devastating during a tough business transition (whether brought on by micro or macro factors).
Over shorter time horizons -- and,in my book, a few years or less qualifies as a shorter time horizon when it comes to equity investment -- the impact on returns may not be all that obvious. Full business cycle core economics become masked. (Especially during periods of exceptional prosperity whether industry-specific or more general.) It's over longer time frames, when the impact on compounding becomes the dominant influence on total returns (instead of trading market price action), that the "anchor" becomes increasingly plain as day. This doesn't mean there aren't good capital-intensive businesses; this does mean the risk-reward profile is necessarily unique and unwise to ignore.
Buffett also mentions that Berkshire has a few businesses that earn 100 percent on capital (and this was covered to an extent in the Berkshire annual report) while their energy business produces more like 11-12 percent per year.
"And that's a very decent return, but it's a different sort of animal than the business with very low capital-intensity."
The problem isn't only that there aren't many high return on capital businesses available; it's whether the price is right and that they're large enough to matter considering Berkshire's scale.
It's also worth remembering that it's not just about judging if a business can produce high returns on capital now. What matters most is if that business will continue doing so for a very long time -- often far from easy to judge with enough warranted confidence.
Charlie Munger followed with this...
"...when our circumstances changed, we changed our minds. In the early days quite a few times, we bought a business that was soon producing 100 percent per annum on what we paid for it and didn't require much reinvestment. If we'd been able to continue doing that, we would have loved to do it. But when we couldn't we went to Plan B. And Plan B's working pretty well and in many ways, I've gotten so where I sort of prefer it."
I'm always a bit surprised just how often I'll see an analysis or opinion on a business that places little emphasis on the importance of this "double-barrel effect".
Making an investment without giving due consideration to returns on capital --along with how competitive dynamics and technology might reduce the advantages a business possesses in a way that drastically alters future returns on capital -- is, to me, just a misjudged investment in the making. I'd have no idea how to approach risking capital in such a way.
Return on capital is all-important yet, for some reason, other factors seem to get a great deal more attention instead by some market participants. All the energy that goes into how quarterly earnings and/or some new product might impact the near-term price action of a stock -- or, alternatively, how macro factors might influence the market as a whole -- comes to mind. This is, to me, attempting to consistently guess correctly what is nearly unguessable instead of focusing that energy more productively elsewhere.
In fact, just how infrequently returns on capital comes up when someone is making a case in favor of (or against) a particular equity investment is, to me, rather revealing.
A passing mention (or no mention at all) too often is the norm whether that case is being made in writing or otherwise.*
Now, return on capital certainly isn't the only thing that matters.
Equity investing will never be that straightforward.
It just needs to be given a proper weighting.
Every business and the industry will have many unique things to consider much of which will not be quantifiable.
Well, at the very least not in a precise manner.
There's much to think about with any investment and returns on capital is just one of many important considerations. That's why trying to understand every investment opportunity is usually a recipe for understanding nothing at all with sufficient depth.
It's inevitable that a potentially attractive investment opportunity will show up on someone's radar yet should be "missed" because it just happens to be outside that investor's comfort zone.
What to avoid is necessarily unique for each investor. Knowing what one doesn't know then buying only what's understandable -- at a plain discount, of course -- generally requires the right temperament, independent thinking, discipline, and an awareness of limits over pure genius.
Here's Buffett at the 2009 Berkshire meeting:
"If you have a 150 IQ, sell 30 points to someone else. You need to be smart, but not a genius. What's most important is inner peace; you have to be able to think for yourself. It's not a complicated game."
Those who do choose to extend beyond their comfort zone might find that justified conviction won't be there when it's needed most.
Adam
Long position in BRKb established at much lower than recent prices
Related posts:
High Returns on Capital vs High Returns on Incremental Capital
Not Picking Stocks By The Numbers
Buffett: Cigar Butts & Wonderful Businesses
Buffett: Severe Change, Exceptional Returns Don't Mix
Buffett: 57% Return on Equity Capital
Inexpensive Stock?
Circle of Competence
Inactive Investing
* I do not mean to paint with too broad a brush here. Obviously many capable investors give returns on capital the consideration it deserves.
---
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, April 19, 2016
Bezos: The "Inseparable Twins" of Failure and Invention
Here's what Jeff Bezos had to say in the latest Amazon (AMZN) shareholder letter:
"This year, Amazon became the fastest company ever to reach $100 billion in annual sales. Also this year, Amazon Web Services is reaching $10 billion in annual sales … doing so at a pace even faster than Amazon achieved that milestone.
What's going on here? Both were planted as tiny seeds and both have grown organically without significant acquisitions into meaningful and large businesses, quickly. Superficially, the two could hardly be more different. One serves consumers and the other serves enterprises. One is famous for brown boxes and the other for APIs. Is it only a coincidence that two such dissimilar offerings grew so quickly under one roof? Luck plays an outsized role in every endeavor, and I can assure you we've had a bountiful supply. But beyond that, there is a connection between these two businesses. Under the surface, the two are not so different after all. They share a distinctive organizational culture that cares deeply about and acts with conviction on a small number of principles. I'm talking about customer obsession rather than competitor obsession, eagerness to invent and pioneer, willingness to fail, the patience to think long-term, and the taking of professional pride in operational excellence. Through that lens, AWS and Amazon retail are very similar indeed.
A word about corporate cultures: for better or for worse, they are enduring, stable, hard to change. They can be a source of advantage or disadvantage. You can write down your corporate culture, but when you do so, you're discovering it, uncovering it – not creating it. It is created slowly over time by the people and by events – by the stories of past success and failure that become a deep part of the company lore. If it's a distinctive culture, it will fit certain people like a custom-made glove. The reason cultures are so stable in time is because people self-select. Someone energized by competitive zeal may select and be happy in one culture, while someone who loves to pioneer and invent may choose another. The world, thankfully, is full of many high-performing, highly distinctive corporate cultures. We never claim that our approach is the right one – just that it's ours – and over the last two decades, we've collected a large group of like-minded people. Folks who find our approach energizing and meaningful.
One area where I think we are especially distinctive is failure. I believe we are the best place in the world to fail (we have plenty of practice!), and failure and invention are inseparable twins. To invent you have to experiment, and if you know in advance that it's going to work, it's not an experiment. Most large organizations embrace the idea of invention, but are not willing to suffer the string of failed experiments necessary to get there."
One of the more challenging aspects of investing is judging the value of qualitative factors. When the focus is only on the quantitative some of the most significant elements of intrinsic value can be missed.
It's worth noting that qualitative factors do not necessarily only materially add to value; they can and often do subtract in a big way.
Adam
No position in AMZN
Related posts:
Buffett and Munger Talk Retail Businesses, NFM, and Amazon
Washington Post Sold To Jeff Bezos
Amazon, Apple, and Intrinsic Value - Part II
Amazon, Apple, and Intrinsic Value
Negative Working-Capital Cycle
Amazon, Apple, and Margin of Safety
Amazing Amazon
Barron's on Bezos: Time to Reign in Amazon's CEO?
Amazon's Jeff Bezos On Inventing & Disrupting
Amazon Sells Kindle Fire Below Cost
Technology Stocks
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.
"This year, Amazon became the fastest company ever to reach $100 billion in annual sales. Also this year, Amazon Web Services is reaching $10 billion in annual sales … doing so at a pace even faster than Amazon achieved that milestone.
What's going on here? Both were planted as tiny seeds and both have grown organically without significant acquisitions into meaningful and large businesses, quickly. Superficially, the two could hardly be more different. One serves consumers and the other serves enterprises. One is famous for brown boxes and the other for APIs. Is it only a coincidence that two such dissimilar offerings grew so quickly under one roof? Luck plays an outsized role in every endeavor, and I can assure you we've had a bountiful supply. But beyond that, there is a connection between these two businesses. Under the surface, the two are not so different after all. They share a distinctive organizational culture that cares deeply about and acts with conviction on a small number of principles. I'm talking about customer obsession rather than competitor obsession, eagerness to invent and pioneer, willingness to fail, the patience to think long-term, and the taking of professional pride in operational excellence. Through that lens, AWS and Amazon retail are very similar indeed.
A word about corporate cultures: for better or for worse, they are enduring, stable, hard to change. They can be a source of advantage or disadvantage. You can write down your corporate culture, but when you do so, you're discovering it, uncovering it – not creating it. It is created slowly over time by the people and by events – by the stories of past success and failure that become a deep part of the company lore. If it's a distinctive culture, it will fit certain people like a custom-made glove. The reason cultures are so stable in time is because people self-select. Someone energized by competitive zeal may select and be happy in one culture, while someone who loves to pioneer and invent may choose another. The world, thankfully, is full of many high-performing, highly distinctive corporate cultures. We never claim that our approach is the right one – just that it's ours – and over the last two decades, we've collected a large group of like-minded people. Folks who find our approach energizing and meaningful.
One area where I think we are especially distinctive is failure. I believe we are the best place in the world to fail (we have plenty of practice!), and failure and invention are inseparable twins. To invent you have to experiment, and if you know in advance that it's going to work, it's not an experiment. Most large organizations embrace the idea of invention, but are not willing to suffer the string of failed experiments necessary to get there."
One of the more challenging aspects of investing is judging the value of qualitative factors. When the focus is only on the quantitative some of the most significant elements of intrinsic value can be missed.
It's worth noting that qualitative factors do not necessarily only materially add to value; they can and often do subtract in a big way.
Adam
No position in AMZN
Related posts:
Buffett and Munger Talk Retail Businesses, NFM, and Amazon
Washington Post Sold To Jeff Bezos
Amazon, Apple, and Intrinsic Value - Part II
Amazon, Apple, and Intrinsic Value
Negative Working-Capital Cycle
Amazon, Apple, and Margin of Safety
Amazing Amazon
Barron's on Bezos: Time to Reign in Amazon's CEO?
Amazon's Jeff Bezos On Inventing & Disrupting
Amazon Sells Kindle Fire Below Cost
Technology Stocks
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, April 1, 2016
Flying Too Close To The Sun
Warren Buffett, in last year's Berkshire Hathaway (BRKa) special letter*, explained that conglomerates have been at times very popular but became especially so back in the 1960s:
"Since I entered the business world, conglomerates have enjoyed several periods of extreme popularity, the silliest of which occurred in the late 1960s."
This was covered, to an extent, in a post from late last year.
LTV -- a company once run by Jimmy Ling during that era -- is used as an example of a conglomerate structure that goes very wrong. From the letter:
"Through a lot of corporate razzle-dazzle, Ling had taken LTV from sales of only $36 million in 1965 to number 14 on the Fortune 500 list just two years later. Ling, it should be noted, had never displayed any managerial skills. But Charlie told me long ago to never underestimate the man who overestimates himself. And Ling had no peer in that respect.
Ling's strategy...was to buy a large company and then partially spin off its various divisions. In LTV’s 1966 annual report, he explained the magic that would follow: 'Most importantly, acquisitions must meet the test of the 2 plus 2 equals 5 (or 6) formula.' The press, the public and Wall Street loved this sort of talk.
In 1967 Ling bought Wilson & Co., a huge meatpacker that also had interests in golf equipment and pharmaceuticals. Soon after, he split the parent into three businesses, Wilson & Co. (meatpacking), Wilson Sporting Goods and Wilson Pharmaceuticals, each of which was to be partially spun off. These companies quickly became known on Wall Street as Meatball, Golf Ball and Goof Ball.
Soon thereafter, it became clear that, like Icarus, Ling had flown too close to the sun. By the early 1970s, Ling's empire was melting, and he himself had been spun off from LTV . . . that is, fired.
Periodically, financial markets will become divorced from reality – you can count on that. More Jimmy Lings will appear. They will look and sound authoritative. The press will hang on their every word. Bankers will fight for their business. What they are saying will recently have 'worked.' Their early followers will be feeling very clever. Our suggestion: Whatever their line, never forget that 2+2 will always equal 4. And when someone tells you how old-fashioned that math is --- zip up your wallet, take a vacation and come back in a few years to buy stocks at cheap prices."
So a bit of healthy skepticism comes in handy when some repackaged business strategy is being promoted aggressively (especially when bankers and the press fan the flames). This is especially true when questionable accounting and aggressive financing comes into play.
CEO behavior can have a huge impact on intrinsic business value especially over the very long haul. The good news is that plenty of extremely capable business executives are out there. Unfortunately, personality and salesmanship sometimes get in the way of making a sound judgment about a CEOs overall talents. For investors, it's vital to I.D. situations beforehand that lead to inflated perceived prospects and, at least for a time, a valuation that reflects the flawed perception.
The specifics may vary but it almost always is wise to avoid of investing in -- or, at times, alongside -- those who tend to overestimate themselves no matter how smart someone is (or seems to be).
"Smart, hard-working people aren't exempted from professional disasters from overconfidence. Often, they just go aground in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods." - Charlie Munger speech to the Foundation Financial Officers Group
"We recognized early on that very smart people do very dumb things, and we wanted to know why and who, so we could avoid them." - Charlie Munger at the 2007 Berkshire Hathaway Shareholder Meeting
"If you think your IQ is 160 but it's 150, you're a disaster. It's much better to have a 130 IQ and think it's 120." - Charlie Munger at the 2009 Berkshire Hathaway Shareholder Meeting
"If you have a 150 IQ, sell 30 points to someone else. You need to be smart, but not a genius. What's most important is inner peace; you have to be able to think for yourself. It's not a complicated game." - Warren Buffett at the 2009 Berkshire Hathaway Shareholder Meeting
Humility and knowing what you don't know can go a long way in investing.
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
Berkshire's Structure: Why It Works
Corporate Hocus-Pocus
Charlie Munger: Focus Investing and Fuzzy Concepts
Grantham & Buffett: "Career Risk" & "The Institutional Imperative"
Buffett on "The Institutional Imperative"
Buffett: A Portrait of Business Discipline
Buffett on Bold & Imaginative Accounting
Charlie Munger on LTCM & Overconfidence
When Genius Failed...Again
* This is Buffett's special letter that was written for the 50th Anniversary of Berkshire. Munger also wrote a separate letter to recognize this Golden Anniversary. These can also be found at the end of the regular letter (page 24 and 39 respectively).
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
"Since I entered the business world, conglomerates have enjoyed several periods of extreme popularity, the silliest of which occurred in the late 1960s."
This was covered, to an extent, in a post from late last year.
LTV -- a company once run by Jimmy Ling during that era -- is used as an example of a conglomerate structure that goes very wrong. From the letter:
"Through a lot of corporate razzle-dazzle, Ling had taken LTV from sales of only $36 million in 1965 to number 14 on the Fortune 500 list just two years later. Ling, it should be noted, had never displayed any managerial skills. But Charlie told me long ago to never underestimate the man who overestimates himself. And Ling had no peer in that respect.
Ling's strategy...was to buy a large company and then partially spin off its various divisions. In LTV’s 1966 annual report, he explained the magic that would follow: 'Most importantly, acquisitions must meet the test of the 2 plus 2 equals 5 (or 6) formula.' The press, the public and Wall Street loved this sort of talk.
In 1967 Ling bought Wilson & Co., a huge meatpacker that also had interests in golf equipment and pharmaceuticals. Soon after, he split the parent into three businesses, Wilson & Co. (meatpacking), Wilson Sporting Goods and Wilson Pharmaceuticals, each of which was to be partially spun off. These companies quickly became known on Wall Street as Meatball, Golf Ball and Goof Ball.
Soon thereafter, it became clear that, like Icarus, Ling had flown too close to the sun. By the early 1970s, Ling's empire was melting, and he himself had been spun off from LTV . . . that is, fired.
Periodically, financial markets will become divorced from reality – you can count on that. More Jimmy Lings will appear. They will look and sound authoritative. The press will hang on their every word. Bankers will fight for their business. What they are saying will recently have 'worked.' Their early followers will be feeling very clever. Our suggestion: Whatever their line, never forget that 2+2 will always equal 4. And when someone tells you how old-fashioned that math is --- zip up your wallet, take a vacation and come back in a few years to buy stocks at cheap prices."
So a bit of healthy skepticism comes in handy when some repackaged business strategy is being promoted aggressively (especially when bankers and the press fan the flames). This is especially true when questionable accounting and aggressive financing comes into play.
CEO behavior can have a huge impact on intrinsic business value especially over the very long haul. The good news is that plenty of extremely capable business executives are out there. Unfortunately, personality and salesmanship sometimes get in the way of making a sound judgment about a CEOs overall talents. For investors, it's vital to I.D. situations beforehand that lead to inflated perceived prospects and, at least for a time, a valuation that reflects the flawed perception.
The specifics may vary but it almost always is wise to avoid of investing in -- or, at times, alongside -- those who tend to overestimate themselves no matter how smart someone is (or seems to be).
"Smart, hard-working people aren't exempted from professional disasters from overconfidence. Often, they just go aground in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods." - Charlie Munger speech to the Foundation Financial Officers Group
"We recognized early on that very smart people do very dumb things, and we wanted to know why and who, so we could avoid them." - Charlie Munger at the 2007 Berkshire Hathaway Shareholder Meeting
"If you think your IQ is 160 but it's 150, you're a disaster. It's much better to have a 130 IQ and think it's 120." - Charlie Munger at the 2009 Berkshire Hathaway Shareholder Meeting
"If you have a 150 IQ, sell 30 points to someone else. You need to be smart, but not a genius. What's most important is inner peace; you have to be able to think for yourself. It's not a complicated game." - Warren Buffett at the 2009 Berkshire Hathaway Shareholder Meeting
Humility and knowing what you don't know can go a long way in investing.
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
Berkshire's Structure: Why It Works
Corporate Hocus-Pocus
Charlie Munger: Focus Investing and Fuzzy Concepts
Grantham & Buffett: "Career Risk" & "The Institutional Imperative"
Buffett on "The Institutional Imperative"
Buffett: A Portrait of Business Discipline
Buffett on Bold & Imaginative Accounting
Charlie Munger on LTCM & Overconfidence
When Genius Failed...Again
* This is Buffett's special letter that was written for the 50th Anniversary of Berkshire. Munger also wrote a separate letter to recognize this Golden Anniversary. These can also be found at the end of the regular letter (page 24 and 39 respectively).
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
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