A follow up to this post. In this CNBC interview, Warren Buffett helps explain why less than optimal compensation systems come to exist in the first place:
"...once a board has delegated to a committee and they've spent hours working on something, and then they report it and there's 20 other items on the agenda and the Chairman calls on the comp committee to give his report and gives it in about 30 seconds, it never gets voted against. And it would be regarded as sort of usurping the power of the committee to all of a sudden say I've got a better idea. I haven't talked to the compensation consultants, I haven't looked at the figures, but I still have a better idea. It doesn't happen."
Becky Quick -- the CNBC interviewer -- brought up the idea that corporate boards might become rather clubby at times. Buffett responded by saying he finds it "always interesting...to read academic discussions of boards." Some have a tendency to overestimate the likelihood that corporate board actions will be primarily about "business maximization" and underestimate the social component.
"...boards are in part business organizations and in part social organizations. People walk into those with their behavior formed by dozens of — usually your people have achieved some standing, perhaps, in the community. So they've learned how to get along with other people. And they don't suddenly change their stripes when they come into a board meeting. So there's a great tendency to behave in a socially acceptable way and not necessarily in a business maximization way. The motives are good; the behavior is formed by decades earlier."
That comment about boards being social organizations -- and the implications for owners -- deserves some attention. In the real world, corporate board behavior isn't, as some might like to imagine, necessarily all about what's best for the business and owners. During the same interview, Andrew Ross Sorkin later asked:
"I hear you saying this is what happens. My question is should it happen this way?"
Buffett's response:
"Well, no, obviously you know everybody would speak freely and all of that sort of thing, and dialogue would be encouraged and the chairman would love to hear reasons why his ideas were no good, but it isn't quite that way."
Buffett later goes on to explains another important dynamic at work:
"There are a number of directors at any company that are making two or three hundred thousand dollars a year, and that money is important to them. And what they really hope is they get invited to go on other boards.
Now if a CEO comes to another CEO and says I hear you've got so-and-so on the board, we need another woman or whatever it may be, oh, she will behave.
If they say she raises hell at every meeting, she's not going to be on the next board. On the other hand, if they say she's constructive, her compensation committee recommendations have been spot on, et cetera, she's got another $300,000 a year job. That's the real world."
These are, at least in some ways, remarkably blunt comments that reveals just how social -- and not surprisingly a bit self-serving -- things end up being on at least some boards. The idea that "business maximization" is what boards are about is an invented version of how humans -- even very capable ones -- are likely to behave in groups. The error of expecting otherwise seems similar to the error of assuming that market participants will mostly act in a cold and rational manner.
There are, of course, some very good boards. That doesn't mean many boards are not susceptible to some of these adverse dynamics.
It's worth noting that, unlike many other companies, non-executive board members at Berkshire Hathaway (BRKa) do not get paid.
Here's Charlie Munger's take:
"You start paying directors of corporations two or three hundred thousand dollars a year, it creates a daisy chain of reciprocity where they keep raising the CEO and he keeps recommending more pay for the directors..."
He also said the following when asked about the unconventional view that lots of disclosure regarding executive compensation is not necessarily the best thing for shareholders:
"I think envy is one of the major problems of the human condition... And so I think this race to have high compensation because other people do, has been fomented by all this publicity about higher earnings. I think it's quite counterproductive for the nation. There's a natural reaction to all this disclosure because everybody wants to match the highest."
Buffett followed with this:
"It's very natural to think if you're a director of the ABC Corp. and the CEO of the XYZ Corp is getting more, well, our guy is at least as good as theirs. And it goes on and on and on.
So publication of the top salaries has cost the American shareholder money. Maybe disclosure is the great disinfectant, all of that, sunshine is the great disinfectant. Sunshine has cost American shareholders money when it comes to paying their managers."
Munger then quipped that it's "a peculiarity of ours, but we're right".
Basically, publishing the information creates envy that leads to higher pay packages. They think people will generally expect to earn more when they see what others are earning.
In the 2006 letter, Buffett offers some thoughts on Berkshire's board (page 18) and compensation practices (starting at the bottom of page 19).
Also, for some additional thoughts on compensation -- including the misalignment of interests that can occur with stock options -- check out the Compensation section of the 1994 letter.
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
Buffett & Munger on Compensation - Part I
The Illusion of Consensus
---
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.
(1, 6)
Friday, July 4, 2014
Friday, June 27, 2014
Charlie Munger on Complexity, Hedge Funds, and Pension Funds
Some comments by Charlie Munger from the 2006 Wesco meeting:*
On Complexity
We don't do a lot of involved math... Certainly we expect a decent return or we don't do it. We use a lot of experience and do it in our heads. We distrust others' systems [and complex models] and think it leads to false confidence. The harder you work, the more confidence you get. But you may be working hard on something you're no good at. We're so afraid of that process that we don't do it.
The emphasis is on keeping it as simple as possible (but not too simple...it's a balance) and sticking to what they know well.
It's the avoidance of unnecessary complexity and playing to strengths.
On Hedge Funds
Somehow we've created a perverse system of incentives. At Samsung, their meeting of engineers is at 11pm. Our meetings of engineers [meaning our smartest citizens] are also at 11pm, but they're working to price derivatives. I think it's crazy to have incentives that drive your most intelligent people into a very sophisticated gaming system.
A rich system can endure a lot. If 10% of our people over age 60 want to spend X hours per week playing Texas Hold Em, we can afford it. But it's not good. But do we want our auto industry to just crumble away and somebody else's to take over because they do it better? I don't think it's a good outcome. I don't think we can stand a diversion of our best minds to hedge funds.
This may be less than ideal but, considering how lucrative the hedge fund business usually is, it's not terribly surprising. Strong incentives remain in place that likely will continue to divert talent away from more useful things.
For some perspective, hedge fund industry assets under management now stands at $ 2.5 trillion. This is a substantial increase compared to the $ 38 billion that was being managed back in 1990.
On Unrealistic Return Assumptions by Pension Funds
Both Warren and I have said that to predict 9% returns from those pension funds is likely to be wrong and it is irresponsible to allow it. They do it to delay bad news. Look at Berkshire and our paper record, which is obviously much better [than the investment track records of the pension fund managers]: we use 6.5%. For example, the Washington Post has the best record [of virtually any pension fund, yet it assumes a 6.5% annual return].
Munger then goes on to suggest it just might be wise to consider what those who have the best track record have to say over those who do not. These days, too many pensions continue to make unrealistic assumptions about future returns.
The following trend just might end up exacerbating the problem:
How Harvard and Yale's 'Smart' Money Missed the Bull Market
"How did this happen? Well, the average college endowment has just 16% of its investment portfolio in U.S. stocks—half the exposure they had a decade ago. In the years following the Internet bust and then the financial crisis, managers steadily shifted assets to alternative investments like hedge funds, venture capital investments, and private equity."
Recent results haven't been all that impressive but, for the schools highlighted, the longer term results look a whole lot better compared to the S&P 500.**
A similar strategy shift into alternative investments has occurred at corporate and public pension funds.
Big Investors Missed Stock Rally
"Corporate pension funds and university endowments in the U.S. have missed out on much of the rally for stocks since 2009, following a push to diversify into other investments that have had disappointing performances."
Of course, what matters for pension funds and university endowments is the long run results.
What matters is how well their investment policies will work going forward.
It's worth noting that the Washington Post (now Graham Holdings: GHC) -- mostly due to long making reasonable pension promises then producing returns nicely in excess of conservative return assumptions -- continues to have quite a track record.
In fact, the company's pension fund these days sits rather solidly overfunded compared to just about anyone else.
Reasonable promises comfortably aligned with sound investment policy.***
In stark contrast, some seem to have decided to add lots of complexity and frictional costs to their approach.
Complexity that may not at all be needed for achieving desired outcomes.
Costs that, at least in aggregate, create their own headwind.
Adam
Very small long position in GHC
Related posts:
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
Charlie Munger: Focus Investing and Fuzzy Concepts
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
* These comments are based upon notes taken by Whitney Tilson.
** Here's how the returns look for hedge funds, stock-focused funds, and the S&P 500 over the past 10 years: The S&P 500 gained 114% (including dividends), the average hedge fund gained 75%, while the average stock fund gained 68%. Private-equity and venture-capital funds performed much better.
*** Warren Buffett wrote a memo to Katharine Graham in 1975 to guide her on pension obligations and the right investment policy. His input and position on the board for 37 years no doubt has had at least something to do with the company's healthy pension plan. That memo can be found here on pages 118-136. Buffett, in his latest letter, said the following about pension funds and that memo: "During the next decade, you will read a lot of news – bad news – about public pension plans. I hope my memo is helpful to you in understanding the necessity for prompt remedial action where problems exist."
---
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.
On Complexity
We don't do a lot of involved math... Certainly we expect a decent return or we don't do it. We use a lot of experience and do it in our heads. We distrust others' systems [and complex models] and think it leads to false confidence. The harder you work, the more confidence you get. But you may be working hard on something you're no good at. We're so afraid of that process that we don't do it.
The emphasis is on keeping it as simple as possible (but not too simple...it's a balance) and sticking to what they know well.
It's the avoidance of unnecessary complexity and playing to strengths.
On Hedge Funds
Somehow we've created a perverse system of incentives. At Samsung, their meeting of engineers is at 11pm. Our meetings of engineers [meaning our smartest citizens] are also at 11pm, but they're working to price derivatives. I think it's crazy to have incentives that drive your most intelligent people into a very sophisticated gaming system.
A rich system can endure a lot. If 10% of our people over age 60 want to spend X hours per week playing Texas Hold Em, we can afford it. But it's not good. But do we want our auto industry to just crumble away and somebody else's to take over because they do it better? I don't think it's a good outcome. I don't think we can stand a diversion of our best minds to hedge funds.
This may be less than ideal but, considering how lucrative the hedge fund business usually is, it's not terribly surprising. Strong incentives remain in place that likely will continue to divert talent away from more useful things.
For some perspective, hedge fund industry assets under management now stands at $ 2.5 trillion. This is a substantial increase compared to the $ 38 billion that was being managed back in 1990.
On Unrealistic Return Assumptions by Pension Funds
Both Warren and I have said that to predict 9% returns from those pension funds is likely to be wrong and it is irresponsible to allow it. They do it to delay bad news. Look at Berkshire and our paper record, which is obviously much better [than the investment track records of the pension fund managers]: we use 6.5%. For example, the Washington Post has the best record [of virtually any pension fund, yet it assumes a 6.5% annual return].
Munger then goes on to suggest it just might be wise to consider what those who have the best track record have to say over those who do not. These days, too many pensions continue to make unrealistic assumptions about future returns.
The following trend just might end up exacerbating the problem:
How Harvard and Yale's 'Smart' Money Missed the Bull Market
"How did this happen? Well, the average college endowment has just 16% of its investment portfolio in U.S. stocks—half the exposure they had a decade ago. In the years following the Internet bust and then the financial crisis, managers steadily shifted assets to alternative investments like hedge funds, venture capital investments, and private equity."
Recent results haven't been all that impressive but, for the schools highlighted, the longer term results look a whole lot better compared to the S&P 500.**
A similar strategy shift into alternative investments has occurred at corporate and public pension funds.
Big Investors Missed Stock Rally
"Corporate pension funds and university endowments in the U.S. have missed out on much of the rally for stocks since 2009, following a push to diversify into other investments that have had disappointing performances."
Of course, what matters for pension funds and university endowments is the long run results.
What matters is how well their investment policies will work going forward.
It's worth noting that the Washington Post (now Graham Holdings: GHC) -- mostly due to long making reasonable pension promises then producing returns nicely in excess of conservative return assumptions -- continues to have quite a track record.
In fact, the company's pension fund these days sits rather solidly overfunded compared to just about anyone else.
Reasonable promises comfortably aligned with sound investment policy.***
In stark contrast, some seem to have decided to add lots of complexity and frictional costs to their approach.
Complexity that may not at all be needed for achieving desired outcomes.
Costs that, at least in aggregate, create their own headwind.
Adam
Very small long position in GHC
Related posts:
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
Charlie Munger: Focus Investing and Fuzzy Concepts
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
* These comments are based upon notes taken by Whitney Tilson.
** Here's how the returns look for hedge funds, stock-focused funds, and the S&P 500 over the past 10 years: The S&P 500 gained 114% (including dividends), the average hedge fund gained 75%, while the average stock fund gained 68%. Private-equity and venture-capital funds performed much better.
*** Warren Buffett wrote a memo to Katharine Graham in 1975 to guide her on pension obligations and the right investment policy. His input and position on the board for 37 years no doubt has had at least something to do with the company's healthy pension plan. That memo can be found here on pages 118-136. Buffett, in his latest letter, said the following about pension funds and that memo: "During the next decade, you will read a lot of news – bad news – about public pension plans. I hope my memo is helpful to you in understanding the necessity for prompt remedial action where problems exist."
---
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, June 20, 2014
Buffett & Munger on Compensation - Part I
From Warren Buffett's 1985 Berkshire Hathaway (BRKa) letter:
"...retirement announcements regularly sing the praises of CEOs who have, say, quadrupled earnings of their widget company during their reign - with no one examining whether this gain was attributable simply to many years of retained earnings and the workings of compound interest."
He then adds...
"Many corporate compensation plans reward managers handsomely for earnings increases produced solely, or in large part, by retained earnings - i.e., earnings withheld from owners."
When it comes to stock options, according to Buffett, two important factors are too often ignored:
"It would be particularly unthinkable for managers to grant a long-term option on a business that was regularly adding to its capital. Any outsider wanting to secure such an option would be required to pay fully for capital added during the option period.
The unwillingness of managers to do-unto-outsiders, however, is not matched by an unwillingness to do-unto-themselves. (Negotiating with one's self seldom produces a barroom brawl.) Managers regularly engineer ten-year, fixed-price options for themselves and associates that, first, totally ignore the fact that retained earnings automatically build value and, second, ignore the carrying cost of capital."
Unfortunately, when the economic rewards of stock options do end up being reasonable and fair, it usually is by accident:
"Of course, stock options often go to talented, value-adding managers and sometimes deliver them rewards that are perfectly appropriate. (Indeed, managers who are really exceptional almost always get far less than they should.) But when the result is equitable, it is accidental."
He adds that the "managerial Rip Van Winkle, ready to doze for ten years, could not wish for a better 'incentive' system."
Stock options are often described as aligning managers and owners but, in reality, that's just not the case:
"Ironically, the rhetoric about options frequently describes them as desirable because they put managers and owners in the same financial boat. In reality, the boats are far different. No owner has ever escaped the burden of capital costs, whereas a holder of a fixed-price option bears no capital costs at all. An owner must weigh upside potential against downside risk; an option holder has no downside. In fact, the business project in which you would wish to have an option frequently is a project in which you would reject ownership. (I'll be happy to accept a lottery ticket as a gift - but I'll never buy one.)"
The holder of a stock option actually benefits from a no-dividend policy. Funds paid out as dividends reduce retained earnings and should, all else equal, lower option value (whatever the difference is, if anything, between market price and exercise price). So maybe no dividend is paid -- or less of a dividend -- because incentives aren't better aligned. Creative justifications for the policy no doubt likely will follow.
"...most people either seem to have difficulty recognizing what lies in plain sight, right before their eyes, or, perhaps even more pervasively, refuse to recognize the reality because it flies in the face of their deep-seated beliefs, their biases, and their own self-interest. Paraphrasing Upton Sinclair: 'it's amazing how difficult it is for a man to understand something if he's paid a small fortune not to understand it.'" - From John Bogle's remarks at NYU in 2007
The misalignment can lead to behavior often far from ideal for the owners.
Options can work out okay in some circumstances but Buffett's criticism is of "their indiscriminate use". Some managers Buffett admires ("whose operating records are far better than mine") disagree with him on the use of stock options and he mentions this in the letter. Buffett says that certain business leaders have developed the right kind of (but rare) corporate culture where employees mostly think and act like owners. So, in those cases, options end up being an effective incentive despite their flaws and shortcomings.
"'If it ain't broke, don't fix it' is preferable to 'purity at any price'."
The tough part for the investor is judging which company has the right kind of corporate culture.
In contrast, Berkshire's compensation system "rewards key managers for meeting targets in their own bailiwicks. If See's does well, that does not produce incentive compensation at the News - nor vice versa. Neither do we look at the price of Berkshire stock when we write bonus checks. We believe good unit performance should be rewarded whether Berkshire stock rises, falls, or stays even. Similarly, we think average performance should earn no special rewards even if our stock should soar. 'Performance', furthermore, is defined in different ways depending upon the underlying economics of the business: in some our managers enjoy tailwinds not of their own making, in others they fight unavoidable headwinds.
The rewards that go with this system can be large."
The preference is for Berkshire's stock to be purchased by the managers with their own funds:
"Obviously, all Berkshire managers can use their bonus money (or other funds, including borrowed money) to buy our stock in the market. Many have done just that - and some now have large holdings. By accepting both the risks and the carrying costs that go with outright purchases, these managers truly walk in the shoes of owners."
I think it's fair to say that the pay controversy at Coca-Cola (KO) might have gone somewhat differently if they had taken more of this thinking into account.
In this CNBC interview, Warren Buffett commented on Coca-Cola's equity compensation plan (among other things).
Comments that, at least initially, were also somewhat controversial.
Some related articles:
Buffett Punts on Pay
Warren Buffett: We took a stand on Coke's pay package
Buffett Bites Back
Warren Buffett Defends Coca-Cola Abstention
Coke's Pay Hurts the Media's Brain
In any case, it's a plan that Buffett didn't like very much and ended up letting it be known in his own way.
Well, it turns out Coca-Cola's equity compensation plan is now likely to be altered due, at least in part, to some of the pressure.
Here was Munger's take on the way Buffett handled the Coca-Cola compensation controversy during this separate CNBC interview:
"I thought he did it just right. He complained a little, but not too vociferously. I think that was just the right tone, and with compliments which were deserved to the management of Coca-Cola. I thought he handled it perfectly."
More in a follow up.
Adam
Long position in BRKb and KO established at much lower than recent market prices
Related post:
The Illusion of Consensus
---
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.
(3)
"...retirement announcements regularly sing the praises of CEOs who have, say, quadrupled earnings of their widget company during their reign - with no one examining whether this gain was attributable simply to many years of retained earnings and the workings of compound interest."
He then adds...
"Many corporate compensation plans reward managers handsomely for earnings increases produced solely, or in large part, by retained earnings - i.e., earnings withheld from owners."
When it comes to stock options, according to Buffett, two important factors are too often ignored:
"It would be particularly unthinkable for managers to grant a long-term option on a business that was regularly adding to its capital. Any outsider wanting to secure such an option would be required to pay fully for capital added during the option period.
The unwillingness of managers to do-unto-outsiders, however, is not matched by an unwillingness to do-unto-themselves. (Negotiating with one's self seldom produces a barroom brawl.) Managers regularly engineer ten-year, fixed-price options for themselves and associates that, first, totally ignore the fact that retained earnings automatically build value and, second, ignore the carrying cost of capital."
Unfortunately, when the economic rewards of stock options do end up being reasonable and fair, it usually is by accident:
"Of course, stock options often go to talented, value-adding managers and sometimes deliver them rewards that are perfectly appropriate. (Indeed, managers who are really exceptional almost always get far less than they should.) But when the result is equitable, it is accidental."
He adds that the "managerial Rip Van Winkle, ready to doze for ten years, could not wish for a better 'incentive' system."
Stock options are often described as aligning managers and owners but, in reality, that's just not the case:
"Ironically, the rhetoric about options frequently describes them as desirable because they put managers and owners in the same financial boat. In reality, the boats are far different. No owner has ever escaped the burden of capital costs, whereas a holder of a fixed-price option bears no capital costs at all. An owner must weigh upside potential against downside risk; an option holder has no downside. In fact, the business project in which you would wish to have an option frequently is a project in which you would reject ownership. (I'll be happy to accept a lottery ticket as a gift - but I'll never buy one.)"
The holder of a stock option actually benefits from a no-dividend policy. Funds paid out as dividends reduce retained earnings and should, all else equal, lower option value (whatever the difference is, if anything, between market price and exercise price). So maybe no dividend is paid -- or less of a dividend -- because incentives aren't better aligned. Creative justifications for the policy no doubt likely will follow.
"...most people either seem to have difficulty recognizing what lies in plain sight, right before their eyes, or, perhaps even more pervasively, refuse to recognize the reality because it flies in the face of their deep-seated beliefs, their biases, and their own self-interest. Paraphrasing Upton Sinclair: 'it's amazing how difficult it is for a man to understand something if he's paid a small fortune not to understand it.'" - From John Bogle's remarks at NYU in 2007
The misalignment can lead to behavior often far from ideal for the owners.
Options can work out okay in some circumstances but Buffett's criticism is of "their indiscriminate use". Some managers Buffett admires ("whose operating records are far better than mine") disagree with him on the use of stock options and he mentions this in the letter. Buffett says that certain business leaders have developed the right kind of (but rare) corporate culture where employees mostly think and act like owners. So, in those cases, options end up being an effective incentive despite their flaws and shortcomings.
"'If it ain't broke, don't fix it' is preferable to 'purity at any price'."
The tough part for the investor is judging which company has the right kind of corporate culture.
In contrast, Berkshire's compensation system "rewards key managers for meeting targets in their own bailiwicks. If See's does well, that does not produce incentive compensation at the News - nor vice versa. Neither do we look at the price of Berkshire stock when we write bonus checks. We believe good unit performance should be rewarded whether Berkshire stock rises, falls, or stays even. Similarly, we think average performance should earn no special rewards even if our stock should soar. 'Performance', furthermore, is defined in different ways depending upon the underlying economics of the business: in some our managers enjoy tailwinds not of their own making, in others they fight unavoidable headwinds.
The rewards that go with this system can be large."
The preference is for Berkshire's stock to be purchased by the managers with their own funds:
"Obviously, all Berkshire managers can use their bonus money (or other funds, including borrowed money) to buy our stock in the market. Many have done just that - and some now have large holdings. By accepting both the risks and the carrying costs that go with outright purchases, these managers truly walk in the shoes of owners."
I think it's fair to say that the pay controversy at Coca-Cola (KO) might have gone somewhat differently if they had taken more of this thinking into account.
In this CNBC interview, Warren Buffett commented on Coca-Cola's equity compensation plan (among other things).
Comments that, at least initially, were also somewhat controversial.
Some related articles:
Buffett Punts on Pay
Warren Buffett: We took a stand on Coke's pay package
Buffett Bites Back
Warren Buffett Defends Coca-Cola Abstention
Coke's Pay Hurts the Media's Brain
In any case, it's a plan that Buffett didn't like very much and ended up letting it be known in his own way.
Well, it turns out Coca-Cola's equity compensation plan is now likely to be altered due, at least in part, to some of the pressure.
Here was Munger's take on the way Buffett handled the Coca-Cola compensation controversy during this separate CNBC interview:
"I thought he did it just right. He complained a little, but not too vociferously. I think that was just the right tone, and with compliments which were deserved to the management of Coca-Cola. I thought he handled it perfectly."
More in a follow up.
Adam
Long position in BRKb and KO established at much lower than recent market prices
Related post:
The Illusion of Consensus
---
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.
(3)
Friday, June 13, 2014
The Growth Trap: IBM vs Standard Oil
Imagine it's 1950 and a decision needs to be made between two common stock investment alternatives:
- IBM (IBM)
- Standard Oil (now ExxonMobil: XOM)
IBM at that time had superior growth prospects compared to Standard Oil.
Below is a quick summary of the growth measures from 1950-2003 for both companies.*
Revenue Growth
IBM: 12.19% per year
Standard Oil: 8.04%
Earning Per Share Growth
IBM: 10.94%
Standard Oil: 7.47%
Dividend Growth
IBM: 9.19%
Standard Oil: 7.11%
Sector Growth
IBM: 14.65%
Standard Oil: negative 14.22%
So the advantage goes to IBM in every category except the one that really counts.
Standard Oil actually produced the better total return.
Total Return
IBM: 13.83%
Standard Oil: 14.42%
Why did Standard Oil's stock perform better? Simply put, it was the difference in valuation and the effect of dividends reinvested.
Average Price to Earnings
IBM: 26.76
Standard Oil: 12.97
Average Dividend Yield
IBM: 2.18%
Standard Oil: 5.19%
Those higher dividends reinvested, over time, in a stock with a more reasonable valuation made all the difference.** The end result being an investor in Standard oil increased their holdings by 15x while an investor in IBM only accumulated 3x more shares. IBM had vastly superior fundamentals over those 50 plus years. In fact, the market value of IBM actually went up more than Standard Oil. Yet, all those additional shares, bought with reinvested dividends, meant that the individual investor in Standard Oil ended up with the better overall result.
"...despite the better fundamentals, investors paid too high a price for IBM, while old Standard Oil was cheaply priced. I call this the 'growth trap.' Investors make the mistake of buying the new thing, irrespective of price." - Jeremy Siegel in an interview back in 2006
This is at least worth consideration the next time there's the temptation to pay a premium for exciting growth prospects. The return comparison is not all that matters, of course. IBM's results depended on much higher sustained growth. More risk was taken in the process simply due to the higher multiple of earnings paid. One of the best tools available to an investor to manage risk is price. That's under an investor's control; what happens as far as future growth goes is not.
Still, both IBM and Standard Oil generated very nice long run investment results. Things worked out well for long-term investors in both companies but, when you pay a high multiple, the margin of safety just isn't there to protect against what might go wrong.***
This naturally reveals nothing about the unique risks, challenges, and opportunities for these two businesses going forward. Future long-term investment results, at least to me, seem likely to be far more modest. No complaints if things turn out a bit better than expected, of course.
As always, it's not just about the absolute return; it's about judging risk versus reward and comparing to alternatives.
Unlike those 50 plus years, these days IBM has a much lower earnings multiple and, apparently, far less exciting growth prospects. Well, at least for now. It's never easy to tell, favorable or not, how those prospects might change over the very long haul. Price paid should assume and reflect the least optimistic scenario. (Especially for technology stocks.)
In other words, the expected outcome should be an attractive one even if nothing great happens.
If the likely worst case can't be judged with high confidence, buying makes no sense.
Adam
Small long position in IBM; no position in XOM.
Other related posts:
Asset Growth and Stock Returns, Part II - Mar 2014
Asset Growth and Stock Returns - Feb 2014
Buffett and Munger on See's Candies, Part II - Jun 2013
Buffett and Munger on See's Candies - Jun 2013
Aesop's Investment Axiom - Feb 2013
Grantham: Investing in a Low-Growth World - Feb 2013
Buffett: Stocks, Bonds, and Coupons - Jan 2013
Maximizing Per-Share Value - Oct 2012
Death of Equities Greatly Exaggerated - Aug 2012
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Technology Stocks - May 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009
* Source: The Future for Investors by Jeremy Siegel
** Dividend reinvestments function like buybacks but, compared to buybacks, are generally less tax efficient. This depends on the type of account. Other than the tax differences, buybacks and dividend reinvestments -- implemented at reasonable or better valuation levels (i.e. discount to value) -- similarly benefit long-term owners; the former reduces overall share count, while the latter increases the number of shares owned.
*** Both companies, inevitably, ran into plenty of their own specific difficulties over those 50 plus years. Even very good businesses will have their fair share of challenges. Anyone expecting a smooth ride investing in common stocks is, well, guaranteed disappointment.
---
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.
- IBM (IBM)
- Standard Oil (now ExxonMobil: XOM)
IBM at that time had superior growth prospects compared to Standard Oil.
Below is a quick summary of the growth measures from 1950-2003 for both companies.*
Revenue Growth
IBM: 12.19% per year
Standard Oil: 8.04%
Earning Per Share Growth
IBM: 10.94%
Standard Oil: 7.47%
Dividend Growth
IBM: 9.19%
Standard Oil: 7.11%
Sector Growth
IBM: 14.65%
Standard Oil: negative 14.22%
So the advantage goes to IBM in every category except the one that really counts.
Standard Oil actually produced the better total return.
Total Return
IBM: 13.83%
Standard Oil: 14.42%
Why did Standard Oil's stock perform better? Simply put, it was the difference in valuation and the effect of dividends reinvested.
Average Price to Earnings
IBM: 26.76
Standard Oil: 12.97
Average Dividend Yield
IBM: 2.18%
Standard Oil: 5.19%
Those higher dividends reinvested, over time, in a stock with a more reasonable valuation made all the difference.** The end result being an investor in Standard oil increased their holdings by 15x while an investor in IBM only accumulated 3x more shares. IBM had vastly superior fundamentals over those 50 plus years. In fact, the market value of IBM actually went up more than Standard Oil. Yet, all those additional shares, bought with reinvested dividends, meant that the individual investor in Standard Oil ended up with the better overall result.
"...despite the better fundamentals, investors paid too high a price for IBM, while old Standard Oil was cheaply priced. I call this the 'growth trap.' Investors make the mistake of buying the new thing, irrespective of price." - Jeremy Siegel in an interview back in 2006
This is at least worth consideration the next time there's the temptation to pay a premium for exciting growth prospects. The return comparison is not all that matters, of course. IBM's results depended on much higher sustained growth. More risk was taken in the process simply due to the higher multiple of earnings paid. One of the best tools available to an investor to manage risk is price. That's under an investor's control; what happens as far as future growth goes is not.
Still, both IBM and Standard Oil generated very nice long run investment results. Things worked out well for long-term investors in both companies but, when you pay a high multiple, the margin of safety just isn't there to protect against what might go wrong.***
This naturally reveals nothing about the unique risks, challenges, and opportunities for these two businesses going forward. Future long-term investment results, at least to me, seem likely to be far more modest. No complaints if things turn out a bit better than expected, of course.
As always, it's not just about the absolute return; it's about judging risk versus reward and comparing to alternatives.
Unlike those 50 plus years, these days IBM has a much lower earnings multiple and, apparently, far less exciting growth prospects. Well, at least for now. It's never easy to tell, favorable or not, how those prospects might change over the very long haul. Price paid should assume and reflect the least optimistic scenario. (Especially for technology stocks.)
In other words, the expected outcome should be an attractive one even if nothing great happens.
If the likely worst case can't be judged with high confidence, buying makes no sense.
Adam
Small long position in IBM; no position in XOM.
Other related posts:
Asset Growth and Stock Returns, Part II - Mar 2014
Asset Growth and Stock Returns - Feb 2014
Buffett and Munger on See's Candies, Part II - Jun 2013
Buffett and Munger on See's Candies - Jun 2013
Aesop's Investment Axiom - Feb 2013
Grantham: Investing in a Low-Growth World - Feb 2013
Buffett: Stocks, Bonds, and Coupons - Jan 2013
Maximizing Per-Share Value - Oct 2012
Death of Equities Greatly Exaggerated - Aug 2012
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Technology Stocks - May 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009
* Source: The Future for Investors by Jeremy Siegel
** Dividend reinvestments function like buybacks but, compared to buybacks, are generally less tax efficient. This depends on the type of account. Other than the tax differences, buybacks and dividend reinvestments -- implemented at reasonable or better valuation levels (i.e. discount to value) -- similarly benefit long-term owners; the former reduces overall share count, while the latter increases the number of shares owned.
*** Both companies, inevitably, ran into plenty of their own specific difficulties over those 50 plus years. Even very good businesses will have their fair share of challenges. Anyone expecting a smooth ride investing in common stocks is, well, guaranteed disappointment.
---
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, June 6, 2014
Wells Fargo vs S&P 500
From the most recent Berkshire Hathaway (BRKa) shareholder meeting:
The intrinsic value of any business is the present value of all cash distributed between now and Judgment Day. - Warren Buffett
Stock prices can fluctuate -- and, well, almost certainly will fluctuate -- much more so than a fair estimate of per share business value over time.
(Jeremy Grantham, in this letter, provides a useful long-term chart along these lines. See Exhibit 1 on page 8.)
Investing well means mostly learning to ignore what end up being costly distractions. There's just too much coverage of, and energy spent on, what ends up mostly being noise.
Sometimes, it's worthwhile to step back a bit.
With this in mind, let's take a look at the S&P 500's earnings before the financial crisis:
2006 S&P 500 earnings = 87.72 (peak pre-crisis earnings)
S&P 500 at year-end 2006 = 1,418.30
P/E = 16.2
2013 S&P 500 earnings = 107.45
S&P 500 = 1,940.46 (yesterday's close)
P/E = 18.1
% increase in earnings from 2006 to 2013 = 22.5%
A snapshot of earnings -- whether a company or, in this case, an index of many companies -- is only useful if it serves as a reasonable representation of a normalized earning trajectory going forward (over many years); it's only useful if it's a reasonable proxy for all the cash that will be distributed going forward. I'm sure there are all kinds of opinions about how S&P 500 earnings might change over the next few years. Well, I certainly never try to figure out such a thing (that window of time is way too small to be meaningful) even if I think odds are rather good that, let's say 10 or 20 years from now, S&P 500 earnings will likely be quite a bit higher than now.
To me, it's better to ignore short-term predictions. Ditto for fluctuations unless they happen to serve the investor in some way.
Other than choosing to own quality businesses in the first place, it is price, at least up to a point, that can be used to manage risks.*
Sometimes -- in fact, I'd say often -- extreme amounts of patience followed by decisive action will be required to buy enough at the right price.
Consider the wide range of prices that have been paid for what is not terribly difficult to estimate normalized S&P 500 earnings.
Even if the earnings power of the S&P 500 happens to drop dramatically in any given year, its intrinsic value is based upon the estimated earnings trajectory on a normalized and conservative basis over the long haul.
(A 50% drop in earnings in the short run might lead to a similar drop in market prices. That doesn't mean intrinsic value changed by that much.)
Since estimates like this are necessarily within a range, when in doubt choose the lower end of the range to estimate value.
The market prices fluctuate far more than the combined intrinsic value of those many S&P 500 businesses. Again, instead of being a detriment, those sometimes crazy fluctuations should serve the investor. Wild price action simply offers more chances to make purchases at a nice discount to approximate present value or, alternatively, to do some selling when prices become rather high relative to value.
Now, lets take a look at the same sort of numbers for Wells Fargo (WFC).
2006 WFC earnings per share = 2.47 (peak pre-crisis earnings)**
WFC at year-end 2006 = 35.56
P/E = 14.4
2013 WFC earnings per share = 3.89
WFC price = 51.63 (yesterday's close)
P/E = 13.3
% increase in earnings per share = 57.5%
Back in 2006, Wells Fargo seemed more expensive -- based upon on price to earnings -- than some other big banks. That Wells Fargo multiple of earnings may not look particularly high compared to the S&P 500, but it certainly was relatively high compared to some other big banks at that time.
Now, imagine buying Wells Fargo at that relatively expensive looking price back in 2006. Despite the slight P/E multiple contraction -- from 14.4 to 13.3 -- Wells Fargo's share price still went up more than the S&P 500 (and paid out more in dividends despite the dividend temporarily being cut).
The returns, while hardly spectacular -- in part, due to the at least somewhat expensive price back in 2006 -- contrast greatly with some other large financial institutions.
(Beyond those that got wiped out completely, of course.)
Unlike Wells Fargo's 57.5% increase in earning per share since 2006, a bunch of the big banks that are still around earn less than what they earned pre-crisis; in some cases, a small fraction. Much of this is due to dilution, of course. So, even if things go rather well for them from here, it's unlikely that their common shares will get to pre-crisis levels anytime soon.
Wells Fargo, with superior core economics, proved much more resilient than most others despite its own challenges and mistakes.
My point is that the importance of durable and superior economics is not only the upside; it's also the protection it provides on the down side. The financial system will, unfortunately, at some point down the road likely experience some real difficulties again. It seems, at least, wise to assume that's the case.
Some will try to protect against the downside by attempting to cleverly time the market. Good luck to those that do. That'd be one of those good ideas mostly in theory. A more practical approach is owning quality businesses and staying focused on price versus intrinsic worth. For those who decide owning shares of banks is worth the trouble (and I often wonder whether it really is considering alternatives), it's better to stick with quality. What looks cheap might have all kinds of downside. A reasonable valuation certainly matters, but it's just that, when it comes to investing in what are inherently very leveraged businesses, sometimes it's best to be skeptical of what appears on the surface to be a bargain.
In fact, I'm especially wary of financial institutions that look cheap during the good times. What seems like a seaworthy ship when the ocean is calm and the skies are blue can prove to be anything but once the storm clouds arrive.
Now, imagine having bought -- whether it was good fortune or otherwise -- shares of the larger financial institutions when they were selling at or near their lows. I mean, the very best banks as well as the weaker banks saw their stock prices collapse during the financial crisis. Most of the bigger banks -- at least those that survived the crisis a bit bruised but not broken -- would have generated very nice results for those who happened to buy near their lowest market prices.
In the real world, of course, most of us aren't going to consistently be able to buy shares when they are at or near their lows.
Most of the big banks were just generally NOT built such that the investor who, at least somewhat unfortunately, bought at pre-crisis prices came out okay. The fact that a bank like Wells Fargo stock would have produced good or better results, whether purchased pre-crisis or during the crisis, is an indication -- albeit a simplistic one -- of the very different risk versus reward profiles among the bigger banks.
A stock price that declines while per share intrinsic value remains roughly in tact is not, at least in the long run, a real problem. It may not be pleasant to look at the quoted prices for some time, but a stock that drops further below intrinsic value is an opportunity not a problem for the long-term investor. Besides, temporary paper losses are an inevitable part of the investing process. Those that can't stomach such things really shouldn't be exposed to the stock market.
On the other hand, a stock price that declines along with per share intrinsic value is a very real problem.
The quality banks -- usually those with higher return on assets and equity that also possess other important but less easy to measure characteristics -- should generally sell for a relative premium.
Margin of safety still matters but, with banks, it's usually better to avoid the bargain basement.
I'll stick with the quality stuff and, maybe, pay just a bit more if necessary.
(Though, as always, at what is still a nice discount to intrinsic value.)
It's worth mentioning that even the best bank's common shareholders won't necessarily be protected against another very serious financial collapse.
There's no rule that says the most recent financial crisis is as bad as it can get.
These businesses have unique risks even when they are run brilliantly.
Something to consider.
Adam
Long position in BRKb and WFC established at much lower than recent market prices
* The investor has control over what they are willing to pay for an asset they like if not much else. Yet the price paid provides only limited protection against permanent capital loss for some investments. In certain instances, the worst case valuation is either unclear or such that no price is low enough to protect against the worst possible outcomes. Naturally, the price paid should be comfortably below the estimated present per share intrinsic value. My preference is to calculate per share intrinsic value based upon lower end of an estimated range of future free cash flow, discounted appropriately. Confidence in those estimates should be very high and, well, warranted. If not better to move onto something else. Never get caught up in a compelling story. That's a great way to pay too much for promise that may or may not be realized.
** The 2006 annual report showed diluted earnings per common share to be $ 2.49 per share but subsequent reports have it as $ 2.47.
---
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 intrinsic value of any business is the present value of all cash distributed between now and Judgment Day. - Warren Buffett
Stock prices can fluctuate -- and, well, almost certainly will fluctuate -- much more so than a fair estimate of per share business value over time.
(Jeremy Grantham, in this letter, provides a useful long-term chart along these lines. See Exhibit 1 on page 8.)
Investing well means mostly learning to ignore what end up being costly distractions. There's just too much coverage of, and energy spent on, what ends up mostly being noise.
Sometimes, it's worthwhile to step back a bit.
With this in mind, let's take a look at the S&P 500's earnings before the financial crisis:
2006 S&P 500 earnings = 87.72 (peak pre-crisis earnings)
S&P 500 at year-end 2006 = 1,418.30
P/E = 16.2
2013 S&P 500 earnings = 107.45
S&P 500 = 1,940.46 (yesterday's close)
P/E = 18.1
% increase in earnings from 2006 to 2013 = 22.5%
A snapshot of earnings -- whether a company or, in this case, an index of many companies -- is only useful if it serves as a reasonable representation of a normalized earning trajectory going forward (over many years); it's only useful if it's a reasonable proxy for all the cash that will be distributed going forward. I'm sure there are all kinds of opinions about how S&P 500 earnings might change over the next few years. Well, I certainly never try to figure out such a thing (that window of time is way too small to be meaningful) even if I think odds are rather good that, let's say 10 or 20 years from now, S&P 500 earnings will likely be quite a bit higher than now.
To me, it's better to ignore short-term predictions. Ditto for fluctuations unless they happen to serve the investor in some way.
Other than choosing to own quality businesses in the first place, it is price, at least up to a point, that can be used to manage risks.*
Sometimes -- in fact, I'd say often -- extreme amounts of patience followed by decisive action will be required to buy enough at the right price.
Consider the wide range of prices that have been paid for what is not terribly difficult to estimate normalized S&P 500 earnings.
Even if the earnings power of the S&P 500 happens to drop dramatically in any given year, its intrinsic value is based upon the estimated earnings trajectory on a normalized and conservative basis over the long haul.
(A 50% drop in earnings in the short run might lead to a similar drop in market prices. That doesn't mean intrinsic value changed by that much.)
Since estimates like this are necessarily within a range, when in doubt choose the lower end of the range to estimate value.
The market prices fluctuate far more than the combined intrinsic value of those many S&P 500 businesses. Again, instead of being a detriment, those sometimes crazy fluctuations should serve the investor. Wild price action simply offers more chances to make purchases at a nice discount to approximate present value or, alternatively, to do some selling when prices become rather high relative to value.
Now, lets take a look at the same sort of numbers for Wells Fargo (WFC).
2006 WFC earnings per share = 2.47 (peak pre-crisis earnings)**
WFC at year-end 2006 = 35.56
P/E = 14.4
2013 WFC earnings per share = 3.89
WFC price = 51.63 (yesterday's close)
P/E = 13.3
% increase in earnings per share = 57.5%
Back in 2006, Wells Fargo seemed more expensive -- based upon on price to earnings -- than some other big banks. That Wells Fargo multiple of earnings may not look particularly high compared to the S&P 500, but it certainly was relatively high compared to some other big banks at that time.
Now, imagine buying Wells Fargo at that relatively expensive looking price back in 2006. Despite the slight P/E multiple contraction -- from 14.4 to 13.3 -- Wells Fargo's share price still went up more than the S&P 500 (and paid out more in dividends despite the dividend temporarily being cut).
The returns, while hardly spectacular -- in part, due to the at least somewhat expensive price back in 2006 -- contrast greatly with some other large financial institutions.
(Beyond those that got wiped out completely, of course.)
Unlike Wells Fargo's 57.5% increase in earning per share since 2006, a bunch of the big banks that are still around earn less than what they earned pre-crisis; in some cases, a small fraction. Much of this is due to dilution, of course. So, even if things go rather well for them from here, it's unlikely that their common shares will get to pre-crisis levels anytime soon.
Wells Fargo, with superior core economics, proved much more resilient than most others despite its own challenges and mistakes.
My point is that the importance of durable and superior economics is not only the upside; it's also the protection it provides on the down side. The financial system will, unfortunately, at some point down the road likely experience some real difficulties again. It seems, at least, wise to assume that's the case.
Some will try to protect against the downside by attempting to cleverly time the market. Good luck to those that do. That'd be one of those good ideas mostly in theory. A more practical approach is owning quality businesses and staying focused on price versus intrinsic worth. For those who decide owning shares of banks is worth the trouble (and I often wonder whether it really is considering alternatives), it's better to stick with quality. What looks cheap might have all kinds of downside. A reasonable valuation certainly matters, but it's just that, when it comes to investing in what are inherently very leveraged businesses, sometimes it's best to be skeptical of what appears on the surface to be a bargain.
In fact, I'm especially wary of financial institutions that look cheap during the good times. What seems like a seaworthy ship when the ocean is calm and the skies are blue can prove to be anything but once the storm clouds arrive.
Now, imagine having bought -- whether it was good fortune or otherwise -- shares of the larger financial institutions when they were selling at or near their lows. I mean, the very best banks as well as the weaker banks saw their stock prices collapse during the financial crisis. Most of the bigger banks -- at least those that survived the crisis a bit bruised but not broken -- would have generated very nice results for those who happened to buy near their lowest market prices.
In the real world, of course, most of us aren't going to consistently be able to buy shares when they are at or near their lows.
Most of the big banks were just generally NOT built such that the investor who, at least somewhat unfortunately, bought at pre-crisis prices came out okay. The fact that a bank like Wells Fargo stock would have produced good or better results, whether purchased pre-crisis or during the crisis, is an indication -- albeit a simplistic one -- of the very different risk versus reward profiles among the bigger banks.
On the other hand, a stock price that declines along with per share intrinsic value is a very real problem.
The quality banks -- usually those with higher return on assets and equity that also possess other important but less easy to measure characteristics -- should generally sell for a relative premium.
Margin of safety still matters but, with banks, it's usually better to avoid the bargain basement.
I'll stick with the quality stuff and, maybe, pay just a bit more if necessary.
(Though, as always, at what is still a nice discount to intrinsic value.)
It's worth mentioning that even the best bank's common shareholders won't necessarily be protected against another very serious financial collapse.
There's no rule that says the most recent financial crisis is as bad as it can get.
These businesses have unique risks even when they are run brilliantly.
Something to consider.
Adam
Long position in BRKb and WFC established at much lower than recent market prices
* The investor has control over what they are willing to pay for an asset they like if not much else. Yet the price paid provides only limited protection against permanent capital loss for some investments. In certain instances, the worst case valuation is either unclear or such that no price is low enough to protect against the worst possible outcomes. Naturally, the price paid should be comfortably below the estimated present per share intrinsic value. My preference is to calculate per share intrinsic value based upon lower end of an estimated range of future free cash flow, discounted appropriately. Confidence in those estimates should be very high and, well, warranted. If not better to move onto something else. Never get caught up in a compelling story. That's a great way to pay too much for promise that may or may not be realized.
** The 2006 annual report showed diluted earnings per common share to be $ 2.49 per share but subsequent reports have it as $ 2.47.
---
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, May 30, 2014
Buffett on Farms, Real Estate, and Stocks - Part II
A follow up to this post. In the 2013 Berkshire Hathaway (BRKa) shareholder letter, Warren Buffett describes two of his small investments -- a Nebraska farm and a New York retail property -- to help illustrate some important investing fundamentals.
This was covered in the previous post.
"There is one major difference between my two small investments and an investment in stocks. Stocks provide you minute-to-minute valuations for your holdings whereas I have yet to see a quotation for either my farm or the New York real estate.
It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings – and for some investors, it is. After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his – and those prices varied widely over short periods of time depending on his mental state – how in the world could I be other than benefited by his erratic behavior? If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.
Owners of stocks, however, too often let the capricious and often irrational behavior of their fellow owners cause them to behave irrationally as well. Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits – and, worse yet, important to consider acting upon their comments.
Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of 'Don't just sit there, do something.' For these investors, liquidity is transformed from the unqualified benefit it should be to a curse."
Many participants turn what should be an inherent advantage into a disadvantage. Excessive trading is likely to be unproductive or worse. It likely leads to a bunch of unforced and costly errors.
The result? A less favorable balance between risk and reward for a whole lot time and energy not well spent.
What Buffett describes above is a very sensible way to go about the business of investing. It's certainly not complicated nor is it particularly difficult to understand. Yet the noise distracts. The apparent simplicity masks the fact that the job is a whole lot more difficult to do consistently well than it appears. The merits of the approach becomes lost in a sea of opinions, breaking news, economic reports, and stock quotations.
Psychological factors get in the way.
Compounding effects over a long time horizon -- increases to intrinsic value -- should do the heavy lifting when it comes to generating returns. Yet the incredible low cost convenience of buying and selling in modern equity markets leads some (many?) to a kind of destructive hyperactivity. The equity markets potential strength is converted to a weakness. At least it is for those who choose to trade so often.
I think that Morgan Housel said it very well earlier this year:
"I think the single biggest risk you face as an investor is that you'll try to be a trader. It's the financial equivalent of drunk driving -- recklessness blinded by false confidence. 'Benign neglect, bordering on sloth, remains the hallmark of our investment process,' Warren Buffett once said. It probably should be yours, too."
Sometimes, the biggest challenge is knowing when to -- after doing sensible things around one's own very best ideas -- just get out of the way. Invest in what's sound and understandable. Buy only if attractively priced. Be positioned to act decisively when emotions are running high; when, most likely, the uncertainty or euphoria seem to be at or near its highest. Allow other to lose their composure during the a crisis. Allow others to get caught up in the excitement of seemingly endless and rapid rising prices. Study businesses and learn to judge their long run prospects well. Those prospects may change (or be misjudged), of course, and appropriate action will need to be taken. Serious and permanent damage to the economic moat of a business (i.e. not temporary even if very real difficulties) may warrant action, for example. Extreme overvaluation may warrant action. The opportunity to buy something else that's plainly superior may also warrant action.
All of this is easier said than done.
Otherwise, it generally makes no sense to transact frenetically once something of quality has been bought well in the first place.
Attempts to jump in and out of assets at just the right time is folly.
Such behavior not only adds frictional costs, but likely also increases the chance to that mistakes will be made. When someone buys or sells something in their portfolio, it's naturally done with the idea that it will lead to a favorable result. I mean, pretty much no is going to make a portfolio move unless they expect that move will improve future outcomes. Otherwise, they wouldn't make the move. Yet the evidence suggests just the opposite is likely to happen; it suggests portfolio actions generally reduce returns.
More effort; less reward. That may not be intuitive but, at least, deserves some thoughtful consideration. Some will discount this as just an odd anomaly. Some will choose to ignore it.
That's probably a mistake.
Most participants would benefit from fewer thoughtful moves and by considering how their best ideas are likely to play out over longer time horizons. It's just very easy to be overly confident that each short-term action will result in something fruitful.
I mean, most of us mortals have only so many good ideas. Well, those who are trading all the time seem almost certain to be eventually acting on something that is much further down the list of their best ideas.
Also, frenetic trading means attempting to predict the mostly unpredictable:
That is, near-term price action.
It's important to think of stocks as part ownership of a business because, well, that's of course what they actually happen to be. More from the Berkshire letter:
"When Charlie and I buy stocks – which we think of as small portions of businesses – our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out, or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings – which is usually the case – we simply move on to other prospects. In the 54 years we have worked together, we have never foregone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions.
It's vital, however, that we recognize the perimeter of our 'circle of competence' and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses."
Some will be comfortable judging an individual businesses long-term prospects, estimating its value, deciding on the appropriate margin of safety against that value -- to, at least in part, improve risk versus reward* -- while carefully considering the opportunity costs. If these things are not in one's comfort zone then, well, stay away from stocks.
Some fine low cost index fund alternatives exist and, in any case, it's NOT like most active market participants -- professional or not -- end up doing better than a broad-based index.
Either way, whether stocks or low cost index funds make sense, frequent trading is generally unwise.
(There are, no doubt, exceptions to this but a plan built around being one of the exceptions seems like no plan at all.)
So investing well requires tuning out the noise, an emphasis on reducing errors where possible, and an understanding of how and why certain psychological biases create trouble that can be costly.
Like many things, this naturally also requires a realistic assessment of one's own abilities and limits.
Tuning out the noise means mostly ignoring the near-term quoted prices. The inevitable wild fluctuations will be mostly driven by changes to market participant psychology -- and maybe a build up of leverage that, when prices go the wrong way, results in forced transactions to meet margin calls -- instead of changes to intrinsic business value.
For good businesses -- and even some of less quality -- those quoted price fluctuations will inevitably be much greater than changes to underlying per share value.
Make that an advantage.
Adam
Long position in BRKb established at much lower than recent market prices
* The price paid for an asset can serve to improve risk versus reward but only up to a point. In other words, there are limits to how much a reduced price can be used to manage risks. Sometimes, for example, no price is low enough because the low end of estimated intrinsic business value is too difficult to judge.
---
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 was covered in the previous post.
In the letter, after using the two small investments to illustrate those investing fundamentals, Buffett goes on to say the following:
"There is one major difference between my two small investments and an investment in stocks. Stocks provide you minute-to-minute valuations for your holdings whereas I have yet to see a quotation for either my farm or the New York real estate.
It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings – and for some investors, it is. After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his – and those prices varied widely over short periods of time depending on his mental state – how in the world could I be other than benefited by his erratic behavior? If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.
Owners of stocks, however, too often let the capricious and often irrational behavior of their fellow owners cause them to behave irrationally as well. Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits – and, worse yet, important to consider acting upon their comments.
Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of 'Don't just sit there, do something.' For these investors, liquidity is transformed from the unqualified benefit it should be to a curse."
Many participants turn what should be an inherent advantage into a disadvantage. Excessive trading is likely to be unproductive or worse. It likely leads to a bunch of unforced and costly errors.
The result? A less favorable balance between risk and reward for a whole lot time and energy not well spent.
What Buffett describes above is a very sensible way to go about the business of investing. It's certainly not complicated nor is it particularly difficult to understand. Yet the noise distracts. The apparent simplicity masks the fact that the job is a whole lot more difficult to do consistently well than it appears. The merits of the approach becomes lost in a sea of opinions, breaking news, economic reports, and stock quotations.
Psychological factors get in the way.
Compounding effects over a long time horizon -- increases to intrinsic value -- should do the heavy lifting when it comes to generating returns. Yet the incredible low cost convenience of buying and selling in modern equity markets leads some (many?) to a kind of destructive hyperactivity. The equity markets potential strength is converted to a weakness. At least it is for those who choose to trade so often.
I think that Morgan Housel said it very well earlier this year:
"I think the single biggest risk you face as an investor is that you'll try to be a trader. It's the financial equivalent of drunk driving -- recklessness blinded by false confidence. 'Benign neglect, bordering on sloth, remains the hallmark of our investment process,' Warren Buffett once said. It probably should be yours, too."
Sometimes, the biggest challenge is knowing when to -- after doing sensible things around one's own very best ideas -- just get out of the way. Invest in what's sound and understandable. Buy only if attractively priced. Be positioned to act decisively when emotions are running high; when, most likely, the uncertainty or euphoria seem to be at or near its highest. Allow other to lose their composure during the a crisis. Allow others to get caught up in the excitement of seemingly endless and rapid rising prices. Study businesses and learn to judge their long run prospects well. Those prospects may change (or be misjudged), of course, and appropriate action will need to be taken. Serious and permanent damage to the economic moat of a business (i.e. not temporary even if very real difficulties) may warrant action, for example. Extreme overvaluation may warrant action. The opportunity to buy something else that's plainly superior may also warrant action.
All of this is easier said than done.
Otherwise, it generally makes no sense to transact frenetically once something of quality has been bought well in the first place.
Attempts to jump in and out of assets at just the right time is folly.
Such behavior not only adds frictional costs, but likely also increases the chance to that mistakes will be made. When someone buys or sells something in their portfolio, it's naturally done with the idea that it will lead to a favorable result. I mean, pretty much no is going to make a portfolio move unless they expect that move will improve future outcomes. Otherwise, they wouldn't make the move. Yet the evidence suggests just the opposite is likely to happen; it suggests portfolio actions generally reduce returns.
More effort; less reward. That may not be intuitive but, at least, deserves some thoughtful consideration. Some will discount this as just an odd anomaly. Some will choose to ignore it.
That's probably a mistake.
Most participants would benefit from fewer thoughtful moves and by considering how their best ideas are likely to play out over longer time horizons. It's just very easy to be overly confident that each short-term action will result in something fruitful.
I mean, most of us mortals have only so many good ideas. Well, those who are trading all the time seem almost certain to be eventually acting on something that is much further down the list of their best ideas.
Also, frenetic trading means attempting to predict the mostly unpredictable:
That is, near-term price action.
It's important to think of stocks as part ownership of a business because, well, that's of course what they actually happen to be. More from the Berkshire letter:
"When Charlie and I buy stocks – which we think of as small portions of businesses – our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out, or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings – which is usually the case – we simply move on to other prospects. In the 54 years we have worked together, we have never foregone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions.
It's vital, however, that we recognize the perimeter of our 'circle of competence' and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses."
Some will be comfortable judging an individual businesses long-term prospects, estimating its value, deciding on the appropriate margin of safety against that value -- to, at least in part, improve risk versus reward* -- while carefully considering the opportunity costs. If these things are not in one's comfort zone then, well, stay away from stocks.
Some fine low cost index fund alternatives exist and, in any case, it's NOT like most active market participants -- professional or not -- end up doing better than a broad-based index.
Either way, whether stocks or low cost index funds make sense, frequent trading is generally unwise.
(There are, no doubt, exceptions to this but a plan built around being one of the exceptions seems like no plan at all.)
So investing well requires tuning out the noise, an emphasis on reducing errors where possible, and an understanding of how and why certain psychological biases create trouble that can be costly.
Like many things, this naturally also requires a realistic assessment of one's own abilities and limits.
Tuning out the noise means mostly ignoring the near-term quoted prices. The inevitable wild fluctuations will be mostly driven by changes to market participant psychology -- and maybe a build up of leverage that, when prices go the wrong way, results in forced transactions to meet margin calls -- instead of changes to intrinsic business value.
For good businesses -- and even some of less quality -- those quoted price fluctuations will inevitably be much greater than changes to underlying per share value.
Make that an advantage.
Adam
Long position in BRKb established at much lower than recent market prices
* The price paid for an asset can serve to improve risk versus reward but only up to a point. In other words, there are limits to how much a reduced price can be used to manage risks. Sometimes, for example, no price is low enough because the low end of estimated intrinsic business value is too difficult to judge.
---
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, May 23, 2014
Buffett and Munger Talk Retail Businesses, Nebraska Furniture Mart, and Amazon
Warren Buffett and Charlie Munger talked about retail businesses more generally, as well as Nebraska Furninture Mart, and Amazon (AMZN) specifically, in this recent CNBC interview:
MUNGER: I think Warren and I can match anybody's failures in retail.
BUFFETT: Yeah, we have a really bad record, starting in 1966. We bought what we thought was a second-rate department store in Baltimore at a third-rate price, but we found out very quickly that we bought a fourth-rate department store at a third-rate price. And we failed at it, and we failed...
MUNGER: Quickly.
BUFFETT: Yeah, quickly. That's true. We failed other times in retailing. Retailing is a tough, tough business, partly because your competitors are always attempting and very frequently successfully attempting to copy anything you do that's working. And so the world keeps moving. It's hard to establish a permanent moat that your competitor can't cross. And you've seen the giants of retail...a lot of giants have been toppled.
MUNGER: Most of the giants of yesteryear are done.
They go on to talk about a very successful retail business Berkshire's owned since the early 1980s:
BUFFETT: Nobody is going to be able to compete with the Nebraska Furniture Mart. I mean, this store does more home furnishing business than any store in the country. And what are we in, I don't know, the 50th market in the country? This store does $450 million annually. It's doing $40 million during the Berkshire shareholders week. But there's no store that remotely can offer the variety. There's no store that can undersell us. But to achieve that kind of dominance, you can't do it with a chain of stores in Canada when you're competing with Wal-Mart up there and a whole bunch of other people.
Buffett and Munger both share a very favorable view of Amazon.* Here's what they had to say when asked about the company's business model:
MUNGER: Well, I think it's very disruptive compared to everybody else, I think it's a formidable model that is going to change America.
BUFFETT: I agree. It's one of the most powerful models that I've seen in a lifetime, and it's being run by a fellow that has had a very clear view of what he wants to do, and does it every day when he goes to work, and is not hampered by external factors like people telling him what he should earn quarterly or something of the sort. And ungodly smart, focused. He's really got a powerful business, and he's got satisfied customers. That's hugely important.
This certainly isn't the first time accolades have been directed at Jeff Bezos by Buffett.
In fact, last year Buffett said that he was "the ablest CEO in America."
Still, retailing certainly is a tough business.
Figuring out whether a moat can be built and sustained is tough to do but it sure helps to have exceptionally talented leadership.
Of course, these days Amazon has moved beyond strictly being a retailer.
Now, whether Amazon ends up being a great investment is another question altogether.
To me, the respect and admiration for Amazon has been well-earned as noted in prior posts.
(Some concerns and criticisms have also been previously highlighted.)
My main problem has always been valuation. More specifically, I've just never understood how to value the business within an acceptably narrow range.
Tough to value is very different than being overvalued.
Based upon price to earnings the company naturally appears quite overvalued and very well may even be. Yet this company -- almost uniquely -- invests with a long view in mind, often executes very well, and makes brilliant use of its working capital. With this in mind, it seems foolish to underestimate Amazon.
Amazon's business is likely intrinsically worth a lot as of now. How much?
I have no idea.
It also has seems to have a reasonable chance of being worth a whole lot more down the road. How much?
Again, I just have no idea.
In both cases, I'm NOT referring to market capitalization; I'm referring to a rough but meaningful estimate of intrinsic value based upon defensible assumptions and sound logic. If what something is roughly worth -- within a narrow enough range -- isn't clear, it's naturally just not possible to judge what an appropriate margin of safety might be.
(The price paid should be a nice discount to estimated value and protect the investor sufficiently against things not going quite as well as expected.)
This simply means, when it comes to Amazon, I can't figure out whether the returns are likely to be sufficient considering the risks and compared to investment alternatives.
Alternatives that I understand better.
Others may have a way to figure out Amazon's value with enough confidence. Those that can are far better candidates to invest long-term in the company.**
The biggest reason I still always pay attention to Amazon is their ability to potentially disrupt (or damage the economic moat of) some other business or industry. Just because the company doesn't compete directly against someone now, doesn't mean it won't down the road.
In other words, what appear to be solid business economics today, end up being badly eroded down the road.
Clearly, certain businesses and industries are more likely to be challenged some day by Amazon than others.
Though I'm not sure ten years ago many would have imagined or anticipated all the moves that Amazon has made since that time.
Adam
No position in AMZN
Related posts:
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
* Keep in mind they are commenting on Amazon's business NOT necessarily the stock.
** Someone else might find Amazon's intrinsic value easier to estimate, of course. As always, it's knowing what's understandable to you and only investing in those things. This is necessarily unique to each investor. When you stick to what you know fewer errors are likely to be made.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
(5)
MUNGER: I think Warren and I can match anybody's failures in retail.
BUFFETT: Yeah, we have a really bad record, starting in 1966. We bought what we thought was a second-rate department store in Baltimore at a third-rate price, but we found out very quickly that we bought a fourth-rate department store at a third-rate price. And we failed at it, and we failed...
MUNGER: Quickly.
BUFFETT: Yeah, quickly. That's true. We failed other times in retailing. Retailing is a tough, tough business, partly because your competitors are always attempting and very frequently successfully attempting to copy anything you do that's working. And so the world keeps moving. It's hard to establish a permanent moat that your competitor can't cross. And you've seen the giants of retail...a lot of giants have been toppled.
MUNGER: Most of the giants of yesteryear are done.
They go on to talk about a very successful retail business Berkshire's owned since the early 1980s:
BUFFETT: Nobody is going to be able to compete with the Nebraska Furniture Mart. I mean, this store does more home furnishing business than any store in the country. And what are we in, I don't know, the 50th market in the country? This store does $450 million annually. It's doing $40 million during the Berkshire shareholders week. But there's no store that remotely can offer the variety. There's no store that can undersell us. But to achieve that kind of dominance, you can't do it with a chain of stores in Canada when you're competing with Wal-Mart up there and a whole bunch of other people.
Buffett and Munger both share a very favorable view of Amazon.* Here's what they had to say when asked about the company's business model:
MUNGER: Well, I think it's very disruptive compared to everybody else, I think it's a formidable model that is going to change America.
BUFFETT: I agree. It's one of the most powerful models that I've seen in a lifetime, and it's being run by a fellow that has had a very clear view of what he wants to do, and does it every day when he goes to work, and is not hampered by external factors like people telling him what he should earn quarterly or something of the sort. And ungodly smart, focused. He's really got a powerful business, and he's got satisfied customers. That's hugely important.
This certainly isn't the first time accolades have been directed at Jeff Bezos by Buffett.
In fact, last year Buffett said that he was "the ablest CEO in America."
Still, retailing certainly is a tough business.
Figuring out whether a moat can be built and sustained is tough to do but it sure helps to have exceptionally talented leadership.
Of course, these days Amazon has moved beyond strictly being a retailer.
Now, whether Amazon ends up being a great investment is another question altogether.
To me, the respect and admiration for Amazon has been well-earned as noted in prior posts.
(Some concerns and criticisms have also been previously highlighted.)
My main problem has always been valuation. More specifically, I've just never understood how to value the business within an acceptably narrow range.
Tough to value is very different than being overvalued.
Based upon price to earnings the company naturally appears quite overvalued and very well may even be. Yet this company -- almost uniquely -- invests with a long view in mind, often executes very well, and makes brilliant use of its working capital. With this in mind, it seems foolish to underestimate Amazon.
Amazon's business is likely intrinsically worth a lot as of now. How much?
I have no idea.
It also has seems to have a reasonable chance of being worth a whole lot more down the road. How much?
Again, I just have no idea.
In both cases, I'm NOT referring to market capitalization; I'm referring to a rough but meaningful estimate of intrinsic value based upon defensible assumptions and sound logic. If what something is roughly worth -- within a narrow enough range -- isn't clear, it's naturally just not possible to judge what an appropriate margin of safety might be.
(The price paid should be a nice discount to estimated value and protect the investor sufficiently against things not going quite as well as expected.)
This simply means, when it comes to Amazon, I can't figure out whether the returns are likely to be sufficient considering the risks and compared to investment alternatives.
Alternatives that I understand better.
Others may have a way to figure out Amazon's value with enough confidence. Those that can are far better candidates to invest long-term in the company.**
The biggest reason I still always pay attention to Amazon is their ability to potentially disrupt (or damage the economic moat of) some other business or industry. Just because the company doesn't compete directly against someone now, doesn't mean it won't down the road.
In other words, what appear to be solid business economics today, end up being badly eroded down the road.
Clearly, certain businesses and industries are more likely to be challenged some day by Amazon than others.
Though I'm not sure ten years ago many would have imagined or anticipated all the moves that Amazon has made since that time.
Adam
No position in AMZN
Related posts:
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
* Keep in mind they are commenting on Amazon's business NOT necessarily the stock.
** Someone else might find Amazon's intrinsic value easier to estimate, of course. As always, it's knowing what's understandable to you and only investing in those things. This is necessarily unique to each investor. When you stick to what you know fewer errors are likely to be made.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
(5)
Friday, May 16, 2014
Berkshire Hathaway 1st Quarter 2014 13F-HR
The Berkshire Hathaway (BRKa) 1st Quarter 13F-HR was released yesterday. Below is a summary of the changes that were made to the Berkshire equity portfolio during that quarter.
(For a convenient comparison, here's a post from last quarter that summarizes Berkshire's 4th Quarter 13F-HR.)
There was plenty of buying and selling during the quarter. Here's a quick summary of the changes:*
New Positions
Verizon (VZ): Bought 11.0 million shares worth $ 529 million
Liberty Global Class C (LBTYK): 7.35 million shares worth $ 306 million
The above new position in Liberty Global is at least mostly -- though likely entirely -- related to this announcement. Berkshire received a stock dividend of one Liberty Global Class C ordinary share for each Liberty Global Class A (LBTYA) ordinary share they owned (some of which, as shown below, were purchased during the 1st quarter).
Further information on this can be found here.
Berkshire's latest filing did not indicate any activity was kept confidential. Occasionally, the SEC allows Berkshire to keep certain moves in the portfolio confidential. The permission is granted by the SEC when a case can be made that the disclosure may cause buyers to drive up the price before Berkshire makes its additional purchases.
Added to Existing Positions
IBM (IBM): 233 thousand shares worth $ 43.5 million, total stake $ 12.7 billion
Wal-Mart (WMT): 8.57 million shares worth $ 658 million, total stake $ 4.46 billion
U.S. Bancorp (USB): 706 thousand shares worth $ 28.6 million, total stake $ 3.25 billion
DaVita (DVA): 1.16 million shares worth $ 78.6 million, total stake $ 2.55 billion
Verisign (VRSN): 724 thousand shares worth $ 35 million, total stake $ 566 million
Liberty Global Class A (LBTYA): 4.40 million shares worth $ 192 million, total stake $ 321 million
Reduced Positions
DirecTV (DTV): 2.0 million shares worth $ 170 million, total stake $ 2.94 billion
General Motors (GM): 10.0 million shares worth $ 344 million, total stake $ 1.03 billion
Phillips 66 (PSX): 17.4 million shares worth $ 1.43 billion, total stake $ 799 million
Starz (STRZA): 2.62 million shares worth $ 77.7 million, total stake $ 56.9 million
Todd Combs and Ted Weschler are responsible for an increasingly large number of the moves in the Berkshire equity portfolio, even if they still manage a small percentage of the overall portfolio.
These days, any changes involving smaller positions will generally be the work of the two portfolio managers.
(Though some of the holdings they're responsible for have become more substantial over time.)
Top Five Holdings
After the changes, Berkshire Hathaway's portfolio of equity securities remains mostly made up of financial, consumer and, to a lesser extent, technology stocks (mostly IBM).
1. Wells Fargo (WFC) = $ 22.7 billion
2. Coca-Cola (KO) = $ 16.2 billion
3. American Express (AXP) = $ 13.3 billion
4. IBM (IBM) = $ 12.7 billion
5. Wal-Mart (WMT) = $ 4.46 billion
The additional purchases of Wal-Mart shares moved the position into the top five in place of Procter & Gamble (PG).
As is almost always the case it's a very concentrated portfolio.
The top five often represent 60-70 percent and, at times, even more of the equity portfolio. In addition, Berkshire owns equity securities listed on exchanges outside the U.S., plus cash and cash equivalents, fixed income, and other investments.**
According to their latest filing, the combined portfolio value (equities, cash, bonds, and other investments) at the end of the most recent quarter was ~ $ 227 billion (including the investment in Heinz).
The portfolio, of course, excludes all the operating businesses that Berkshire owns outright with, according to the latest letter, a bit more than 330,000 employees combined.
Here are some examples of the non-insurance businesses:
MidAmerican Energy, Burlington Northern Santa Fe, McLane Company, The Marmon Group, Shaw Industries, Benjamin Moore, Johns Manville, Acme Building, MiTek, Fruit of the Loom, Russell Athletic Apparel, NetJets, Nebraska Furniture Mart, See's Candies, Dairy Queen, The Pampered Chef, Business Wire, Iscar, Lubrizol, Oriental Trading Company, as well as 50% of Heinz.
(Among others.)
In addition, the insurance businesses (BH Reinsurance, General Re, GEICO etc.) owned by Berkshire have naturally provided plenty of "float" for their investments over time and continue to do so.
See page 111 of the annual report for a full list of Berkshire's businesses.
Adam
Long positions in BRKb, WFC, KO, AXP, PG, USB, WMT, DTV and PSX established at much lower than recent market prices. Also, small long position in IBM established at slightly less than recent market prices.
* All values shown are based upon Thursday's closing price.
** Berkshire Hathaway's holdings of ADRs are included in the 13F-HR. What is not included are the shares listed on exchanges outside the United States. The status of those shares are updated in the annual letter. So the only way any of the stocks listed on exchanges outside the U.S. will show up in the 13F-HR is if Berkshire happens to buy the ADR. Investments in things like the preferred shares (and, where applicable, related warrants) are also not included in the 13F-HR. The same is true for the Heinz common shares (i.e. not just the Heinz preferred shares).
---
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 a convenient comparison, here's a post from last quarter that summarizes Berkshire's 4th Quarter 13F-HR.)
There was plenty of buying and selling during the quarter. Here's a quick summary of the changes:*
New Positions
Verizon (VZ): Bought 11.0 million shares worth $ 529 million
Liberty Global Class C (LBTYK): 7.35 million shares worth $ 306 million
The above new position in Liberty Global is at least mostly -- though likely entirely -- related to this announcement. Berkshire received a stock dividend of one Liberty Global Class C ordinary share for each Liberty Global Class A (LBTYA) ordinary share they owned (some of which, as shown below, were purchased during the 1st quarter).
Further information on this can be found here.
Berkshire's latest filing did not indicate any activity was kept confidential. Occasionally, the SEC allows Berkshire to keep certain moves in the portfolio confidential. The permission is granted by the SEC when a case can be made that the disclosure may cause buyers to drive up the price before Berkshire makes its additional purchases.
Added to Existing Positions
IBM (IBM): 233 thousand shares worth $ 43.5 million, total stake $ 12.7 billion
Wal-Mart (WMT): 8.57 million shares worth $ 658 million, total stake $ 4.46 billion
U.S. Bancorp (USB): 706 thousand shares worth $ 28.6 million, total stake $ 3.25 billion
DaVita (DVA): 1.16 million shares worth $ 78.6 million, total stake $ 2.55 billion
Verisign (VRSN): 724 thousand shares worth $ 35 million, total stake $ 566 million
Liberty Global Class A (LBTYA): 4.40 million shares worth $ 192 million, total stake $ 321 million
Reduced Positions
DirecTV (DTV): 2.0 million shares worth $ 170 million, total stake $ 2.94 billion
General Motors (GM): 10.0 million shares worth $ 344 million, total stake $ 1.03 billion
Phillips 66 (PSX): 17.4 million shares worth $ 1.43 billion, total stake $ 799 million
Starz (STRZA): 2.62 million shares worth $ 77.7 million, total stake $ 56.9 million
Todd Combs and Ted Weschler are responsible for an increasingly large number of the moves in the Berkshire equity portfolio, even if they still manage a small percentage of the overall portfolio.
These days, any changes involving smaller positions will generally be the work of the two portfolio managers.
(Though some of the holdings they're responsible for have become more substantial over time.)
Top Five Holdings
After the changes, Berkshire Hathaway's portfolio of equity securities remains mostly made up of financial, consumer and, to a lesser extent, technology stocks (mostly IBM).
1. Wells Fargo (WFC) = $ 22.7 billion
2. Coca-Cola (KO) = $ 16.2 billion
3. American Express (AXP) = $ 13.3 billion
4. IBM (IBM) = $ 12.7 billion
5. Wal-Mart (WMT) = $ 4.46 billion
The additional purchases of Wal-Mart shares moved the position into the top five in place of Procter & Gamble (PG).
As is almost always the case it's a very concentrated portfolio.
The top five often represent 60-70 percent and, at times, even more of the equity portfolio. In addition, Berkshire owns equity securities listed on exchanges outside the U.S., plus cash and cash equivalents, fixed income, and other investments.**
According to their latest filing, the combined portfolio value (equities, cash, bonds, and other investments) at the end of the most recent quarter was ~ $ 227 billion (including the investment in Heinz).
Here are some examples of the non-insurance businesses:
MidAmerican Energy, Burlington Northern Santa Fe, McLane Company, The Marmon Group, Shaw Industries, Benjamin Moore, Johns Manville, Acme Building, MiTek, Fruit of the Loom, Russell Athletic Apparel, NetJets, Nebraska Furniture Mart, See's Candies, Dairy Queen, The Pampered Chef, Business Wire, Iscar, Lubrizol, Oriental Trading Company, as well as 50% of Heinz.
(Among others.)
In addition, the insurance businesses (BH Reinsurance, General Re, GEICO etc.) owned by Berkshire have naturally provided plenty of "float" for their investments over time and continue to do so.
See page 111 of the annual report for a full list of Berkshire's businesses.
Adam
Long positions in BRKb, WFC, KO, AXP, PG, USB, WMT, DTV and PSX established at much lower than recent market prices. Also, small long position in IBM established at slightly less than recent market prices.
* All values shown are based upon Thursday's closing price.
** Berkshire Hathaway's holdings of ADRs are included in the 13F-HR. What is not included are the shares listed on exchanges outside the United States. The status of those shares are updated in the annual letter. So the only way any of the stocks listed on exchanges outside the U.S. will show up in the 13F-HR is if Berkshire happens to buy the ADR. Investments in things like the preferred shares (and, where applicable, related warrants) are also not included in the 13F-HR. The same is true for the Heinz common shares (i.e. not just the Heinz preferred shares).
---
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.
Subscribe to:
Posts (Atom)
