In this prior post, I included the following excerpt from the 2000 Berkshire Hathaway (BRKa) shareholder letter:
"...Aesop and his enduring, though somewhat incomplete, investment insight was 'a bird in the hand is worth two in the bush.' To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? "
Aesop's Investment Axiom
Warren Buffett adds that, if the investor can answer these questions, then both the value and the number of "birds" that should be offered can be understood.
"And, of course, don't literally think birds. Think dollars."
Buffett also writes that the difference between investing and speculating may never be "bright and clear" but the differences do matter. Here's one simple attempt, if limited imperfect way, to make a distinction.
The speculator would be generally troubled if the price of an asset dropped substantially -- even if temporarily -- after purchase. We're talking about necessarily rather short time horizons. So the emphasis is not only on price action going in the right direction, but as soon as possible. When dealing with such short time frames, the reason for the drop ends up mattering not much at all.
Whether the drop is caused by emotions, perceptions, technical factors, the market environment as a whole, or real company specific problems just isn't relevant. With speculation, it's the price action that rules.
The investor should be generally troubled, instead, only if the intrinsic value of something went down substantially after purchase. The emphasis is on price versus value; it's on the stream of cash flows that an asset can produce over the long haul; it's on Aesop's investment axiom. With investment, it's the value that rules.
A drop in what something is intrinsically worth (or if value was misjudged in the first place) is when there's a real chance of permanent capital loss. Otherwise, for the investor, a price dropping against well-judged value can be a very good thing.
Buffett explained it the following way back in 2009:
"When I do invest, I don't care if the stock price goes from $10 to $2 but I do care about if the value went from $10 to $2."
If the investor pays a discount to what that future stream of income is worth in present terms, why should a further drop in price be a problem? Of course an investor wants market prices to reflect the actual business economics in the long run. Yet, the participant with a true emphasis on investment should know that a near-term (or even longer) drop in price is a good thing if it represents an increasingly large discount to estimated value.
Some might correctly make the point that the speculator (with a long position) also likes to see value going up. While this is true, the speculator is not concerned with whether there was an actual change in value, or whether emotions, perceptions, or something else has temporarily moved the market price.
The price needs to increase, for whatever reason, just long enough to sell; enduring value is of little concern.
Now, it's not like non-fundamental forces don't potentially help the investor as well. If, for example, the shares happen to temporarily sell at a bigger discount because of psychological factors that can serve the long-term oriented owner very well. Still, favorable investment outcomes mostly come down to what the business itself produces long-term.
It mostly comes down to whether enduring value is created over time.
Prices from time to time in capital markets will go to extremes.*
From an interview with Buffett:
"Basically, it's subjective, but in investment attitude you look at the asset itself to produce the return."
He adds:
"On the other hand if I buy a stock and I hope it goes up next week, to me that's pure speculation."
For the investor it's about the long run core economics of the business.
For the speculator it's the price.
It may not be black and white -- and there's surely plenty of overlap -- but the differences do matter.
Ben Graham long ago expressed concerns that the two distinct activities were becoming blurred.
Also, John Maynard Keynes once wrote:
"If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life, it is by no means always the case that speculation predominates over enterprise. As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase."
Keynes understood that investing was mostly about what an enterprise could produce over time.
(Apparently, for Keynes, the word enterprise and investment were equivalent.)
John Bogle certainly seems to think that speculation and investment has unfortunately become nearly equivalent in the minds of too many.
Keep in mind I'm not suggesting there's something inherently wrong with speculation. Both investment and speculation can be useful in the right proportion. I'd argue the whole system has evolved to overemphasize the latter. Capital markets might just end up functioning in a way that better serves us if the distinction was more broadly appreciated. Considering where we are today, some sensible changes that encourage greater engagement in true investment activities by more participants seems in order.
These days, instead, stock "rental" dwarfs ownership.**
Meaningful improvements to the situation appear very unlikely unless it also occurs at a cultural level. How many today associate the stock market with the convenient ownership of businesses for the long run? I think it's fair to say that many think of it, first and foremost, as a place to speculate on stocks. Change how that question is generally answered and maybe, albeit no doubt slowly, behavioral norms might just change. The emphasis may become more about long-term effects and outcomes; it may become more about wise capital formation and allocation.
Nothing about the current situation is inevitable. That doesn't mean improvements will come easily. Even some modest enhancements in this regard would be a healthy development.
Also, for those who see stocks for what they are -- convenient partial business ownership -- and can resist the temptation to trade frenetically, the fact is it has never been more straightforward and low cost to invest for the long haul.
It's not a good thing that these two distinct activities are now so often viewed as being nearly one and the same. That's not to say there isn't a place for speculation. Trading with an emphasis on the short-term is a necessary and useful element in the capital markets. At least, it is up a point. Just because a certain amount of something is useful doesn't logically mean more of it is even more wonderful. With systems, even relatively simple ones, the right proportion matters.
I mean,take something like a petrol engine. It works just fine with the right amount of air and fuel. Well, at least it does if the ratio remains within a narrow range. Yet, step outside that range and it just doesn't work. So the right amount of fuel is a good thing but, eventually, too much of it begins hurting engine performance.
This is just one less than perfect, but possibly useful, way to think about the implications of excessive speculation.
More from the 2000 Berkshire letter:
"...there are many times when the most brilliant of investors can't muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed. This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination. In cases of this sort, any capital commitment must be labeled speculative.
Now, speculation -- in which the focus is not on what an asset will produce but rather on what the next fellow will pay for it -- is neither illegal, immoral nor un-American. But it is not a game in which Charlie and I wish to play. We bring nothing to the party, so why should we expect to take anything home?
The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money."
There is nothing inherently wrong with speculation but each participant should know where their own true emphasis lies.
Keep in mind that both speculation and investment may utilize fundamental factors to guide their decisions.
So the difference does not necessarily come down to whether the fundamentals influence decision-making. Occasionally, I'll hear or read that someone is a "fundamental investor". Yet their typical holding period will be very short.
Well, that's still mostly speculation in my book. The fact that fundamentals are taken into account does not turn the activity into investment.
There's nothing inherently wrong with speculation but it shouldn't be confused with investment; they're, in fact, two rather distinct activities.
The real problem with speculation is that, for too many, it creates high levels of activity and frictional costs instead of high returns. Lots of effort; modest rewards or losses.
There's nothing wrong with speculation until the vast proportion of market participants are engaged in it.
There's nothing wrong with speculation unless the scale becomes so large that it absorbs lots of capable people who could, instead, be engaged in something more productive and useful.
Come to think of it, there's plenty wrong with amount of speculation these days.
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
Munger: "Cognitive Failure" In Economics
Ignore The Noise: John Bogle on Market Fluctuations
Aesop's Investment Axiom
Margin of Safety & Mr. Market's Mood
On Speculation and Investment
John Bogle: The Clash of the Cultures
Buffett on Gambling and Speculation
Buffett on Speculation and Investment - Part II
Buffett on Speculation and Investment - Part I
Buffett: "Two Types of Assets"
Munger: "Separate Derivatives from the Basic Bridges of Civilization"
Bogle: History and the Classics
"Stock Renters"
Buffett on Aesop's Formula for Value
Michael Porter on Business and Investing
* This inherent moodiness should either be ignored or turned into an advantage. A temporary drop in price even further below well-judged value provides a chance to buy more shares at a discount. The other extreme might offer the opportunity to sell. The tough part is avoid being tempted toward excessive amounts of activity. Otherwise, investment will quickly morph into speculation even with the best intentions. Excessive activity can lead to lots of unnecessary mistakes and frictional costs. Also, equities will always become mispriced, but that doesn't make attempts to reduce the damage these huge distortions can do not worthwhile. The current system seems, at times, a capital misallocation machine. The compounded effect of such things is almost certainly harmful.
** How many drive a rental car with the idea they want to make sure it remains a useful asset for as long as possible? Well, when speculation and short-term oriented traders -- the "renters" -- dominate, maybe some valuable business assets end up being treated much like that rental car. When the intent is to own something for minutes, days, weeks, months, or even a few years, the long-term implications of decisions being made today can take a back seat. Well, even the best businesses face unique challenges and opportunities. More true "owners" would be welcome. The average public company may then just end up with improved governance and executive leadership.
---
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, July 18, 2014
Friday, July 11, 2014
Altria: Timing Isn't Everything
On October 11th, 2007, the S&P 500 reached its intraday pre-crisis peak.
The market as a whole certainly has been on a wild ride since then.
Now, let's consider a stock like Altria (MO).
It also had quite a ride since then -- I mean, few stocks were completely immune to the volatility -- even if it was somewhat less intense than the market as a whole.
Yet let's look at the overall results if Altria had been bought, rather unfortunately, at the peak on October 11th, 2007.
Well, those who purchased Altria's stock on October 11th and hung in there actually experienced a very nice result.
In fact, shares of Altria bought on that far from ideal date produced -- including the substantial reinvested dividends -- an annualized total return of roughly 17%.*
At that rate of return, and over that time frame, the value would have increased to nearly 3x the original investment.
Not a bad result considering that the starting point was on what was a very inopportune day. Naturally, some additional buying as the crisis unfolded -- as the stock price was getting cheaper -- could have only improved the result.
Of course, Altria's stock wasn't going to be immune to the nasty market price action that arose during the financial crisis, but the increasingly cheap shares were an ally to the long-term oriented owner. In fact, it was beneficial to continuing shareholders even if -- other than dividend reinvestments and buybacks -- no incremental purchases were made as the shares became cheaper.
Additional purchases by a continuing shareholder, at the temporarily reduced prices, would naturally also have been beneficial.
The point is that the lower prices can be a benefit, through the wise use of a company's excess capital, even if the shareholder decides to NOT purchase incremental shares.
(A dividend, of course, is excess capital produced by the company that's distributed to the owners but, unlike excess capital used for buybacks, the decision to invest in more shares must be made by each individual shareholder.)
The key is that market prices became reduced but per share intrinsic value did not. That's a very good combination for long-term owners. It is a permanent and substantial drop in per share intrinsic value that creates a real problem for investors.
More on this in a bit.
First, some context is in order.
Altria produced a 19.88% annual return (incl. reinvested dividends) over a roughly fifty year period that ended in 2006.
A 19.88% return over such a time horizon will turn a $ 10,000 initial investment into over $ 80 million.
The stock, including the impact of reinvested dividends, has -- much like what happened since October 2007 though not surprisingly somewhat better -- more than tripled since the end of 2006.
So that would put the tally on the initial $ 10,000 investment at something close to ~ $ 280 million. The power of compounding and a long time horizon.
There are, in my view, reasons why future results likely won't be nearly as favorable for Altria. Some of this comes down to whether the shares will again sell at a low earnings multiple. As it stands now, that's not the case. The stock often has sold at a low multiple over the decades and that had a lot to do with the investment outcome.
(While I intend to remain a long-term Altria shareholder, additional shares in the company are of little to no interest near current prices.)
Still, lots of useful investment lessons can be learned from Altria -- some of them counterintuitive -- then applied elsewhere if the opportunity arises.
Even if the stock itself happens to be of little interest, it can serve as a useful investment case study.
At least that is my view.
Some will argue, maybe correctly, that eventually all the things working against Altria (legal and regulatory risks, taxation, volume declines etc.) are finally going to catch up with the company and its investors.
It's also possible, however, that many of the inherent business strengths continue to at least mostly be there.
Now, lets get back to market prices, intrinsic values, and the implications for long-term investors. A big part of the explanation for Altria's high returns over the decades is that the stock was often rather cheap (price < intrinsic value). That resulted in per share intrinsic value growing faster than the overall intrinsic business value. How? Well, in effect, the less patient -- shorter term oriented -- owners and traders were transferring a portion of the per share intrinsic value to continuing owners over time. This intrinsic value transfer happened because they were consistently selling their shares at a discount to value. This meant, over time, that additional shares could be accumulated below -- maybe even far below -- per share intrinsic value through corporate buyback activity as well as dividend reinvestments.
(Buybacks can make sense when both more than sufficient funds are available to meet all operational/liquidity needs of a business AND the stock is cheap. The decision to pay a dividend -- by the board/management -- should come down to whether the business needs are covered while the decision to reinvest that dividend -- by the investor -- should be based on whether shares sell at a discount to value.)
Well, that transferred value doesn't just disappear, it ends up in the hands of continuing owners, and boosts total return.
Again, as noted above, the long-term investor in Altria could also decide from time to time to accumulate additional shares whenever they became cheap and it made sense in the context of the overall portfolio.
Yet, lacking incremental purchases, the dividend reinvestments and buybacks alone can benefit the long-term oriented owner greatly if the stock often sells nicely below per share intrinsic value.
This is how per share performance can exceed business performance, and sometimes to a substantial degree. Altria's businesses did just fine; its shares did even better.
The compounded effect is not at all a small one. It does allow per share intrinsic business value to outrun overall intrinsic business value. The power of this dynamic is, at least at times, more than a little underappreciated. It at least begins to explain the gap that can exist between business performance and stock price performance.
So, for long-term owners, the low prices that came about as a result of the financial crisis were a very good thing. Returns since 2007 were enhanced greatly by that drop in the stock price. This is why the price declines were actually an "ally" to those in it for the long haul. At the very least, something to consider the next time a sound long-term investment goes up in price in the near-term (or even intermediate-term).
Most end up feeling pretty good when they see their stock going up.
That's actually not the logical reaction unless one is, in fact, selling soon.
Unfortunately, Altria's shares are much more fully priced these days. If this situation were to persist going forward -- or worse, become priced even more highly relative to per share intrinsic business value -- it would lead to, all else equal, reduced future returns.
It's understandably tough to convince traders to think this way.
It should be easier to convince those with much longer time horizons but, well, it's just not.
Beyond the often low stock price relative to earnings power (and intrinsic value), these high equity returns also came down to the company's historic competitive advantages, and attractive core economics, across many of its businesses.
(Which, of course, once included food products and international tobacco products.)
These advantages contributed to pricing power and high returns on capital.
That pricing power, at least up to now, has generally made up for long-standing volume declines in Altria's core smokeable products business.**
Volume declines that have been substantial since 2007 alone, and, well, are generally expected to continue. For Altria in its current form, only U.S. volumes have been relevant since the Philip Morris International (PM) spin-off.
In any case, exciting growth is mostly not at all behind these results; it's just not a big part of the story.
Quite the opposite.
The question is whether Altria still possesses inherent advantages that will mostly persist going forward. The volume declines likely aren't going away anytime soon. The company -- other than the SABMiller (SBMRY) stake -- no longer has meaningful exposure to international markets. At some point will these things hurt investors? Will technology (e-cigarettes) change the competitive landscape and, more importantly, the business economics? A new technology can be an opportunity but doesn't only offer economic upside. Fundamental change can just as easily cut the other way; it can upset what had previously been excellent and sustainable business economics. So the future could offer a very different set of circumstances for Altria. As with any investment these kind of things must be considered. Of course, the future need not be quite as favorable as the past for the risk versus reward to still make sense.
At least if the price is right; if the value can still be estimated within a narrow enough range; if, going forward, the stock often sells at a discount to value so continuing owners can benefit from the intrinsic value transfer.
Altria's long-term past performance promises nothing about the future, of course. Still, the dynamics and factors that created the outcome, at the very least, seem well worth understanding.
So the assumption that growth is a required ingredient for high returns just isn't correct. For investors, this mistaken assumption can be costly.
How could growth not be a good thing? Well, sometimes growth is a very good thing. It's just not always a good thing.
Some seem to assume that all growth is of the high return variety.
Some seem to assume that the only road to high returns comes in the form of high growth.
Neither assumption is necessarily correct.
It's also clearly not about the timing; it's about how price compares to well-judged value, and how that value is likely to change -- considering the specific risks -- over the longer run; it's about identifying businesses that can maintain attractive core economics.
In other words, getting the price versus value judgment mostly right is difficult enough. Attempting to also time things consistently well can lead to unnecessary mistakes. The addition of timing to the equation is a distraction that's easy to do mostly in theory. Even if there surely are exceptions, it seems that more talk (or write) about timing things well than actually get results this way. Well, building an approach based upon the exception seems hardly wise. I'm guessing some who tried to cleverly time things -- who were given many chances to own sensible things at big discounts -- might now be having a rather difficult time finding stocks to buy. In fact, they may now be chasing things that are no longer selling with a sufficient margin of safety (or worse).
At a minimum, some skepticism is more than a little warranted when it comes to those who claim they can time things in a consistently effective way.
On the other hand, it is possible to turn the market dynamics -- sometimes driven by cognitive and emotional factors but barely related to economic value -- that tend to move prices near-term into an advantage. When something that was already cheap gets temporarily even cheaper this is hardly a disaster. The same goes for something originally bought cheap that goes to the other extreme.
Otherwise, better to ignore the near-term noise.
More in a follow-up.
Adam
Long positions in MO and PM established at much lower than recent market prices. As noted above, no intent to buy or sell near current prices.
Other related posts:
Altria: Timing Isn't Everything, Part II - Jul 2014 (follow-up)
The Growth Trap: IBM vs Standard Oil - Jun 2014
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
Boring Stocks - Jun 2013
Aesop's Investment Axiom - February 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
The Quality Enterprise, Part II - Aug 2012
The Quality Enterprise - 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
Consumer Staples: Long-term Performance, Part II - Dec 2011
Consumer Staples: Long-term Performance - Dec 2011
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Defensive Stocks Revisited - Mar 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Altria Outperforms...Again - Oct 2010
Altria vs Coca-Cola - Jul 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
GM vs Philip Morris (Altria) - Apr 2009
Defensive Stocks? - Apr 2009
* The Philip Morris International (PM) spin-off needs to be accounted for the get the return calculation correct. In other words, actual returns would naturally depend on whether or not the Philip Morris International shares were sold after the spin-off. It actually did work out somewhat better so far -- excluding tax implications -- if Philip Morris International shares had been sold and the proceeds were used to buy more Altria shares. Yet, either way, the investment outcome worked out just fine. Also, the two stocks have different risks that have to be considered. Keep in mind that these return numbers don't account for tax considerations.
** Smokeable products is the biggest driver of value for Altria in its current form. Smokeless products and the SABMiller (SBMRY) stake also make meaningful contributions to value. Wine is a very small contributor. Before the Kraft and Philip Morris International spin-offs, food products and international tobacco products were once a big part of the story.
----
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 market as a whole certainly has been on a wild ride since then.
Now, let's consider a stock like Altria (MO).
It also had quite a ride since then -- I mean, few stocks were completely immune to the volatility -- even if it was somewhat less intense than the market as a whole.
Yet let's look at the overall results if Altria had been bought, rather unfortunately, at the peak on October 11th, 2007.
Well, those who purchased Altria's stock on October 11th and hung in there actually experienced a very nice result.
In fact, shares of Altria bought on that far from ideal date produced -- including the substantial reinvested dividends -- an annualized total return of roughly 17%.*
At that rate of return, and over that time frame, the value would have increased to nearly 3x the original investment.
Not a bad result considering that the starting point was on what was a very inopportune day. Naturally, some additional buying as the crisis unfolded -- as the stock price was getting cheaper -- could have only improved the result.
Of course, Altria's stock wasn't going to be immune to the nasty market price action that arose during the financial crisis, but the increasingly cheap shares were an ally to the long-term oriented owner. In fact, it was beneficial to continuing shareholders even if -- other than dividend reinvestments and buybacks -- no incremental purchases were made as the shares became cheaper.
Additional purchases by a continuing shareholder, at the temporarily reduced prices, would naturally also have been beneficial.
The point is that the lower prices can be a benefit, through the wise use of a company's excess capital, even if the shareholder decides to NOT purchase incremental shares.
(A dividend, of course, is excess capital produced by the company that's distributed to the owners but, unlike excess capital used for buybacks, the decision to invest in more shares must be made by each individual shareholder.)
The key is that market prices became reduced but per share intrinsic value did not. That's a very good combination for long-term owners. It is a permanent and substantial drop in per share intrinsic value that creates a real problem for investors.
More on this in a bit.
First, some context is in order.
Altria produced a 19.88% annual return (incl. reinvested dividends) over a roughly fifty year period that ended in 2006.
A 19.88% return over such a time horizon will turn a $ 10,000 initial investment into over $ 80 million.
The stock, including the impact of reinvested dividends, has -- much like what happened since October 2007 though not surprisingly somewhat better -- more than tripled since the end of 2006.
So that would put the tally on the initial $ 10,000 investment at something close to ~ $ 280 million. The power of compounding and a long time horizon.
There are, in my view, reasons why future results likely won't be nearly as favorable for Altria. Some of this comes down to whether the shares will again sell at a low earnings multiple. As it stands now, that's not the case. The stock often has sold at a low multiple over the decades and that had a lot to do with the investment outcome.
(While I intend to remain a long-term Altria shareholder, additional shares in the company are of little to no interest near current prices.)
Still, lots of useful investment lessons can be learned from Altria -- some of them counterintuitive -- then applied elsewhere if the opportunity arises.
Even if the stock itself happens to be of little interest, it can serve as a useful investment case study.
At least that is my view.
Some will argue, maybe correctly, that eventually all the things working against Altria (legal and regulatory risks, taxation, volume declines etc.) are finally going to catch up with the company and its investors.
It's also possible, however, that many of the inherent business strengths continue to at least mostly be there.
Now, lets get back to market prices, intrinsic values, and the implications for long-term investors. A big part of the explanation for Altria's high returns over the decades is that the stock was often rather cheap (price < intrinsic value). That resulted in per share intrinsic value growing faster than the overall intrinsic business value. How? Well, in effect, the less patient -- shorter term oriented -- owners and traders were transferring a portion of the per share intrinsic value to continuing owners over time. This intrinsic value transfer happened because they were consistently selling their shares at a discount to value. This meant, over time, that additional shares could be accumulated below -- maybe even far below -- per share intrinsic value through corporate buyback activity as well as dividend reinvestments.
(Buybacks can make sense when both more than sufficient funds are available to meet all operational/liquidity needs of a business AND the stock is cheap. The decision to pay a dividend -- by the board/management -- should come down to whether the business needs are covered while the decision to reinvest that dividend -- by the investor -- should be based on whether shares sell at a discount to value.)
Well, that transferred value doesn't just disappear, it ends up in the hands of continuing owners, and boosts total return.
Again, as noted above, the long-term investor in Altria could also decide from time to time to accumulate additional shares whenever they became cheap and it made sense in the context of the overall portfolio.
Yet, lacking incremental purchases, the dividend reinvestments and buybacks alone can benefit the long-term oriented owner greatly if the stock often sells nicely below per share intrinsic value.
This is how per share performance can exceed business performance, and sometimes to a substantial degree. Altria's businesses did just fine; its shares did even better.
The compounded effect is not at all a small one. It does allow per share intrinsic business value to outrun overall intrinsic business value. The power of this dynamic is, at least at times, more than a little underappreciated. It at least begins to explain the gap that can exist between business performance and stock price performance.
So, for long-term owners, the low prices that came about as a result of the financial crisis were a very good thing. Returns since 2007 were enhanced greatly by that drop in the stock price. This is why the price declines were actually an "ally" to those in it for the long haul. At the very least, something to consider the next time a sound long-term investment goes up in price in the near-term (or even intermediate-term).
Most end up feeling pretty good when they see their stock going up.
That's actually not the logical reaction unless one is, in fact, selling soon.
Unfortunately, Altria's shares are much more fully priced these days. If this situation were to persist going forward -- or worse, become priced even more highly relative to per share intrinsic business value -- it would lead to, all else equal, reduced future returns.
It's understandably tough to convince traders to think this way.
It should be easier to convince those with much longer time horizons but, well, it's just not.
Beyond the often low stock price relative to earnings power (and intrinsic value), these high equity returns also came down to the company's historic competitive advantages, and attractive core economics, across many of its businesses.
(Which, of course, once included food products and international tobacco products.)
These advantages contributed to pricing power and high returns on capital.
That pricing power, at least up to now, has generally made up for long-standing volume declines in Altria's core smokeable products business.**
Volume declines that have been substantial since 2007 alone, and, well, are generally expected to continue. For Altria in its current form, only U.S. volumes have been relevant since the Philip Morris International (PM) spin-off.
In any case, exciting growth is mostly not at all behind these results; it's just not a big part of the story.
Quite the opposite.
The question is whether Altria still possesses inherent advantages that will mostly persist going forward. The volume declines likely aren't going away anytime soon. The company -- other than the SABMiller (SBMRY) stake -- no longer has meaningful exposure to international markets. At some point will these things hurt investors? Will technology (e-cigarettes) change the competitive landscape and, more importantly, the business economics? A new technology can be an opportunity but doesn't only offer economic upside. Fundamental change can just as easily cut the other way; it can upset what had previously been excellent and sustainable business economics. So the future could offer a very different set of circumstances for Altria. As with any investment these kind of things must be considered. Of course, the future need not be quite as favorable as the past for the risk versus reward to still make sense.
At least if the price is right; if the value can still be estimated within a narrow enough range; if, going forward, the stock often sells at a discount to value so continuing owners can benefit from the intrinsic value transfer.
Altria's long-term past performance promises nothing about the future, of course. Still, the dynamics and factors that created the outcome, at the very least, seem well worth understanding.
So the assumption that growth is a required ingredient for high returns just isn't correct. For investors, this mistaken assumption can be costly.
How could growth not be a good thing? Well, sometimes growth is a very good thing. It's just not always a good thing.
Some seem to assume that all growth is of the high return variety.
Some seem to assume that the only road to high returns comes in the form of high growth.
Neither assumption is necessarily correct.
It's also clearly not about the timing; it's about how price compares to well-judged value, and how that value is likely to change -- considering the specific risks -- over the longer run; it's about identifying businesses that can maintain attractive core economics.
In other words, getting the price versus value judgment mostly right is difficult enough. Attempting to also time things consistently well can lead to unnecessary mistakes. The addition of timing to the equation is a distraction that's easy to do mostly in theory. Even if there surely are exceptions, it seems that more talk (or write) about timing things well than actually get results this way. Well, building an approach based upon the exception seems hardly wise. I'm guessing some who tried to cleverly time things -- who were given many chances to own sensible things at big discounts -- might now be having a rather difficult time finding stocks to buy. In fact, they may now be chasing things that are no longer selling with a sufficient margin of safety (or worse).
At a minimum, some skepticism is more than a little warranted when it comes to those who claim they can time things in a consistently effective way.
On the other hand, it is possible to turn the market dynamics -- sometimes driven by cognitive and emotional factors but barely related to economic value -- that tend to move prices near-term into an advantage. When something that was already cheap gets temporarily even cheaper this is hardly a disaster. The same goes for something originally bought cheap that goes to the other extreme.
Otherwise, better to ignore the near-term noise.
More in a follow-up.
Adam
Long positions in MO and PM established at much lower than recent market prices. As noted above, no intent to buy or sell near current prices.
Other related posts:
Altria: Timing Isn't Everything, Part II - Jul 2014 (follow-up)
The Growth Trap: IBM vs Standard Oil - Jun 2014
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
Boring Stocks - Jun 2013
Aesop's Investment Axiom - February 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
The Quality Enterprise, Part II - Aug 2012
The Quality Enterprise - 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
Consumer Staples: Long-term Performance, Part II - Dec 2011
Consumer Staples: Long-term Performance - Dec 2011
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Defensive Stocks Revisited - Mar 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Altria Outperforms...Again - Oct 2010
Altria vs Coca-Cola - Jul 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
GM vs Philip Morris (Altria) - Apr 2009
Defensive Stocks? - Apr 2009
* The Philip Morris International (PM) spin-off needs to be accounted for the get the return calculation correct. In other words, actual returns would naturally depend on whether or not the Philip Morris International shares were sold after the spin-off. It actually did work out somewhat better so far -- excluding tax implications -- if Philip Morris International shares had been sold and the proceeds were used to buy more Altria shares. Yet, either way, the investment outcome worked out just fine. Also, the two stocks have different risks that have to be considered. Keep in mind that these return numbers don't account for tax considerations.
** Smokeable products is the biggest driver of value for Altria in its current form. Smokeless products and the SABMiller (SBMRY) stake also make meaningful contributions to value. Wine is a very small contributor. Before the Kraft and Philip Morris International spin-offs, food products and international tobacco products were once a big part of the story.
----
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, July 4, 2014
Buffett & Munger on Compensation - Part II
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)
"...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, 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.
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