Friday, December 26, 2014

Quotes of 2014

A collection of quotes said or written at some point during this calendar year.

In a review of the book: Fortune Tellers, James Grant offered the following on the limitations of forecasting and predictions:

Henry Singleton: Why Flexibility Beat Long-Range Planning

"Henry Singleton (1916-99), longtime chief executive officer of the technology conglomerate Teledyne Inc...understood the limits of forecasting. Once a Business Week reporter asked him if he had a long-range plan. No, Singleton replied, 'we're subject to a tremendous number of outside influences and the vast majority of them cannot be predicted. So my idea is to stay flexible.' His plan was to bring an open mind to work every morning." - James Grant

Some thoughts from Warren Buffett on Berkshire Hathaway's (BRKa) intrinsic value and buybacks:

Intrinsic Value

"As I've long told you, Berkshire's intrinsic value far exceeds its book value. Moreover, the difference has widened considerably in recent years. That's why our 2012 decision to authorize the repurchase of shares at 120% of book value made sense. Purchases at that level benefit continuing shareholders because per-share intrinsic value exceeds that percentage of book value by a meaningful amount. We did not purchase shares during 2013, however, because the stock price did not descend to the 120% level. If it does, we will be aggressive.

Charlie Munger, Berkshire's vice chairman and my partner, and I believe both Berkshire's book value and intrinsic value will outperform the S&P in years when the market is down or moderately up. We expect to fall short, though, in years when the market is strong – as we did in 2013. We have underperformed in ten of our 49 years, with all but one of our shortfalls occurring when the S&P gain exceeded 15%." - Warren Buffett

Sometimes, the ability to calculate extremely well can be an obvious advantage yet also a blind spot. Earlier this year, in a review of the book Brilliant Blunders, Freeman Dyson offered up Lord Kelvin as an example. Dyson describes "Kelvin's wrong calculation of the age of the earth" as resulting from "blindness to obvious facts." He attributes the misjudgment, at least in part, to Kelvin's exceptional math skills. In other words, too much focus on what can be calculated without due consideration for other, more important, less quantifiable factors can lead to avoidable misjudgments/incorrect conclusions. This can be as relevant to investment decision-making as it is to the development of scientific theory.*

On the downside of calculating too much:

Intrinsic Value

"Kelvin lacked our modern knowledge of the structure and dynamics of the earth, but he could see with his own eyes the eruptions of volcanoes bringing hot liquid from deep underground to the surface. His skill as a calculator seems to have blinded him to messy processes such as volcanic eruptions that could not be calculated." - Freeman Dyson

Here's Buffett on some of the fundamental elements of investing:

Buffett on Farms, Real Estate, and Stocks

"You don't need to be an expert in order to achieve satisfactory investment returns. But if you aren't, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don't swing for the fences. When promised quick profits, respond with a quick 'no.'" - Warren Buffett

"Focus on the future productivity of the asset you are considering. If you don't feel comfortable making a rough estimate of the asset's future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility. But omniscience isn't necessary; you only need to understand the actions you undertake." - Warren Buffett

"If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so. Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game." - Warren Buffett

"Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays." - Warren Buffett

"...macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle's scathing comment: 'You don't know how easy this game is until you get into that broadcasting booth.')" - Warren Buffett

Below, Warren Buffett and Charlie Munger offer some views on retail businesses:

Buffett and Munger Talk Retail Businesses, Nebraska Furniture Mart, and Amazon

MUNGER: I think Warren and I can match anybody's failures in retail.

BUFFETT: Yeah, we have a really bad record, starting in 1966. We bought what we thought was a second-rate department store in Baltimore at a third-rate price, but we found out very quickly that we bought a fourth-rate department store at a third-rate price. And we failed at it, and we failed...

MUNGER: Quickly.

BUFFETT: Yeah, quickly. That's true. We failed other times in retailing. Retailing is a tough, tough business, partly because your competitors are always attempting and very frequently successfully attempting to copy anything you do that's working. And so the world keeps moving. It's hard to establish a permanent moat that your competitor can't cross. And you've seen the giants of retail...a lot of giants have been toppled.

MUNGER: Most of the giants of yesteryear are done.

More specifically, here's how they view Amazon (AMZN):

MUNGER: Well, I think it's very disruptive compared to everybody else, I think it's a formidable model that is going to change America.

BUFFETT: I agree. It's one of the most powerful models that I've seen in a lifetime, and it's being run by a fellow that has had a very clear view of what he wants to do, and does it every day when he goes to work, and is not hampered by external factors like people telling him what he should earn quarterly or something of the sort. And ungodly smart, focused. He's really got a powerful business, and he's got satisfied customers. That's hugely important.

More in a follow-up.

Adam

Long position in BRKb established at much lower prices. No position in AMZN.

Quotes of 2013 Part I & II

* Here's how Charlie Munger explained it at the 2002 Wesco annual meeting: "Organized common (or uncommon) sense -- very basic knowledge -- is an enormously powerful tool. There are huge dangers with computers. People calculate too much and think too little."

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

Friday, December 19, 2014

Should Buffett Buy Uber?

A recent Fortune article made the case for something that at first glance seems rather unlikely. In it, Dan Primack argues that Warren Buffett should consider buying Uber. With this in mind and for context, let's look at some things Buffett has written over the years. Back in 2007, Berkshire Hathaway's (BRKa) four largest equity investments were Coca-Cola (KO) Wells Fargo (WFC), American Express (AXP), P&G (PG).

Here's what he had to say about those investments:

"...note that American Express and Wells Fargo were both organized by Henry Wells and William Fargo, Amex in 1850 and Wells in 1852. P&G and Coke began business in 1837 and 1886 respectively. Start-ups are not our game." - From the 2007 Berkshire letter

Three of those stocks remain top four holdings. More recently (over the past five years or so) some of Buffett's bigger purchases -- everything from partial ownership via equities to outright acquisitions -- have included things like Burlington Northern Santa Fe, Lubrizol, IBM (IBM), Heinz, Exxon Mobil (XOM), and Duracell. The youngest of these businesses is 86 years old. So, to say the very least, Buffett generally likes businesses with a very long track record that are less likely to experience major change* -- especially the kind of change that fundamentally alters the core business economics -- going forward.

"In studying the investments we have made in both subsidiary companies and common stocks, you will see that we favor businesses and industries unlikely to experience major change. The reason for that is simple: Making either type of purchase, we are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek." - From the 1996 Berkshire letter

So Uber would be a rather significant break, I think it's fair to say, from Berkshire's traditional approach.  Startups -- even very successful ones -- that compete in a rapidly changing environment isn't usually a part of the Berkshire playbook. Yet you never know. If the price was right, maybe something that now seems rather improbable could suddenly make a whole lot of sense.

The fact is that there have been many great businesses launched -- and Uber just might prove to be one of them though, at this point, I have no idea -- during the period that Buffett has been managing Berkshire (roughly five decades).

Berkshire's success over that time -- a 693,518% total return through the end of last year -- has essentially come from none of them.**

Many more great businesses will no doubt be created in the coming decades.

It seems likely they also won't be contributing much to Berkshire's intrinsic value going forward.

If nothing else, Berkshire's approach shows that attractive investment results do not necessarily depend on some unusual acuity for finding the next big thing. Exciting growth prospects and dynamic change might, in fact, offer the possibility for big investment gains. The problem is they also sometimes offer the chance to lose a whole lot of money. Big wins and big losses usually reside in the same neighborhood. They can be tough to reliably tell apart beforehand without making large mistakes.

This is not only due to unpredictable future prospects and a wide range of possible outcomes; this is also because the price one usually has to pay upfront for the most promising businesses is rather high.

Insufficient margin of safety.

Of course, some might be able to reliably pick the big winners, but it's easy to underestimate how difficult this is to do without also incurring big losses.

That may offer a more exciting ride but it's the net result, in the context of risk, that matters.

Owning businesses that can maintain attractive economics for decades, bought at a reasonable price or, better yet, at a meaningful discount to a conservative estimate of value, isn't a bad way to balance risk and reward. Exciting growth prospects not required.

Almost any business -- even a very good one -- will eventually experience real difficulties and unexpected challenges. Buffett's approach is, in part, an attempt to reduce the likelihood that investment results will be ruined by what are almost inevitable future business challenges.

"It's vital, however, that we recognize the perimeter of our 'circle of competence' and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses." - From the 2013 Berkshire Hathaway letter

So, even with such an approach, mistakes will still get made.

Just because a particular business has succeeded for a very long time guarantees absolutely nothing.

Adam

Long positions in all common stocks mentioned excluding XOM

* This is not meant to be an all-inclusive list of Berkshire's more recent investment activity but, instead, just some good examples of the larger moves that have been made. Burlington Northern's historical lineage dates back to the late 1840s. Heinz was founded in 1869. Exxon was formed in 1870. IBM was founded in 1911. Duracell began in 1916. Lubrizol was founded in 1928. The names may have changed over time but all of these go back quite a ways. Naturally, all of these businesses have dealt with change over time but the question is how likely those changes will damage business economics. IBM would seem to fit the least well when it comes down to whether its business is likely to experience major change going forward. The Heinz investment is made up of common stock, warrants, and preferred shares. Berkshire also made a large investment in Bank of America (BAC) preferred stock and warrants. It won't be clear for some time how much BofA common stock Berkshire will end up owning though at this point it appears that it will be substantial. Once again, the bank isn't exactly a startup.
** This total return over five decades or so means that $ 10,000 invested in Berkshire would have grown to just under $ 70 million.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, December 12, 2014

Wide Moat Businesses at the Right Price

For equity investors, it's not enough that a business currently possesses real competitive advantages if those advantages can't be sustained and, better yet, even strengthened over time.

Warren Buffett explained it this way in the 2007 Berkshire Hathaway (BRKa) shareholder letter:

"A truly great business must have an enduring 'moat' that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business 'castle' that is earning high returns."

An enduring 'moat' can come from things like an ongoing cost advantage or a strong brand that creates pricing power. Buffett later adds:

"Our criterion of 'enduring' causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism's 'creative destruction' is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all."

That the 'moat' remains robust -- and, in fact, is made even stronger -- requires that management isn't too distracted by short-term goals in lieu of what Buffett calls 'widening the moat'. A management who chooses the former over the latter can do real and permanent damage.

From the 2005 letter:

"Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous.

When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as 'widening the moat.'"

A business might currently have -- or appear to have -- a decent (or better) competitive advantages, but what those advantages will look like further down the road is questionable or difficult to understand. Well, big investment mistakes can get made when that's the case. If the moat that now exists will be meaningfully reduced, or worse, disappear altogether, then the estimate of intrinsic value has a great chance of being very wrong. When attractive core economics today become much less so later on, misjudgments regarding current valuation -- and how valuation will change over time -- are more likely. An unreliable moat means that, as time passes, future free cash flows become increasingly uncertain. The result possibly being poor investment results or even permanent capital loss.

Exciting growth rates may not prove to be worth much if the moat collapses sooner than expected.

So quality businesses are those with advantages that are obvious, sustainable, and can be strengthened by competent management over time. A management who knows how to enhance whatever advantages exist, smooth out the important imperfections, and ultimately make the business tougher to dislodge from what is already an enviable position, can create a lot of long-term value.

The very best businesses can comfortably withstand mediocre (or worse) business leadership from time to time even if some real, at the very least temporary but possibly permanent, economic damage is caused by their actions (and maybe inactions).

Yet, as always, shares of even the best business needs to bought at a large enough discount to value to protect the investor from what is necessarily an uncertain future.

How price compares to a conservative estimate of value is one way -- though this has its limits -- to manage the unknown and often unknowable future risks. Always buying at a comfortable discount -- and what will be comfortable is necessarily stock specific -- protects, up to a point, against what might go wrong. Most of the time it's just not possible for me to come up with a reliable estimate of per share valuation for a particular stock. Well, at least not within a narrow enough range. This could be due to my own limitations or the characteristics of the business itself.

Either way, the right course of action will always be to stay well clear of any investment alternative where per share value within a range isn't obvious. The good news is that the investor always has the option of moving onto something else that's more understandable. For most stocks, it is simple avoidance that will be the way to go. The possibility of permanent capital loss is best reduced by paying an appropriately discounted price, considering the specific risks, for well understood businesses where per share intrinsic value can be estimated with high levels of confidence.

Buying the highest quality businesses -- those that generally have the very widest moats -- feels safer and certainly can be. At least that's the case if the price is right. In the late 1990s -- as well as with the so-called Nifty Fifty of the early 1970s -- some very good businesses became riskier to buy simply because of the extremely high prices relative to per share intrinsic value. Many still produced good investment results over the very long run but, since none of us have the luxury of investing with a rear-view mirror, paying such high prices did not offer much protection against what might go wrong. Just because it worked out that time tells you nothing about what's in store in the coming decades.

That's why margin of safety is such a fundamental investing principle.

In a 2007 memo, Howard Marks wrote the following:

"...the history that took place is only one version of what it could have been."

So that means "the relevance of history to the future is much more limited than may appear to be the case."

Shares of a merely decent business -- one with a moat though it may not be particularly wide -- bought at a huge discount to intrinsic value can actually be safer than the best businesses selling at a substantial premium. Still, all else equal and with the long-term in mind, I'd generally rather buy the higher quality businesses at merely reasonable prices than the lesser businesses with seemingly much bigger discounts. It's a matter of balancing the risk of permanent loss with potential reward.

The more uncertain something is, the bigger the discount to value one should pay. The tough part is that it's impossible to quantify all the risks. Judgment calls have to be made without precise numbers to rely on.

In a recent memo, Howard Marks wrote that the estimation of risk "will by necessity be subjective, imprecise and more qualitative than quantitative (even if it's expressed in numbers)."

I mentioned above that price has its limits when it comes balancing risk and reward. At times, the worst case scenario is so unacceptable that avoiding an investment with otherwise lots of potential upside is the right course of action. In other words no price will be low enough.

Later in the same memo, Marks offered the example of not wanting to be a skydiver who's successful just 95% of the time. With this in mind I added the following in a prior post:

That's a useful way to think about it. The outcome 5% of the time is just unacceptable no matter how good things go the other 95% of the time. There will be times where there's just no way to know the range of possible outcomes (sometimes due to investor limitations, sometimes due to external factors). The risk versus reward may in fact be very favorable, but it's just not clear so decisive action cannot be taken.

Otherwise, the price paid often dictates the risks that are taken. If a high quality business is selling at 50x earnings -- or maybe even 100x earnings -- it is possibly far riskier than a decent business with some real challenges and little or no growth selling at 5x normalized earnings. The decent business may lack a compelling 'story' but, then again, the 'story' is often just a distraction from what really matters when it comes to investment risk and reward.

Again, this works only up to a point because many moat-less businesses are to be avoided altogether -- because of the worst case downside -- no matter how cheap they seem to be.

Notice that growth hasn't been mentioned at all. Growth can be an important ingredient but it is just not necessarily an important ingredient.

Adam

Long position in BRKb established at much lower than recent market prices

Related posts:
Howard Marks on Risk
Risk and Reward Revisited
Buffett on Risk and Reward
Nifty Fifty - Part II
Nifty Fifty
Buffett on Widening the Moat

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

Friday, December 5, 2014

Investors Overestimate Their Own Returns

So it turns out that market participants have a tendency to overestimate their own investment results.

I found this particular bias very surprising -- much more so than the many other common investing biases -- when I first came across it. I mean, how could it be that the overestimation of returns is a pervasive problem? Well, it apparently occurs quite a lot. Maybe others are less surprised by the tendency, but it's certainly far more prevalent than I would have expected.

Jason Zweig recently pointed out that "nearly 90% of investors exaggerated their returns and that many who thought they had beaten the market had been beaten by it."

This is based on some research that was done in the late 1990s.

More recent research offered a similar conclusion. It points out that investor experience does reduce "the simple mathematical error of estimating portfolio returns, but seems not to influence their behavioral mistakes pertaining to how good (in absolute sense or relative to other investors) they are."

So experience matters but in a rather limited way. In fact, it showed that investors overestimate their returns and not by a small amount. It turns out that investors actually overestimated their own returns by greater than 11 percent each year.*

Every study has its limits, of course, but this is at least an indication that many do far worse than they think.

What makes this behavior tough to alter? Well, a tendency to believe that overestimating investment results is a bias that others have is certainly a contributing factor.

Here's how one study explains what's known as bias blind spot:**

"...individuals see the existence and operation of cognitive and motivational biases much more in others than in themselves."

A separate study describes it this way:

"Bias turns out to be relatively easy to recognize in the behaviors of others, but often difficult to detect in one's own judgments."

It would seem like that what leads investors to overestimate their returns should be easy to avoid but, well, it's apparently just not.

Awareness alone will hardly combat the tendency but it's a start.

An objective measurement system for the complete portfolio against an appropriate benchmark with an emphasis on the long-term might be helpful but, as the study above points out, this isn't strictly a measurement problem. It's important that things are NOT compartmentalized into separate buckets. In other words, if money was lost on something speculative, for example, it counts. Whether highly speculative or not, it's a permanent capital loss. Some also might choose to recognize gains while ignoring certain losses. It all naturally counts.***

So why do investors tend to not judge their own performance objectively?

Well, some suggest that market participants -- especially those who are very active -- may act this way to make themselves feel better about their results and to justify all the effort. They choose to selectively remember the most lucrative moves they've made while ignoring those that were less so. Whatever the reasons, if better understood by participants it just might lead to changes in behavior and, ultimately, a more realistic assessment of results.

In this article, Professor Terrance Odean said that even when investors "are not better than average, they pretty much have to believe they are just in order to do what they are doing, to be active investors."

It's not that temporary losses in the short run -- and sometimes even over the intermediate run -- are necessarily a problem. In fact, temporary losses are pretty much inevitable even for those who are very good at investing in equities. It's that, in order to measure results in a meaningful way, the poor performers -- especially those that are likely to become either permanent losses or produce subpar results over the long run -- can't be ignored.

Yet that's what some choose to do in order to make themselves feel better about their overall results.

Here's how Professor Meir Statman explained it later in the same article.

"The people who like to trade, who want to trade or who feel better when they are trading, they will look at their numbers in a way that justifies" continuing to trade.

Statman also said:

"They're going to justify it and they will sound logical -- at least to themselves..."

Feeling better and justifying doesn't change the fact that the results are subpar. Allowing oneself to be fooled in this way is a terrible way approach such a serious thing.

There are other ways of compartmentalizing, in order to feel better about results, even if it increasingly torches reality. For example, choosing to not include cash in the total return calculation. Well, all the investable cash counts whether it happens to be invested at any particular time or not. If a fund manager sits on some extra cash for whatever reason, whether it turns out to be wise or not, that directly impacts total return. It is counted -- and very much should be counted -- in the total return calculation. This is done whether being in more cash leads to a favorable outcome or not. The same thing applies for the rest of us if relative and absolute results are to be objectively measured.

"The first principle is that you must not fool yourself -- and you are the easiest person to fool." - Richard Feynman

So setting up an objective way to measure sounds easy enough but much of the above research more than suggests it's not.

I'd add that it's also important to not measure results over shorter time horizons. How someone has performed over one or three years -- and especially less than that -- should be of little interest. The problem here is that it might be a very long time before the results reveal it wasn't worth all the trouble.

In any case, if after a reasonable period of time an investor is underperforming -- especially if, as the research above seems to indicate, by a substantial amount  -- it's probably time to move on to more of an index fund approach.

Time will be better spent elsewhere.

The bottom line is that investors tend to overrate themselves.

Best to work hard at trying to not be one of them.

Adam

[An earlier version of this post was a draft that was mistakenly posted.]

* This has been covered to an extent in prior posts.
** A quick reference to this was made in my most recent post.
*** It's also naturally important that relative risk, though far more difficult to quantify than returns, is considered carefully.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, November 28, 2014

The Curse of Liquidity

I think it's fair to say that it's never been easier to minimize frictional costs when it comes to investing in stocks.

Transaction costs these days are, at many brokerages, reasonable or better for stocks and ETFs.

Many fine low cost fund alternatives exist.

Yet what should be plain advantage is often converted into a curse.

In this CNBC appearance back in October, Warren Buffett said that "if you are buying a business to own...the idea of what the market does on any given day, it's just meaningless. What you really have to look at is where you expect the business to be 5 or 10 or 20 years from now."

That's how most will think about businesses that aren't traded daily but, because stocks are quoted so frequently, behavior is changed for the worse.

 "...you can look at stock prices minute by minute. And that should be an advantage but many people turn it into a disadvantage."

Buffett wrote something similar earlier this year:

"Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of 'Don't just sit there, do something.' For these investors, liquidity is transformed from the unqualified benefit it should be to a curse." - From the 2013 Berkshire Hathaway (BRKa) Shareholder Letter

Low frictional costs and the convenience of buying and selling creates a temptation to try and be in and out of certain things at just the right time. What then usually happens is -- as a result of this behavior -- not only is the low frictional cost advantage lost or reduced, unnecessary mistakes get made. Making judgments about how price compares to value is far from easy, but it can be done. Mistakes occur when attempts at timing is added to the equation. Stocks move unexpectedly. Timing when to buy or sell, if not impossible, is difficult to do reliably well. Nor is it necessary. What matters far more is a reasonable appraisal of business value combined with patience and price discipline. Get that right and, in the long run, good things are more likely to happen.

Attempts at timing are more likely to subtract or, at a minimum, distract from what really counts.

So that means the relationship between price and value -- along with opportunity costs -- should primarily dictate action; timing should not.

Part of the problem is that some behave as if the mistakes will only be made by the other participants. Morgan Housel explains this tendency -- what's known as the bias blind spot -- the following way:

"People love reading about flaws people fall for when handling money. But few of them admit, or even realize, that they're reading about themselves."

He adds: "We're blind to our blindness."

Some think they can be in the right stock (or stock fund) at just the right time. What happens instead is they end up just compounding mistakes and incurring unnecessary costs when much less activity would have yielded a vastly better outcome.

Liquidity is much overrated. It can be an advantage, of course, but only up to a point.

"A modest amount of liquidity will service the true needs of a civilization. A large amount of liquidity will bring out the worst in human nature." - Charlie Munger at the 2008 Wesco Financial Shareholder Meeting

The risk that a stock or fund that's been bought might drop substantially gets most of the consideration. Loss aversion contributes greatly to this. Yet the risk that what can be bought sensibly today may at some point not be available at attractive prices -- though not in a predictable manner as far as timing goes -- deserves at least equal attention.

"Since the basic game is so favorable, Charlie and I believe it's a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of 'experts,' or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it." - From the 2012 Berkshire Hathaway (BRKa) Shareholder Letter

Those who try to "dance in and out" aren't giving due consideration to the risk of not participating sufficiently. They think they'll be in and out at the right times. Somehow, they'll consistently avoid the downside while capturing the upside. Easier said. If the share price of a lousy business drops that, of course, can be a real problem. On the other hand, for those who feel comfortable judging prospects and value, if the share price of a sound business temporarily drops that's far from a problem for the long-term investor.

More from Buffett's CNBC appearance back in October:

"I don't know how to tell what the markets going to do. I do know how to pick out reasonable businesses to own over a long period of time. And a lot of people do, incidentally."

It's, in fact, an opportunity when prices fall.

"The stocks I was buying yesterday I hope go down today. Put it that way. And I hope they go down next week, and I hope they go down the week after. Nothing is going wrong with the companies."

Effectively judging business economics is paramount when buying an individual stock. For some, that's where a good fund might be more suitable.

Many stocks, these days, have become quite expensive or, at least, not cheap. Though there are always individual exceptions, the time to buy with a substantial margin of safety, at least for now, has mostly passed.

Stocks may continue rising, of course, but those gains increasingly will be driven by speculation instead of increases to intrinsic value. When stocks will become broadly undervalued again, and what the cause will be, is always uncertain. Those who still think bull markets are such a wonderful thing might want to keep these things in mind.

Bull markets make it more difficult to accumulate meaningful positions.

Managing risk and reward just becomes more challenging.

Liquidity should be an advantage. Well, at least it should be for those who tend to buy pieces of sound businesses with the idea that gains will come primarily via long-term intrinsic value increases. Returns should mostly driven by the compounded effect of what the businesses produce -- free cash flow generated at high returns on capital -- for owners over the long haul. Too often, instead, the focus is profiting from near-term price action; the focus is on speculative bets on where prices are going.

So, as a result, what ought to be beneficial liquidity morphs into a curse.

Broadly speaking, outcomes likely improve when there's greater emphasis on what businesses -- whether owned as individual stocks or through a fund -- can produce over a very long time.*

To me, there should be much less emphasis on the wonders of liquidity.

As always, what's sensible to buy at one price becomes less so as prices increase.

So buying at least reasonably well (i.e. a nice discount to conservatively estimated value) in the first place naturally matters a great deal.

Investment results ought to be mostly about long-term increases to per share intrinsic value.

They shouldn't be dependent on selling at speculative prices.

Adam

Long position in BRKb established at much lower than recent market prices

* This naturally also applies to owning a business outright for those inclined and able to do so.

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

Friday, November 21, 2014

Mr. Market

Roughly 15 years ago, Warren Buffett was asked to speak at Sun Valley not long before the tech bubble burst.*

Here's how an article on CNBC described the reaction:

"Many of the people in the room had amassed vast paper profits from stocks shooting ever higher in the Internet boom. Buffett wasn't playing that game, and some of the younger people in the audience thought he was stuck in the past, unable to understand that this time it would be 'different.'"

His message to the audience was rather straightforward:

"There was no new paradigm..."

Despite his long-term investing track record, many chose to discount or ignore what Buffett was saying back in 1999. There was, in a similar way, a fair amount of skepticism toward his favorable views of stocks during the financial crisis and even more recently (in both cases the market overall was substantially lower than it is now).

It's not that Buffett gets the timing right. In fact, Buffett doesn't try to guess where prices are going or to get the timing right.

"...we have no idea - and never have had - whether the market is going to go up, down, or sideways in the near- or intermediate term future." - From the 1986 Berkshire Hathaway (BRKa) Shareholder Letter

Predicting, in a reliable manner, where prices will be going is close to impossible and mostly a waste of energy.

Fortunately, being a successful long-term investor doesn't require brilliant timing.

"I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two. 

But I think it is very easy to see what is likely to happen over the long term." - Warren Buffett in Fortune, December 2001

Trying to guess where prices are going in the coming weeks, months, or even over several years ends up best case being a distraction and, more likely, is just a plain foolish thing to do. Investing is (or should be) about how price compares to intrinsic value and how that value is likely to change over a longer time horizon. The emphasis is long-term effects instead of some unusual acuity for jumping in and out at just the right time.

Attempting to time things is a great way to make unnecessary mistakes and incur unnecessary frictional costs. The emphasis on what market prices might do next can end up being a big contributor to unsatisfactory investment outcomes (or worse).

In 1999, it was all about the upside. At the time there was lots of enthusiastic buying of stocks that offered incredibly high risk of permanent capital loss. For too many, those losses indeed became very real and very permanent.

Errors of commission.

In 2008, when the world was a real economic mess -- with compelling and scary headlines everywhere -- buying seemed dangerous and the enthusiasm for stocks all but disappeared. At that time many stocks were unusually undervalued. The risk of permanent capital loss -- especially for those with a long-term investment time horizon -- was rather low. Those missed gains were also very real and very permanent.

Errors of omission.

With the benefit of hindsight, these outcomes may seem obvious, but being correct and decisive in real time while keeping emotions in check just isn't the easiest thing to do.

Errors of commission might be more plain to see but that doesn't mean errors of omission don't matter a whole bunch.

They certainly do.

These days, many stocks have become rather, at the very least, not at all cheap. The risk of permanent loss -- or, at least, subpar returns considering the risks -- is now much higher and getting worse as the rally continues. Margin of safety is, in many cases, way too low for incremental purchases as far as I'm concerned.

Unfortunately, some will make of mistake of getting interested in stocks now after having mostly missed the chance to buy when prices were attractive.

"Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can't buy what is popular and do well." - Warren Buffett

Prices may continue to go up, of course. What's already not cheap goes on to become plainly expensive.

There's no way to know this beforehand.

There's also no need to know it.

"Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game." - From the 1987 Berkshire Letter

For those with a long investing time horizon, if prices do continue to rise in the near-term or intermediate-term, it's not a good thing at all.

To me, while there are naturally always individual exceptions, the chance to buy part of a good business at a really substantial discount is, at least until the next bear market or substantial market correction, mostly in the rear-view mirror.

Investing well inevitably involves lots of waiting for a good opportunity to present itself; it inevitably involves lots of preparation. Ultimately, it requires sound business judgment and price discipline. So energy should be spent trying to better understand existing or potential investments. In combination, this makes it possible to act decisively while others -- those caught up in the emotions of the moment and less prepared -- simply cannot.

In the end, how the business performs is what mostly matters while price action does not.

"...Charlie [Munger] and I let our marketable equities tell us by their operating results - not by their daily, or even yearly, price quotations - whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it." - From the 1987 Berkshire Letter

These days, while most things are far from cheap, it is still nothing like 1999. Back then valuations became completely nonsensical for way too many assets. That doesn't mean right now is a wonderful time to be buying stocks.

Far from it.

Those who think results over the next five years are likely to be as attractive as the past five years are likely to be disappointed. Put another way, the only way for stocks to produce similar results is if prices run far ahead of increases to per share intrinsic value.

That can happen, of course, but I certainly hope it does not. Bubbles do real damage. Some of it subtle; some of it not.

In fact, a good chunk of the returns these past five years have been, in many cases, driven by a closing of the discount to value gap. It's not that per share intrinsic value didn't increase somewhat. For good businesses they did and will continue to do so. It just that the increases were far less than the returns would imply.

In the very long run, as long as the purchase price was reasonable in the first place, what matters is whether a business can increase per share intrinsic value at attractive rate. The bonus returns in recent years resulted from the big discounts to value that existed for a time.

The crisis created those big discounts and, for the most part, they are now gone. So price has caught up -- and in some instances no doubt now has even exceeded  -- per share intrinsic value.

So total return expectations -- even for very high quality businesses -- should be more modest going forward (at least until the market goes meaningfully south again).

Otherwise, allow the market to serve.

Adam

Long position in BRKb established at much lower than recent market prices

* The 1999 Sun Valley speech by Buffett that I mentioned above was covered in Chapter 2 of 'The Snowball'. It was also covered in a 1999 Fortune article where he said the following: "Investors in stocks these days are expecting far too much, and I'm going to explain why. That will inevitably set me to talking about the general stock market, a subject I'm usually unwilling to discuss."
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, November 17, 2014

Berkshire Hathaway 3rd Quarter 2014 13F-HR

The Berkshire Hathaway (BRKa3rd Quarter 13F-HR was released on Friday. Below is a summary of the changes that were made to the Berkshire equity portfolio during that quarter.
(For a convenient comparison, here's a post from last quarter that summarizes Berkshire's 2nd Quarter 13F-HR.)

There was plenty of buying and selling during the quarter. Here's a quick summary of the changes:*

New Positions
Liberty Media (LMCK): 8.0 million shares worth $ 376 million**
Express Scripts (ESRX): 449 thousand shares worth $ 31.7 million

Added to Existing Positions
IBM (IBM): 304 thousand shares worth $ 57.7 million, total stake $ 13.4 billion
Wal-Mart (WMT): 1.59 million shares worth $ 121 million, total stake $ 4.62 billion
DirecTV (DTV): 6.53 million shares worth $ 565 million, total stake $ 2.60 billion
General Motors (GM): 7.04 million shares worth $ 225 million, total stake $ 1.28 billion
Charter (CHTR): 2.64 million shares worth $ 400 million, total stake $ 749 million
Suncor (SU): 2.02 million shares worth $ 73.0 million, total stake $ 668 million
Viacom (VIAB): 101 thousand shares worth $ 7.77 million, total stake $ 593 million
Precision Castparts (PCP): 206 thousand shares worth $ 48.7 million, total stake $ 493 million
Visa (V): 347 thousand shares worth $ 73.9 million, total stake $ 458 million
Liberty Global (LBTYA): 534 thousand shares worth $ 22.7 million, total stake $ 442 million
Mastercard (MA): 665 thousand shares worth $ 49.2 million, total stake $ 349 million

Not all of the activity has been disclosed. In the 3rd quarter of 2014, apparently some activity was kept confidential. Berkshire's latest filing says: "Confidential information has been omitted from the public Form 13F report and filed separately with the U.S. Securities and Exchange Commission."

Occasionally, the SEC allows Berkshire to keep certain moves in the portfolio confidential. The permission is granted by the SEC when a case can be made that the disclosure may cause buyers to drive up the price before Berkshire makes its additional purchases.

Reduced Positions
Bank of New York Mellon (BK): 1.28 million shares worth $ 49.4 million, total stake $ 905 million
Phillips 66 (PSX): 293 thousand shares worth $ 23.9 million, total stake $ 504 million
National Oilwell Varco (NOV): 920 thousand shares worth $ 70.0 million, total stake $ 486 million
ConocoPhillips (COP): 883 thousand shares worth $ 67.6 million, total stake $ 36.1 million

Sold Positions
Deere & Company (DE): All 3.98 million shares worth $ 326 million

Todd Combs and Ted Weschler are responsible for an increasingly large number of the moves in the Berkshire equity portfolio. These days, any changes involving smaller positions will generally be the work of the two portfolio managers.
(Though some of the holdings they're responsible for have become more substantial over time.)

Top Five Holdings
After the changes, Berkshire Hathaway's portfolio of equity securities remains mostly made up of financial, consumer and, to a lesser extent, technology stocks (mostly IBM).

1. Wells Fargo (WFC) = $ 24.0 billion
2. Coca-Cola (KO) = $ 17.1 billion
3. IBM (IBM) = $ 13.4 billion
4. American Express (AXP) = $ 13.3 billion
5. Wal-Mart (WMT) = $ 4.62 billion

As of the end of the quarter, Berkshire's Wal-Mart position was only somewhat larger than its Procter & Gamble (PG) position. Well, that's going to change with Berkshire recently agreeing to acquire Duracell from P&G in exchange for Berkshire's ownership stake in the consumer goods company.
(P&G will also contribute some cash.)

As is almost always the case it's a very concentrated portfolio. The top five often represent 60-70 percent and, at times, even more of the equity portfolio. In addition, Berkshire owns equity securities listed on exchanges outside the U.S., plus cash and cash equivalents, fixed income, and other investments.***

According to their latest filing, the combined portfolio value (equities, cash, bonds, and other investments) is ~ $ 240 billion including the investment in Heinz.
(Heinz is separately on the books for just under $ 12 billion, but that book value is likely to diverge greatly from economic value over time.)

The portfolio, of course, excludes all the operating businesses that Berkshire owns outright with, according to the latest letter, a bit more than 330,000 employees combined.

Here are some examples of the non-insurance businesses:

MidAmerican Energy, Burlington Northern Santa Fe, McLane Company, The Marmon Group, Shaw Industries, Benjamin Moore, Johns Manville, Acme Building, MiTek, Fruit of the Loom, Russell Athletic Apparel, NetJets, Nebraska Furniture Mart, See's Candies, Dairy Queen, The Pampered Chef, Business Wire, Iscar, Lubrizol, Oriental Trading Company, as well as 50% of Heinz.
(Among others.)

In addition, the insurance businesses (BH Reinsurance, General Re, GEICO etc.) owned by Berkshire have naturally provided plenty of "float" for their investments over time and continue to do so.

See page 111 of the annual report for a full list of Berkshire's businesses.

Adam

Long positions in BRKb, WFC, KO, AXP, USB, WMT, PG, DTV, COP, and PSX established at much lower than recent market prices. Also, small long position in IBM established at slightly higher than recent market prices.

* All values shown are based upon the last trading day of the 3rd quarter.
** Resulting from Liberty Media's stock split
*** Berkshire Hathaway's holdings of ADRs are included in the 13F-HR. What is not included are the shares listed on exchanges outside the United States. The status of those shares are updated in the annual letter. So the only way any of the stocks listed on exchanges outside the U.S. will show up in the 13F-HR is if Berkshire happens to buy the ADR. Investments in things like the preferred shares (and, where applicable, related warrants) are also not included in the 13F-HR. The same is true for the Heinz common shares (i.e. not just the Heinz preferred shares).
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, November 14, 2014

Berkshire Agrees To Acquire Duracell

Procter & Gamble (PG) is in the process of shedding brands to simplify its business and focus more on its core products.

Well, consistent with that objective, Berkshire Hathaway (BRKa) yesterday agreed to acquire Duracell from the company. Berkshire will acquire Duracell, in part, by exchanging the P&G shares that Berkshire currently owns for the battery business.

P&G will also contribute some cash.

According to P&G's filing:

Berkshire's stock ownership is currently valued at approximately $4.7 billion. P&G said it expects to contribute approximately $1.8 billion in cash to the Duracell Company in the pre-transaction recapitalization.

P&G said the transaction maximizes the after-tax value of the Duracell business and is tax efficient for P&G. The value received for Duracell in the exchange is approximately 7-times fiscal year 2014 adjusted EBITDA. This equates to a cash sale valued at approximately 9-times adjusted EBITDA.

Essentially, Buffett is paying 7-times this EBITDA for Duracell but, for P&G, this is equivalent to selling the company for 9-times EBITDA to a cash buyer. So, based upon the numbers available, Berkshire is paying net $ 2.9 billion ($ 4.7 billion - $ 1.8 billion) for a bit more than $ 400 million in EBITDA.

Well, if that's the case, then pre-tax operating earnings of $ 250-300 million or so doesn't seem like a stretch.

As it stands, the cost basis of Berkshire's current stake in P&G is $ 336 million.*

Simply put, that $ 336 million initial investment has resulted in current annual operating earnings that's not much less than the initial amount paid for the shares.
(If the current earning power remains at all durable, that's certainly quite an earnings yield compared to the original investment.)

Plus $ 1.8 billion in cash.

Plus the very nice and growing stream of dividends that P&G has paid to Berkshire over the years.
(Some of those dividends no doubt have helped fund other investments during that time.)

All accomplished very efficiently as far as taxes go.

Berkshire's ownership of P&G's stock began in 2005 but is directly related to a much earlier investment in Gillette. Initially, Berkshire invested $ 600 million in Gillette convertible preferred shares back in 1989. That original investment became shares of Gillette common stock in 1991. Then Berkshire became a shareholder of P&G in 2005 when P&G purchased Gillette.

In the recent past, Berkshire has done some similar deals that involved the exchange of stock to acquire business assets in a tax efficient manner.

Adam

Long positions in BRKb and PG established at much lower than recent market prices

* Before selling some shares both during and after the financial crisis, Berkshire previously had a higher cost basis in P&G. In fact, as recently as 2007, Berkshire's cost basis was as high as ~ $ 1 billion.

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

Friday, November 7, 2014

The Seventh Best Idea

From this Warren Buffett speech at the University of Florida:

"If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into a seventh one instead of putting more money into your first one is gotta be terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea. So I would say for anyone working with normal capital who really knows the businesses they have gone into, six is plenty, and I probably have half of what I like best. I don't diversify personally."

Clearly, this view on diversification is far from conventional. Charlie Munger -- and this is not exactly a surprise -- once said something rather similar in a speech to the Foundation Financial Officers Group:*

"I have more than skepticism regarding the orthodox view that huge diversification is a must for those wise enough so that indexation is not the logical mode for equity investment. I think the orthodox view is grossly mistaken."

Identifying what, over the long run, will end up being six wonderful businesses to own then waiting patiently until the shares can be bought at attractive prices may not be impossible to do, but it is easier said than done. Unwarranted confidence in a concentrated portfolio is, at the very least, simply a recipe for big and expensive mistakes.

Many will find they do need to have broader diversification or that they are better off in an index fund. That's, of course, necessarily unique for each investor. Some of this will come down to one's own realistically assessed capabilities, but much else comes down to temperament and other psychological factors.

Beyond the requisite skills and background, patience followed by decisiveness when the opportunity presents itself is needed. Here's Munger's take from the 2004 Wesco shareholder meeting:

"It wasn't hyperactivity, but a hell of a lot of patience. You stuck to your principles and when opportunities came along, you pounced on them with vigor."

and

"Success means being very patient, but aggressive when it's time."

Now, the fact is that Buffett's current equity portfolio has far more than six stocks in it. This would appear at odds with Buffett says above, but the top 5 or 6 stocks continue to make up a substantial proportion of the portfolio.

Among the reasons for the large number of stocks in the current portfolio, is that many of the smaller positions are the work of his two investment managers, Todd Combs and Ted Weschler.

Then there's just the sheer scale of what Buffett has to manage these days compared to earlier times.**

Some commentators, when asked, seem willing to opine on just about any equity investment alternative. Well, maybe someone can actually understand such a wide variety of businesses and industries with sufficient depth, just consider me just a little bit skeptical of this. I mean, who can properly understand nearly everything in the equity investment universe? Focus is needed. Otherwise, brilliant outcomes in terms of risk and reward just don't seem likely.

Lots of breadth might mean too little depth. In other words, knowing just enough to be dangerous about many different stocks. Eventually, this way of operating seems almost certain to take an investor far outside their own necessarily unique circle of competence. That's a great way to get spread too thin and make unnecessary mistakes.

"To kill an error is as good a service as, and sometimes even better than, the establishing of a new truth or fact." - Charles Darwin

"...Warren and I are better at tuning out the standard stupidities. We've left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error." - Charlie Munger in Stanford Lawyer

My own favorite stocks may or may not prove to be great long-term investments but, to me, essentially none of them are selling at attractive enough prices to buy these days. As usual, the buying needed to happen in a decisive manner when it felt most uncomfortable. That, of course, was during the financial crisis and, well, even as recently as a few years ago. Some very good assets were properly cheap three to five years ago even if wild near-term price action -- especially during the height of the crisis -- had to be tolerated.***
(What appeared rather cheap often temporarily became cheaper. This was the case even among the very highest quality businesses.)

Will stocks rise or fall from here? No idea. I never try to figure out such things. The focus, instead, is on how price compares to estimated intrinsic value. It's never about trying to guess how stock prices might fluctuate. That sort of thing is a total waste of energy.

In any case, at least for now, the balance of risk and reward has changed dramatically for the worse. Prices would need to meaningfully fall -- or, alternatively, per share intrinsic values would need to increase over time without much change in price -- for the balance of risk and reward to improve.

When stocks do not sell at a plain discount to a conservative estimate of value, it's time to be patient. It's time to keep chipping away at the ongoing process of understanding what I own -- and what I might someday like to own -- in a better way. It's time to make sure I'm prepared to act decisively if/when they become cheap again.

This doesn't necessarily mean all my favorite investments are overvalued.

This doesn't necessarily mean I'll be selling; attempting to frequently buy and sell is a recipe for unnecessary mistakes and frictional costs.

This does mean, at the very least, that the margin of safety is currently insufficient for me to be willing to make incremental purchases.

Adam

Related posts:
Portfolio Theory & Diversification
Buffett on Diversification
Munger & Buffett on Diversification - Part II
Munger & Buffett on Diversification

* Here are some additional examples of Munger's view of diversification: 

"We believe almost all good investments will involve relatively low diversification." - From the 2004 Wesco meeting

"The academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification." - From an interview in Kiplinger's

** Some other reasons it can be challenging to have a concentrated portfolio include the fact that a best idea may not be available at a attractive enough market price, insufficient funds are available when the market price is right, and, well, pure indecision (i.e. an error of omission).
*** The key thing was recognizing when the drop in price was far greater than the reduction in per share intrinsic value. Well, at least what intrinsic value would look like in a more normalized environment. It's worth noting that the very good businesses can actually increase their per share intrinsic value during a crisis (even if near-term market price action would temporarily seem to indicate otherwise).
---
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.
 
Site Meter