Are Large Cap Stocks on Sale?

A follow up to this post:

Buffett: Waiting For The Fat Pitch

If not quite fat pitches yet, many big cap stocks seem not at all expensive.

Last week I noted that many stocks among the Dow 30 are, on the surface, very reasonably valued.

Some, of course, more than others. I'm wary of businesses that may be benefiting from cyclical tailwinds that make them look cheap now but on a normalized long-term basis they end up not such a bargain.

In general, I wouldn't take the bat off the shoulder for most commodity businesses unless they have a clearly sustainable low cost advantage, a conservative balance sheet, selling at a price that reflects a weak business outlook. In other words, a much larger than average margin of safety is needed.

In fact, I wouldn't go near something like Alcoa (AA) no matter how inexpensive it was.

For most businesses, especially the capital intensive/cyclical ones, current earnings doesn't help much in estimating intrinsic value. Cyclical stocks often look cheap when they are most expensive. The use of what ends up being near peak earnings to value a cyclical business, a common mistake, can be very costly*.

In my view, earnings produced on average over at least a full business cycle (much longer if recent bubble conditions have caused distortions) must be used with quality of earnings carefully checked.

To me, this is not the case for the great consumer franchises. For those businesses, recent annual earnings is usually sufficient given the resilience of their earning power.

Dow 30
3M (MMM), AT&T (T), Alcoa (AA), American Express (AXP), Bank of America (BAC), Boeing Co (BA), Caterpillar Inc (CAT), Chevron Corp (CVX), Cisco Systems (CSCO), Coca-Cola (KO), Disney (DIS), Du Pont (DD), Exxon Mobil (XOM), General Electric (GE), Hewlett-Packard (HPQ), Home Depot Inc (HD), IBM (IBM), Intel (INTC), Johnson & Johnson (JNJ), Kraft Food Inc (KFT), McDonalds (MCD), Merck (MRK), Microsoft (MSFT), J.P. Morgan (JPM), Pfizer (PFE), Procter & Gamble (PG), Travelers (TRV), United Technologies (UTX), Verizon (VZ), Wal-Mart Stores (WMT)

The focus here is always on purchasing shares of good businesses, with an appropriate margin of safety, then allowing the economics of the business itself, the drivers of growth in intrinsic value, to do the heavy lifting over a long period of time. No special ability to trade or time the market required.
(I never have an opinion when it comes to the trading of any stock. Fortunately, nor is some unusual talent for trading required if price vs value is frequently judged well.)

Many large tech stocks, pharma stocks, and integrated energy stocks currently sell at single digit price to earnings ratios. A low multiple isn't enough. Ultimately, what matters is whether the business has durable competitive advantages that allow it to produce a high return on capital** over a very long period of time. Durable high return on capital is useful for gauging how intrinsic value may grow over time (though there is no precise method to predict long-term growth in value, of course).

Again, the durable high return on capital is what drives long-term investment returns not some kind of superior trading skills.

It's often better to pay a slightly greater multiple (maybe more than slight) for a business that's positioned to produce a high return on capital for years to come.

Return on capital for tech stocks often looks pretty solid but the question is not usually how attractive current or near term return on capital happens to be for most tech stocks.  The question is how sustainable those seemingly favorable economics will be in a constantly changing competitive landscape with evolving future threats. That's why I'm not comfortable with most tech stock investments unless the discount to likely value is very large.

The single digit multiples found among some of the above stocks appear to be pricing in a future not likely to happen. I have no idea what the stocks will do in the short-to-intermediate run but, for me, quite a few of these do have a decent margin of safety. 

They seem as strangely cheap today as they were strangely expensive roughly a decade ago. Yet, I wouldn't describe any as being along the lines of what Buffett calls a fat pitch.

A decade ago prices reflected a rosy future that didn't happen. For many of the better businesses here with prices that reflect a lousy expected future, I suspect things will end up being a bit better than lousy and long-term investors will do okay.

Most big banks also sell at a single digit multiple of likely normalized earnings (some are already at single digit multiples even with earnings depressed well below potential).

As far as banks go, for me, something like Wells Fargo (WFC) still looks very reasonable even if the regulatory and systemic risks remain significant. The long-term economics of Wells is exceptional. Even as the rules of the banking game change I'm of the opinion they will continue to have an advantage.

I may, of course, be proven wrong about Wells. The question is whether any bank is worth the trouble when considering all the other reasonably valued assets available. Many things can go wrong for a bank, some beyond its control, that simply cannot for other businesses.

As always, some of this comes down to how comfortable an individual investor is with the inherent risks of one asset versus another asset. Buy an asset where you don't understand the inherent risks and potential and the conviction required to hang in there if the market price starts to break down probably will not be there.

For my money, adjusted for risk the best businesses to own long-term remain the great franchises (Diageo: DEO, and Pepsi: PEP and Johnson & Johnson: JNJ among many others) when bought at the right price. These all have huge and durable economic moats. The durability of their economics come primarily from a combination of strong product, brands, distribution, and scale. Each are very difficult to dislodge from their unique positions of strength and have proven economics to back it up.

These stocks may lack characteristics that those involved in hyperactive trading are looking for but the merits of their long-term effects, especially on a risk/reward basis and when bought at the right price, are real.

"...why should such an owner care if at any time most other investors are faring somewhat better or worse. And particularly so when he rationally believes, like Berkshire, that his long-term results will be superior by reason of his lower costs, required emphasis on long-term effects, and concentration in his most preferred choices." - Charlie Munger in a speech to the Foundation Financial Officers Group

The problem is most of these are not particularly inexpensive (though certainly not overvalued) at this time so some patience is required.

Adam

Accumulating, or planning to accumulate, long positions in some of the above stocks as they hopefully drop further in value. Previously have established long-term positions in KO, PEP, DEO, PG, JNJ, AXP, and WFC. Many of these were established at much lower prices. Technology positions require a larger margin of safety.

* That it was bought near the cyclical peak of earnings is often only obvious after the fact...when it's already too late to sell.
** Return on capital measures how well a company employs its resources to generate profits. The best business has durable competitive advantages yet needs little capital relative to the profits it produces. The durability characteristics make it likely that not only can a business earn a nice return now, but that those favorable economics are sustainable for a long time. A business that needs modest capital compared to earnings power (whether financed by equity, debt or the future free cash generated) has lots of options that benefit shareholders. Capable management can either return excess cash to shareholders (dividends or buybacks depending on attractiveness of the share price) or use it to produce high returns on capital when the opportunity to deploy incremental capital presents itself. The problem for shareholders begin when management uses capital to pursue growth for its own sake regardless of return. 
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Buffett: Waiting For The Fat Pitch - Berkshire Shareholder Letter Highlights

From Warren Buffett's 1997 Berkshire Hathaway (BRKa) shareholder letter:

"In his book The Science of Hitting, Ted explains that he carved the strike zone into 77 cells, each the size of a baseball. Swinging only at balls in his 'best' cell, he knew, would allow him to bat .400; reaching for balls in his "worst" spot, the low outside corner of the strike zone, would reduce him to .230. In other words, waiting for the fat pitch would mean a trip to the Hall of Fame; swinging indiscriminately would mean a ticket to the minors.

If they are in the strike zone at all, the business 'pitches' we now see are just catching the lower outside corner. If we swing, we will be locked into low returns. But if we let all of today's balls go by, there can be no assurance that the next ones we see will be more to our liking. Perhaps the attractive prices of the past were the aberrations, not the full prices of today. Unlike Ted, we can't be called out if we resist three pitches that are barely in the strike zone; nevertheless, just standing there, day after day, with my bat on my shoulder is not my idea of fun."

When the above was written, the party that ultimately led to the tech bubble era valuations* had already begun in the equity markets.

Overvaluation, in some cases extreme, became the norm.

A field day for those speculating on price action yet not so amusing for those in the business of estimating current value, likely future value, and trying to buy things at a sufficient discount.

So, at the time, marketable securities became increasingly decoupled from the economic forces that determine value. The financial equivalent of ignoring Sir Isaac Newton's law of universal gravitation.

Now, gravity and, more specifically, a so-called zero gravity flight provides a useful way to think about what happens in markets from time to time.

For a brief period measured in 20 or 30 seconds, a zero gravity flight can, in fact, simulate weightlessness and make it seem to passengers like there's no gravity. Yet, while a zero gravity flight can make it seem there are negligible gravitational forces at work for a short time, eventually the plane will leave the zero gravity phase -- the parabolic arc -- and the fact that gravity is still very much there becomes front and center again to the passengers.

An easy to understand temporary illusion.

A similarly easy to understand temporary illusion happened in the late 1990s in the equity markets.

In the long run it is intrinsic value** -- the discounted value of all cash that can be taken out of a business during its remaining life -- that anchors market prices the same way gravity keeps us firmly planted on terra firma.

In the long run.

In the short-to-intermediate run it's a very different story.

Markets do occasionally enter a period analogous to a zero gravity flight. It may be for a period greater than 20-30 seconds, but basically that's what happens. Consider the late 1990s. For several years the passengers (i.e. market participants) were stuck in the zero gravity phase of the financial flight, where it seemed that the market's equivalent to gravity (i.e. intrinsic value) was no longer at work, but some made the mistake of thinking it somehow was not just an illusion.

The zero gravity phase for the equity markets ended when the dot com bubble burst.

So, in 1997, market prices had already begun decoupling from economic reality. After a while enough market participants believed the illusion was real (others saw it for what it was but likely believed they'd be able to find a chair when the music stopped). It was not a fun time if, like Buffett, buying shares of a good business (or, in his case, sometimes, an entire business) at a meaningful discount to their intrinsic value was your game.

Even though market prices got even sillier a few years later (the decoupled getting even more decoupled), it was already difficult in 1997 to find shares of a good business selling at prices that offered a substantial margin of safety to the investor.

Today, the investing landscape is very different in my view. On the surface, the market as a whole is not exceptionally cheap.

Yet, below that surface I happen to think we find ourselves in an investing universe that, while not containing an overwhelming number of fat pitches, there's certainly enough to occasionally take the bat off the shoulder.

Adam

Long BRKb

* I've said previously, it was not just the tech and internet stocks though that is certainly where valuations became the most extreme.
** From the Berkshire owner's manual: "Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life." Of course, there is no perfect estimate of what the cash that can be taken out of a business during its remaining life will be. Yet, despite the zero gravity illusion -- or, at least, the equity markets equivalent -- stock prices should to an extent be anchored by intrinsic value within some plausible range. Still, expect the alternately manic-then-depressed nature of markets to reinforce the illusion. Short run -- and even longer run -- price action will sometimes completely decouple from the intrinsic value anchor.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

Buffett on "The Inevitables": Berkshire Shareholder Letter Highlights

From Warren Buffett's 1996 Berkshire Hathaway (BRKa) shareholder letter:

I was recently studying the 1896 report of Coke (and you think that you are behind in your reading!). At that time Coke, though it was already the leading soft drink, had been around for only a decade. But its blueprint for the next 100 years was already drawn. Reporting sales of $148,000 that year, Asa Candler, the company's president, said: "We have not lagged in our efforts to go into all the world teaching that Coca-Cola is the article, par excellence, for the health and good feeling of all people." Though "health" may have been a reach, I love the fact that Coke still relies on Candler's basic theme today - a century later. Candler went on to say, just as Roberto could now, "No article of like character has ever so firmly entrenched itself in public favor." Sales of syrup that year, incidentally, were 116,492 gallons versus about 3.2 billion in 1996.

I can't resist one more Candler quote: "Beginning this year about March 1st . . . we employed ten traveling salesmen by means of which, with systematic correspondence from the office, we covered almost the territory of the Union." That's my kind of sales force.

Companies such as Coca-Cola and Gillette might well be labeled "The Inevitables." Forecasters may differ a bit in their predictions of exactly how much soft drink or shaving-equipment business these companies will be doing in ten or twenty years. Nor is our talk of inevitability meant to play down the vital work that these companies must continue to carry out, in such areas as manufacturing, distribution, packaging and product innovation. In the end, however, no sensible observer - not even these companies' most vigorous competitors, assuming they are assessing the matter honestly - questions that Coke and Gillette will dominate their fields worldwide for an investment lifetime. Indeed, their dominance will probably strengthen. Both companies have significantly expanded their already huge shares of market during the past ten years, and all signs point to their repeating that performance in the next decade.

In the letter, Buffett mentions that the stock prices of businesses like Coca-Cola (KO) and Gillette (now part of Procter & Gamble: PG) end up out of line with value. He also says that even outstanding businesses have historically been susceptible to management that become distracted and unfocused from time to time.

You can, of course, pay too much for even the best of businesses. The overpayment risk surfaces periodically and, in our opinion, may now be quite high for the purchasers of virtually all stocks, The Inevitables included. Investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid.

A far more serious problem occurs when the management of a great company gets sidetracked and neglects its wonderful base business while purchasing other businesses that are so-so or worse. When that happens, the suffering of investors is often prolonged. Unfortunately, that is precisely what transpired years ago at both Coke and Gillette. (Would you believe that a few decades back they were growing shrimp at Coke and exploring for oil at Gillette?) Loss of focus is what most worries Charlie and me when we contemplate investing in businesses that in general look outstanding. All too often, we've seen value stagnate in the presence of hubris or of boredom that caused the attention of managers to wander.

Around the time that letter was written, stocks like Coca-Cola were beginning to sell at multiples of earnings that made little sense. Even an outstanding business like Coca-Cola, if bought at 40-50x earnings, almost guarantees the investor a stagnant or worse decade ahead (in terms of stock performance) as the intrinsic value* of the business catches up to market price (or market price falls more in line with current value).

These are value creating machines but paying too much in anticipation of future worth will naturally damage investor returns.

Many stocks, of course, would go on to get even more expensive after he wrote that letter and it certainly was not just the tech stocks.

These days, Wal-Mart (WMT) is often cited as a stock that has gone nowhere in the past decade. The listless performance has more to do with the price paid by market participants for Wal-Mart's stock, especially in the 1st half of the past decade, not business performance over that time.

The business itself did just fine.

Over that time the Wal-Mart's business more than tripled its earning power. Not a bad decade of work especially for a company that size.

A decade ago market participants were willing to pay around forty dollars for every dollar of Wal-Mart's earnings. Now, investors are paying less than 12 dollars for every dollar of earnings.

Unless something material is going to happen to Wal-Mart's moat, at current market price the next decade should be a much different story as far as that stock goes.

Adam

Long all stocks mentioned

* From the Berkshire Hathaway owner's manual:
"Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.

The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are 5 revised. Two people looking at the same set of facts, moreover – and this would apply even to Charlie and me – will almost inevitably come up with at least slightly different intrinsic value figures."
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

Charlie Munger: Two Kinds of Businesses - Part II

A follow up to this previous post.

With the following thought from Charlie Munger in mind...

"There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there's never any cash. It reminds me of the guy who looks at all of his equipment and says, 'There's all of my profit.' We hate that kind of business."

...consider a typical automobile manufacturer.

Occasionally, though for some not very often*, an automaker will actually have some earnings. The problem is much (if not all of it) will go toward:
- helping fund the creation of the next generation vehicles, and
- absorbing the nearly certain future operating losses (during the next meaningful economic downturn).

In my view, you can't look at price to current earnings to gain any meaningful insight with most automobile manufacturers. In fact, if you look at many of the automakers over a few business cycles, there's not all that much in the way of normalized earnings. It's especially ugly for investors when viewed in the context of the amount of capital that is being employed to produce the rather meager (or nonexistent) earnings.

So what seem like earnings are, in fact, mostly illusory. Return on capital ends up being subpar or much worse. For many auto manufacturers, their earnings are a necessary and useful fuel for staying in the game. Yet, the last time I checked, effective investing doesn't involve putting capital at risk just so a business can survive while ultimately generating unsatisfactory or negative returns. (An FDIC insured bank account provides a much safer way to produce modest returns with essentially no risk of negative returns.) It's about getting much more out, commensurate with the risks taken, primarily through the increases of a businesses earning power per share over time.

It's pretty simple. A business that needs most (or all) of its earnings just to stay remain a viable going concern cannot produce satisfactory economic returns for investors.

Any automaker that invests insufficiently or ineffectively in the next generation of products has a high probability of being on the ropes once the inevitable next recession hits. It takes little time for the current generation of vehicle to lose competitiveness in the marketplace.

Still, even those that survive are not likely to produce much in the way of returns for shareholders. Let's say someone buys the following two stocks in the late 1950s and reinvests the dividends over the next fifty years.

$ 10,000 invested in General Motors (GM) stock in the late 1950s, even before it went bankrupt, had not produced much shareholder value fifty years later (considering the time frame). Of course, ultimately the stock was worth nothing. First of all, investors in an inherently weaker business like GM would have been better off if those dividends were not reinvested. Actually, considering the challenges (its capital intensiveness and brutal competition led to low return on capital and reduced business durability) that was facing an enterprise like General Motors, better to not invest at all.

In contrast, over the same fifty year period, $ 10,000 invested in Philip Morris/Altria (MO) grew to over $ 80 million (incl. reinvested dividends).

Philip Morris/Altria generated an annual return of nearly 20% during that time frame.

An asset that returns that much annually left to the magic of compounding turns $ 10,000 into $ 80 million in 50 years.

That means a roughly 6x increase in value has been a typical decade for MO. Some of this came about as a result of a consistently low stock price. The threat of legal liabilities and that some investors don't want anything to do with a business that sells tobacco products meant the shares were often cheap. The fact that it is a business with high return on capital and the dividends could be used to buy shares consistently cheap were key factors in generating high long-term returns. This works with buybacks as well even if the tax implications, depending on the type of account, are generally not the same. 

Excluding the tax differences, buybacks and dividend reinvestments -- implemented at reasonable or better valuation levels (i.e. discount to intrinsic value) -- similarly benefit long-term owners; the former reduces overall share count, while the latter increases the number of shares owned.

Odds are pretty good that both MO, and the spin-off Philip Morris International (PM), will continue to do just fine as investments though, I think it's fair to assume, they're not likely to generate anything close to those spectacular returns going forward.
(Now, if it turns out to be better than expected there'll surely be no complaints.)

In any case, all else equal, they'll be even better long-term investments if the shares consistently remain rather cheap.

Imagine having $ 10,000 laying around back in the 1950s and not being sure whether to make a long-term investment in GM or MO. I'm guessing most investors back then thought of GM as an unstoppable business juggernaut while MO was a company heading into uncertain legal liabilities and reduced demand for their products.

Occasionally, a well run automaker will do better than GM and maybe even make more than modest returns for investors. So theoretically there are exceptions.

The problem is you have to pick the right one.

Unfortunately, the right one in the auto industry will probably do worse for investors than a laggard in some other field. In certain industries, the leader will produce excellent return but even the laggards produce good results for investors.

The cereal business come to mind. More from Charlie Munger:

"If it's a pure commodity like airline seats, you can understand why no one makes any money....Yet, in other fields—like cereals, for example—almost all the big boys make out. If you're some kind of a medium grade cereal maker, you might make 15% on your capital. And if you're really good, you might make 40%."

It's easier to pick a needle out of a stack on needles.

Yet, the generally subpar long-term returns produced by automotive manufacturers are not simply the result of weak management. For an investor, I think the problem goes deeper than that. These are fundamentally difficult businesses with almost no chance of producing a high return on capital for investors. A well run auto manufacturer is, in most cases, just going to be the best house in a bad neighborhood.

So that mean, even with the best, an investor takes on more risk for lower returns versus many alternative investments.

Think about how much Ford (F), GM and other major automakers have had to spend on new car models over the past 30 years. Yet, even with all that money put to work, there is still no real moat protecting the future economics of these businesses. They are only as secure as the competitiveness of the next models that they produce. Underinvest or misfire on key new product launches and it won't take much time for any automaker to be in some trouble.

A good business that invests heavily in its future over time should also be able to build some kind of an economic moat. Something that protects the economics of a business for an extended period into the future against competition (some combination of brand strength, a cost advantage, broader distribution etc). Automakers have a very tough time doing this.

In contrast, how much has someone like Wrigley had to spend producing its next generation pack of gum over the past 30 years?

Here's how Munger looks at it:

"If I go to some remote place, I may see Wrigley chewing gum alongside Glotz's chewing gum. Well, I know that Wrigley is a satisfactory product, whereas I don't know anything about Glotz's. So if one is 40 cents and the other is 30 cents, am I going to take something I don't know and put it in my mouth which is a pretty personal place, after all for a lousy dime?"

So Wrigley has little difficulty charging something like 33% more in price for essentially the same product because of the trust and familiarity of the brand. What would an automaker have to put into one of it's machines to get a customer to pony up 33% more dollars. Yes, brand matters in the auto business but even the better ones would struggle to charge a higher price without more...more...more. More options, more horsepower, more engineering etc.

Meanwhile, Wrigley sells variations of gum and other candies, with updated packaging of some kind every now and then, and gets to charge a nice premium. I'm not saying that running Wrigley's well is easy. Yet, I'd bet if there was not a single update to that pack of gum over the next decade they'd still basically have a pretty good business.

That's the best evidence of Wrigley's moat. They'd still make a nice living even if they stopped innovating tomorrow (though they may miss a whole lot of upside).

Not true for automakers.

Some of this comes down to being a small ticket item instead of a big ticket item relative to an individual's average annual budget. If you are about to spend $ 100 on groceries no one is going to sweat ten cents more for the pack of gum that you like and trust.

Not so for a big ticket item like a car.

I realize producing automobiles for a living is probably a lot of fun but, from an investors point of view, which kind of business would you rather own?**

In lower quality businesses like automobile manufacturing, the problem is that the basic alternatives for management are unattractive:

-stay competitive by making the investments in new technology while producing lousy shareholder returns (not necessarily zero or negative, but certainly not great long-term relative to alternatives given the risks)

-do not make those investments, lose competitiveness, and watch earning power shrink over time (as competitors adopt the new technology) while producing even crappier returns

Durable competitive advantage, pricing power, and modest capital requirements are found among the better businesses. Selling a desirable small ticket item doesn't hurt.

Pretty much the opposite of almost all auto manufacturers.

The better businesses have earnings that are truly free to benefit shareholders (i.e. not continuously needed to shore up business competitiveness).

Earnings that are either available to be distributed to shareholders or can be used for incremental investments that ultimately produce even higher future returns for shareholders.

Investing is not about earning or earnings growth in a vacuum; it's about return on capital. What matters is the earnings that can be produced relative to the capital that is employed. Well, many high quality businesses -- those that produce terrific and durable returns on capital in their current form -- often have limited opportunities to deploy incremental capital at a high rate of return.***

Some businesses may be growing earnings fast but require the deployment of capital at an even faster rate. Investors may chase that sort of growth but simple arithmetic gets in the way of shareholder returns in the long run.
(It's another story for traders, of course.)

Return on capital mostly dictates long-term overall returns. An investor can't escape the long run gravitational force that causes returns to converge on what a business can generate in earnings relative to the capital employed. 

Bottom line: buy quality businesses at the right price and the rest should take care of itself over the long-term.

Adam

Long position in MO and PM

Related prior post:
Charlie Munger: Two Kinds of Businesses

* As an example, if you add up the earnings from each of the past ten years, Ford Motor Company's losses were more than $ 20 billion.
** I'm not making a judgment on the merits of trading any automaker's stock here. I am looking at how much intrinsic value a business creates in the long run. The stock may end up working just fine as a trading vehicle over a business cycle. I have no useful skills or opinions regarding that sort of thing.
*** Both incremental capital and ongoing capital that's needed to maintain or even improve the existing "machinery". In other words, the investments necessary to fortify the important existing physical and intangible assets already in place. Capital that at least maintains but ideally improves (widening the moat) a firm's competitive position. It's generally when incremental capital gets deployed at low returns, in the blind pursuit of growth, where long-term investors end up getting hurt.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Charlie Munger: Two Kinds of Businesses

Some businesses must utilize almost all of its earnings (or what seems like earnings) just to remain competitive.

To some extent, this was covered in my previous post.

Airlines and automakers come to mind as good examples.

Those businesses tend to have earnings more in an accounting sense but less so in a real economic sense.
(If earnings need to be reinvested in the asset just to survive, they can hardly be considered useful economically to owners. It's the investment equivalent of running to stay in place.)

The very best investments require modest amounts of capital to deliver a steady or increasing stream of excess cash. If most, or all, of the cash earned needs to be plowed back into a business just to remain competitive, shareholders cannot do well in the long run.

Investing is about buying an asset at a price that allows the excess cash produced to provide a sufficient return considering the risks being taken and the total capital that's employed (over the full life cycle of the investment).

Businesses like Pepsi (PEP), Heinz (HNZ), Johnson & Johnson (JNJ), and Kellogg (K) among others generally produce lots of excess cash earnings that can be distributed to shareholders or used for incremental investments that ultimately benefit shareholders at a later time.

Each needs modest capital to remain competitive.

Each requires little in the way of capital relative to the cash produced.

At least that's been the case historically. The question is, as always, whether that'll change. In the previous post I mentioned the following quote by Charlie Munger:

"There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there's never any cash. It reminds me of the guy who looks at all of his equipment and says, 'There's all of my profit.' We hate that kind of business."

Pepsi, of course, is an example the first kind of business while things like airlines generally represent the second kind.*

Here is another variation of this idea that Munger presented during this 1994 talk at USC:

"The great lesson in microeconomics is to discriminate between when technology is going to help you and when it's going to kill you. And most people do not get this straight in their heads. But a fellow like Buffett does.

For example, when we were in the textile business, which is a terrible commodity business, we were making low-end textiles—which are a real commodity product. And one day, the people came to Warren and said, 'They've invented a new loom that we think will do twice as much work as our old ones.'

And Warren said, 'Gee, I hope this doesn't work because if it does, I'm going to close the mill.' And he meant it.

What was he thinking? He was thinking, 'It's a lousy business. We're earning substandard returns and keeping it open just to be nice to the elderly workers. But we're not going to put huge amounts of new capital into a lousy business.'

And he knew that the huge productivity increases that would come from a better machine introduced into the production of a commodity product would all go to the benefit of the buyers of the textiles. Nothing was going to stick to our ribs as owners.

That's such an obvious concept—that there are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that's still going to be lousy. The money still won't come to you. All of the advantages from great improvements are going to flow through to the customers."

So, once again, what seems like earnings is actually of the poor quality variety. Those earnings are an illusion. They are there up until the point that shareholders would like to benefit from them.

The earnings exist, for the most part, in an accounting sense only. They are effectively good 'til needed by the owners, I guess. Like a fruit that's rotten before it is even ripe.

The result?

Earnings that are not available as dividends (or buybacks).

Earnings that cannot be used to fund future investments that will produce an attractive return.

Why? They mostly get used up just keeping the existing business alive.

Running in place.

Adam

Long PEP and JNJ

Related post:
Charlie Munger: Two Kinds of Businesses - Part II (follow-up)

* Pepsi is just one good example among many. It is both able to pay cash dividends to shareholders, make investments in new products, distribution etc. at a high rate of return to produce future streams of cash, while remaining competitive in its existing business. Favorable returns can also come from something like See's Candies: a business that has little need for capital yet reliably produces a growing stream of cash. If See's were a separate public company, a nice dividend, buyback (if shares were cheap enough), or smart acquisitions would be in order since there aren't many high return investment opportunities within the business. In other words, the incremental capital that can be put to work internally is limited (even if the capital that it does employ generates very attractive returns). So the excess capital needs to be intelligently redeployed by competent management.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Stocks Cheapest in 26 Years

At least that's what this Bloomberg article suggests.

Bloomberg: Stocks Cheapest in 26 Years as S&P Falls, Profit Rises

Valuations do seem not at all expensive for some stocks. The Dow Industrials, for example, at this time offer a number of examples of stocks selling near or even below 10 times earnings.

Obviously, the earnings expectations could prove to be optimistic. We could be heading into a soft patch (or worse) that ultimately make those earnings look more than a bit inflated.

Still, with the earnings yields (inverse pricing to earnings) in the 8% to 10% range, valuations do seem reasonable even if earnings growth turns out to be modest. Some of these franchises -- though, of course, not all -- even have somewhat better than modest earnings growth prospects. The better ones produce lots of excess cash that'll be available for distribution to shareholders. What does get reinvested can produce attractive returns that also ultimately benefit shareholders. In fact, just a little bit of growth on top of an 8% to 10% earnings yield (as long as earnings are of the high quality variety and capital allocation is sound) quickly becomes above market returns.

Will capital will be allocated reasonably well? Do current earnings roughly reflect normalized free cash flow (i.e. not at a cyclical peak and not needed to maintain business competitiveness)?

That's what'll matter in the long run.

The key thing is that earnings are 1) free to be distributed to shareholders and/or 2) can be used for incremental investments that ultimately produce high returns for long-term shareholders. Some businesses need to use just about all their earnings (or what seems like earnings) to remain competitive. Many airlines and some automakers come to mind. Those companies only have earnings in an accounting sense but less so in an economic sense. Here's how Charlie Munger looks at it:

"There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there's never any cash. It reminds me of the guy who looks at all of his equipment and says, 'There's all of my profit.' We hate that kind of business."

Speculators can try to jump in and out the second kind of businesses if they want.

Most investors, it would seem, have better things to do with their money.

The risk of poor near term price action after buying shares of even the very best business "too early" is very real. Yet missing the chance to benefit from potential favorable long run economics of a franchise can be just as costly (errors of omission).

Warren Buffett has pointed out how costly errors of omission can be:

"During 2008 I did some dumb things in investments. I made at least one major mistake of commission and several lesser ones that also hurt... Furthermore, I made some errors of omission, sucking my thumb when new facts came in."

Investing well is not about successfully buying at the lows. That's effectively impossible and, in fact, the attempt to do so creates its own problems. Investing is about buying something understandable at a discount (to intrinsic value). In fact, attempting to time things perfectly might result in missing the chance to buy something at a sensible price.
(Near-term price action is inherently unpredictable....in BOTH directions. When the focus is on judging how price compares to value and long-term effects, the price action tends to end up mattering much less than some seem to think.)

The key question is the sustainability of each franchise. It's about whether the long run economics are likely to remain in tact. The focus should always be, at least for long-term owners, on price paid relative to a conservative estimate of value. In fact, if the price drops further it sometimes can create an opportunity.
(By offering the chance to buy shares of a good business at a discount via incremental purchases, buybacks, and dividend reinvestments.)

10-year Treasuries yielding less than 3% seem, by comparison, very unattractive.

Those 10-year Treasuries probably feel safer to some investors in the short run but that doesn't mean they are actually safer when all risks are considered.

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.

For Big Cap Tech, Cash is King

At the end of the most recent quarter, net cash and investments (cash and investments minus debt) on the balance sheet of Microsoft (MSFT, Cisco (CSCO), Google (GOOG), and Apple (AAPL) combined was over $ 160 billion.

AAPL   |  $ 65 billion
MSFT   |  $ 38 billion
GOOG   |  $ 31 billion
CSCO    |  $ 28 billion

Together, these four businesses add to that pile of cash at a near $ 60 billion annualized rate. So they will soon have over $ 200 billion combined unless one or more of them has an extremely large acquisition or buyback in the works.

So cash rich, yes, but will the money be put to good use? Tougher call.

I'm guessing most chief financial officers in corporate america would trade places in a heartbeat to have that much financial flexibility.

It's not just these 4 companies that are sitting on lots of cash....

From this Jason Zweig article:

All told, the companies in the Standard & Poor's 500-stock index are sitting on more than $960 billion in cash, a record.

What's unusual is that not only are companies sitting on more cash than ever before, they are paying out much less of it as a proportion of earnings than they have historically.

Meanwhile, the payout ratio—the proportion of earnings paid out as dividend income to shareholders—fell to 28.9% for the past four quarters. That, says S&P senior index analyst Howard Silverblatt, is the lowest level since 1936. Dividends are going up—Intel, UnitedHealth Group and WellPoint have recently raised them—but cash is still piling up far faster than most industrial giants can possibly find a prudent use for it.

Consider that the combined market cap of the four above tech companies is approximately $ 750 billion. Subtract the $ 160 billion in net cash and you are paying ~ $ 590 billion for around $ 60 billion in free cash flow.

Adam

Long MSFT, CSCO, GOOG, and AAPL

Related post:
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.

Buffett: An Ordinary Horse Sold As Secretariat - Berkshire Shareholder Letter Highlights

From Warren Buffett's 1995 Berkshire Hathaway (BRKa) shareholder letter:

...sellers and their representatives invariably present financial projections having more entertainment value than educational value. In the production of rosy scenarios, Wall Street can hold its own against Washington.

In any case, why potential buyers even look at projections prepared by sellers baffles me. Charlie and I never give them a glance, but instead keep in mind the story of the man with an ailing horse. Visiting the vet, he said: "Can you help me? Sometimes my horse walks just fine and sometimes he limps." The vet's reply was pointed: "No problem - when he's walking fine, sell him." In the world of mergers and acquisitions, that horse would be peddled as Secretariat.

A business run by management in the habit of paying Secretariat prices for so-called strategic acquisitions is a sell.

In most cases, that so-called strategic deal is just a cloak around the reality that a wealth transfer from acquirer to acquiree shareholders is taking place. A company with entrenched management that behaves this way materially reduces the growth in intrinsic value of a business (in fact may shrink it) and, of course, shareholder wealth.

Imagine Berkshire Hathaway without all the smart deals done over the years. Intrinsic value today would be an awful lot less.

Any use of the words like strategic or synergistic to justify a deal warrants skepticism. Consider those words as code for "we are getting bigger at shareholder expense". When these terms are employed, it's almost guaranteed that management overpaid and is selling the rich price to shareholders on the basis of some mysterious hidden value. The likely reality is that animal spirits kicked in during the acquisition process and management began buying the kind of "rosy scenarios" that Buffett refers to above.

So the pitch to shareholders on the merits of the deal will often be under the guise that value not yet revealed will, out of thin air, somehow emerge. Naturally, once the deal is done if that value does not appear down the road there is no recourse. The wealth transfer will have happened with acquiring shareholders feeling (in fact being) a bit poorer.

The bottom line is that management should, in most cases, pay only for the proven economics of a business...not promise.

If not a rule it's the next best thing.

The intrinsic value of a business is raised by having a management team in place that consistently makes smart acquisitions at fair, or better yet, limping horse prices.

Adam

Long BRKb
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

In Praise of Two Troubled Sectors

Here's a recent Barron's Magazine interview with David Katz of Matrix Asset Advisors.

In it, he says financials have the potential to rise 30-50% in the next year or two.

He also point out how cheap larger tech stocks happen to be.

A long and growing list of value-oriented investors have pointed out that financials and technology are inexpensive and I happen to agree with it.

I've highlighted tech stocks as being inexpensive for quite a while.

As stocks they are going nowhere fast and I won't be surprised if that continues.

Bank stocks have also done poorly for an extended period. That's also likely to continue.

"The last time I was heavily involved with the banks, it was a five-to-ten-year period. And I'm always early, which in a way is a good thing because if you were right on day one, you'd have a much smaller position." - Bruce Berkowitz of Fairholme in Institutional Investor Magazine

With value investing, even if you get something right in the long run (defined as above market returns over the entire investment horizon that the asset is held), you'll probably be staring at red for a very long time.

"...if you are a value manager, you buy cheap assets. If you are very 'experienced,' a euphemism for having suffered many setbacks, you try hard to reserve your big bets for when assets are very cheap. But even then, unless you are incredibly lucky, you will run into extraordinarily cheap, even bizarrely cheap, assets from time to time, and when that happens you will have owned them for quite a while already and will be dripping in red ink." - Jeremy Grantham from his letter with the title: Time To Be Serious (and probably too early) Once Again

That's why I don't think someone should buy something that seems inexpensive, unless that investor has extraordinary personal conviction that the price paid provides a sufficient discount to their own conservative estimate of intrinsic value. That's also why I don't think it's wise to buy something unless it's based upon one's own analysis and conclusions. I happen to think no investor should buy something based upon someone else's opinion. Read everything possible, listen to lots of viewpoints, but reach your own conclusions. When an investor does not have high levels of conviction at their disposal, they end up shaken out before the full story plays out, in some cases, over many years.

So the norm is to be too early because an investment looks cheap not knowing that it will, at first, get even cheaper.

In a similar way, selling an investment too early also tends to happen when something starts to look expensive (only to watch it become more expensive).

It goes with the territory of making buy and sell decisions that are grounded by valuation.

"I made my money by selling too soon." - Bernard Baruch

An asset that is already cheap becoming even cheaper is just the flip side of what happened during some of our recent bubbles. Expensive stocks got even more expensive before ultimately being checked by economic reality. The forces that cause bizarre prices in either direction begin with either a real problem or real potential taken to extreme. Never expect rationality when it comes to short-to-intermediate run market prices.

The remaining true believers of efficient market hypothesis won't care much for this thinking. In the short-to-intermediate run a market price has only a loose connection to the value of a business itself.

I think the evidence in support of this view is overwhelming.

There are many short-to-intermediate term events that move a stock price in any direction that has little to do with what the intrinsic value of an asset will be over the long haul.

When volatile short-term price movements morph into persistent downward selling pressure many, especially those lacking conviction in what the asset is ultimately worth, will just bail out.

Financials stocks, in particular, are probably not the place to be for those seeking a straightforward investment (I'm not sure there is such a thing, but, for example, a proven consumer staple franchise is certainly less tricky to own than a bank). Many things can go wrong with even a good bank that is beyond management control. As we've seen recently, confidence in and stability of the financial system as a whole is bigger than any one bank and can dramatically impact future intrinsic value per share.

There will likely be many twists and turns before things like the regulatory, legal, and mortgage clouds are put mostly in the rear-view mirror for financials. Future regulatory risks are especially difficult to predict.
(I say that as someone who wants further limits on speculation by banks, far beyond the so-called Volcker Rule, substantially reduced use of derivatives, and significant changes to bank executive compensation systems so leaders of the key financial institutions have more skin in the game...more to lose longer term.)

The problem? It's just as likely that poorly focused regulatory over-reach will occur that just adds complexity and costs but does little to address those things that lead to systemic instability (many didn't listen to Brooksley Born in the 1990s and I'm not sure we making enough wise moves now).

Still, the highest quality financials over ten year horizon should do just fine even if the ride will likely be very bumpy. There are many difficult to understand risks in the short-to-intermediate term. During that time, again, I'd expect many investors to just get tired of all the noise and for prices to go nowhere. There are easier ways to get results.

As far as technology stocks go, many larger tech stocks have been cheap for quite a while yet continue to get even cheaper. Who knows how long this persists. Unlike financials, it would seem the biggest risks are unknowable technology shifts and new competitors that out of nowhere threaten the economic moat of a franchise.

That's the nature of tech.

How long do these two sectors struggle? In my experience it is always longer than one expects. Long enough for most who have had their money tied up in a dead money stock (or worse) for a long time to get frustrated, annoyed, and just sell.

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.

Tweedy, Browne: Strong Consumer Brands for the Emerging Middle Class

Some excerpts from the Tweedy, Browne Annual Shareholder Letter.

The letter highlights companies like: Diageo (DEO), Unilever (UL), Philip Morris International (PM), Kimberly Clark (KMB), Nestle (NSRGY), Heineken (HINKY) and Novartis (NVS) and others.

...our Funds' portfolios today include many large, globally diversified companies, many of them branded consumer products companies, that conduct a considerable amount of business in faster growing parts of the globe where a new middle class is emerging. These are companies such as Nestle, Heineken, Diageo, Unilever, Philip Morris International, Kimberly Clark, Henkel, and Novartis, among others. While our interest in these businesses wasn't predicated on this idea of a rising middle class, but rather from the fact that these businesses were attractively valued at various points in time, their strong consumer brands and global operating experience gives these companies a leg up when competing for this new and rapidly growing source of demand.

In the letter, some important shifts that are likely to occur over the next 5 to 10 years are highlighted:

...by 2015, for the first time in 300 years, the number of Asian middle class consumers will equal the number in Europe and North America.

It also points out that it is very likely over the next ten years for Europe and North America's nearly 1 billion combined middle class consumers will remain essentially flat. In contrast to that, Asia Pacific's one half billion middle class consumers should easily triple in size.

Consumption in Asia Pacific, around $ 5 trillion already (nearly the same size as North America alone), is expected to roughly triple over the next decade.

Some comments were made on specific stocks that benefit.

Here are two:

On Philip Morris International

Philip Morris International, another one of our holdings, is the world's leading international tobacco company, with seven of the world’s top fifteen international brands. Approximately 35% of company profits derive from the emerging markets. In the 4th quarter of 2010, it reported a 15% increase in profits driven largely by a 24% surge in volume in Asian markets such as Indonesia, the Philippines, and South Korea.

The letter points out that Philip Morris International is the only international tobacco company to strike a deal with the Chinese National Tobacco Corporation to sell the Marlboro brand. Philip Morris has a good prospects going forward even if nothing material happens in China. So I wouldn't count on China producing terrific economics for the company but consider it upside.

Philip Morris International has a great combination of assets and future prospects but the recent extremely cheap valuation of the shares is no longer there. Still, if bought and held for 20 years I'd be surprised if it did not produce good investor returns.

Historically, I've preferred accumulating shares in tobacco companies when legal clouds have been at or near their darkest. For me, any additional shares would likely be bought as a result of some new ugly headlines. For now the legal front is relatively quiet but you never know when that will change.

It was easier to buy at a discount when Altria (MO) owned Philip Morris International's assets. When it traded as one stock, it made the specific risks associated with the legal environment in the U.S. (those that directly impact the U.S. tobacco business) hurt the valuation of those assets that are now separately Philip Morris International.

On Diageo

Diageo, the world's leading spirits company, today derives about about one-third of its sales from the emerging markets, with much of that growth coming from China, where drinkers are consuming more and more Johnnie Walker Scotch and Guinness beer. Ivan Menezes, the company's President, North America and Chairman, Asia Pacific, expects that in just a few years, 50% of its business will originate in the emerging markets. An important factor in this growth has been "premiumizing" or the trading up to higher priced brands. Diageo has eight of the top twenty brands in spirits.

At its current size, Diageo is not the fastest growing spirits company but the economic moat that comes from its brands and distribution is significant. It's also an expensive stock. A short-term disappointment (sub-par growth, poor execution, the macro environment or something similar) in the future is probably going to be needed to make the stock sell at a more attractive level.

I understand some will not buy the so-called sin stocks for reasons that go beyond investing. For those preferring non-tobacco and non-alcohol related businesses in their portfolio, the other branded consumer companies noted in the Tweedy Browne letter have assets that should produce solid future returns (though I'd prefer Pepsi: PEP  or Coca-Cola: KO at the right price).

The specific risks and opportunities of each, of course, do differ significantly but if bought at the right price most would make a worthwhile long-term core holdings in my view.

Adam

Long positions in DEO, PM, MO, PEP, and KO established at much lower prices

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.