Thursday, July 30, 2009

Recent Study on Investor Returns

The following is based upon a recent study on mutual fund investor performance by DALBAR's Quantitative Analysis of Investor Behavior (QAIB).

According to DALBAR, the S&P 500 returned 8.35% over the 20 years that ended in 2008 while, on average, equity fund investors earned just 1.87% (less than the inflation rate of 2.89%).

Beyond the performance of the actively managed equity mutual funds themselves, much of these poor returns come down to investor behavior. Buying the hot stock or mutual fund because it has been going up a lot recently and selling after the market has gone down out of panic or fear. That's a tough way to make money but studies have revealed how common this behavioral pattern is among investors. Many may think they can overcome this tendency but the prevailing evidence strongly suggests most do not. From the annual DALBAR study according to this press release and post:

"The dramatic events that continue to plague our financial markets have provoked panic, which exacerbates the ongoing carnage," said Lou Harvey, president of DALBAR. "For 15 years, QAIB has shown that investor returns lag what performance reports and prospectuses would lead one to believe is achievable. While those returns are, in fact, theoretically achievable, the reality is that investors are not rational, and make buy and sell decisions at the worst possible moments," he said.

That pattern wrecks long-term returns. It's a defect that needs to be unlearned and replaced with a more effective trained response. If good businesses are selling below intrinsic value, buy especially when it feels bad and the headlines are awful (and sell some holdings whenever you sense euphoria entering the equation and equities have become plainly expensive).*

"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

Easier said but having the right temperament definitely matters.

Learning from this might help erase some of that 6.5% performance gap. It won't change the fact that too many professional managers underperform.

Still, investors would generally get improved results if they didn't chase performance and bought when the prevailing economic conditions are ugly and no one seems to want to own stocks.

Adam

* For many investors index funds make a lot of sense. The added risk and complexity of owning individual stocks works against long-term returns unless the investor truly understands business economics, consistently judges value well, and always buys with an appropriate margin of safety. The evidence supporting the idea that index funds are often the way to go is not insignificant. Yet whether buying individual marketable stocks or index funds it's important to not be buying what is popular at the moment. If it feels good to buy it's probably not cheap.

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

Tuesday, July 28, 2009

High Growth Doesn't Equal High Investor Returns

So China's economy apparently grew 7.9%. Here's a recent article in the Wall Street Journal. The article makes the point that high growth does not equate to high stock returns. In fact, the economies with high growth produce the lowest stock returns by quite a margin.

Highest Growth Countries: 6% avg annual return
Slowest Growth Countries: 12% avg annual return

According to the article, this is based upon decades of data from 53 countries.

On a $ 50,000 investment...
  • At 6%/year over 35 years you'd have $384,000
  • At 12%/year over 35 years you'd have $2,640,000
...so ignoring this admittedly counter-intuitive reality is costly.

As usual, higher growth attracts competition and the new companies require capital. Labor costs are increased. Pricing power is diminished.

All of this may be good for civilization but generally adds up to reduced return on capital for investors.

It's a widely held false notion that high economic growth is correlated with high stock returns.

Adam

Related posts:
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, July 27, 2009

Jeremy Grantham's Latest Letter

Here's some excerpts from the July letter. Always a good read.

"As value purists (at least most of the time), we were very constrained by the fact that we still measured U.S. quality blue chips as the highest return global equities even at the very low. This was in complete contrast to the situation at the low in 2002, where the best values were in risky emerging markets and small caps..." - Jeremy Grantham

"The easy winner of the cheapest equity sub-category contest is still high quality U.S. blue chips. They were really trashed on a relative basis by the second quarter rally in junk." - Jeremy Grantham


"Without an unexpectedly strong improvement in the economy, it is hard to see high quality stocks losing much more ground, given their extreme value gap over junky stocks – more than an 11 percentage point spread per year on our seven-year forecast!" - Jeremy Grantham

Grantham admits "high quality" is subjective but that they've been estimating this way for 30 years and have a good record with it.

So U.S. high quality stocks seem rather inexpensive relative to other asset classes. This was not true roughly a decade ago.

Adam

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

Friday, July 24, 2009

Munger on Accounting

Charlie Munger said the following in the Stanford Lawyer back in 2002:

"Proper accounting is like engineering. You need a margin of safety. Thank God we don't design bridges and airplanes the way we do accounting."

He also added the following during a talk at USC Business School in back in 1994:

"...you have to know accounting. It's the language of practical business life. It was a very useful thing to deliver to civilization. I've heard it came to civilization through Venice which of course was once the great commercial power in the Mediterranean. However, double-entry bookkeeping was a hell of an invention.

And it's not that hard to understand.

But you have to know enough about it to understand its limitations—because although accounting is the starting place, it's only a crude approximation. And it's not very hard to understand its limitations. For example, everyone can see that you have to more or less just guess at the useful life of a jet airplane or anything like that. Just because you express the depreciation rate in neat numbers doesn't make it anything you really know."

Financial statements provide an estimate, not some absolute truth about what's going on in a business. As a result, sound judgment on the impossible or hard to measure aspects of a business matters a bunch.

If you cannot measure something well it doesn't necessarily make the factor lose significance. Over-analyzing the easy to measure stuff while ignoring what's difficult to measure but important can prove rather costly for an investor.

Adam

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

Wednesday, July 22, 2009

Coca-Cola's 2Q Earnings

Some comments by Coca Cola's CEO Muhtar Kent on the earnings conference call yesterday:

QUESTION: Can you give us your assessment of the macro, the consumer environment, particularly markets like Russia or eastern Europe where trends have been pretty weak?

RESPONSE: Think of four different quadrants as far as the consumer sentiment is concerned. On the top left quadrant, you've got Europe, you've got North America and maybe a couple of other economies where we will probably be experiencing resets in terms of the consumer psyche where they will probably do things differently than they have done in the past and mostly related to, in terms of durable consumers, consumer consumption habits, but also in general. There will be a reset in the mind.
And then you've got on the top right, you've got China, India, other parts of Brazil, where I think there will be a very strong, quick rebound.
Then you've got on the bottom left quadrant a Japan stagnation and then you've got ... eastern Europe, Russia, Ukraine, on the bottom right quadrant, which is basically I call volatility, more zigs than zags. It could come could back quickly, then could go back down quickly.
I think we're in for a few years of zigs and zags for Russia, eastern Europe and so forth.

A full transcript of the conference call can be found here.

Also, here is a summary of Coke's 2Q results from the 2Q09 earnings press release.

Adam

Long position in KO

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

Tuesday, July 21, 2009

Stocks to Watch

Below is a list of stocks I like* for my own portfolio at the right price. As an example: JNJ's recent price of $ 59.23/share is still below the $ 65/share I'd be willing to pay. Some other stocks on the list below are currently selling above what I'd pay (RMCF, PKX, HANS, LOW, MHK, MO) but I still think they are great businesses to buy shares of at the right price.

These are all intended to be long-term investments. A ten year horizon or longer. No trades here.

The stocks in bold have two things in common. They are:

1) currently owned by Berkshire Hathaway (as of 3/31/09) and,
2) selling below the price that Warren Buffett paid.

There are several other Berkshire Hathaway holdings on this list but they don't have the 2nd thing going for them.

Stock/Maximum Price I'd Pay/Recent Price**
JNJ/65.00/59.23 - Buffett paid approx $ 62/share
COP/50.00/42.38 - Buffett paid approx $ 82/share...ouch
KFT/30.00/27.43 - Buffett paid approx $ 33/share
USB/24.00/17.96 - Buffett paid approx $ 31/share
BNI/80.00/74.80 - Buffett paid approx $ 75/share
WFC/28.00/25.00 - Buffett paid approx $ 32/share
BRKb/3000/2951
KO/55.00/50.32
PG/60.00/55.92
AXP/35.00/28.02
PEP/60.00/56.66
ADP/37.00/35.31
PM/45.00/44.00
DEO/60.00/57.95
---------------------
MO/16.00/17.34
LOW/19.00/20.42
MHK/30.00/37.78
HANS/25.00/29.48
RMCF/6.00/8.06
PKX/80.00/89.13
(Splits, spinoffs, and similar actions inevitably will occur going forward. Will adjust as necessary to make meaningful comparisons.)

Tactically, these may seem difficult to buy with the S&P 500 having moved from a recent low of 872 on 7/10/09 to 951 as of yesterday. Mr. Market's mood has improved a bit.

Many stocks have rallied so the risk of paying more than necessary in the short-term is there.

Yet, another risk, of course, is missing a stock entirely because it continues to rally. There is no perfect answer to this. The risk of missing something you like when a fair price is available (error of omission) can be more costly than suffering a short-term paper loss.

Here are some thoughts on errors of omission by Warren Buffett from an article in The Motley Fool.

And also...

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

In other words, not buying what's still attractively valued to avoid short-term paper losses is far from perfect with your best long-term investment ideas.

To me, if an investment is initially bought at a fair price, and is likely to increase substantially in intrinsic value over 20 years, it makes no sense to be bothered by a temporary paper loss. Of course, make a misjudgment on the quality of a business and that paper loss becomes real (error of commission).

Bottom line: when highly confident that a great business is available at a fair price it's important to accumulate enough while the window of opportunity exists. Sometimes ignoring the risk of short-term losses is necessary to make sure a meaningful stake is acquired. Ending up with just the quantity of "an eyedropper" when I'd like a full glass is no fun.

Hey, investing is never easy.

Adam

* This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to remain long the above stocks (at least those that at some point became cheap enough to buy) unless market prices become significantly higher than intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
** As of July 17, 2009

Monday, July 20, 2009

When Genius Failed...Again

"'GIVE ME but one firm spot in which to stand,' Archimedes declared, 'and I will move the earth.' While the ancient Greeks discovered the principle of leverage some 2,200 years ago, it was John Meriwether and his Long-Term Capital Management LP that showed how far leverage could take you in financial speculation." - Forbes article by Robert Lenzner in 1998

John Meriwether, is closing his latest failed hedge fund (JWM Partners) after losing 44% in less than 18 months. Of course, Meriwether is best known for the Long-Term Capital Management (LTCM) disaster back in 1998. Back then, many feared LTCM's failure would threaten the stability of the global financial system without intervention. As a result, a bailout was organized by the Federal Reserve Bank of New York in order to prevent a wider collapse in the financial markets.

The book When Genius Failed tells the full story, but basically LTCM was an extremely leveraged outfit that gambled with various forms of arbitrage and lost a ton of money.

LTCM was made up of several former professors, including Nobel Prize-winning economists Robert Merton and Myron Scholes.

...its enormously leveraged gamble with various forms of arbitrage involving more than $1 trillion dollars went bad, and in one month, LTCM lost $1.9 billion. On the precipice of not only an American financial disaster, the fund's imminent collapse had significant international monetary implications, jeopardizing the financial system itself. - From Wikipedia on the book, When Genius Failed

From a recent Bespoke Investment Group post on his latest failed fund:

Only a little less than ten years after his first hedge fund [LTCM] blew up and threatened the stability of the financial system, John Meriwether has announced that his current fund, JWM Partners, will wind down operations after a loss of 44% from September 2007 through February 2009.

Bespoke also added...

...Bloomberg reported that, "For many investors, John Meriwether is by now just another hedge-fund manager." Just another hedge-fund manager? How many other hedge fund managers do you know with a resume that includes a US Treasury trading scandal, Long-Term Capital, and now this?

Here's an excerpt from an article about John Meriwether that was published earlier this year:

"Some people really do live a cartoon life. They blow themselves up, and for a second, there they are, all charred and burned. But then in the next frame, they've got a fresh stick of dynamite in their hands and they're good as new. Such is the fanciful tale of John Meriwether, the mad genius behind Long-Term Capital Management, the original hedge-fund disaster story. There are some analysts who now see the 1998 government bailout of LTCM as planting the seeds of our current predicament — the moment when sophisticated financial managers learned that causing systemic risk was something they didn't really have to worry about, because the government would be there to have their backs." - From John Meriwether, The Wile E. Coyote of Hedge Funds by Hugo Lindgren

We've seen this movie:

1) Excess leverage,

"Leverage is the only way a smart guy can go broke." - Warren Buffett on The Charlie Rose Show


2) complex formulas,

"Beware of geeks bearing formulas." - Warren Buffett in the 2009 Berkshire Hathaway Shareholder Letter

3) and overconfidence based on high IQ.*

"We'd argue that what's taught is at least 50% twaddle, but these people have high IQs. We recognized early on that very smart people do very dumb things, and we wanted to know why and who, so we could avoid them." - Charlie Munger at the 2007 Berkshire Hathaway Shareholder Meeting

"If you have a 150 IQ, sell 30 points to someone else. You need to be smart, but not a genius. What's most important is inner peace; you have to be able to think for yourself. It's not a complicated game." - Warren Buffett at the 2009 Berkshire Hathaway Shareholder Meeting

When all three are combined, it's smart to keep hard earned money as far away as possible.

Adam

Related posts:
Smart Money?
The Madness of Crowds
Max Planck: Resistance of the Human Mind

* From John Kenneth Galbraith's bookA Short History of Financial Euphoria"...the investing public is fascinated and captured by the great financial mind. That fascination derives, in turn, from the scale of the financial operations and the feeling that, with so much money involved, the mental resources behind them cannot be less.

Only after the speculative collapse does the truth emerge. What was thought to be unusual acuity turns out to be only a fortuitous and unfortunate association with the assets. Over the long years of history, the result for those who have been thus misjudged (including, invariably, by themselves) has been opprobrium followed by personal disgrace or a retreat into the deeper folds of obscurity. Or it has been exile, suicide, or, in modern times, at least moderately uncomfortable confinement. The rule will often be here reiterated: financial genius is before the fall."

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

Friday, July 17, 2009

Buy a Stock...Hope the Price Drops?

An investor buys Coca-Cola (KO) today and it immediately drops 50%.

The stock then stays at that 50% discount to the price he paid for 5-10 years. As a result, that investor becomes substantially richer in the long run.

The longer it stays undervalued the higher the long-term return.

What's going on?

Well, for starters, this works best when:
  • The investment horizon that is at least 5-10 years and ideally even longer
  • Comfortably financed businesses (strong balance sheet/lots of liquidity) with ample free cash flow and high return on capital are purchased
  • Shares are bought below (ideally well below) intrinsic value
Now, I realize the above investor would feel pretty unlucky for having bought at a price so much higher than what became available soon after. I know persistently undervalued shares will increase my long-term returns yet it's still not easy to see a stock that was just purchased go down in price.

Loss aversion is a powerful force that's difficult to manage even when you are aware of it.

So, even with a decent understanding of loss aversion, my initial instinctive response to a price drop after purchase is sometimes still negative but, over time, it's been possible to develop a trained more rational response.

To celebrate.

Naturally, in the long run, an investor wants the shares that were bought to be materially higher. Yet, unless a shareholder intends to sell shares soon, a drop in price* in the near to intermediate term works to the investor's advantage.
A persistently cheap stock price relative to value allows a larger percentage of the shares outstanding to be bought with the company's own cash flow from operations over time (or via cash on the balance sheet and, in some cases, debt issuance).

The math, of course, is simple.

A 50% drop in price may be terrible to stare at on a computer screen or monthly statement, but it allows 2x as many shares to be bought back with the same amount of dollars. Do that consistently over time and it creates a ton of wealth for remaining long-term shareholders.

Let's say shares of a good business are bought at 10x free cash flow and the shares then drop 50%.

In that situation, even if the earnings do not grow, share count would be reduced by 50% over two and a half years using just free cash flow (even if free cash flow shrunk somewhat the returns are clearly very favorable for the owners that hang on for the long haul).

The key again is that the shares are, in fact, being bought below intrinsic value. Too often with buybacks that is not the case. Using a company's dividend to buy more shares when selling below intrinsic value can accomplish a similar thing.**

The difference in returns is not academic. Consider the case of Philip Morris/Altria where $ 10,000 invested in 1957 grew to more than $ 80 million (incl. reinvested dividends) over roughly 50 years -- an annual return of nearly 20%. Philip Morris shareholders had frequent undervaluation and, of course, the durable superior core economics of the business itself working for them over those years.
(Attractive risk and reward characteristics, if bought at the right price, may still exist but it seems very unwise to expect anything close to these kind of returns going forward. There are a number of reasons that's simply not likely to happen even if it's still an otherwise sound investment. Now, if it turns out to be better than expected there'll surely be no complaints.)

This works best for well-financed (strong balance sheet, lots of liquidity) businesses with durable core economics that can reliably produce far more capital than it ever needs to run the business. Those with superior economics and durable competitive advantages are the best candidates.***

Interestingly, even though Coca-Cola has been a great investment over the past twenty years, one of the reasons the stock did not perform as well as it would have otherwise was its extremely high valuation in the 1990s (particularly the late 1990s). It became way overvalued and stayed that way for years. This prevented Coca-Cola management from reducing shares outstanding on the cheap.

The bad news is that the stock of quality businesses like Coca-Cola do not often sell at a large discount to value. The good news is even a slightly undervalued stock price bought back consistently can make a meaningful difference over time.

Naturally, when someone buys a stock they want to see it go up but that high price actually does reduce long-term returns. Seeing a stock sell below the price paid for an extended period is difficult for some investors to tolerate. Quite a few end up bailing out before the benefits of shares bought at cheap prices has really had an impact.

Shares of a good business bought consistently below intrinsic value has powerful long-term effects. This works whether it is the individual investor (through additional share purchases or dividend reinvestment) or the company itself that is doing the buying.

None of this works, of course, if value is misjudged or shares of what turns out to be a lousy business were purchased.

Also, the investor must have a truly long-term investing horizon.

Otherwise, it just isn't very likely to work out all that well.

Adam

Long positions in KO, MO, and the recent spin-off of PM

* Of course, eventually an investor wants the stock to go up. It's just that an investor is better off if market participants misjudge intrinsic value on the low side for as long as possible. It only matters if the investor decides to sell many years later. Until a stock is sold ideally many years down the road, a low price, even if it sells below the price paid for an extended period, is in fact an advantage. What's an exception to this? Here's one scenario to consider. Unfortunately, there's the very real risk that a buyout offer comes in at a premium to market value but a discount to intrinsic value. If enough owners are okay with the gain that will have occurred compared to the recent price action, the deal may be approved. If too few have conviction about longer run prospects, the deal may get approved. When too many owners of shares are in it for the short-term or, at least, primarily to profit from price action, the chance of this happening increases. Well, those that became owners because of the plain discount to intrinsic value and the company's long run prospects will likely get hurt in this scenario.
** Economically a stock buyback vs dividend reinvestment are similar. Yet there is a potentially a difference from a tax standpoint since, depending on the type of account, one has to pay taxes on those dividends. That's not the case for buybacks. So, if management is a good capital allocator (a big if), the investors are generally better off if the company repurchases the shares. 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.
*** First and foremost, the amount of capital required to run the business and how much the free cash flow generation can grow over time are the crucial factors in long-term value creation. After that it comes down to how well management allocates capital.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

Stocks & Gravity

I think of the overall stock market returns as the equivalent of gravity for an investor.

On Earth, a person with a four foot vertical leap would be considered a world class athlete. On the Moon (with gravity at 1/6 the Earth's), obviously a person could jump a lot higher with no additional skills or effort.

The same is true for investing. From 1982-2000 suddenly even below average investors seemed to get good results. When a market goes up 10x everyone feels pretty smart. As an investor, moving from the 1966-1982 era to the 1982-2000 era was like moving from the Earth to the Moon. Investor "gravity" changed dramatically. Those that gauged their investment returns from the 80's and 90's without this in mind overestimated their talents.

"I would consider a year in which we declined -15% and the [Dow Jones Industrial] Average -30%, to be much superior to a year when both we and the Average advanced 20%." - Warren Buffett in his 1960 Partnership Letter

The -30% market return is, for investing purposes in the short run, that years functional equivalent of gravity. Sometimes over the short run, sometimes very much longer. So "leaping" twice as high as the, in this case, declining average is more than a solid performance.

"You make most of your money in a bear market, you just don't realize it at the time." - Shelby Davis

Being down -15% won't feel good with all those red arrows and paper losses but people felt great buying at the height of financial euphoria in 1999; the worst possible time to buy.

From an investor perspective, we have been back to the Earth's gravitational pull (and then some) for a while. When you have excess returns over a long period like 1982-2000 the following period is a painful process of normalizing returns. That process historically takes a long time. Whether it is, as Art Cashin says, a 17.6 year cycle or not, the relevant point is it usually take more than a decade. Mr. Market is a bit like Jerry Seinfeld, annual returns end up "even Steven", or around 7-10% annualized, over the long haul.

So the everyone feels like a genius market of the 80's and 90's has been replaced in the past 10 years with the I'm starting to feel like George Costanza market:

Kramer: "You're wasting your life! George: "I am not. What you call wasting, I call living. I'm living my life!" Kramer: "OK, like what? No, tell me. Do you have a job?" George: "No." Kramer: "You got money?" George: "No." Kramer: "Do you have a woman?" George: No. Kramer: Do you have any prospects? George: "No." Kramer: "You got anything on the horizon?" George: "Uh...no." Kramer: "Do you have any action at all?" George: "No." Kramer: "Do you have any conceivable reason for even getting up in the morning?" George: "I like to get the Daily News!"

No doubt we will eventually enter a period like 1982-2000 where everyone begins to feel smart again.

"Let it be emphasized once more, and especially to anyone inclined to a personally rewarding skepticism in these matters: for practical purposes, the financial memory should be assumed to last, at a maximum, no more than 20 years. This is normally the time it takes for the recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind. It is also the time generally required for a new generation to enter the scene, impressed, as had been its predecessors, with its own innovative genius." - John Kenneth Galbraith in his book: A Short History of Financial Euphoria (Page 87)

Of course, many will probably actually believe it thanks to Galbraith's 20 years of financial memory.

Adam

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

Art Cashin: The 17.6-Year Market Cycle

Whether Art Cashin turns out to be correct or not, it's often worthwhile for an investor to step back and think about longer time horizons for some perspective.

Consider the following from CNBC:

Cashin revisited his theory of "the 17.6-year cycle".

"It's like the Biblical story of the fat and lean years. During the fat, you can throw a dart at the wall, and anything you buy goes up."


Stocks may go up 7-10% per year on average in the long run but historically extended periods when markets move sideways (within a wide range) followed by long periods of returns well in excess of normal. For example:
  • 1966-1982 the market went bounced around but essentially went nowhere
  • 1982-2000 the market went up more than 10 fold
The average annual return across those 34-35 years was in the range of normal (7.5%). Within those periods...anything but normal.

We are almost a decade into one of those possible 15-20 year sideways grinds that Art Cashin describes.

Being roughly half way through would be the good news I guess.

Of course, the way it plays out might be a whole lot different this time around.

What really matters in the longer run is whether shares of good businesses can be bought at a nice discount to value.

Adam

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

Wednesday, July 15, 2009

The Growth Myth Revisited

This article, "In Praise of How Not to Invest", appeared in last weekend's issue of Barron's. According to the article:

- Companies that are the fastest market-share growers underperform

- Companies that are growing assets the fastest also underperform

It's another example of how it is not growth, in itself, that matters. Investor with faith in buying growth to in order to produce above average returns might want to take notice.

 As Jeremy Grantham said in an interview with Morningstar back in May:

"...in the end, returns in a stock market are overwhelmingly to do with return on capital (ROC). It isn't about top line growth. Nobody believes this but it's true. Growth stocks simply don't beat value stocks. Growth countries, for the record, have no history of reliably beating slower growth countries. Although everyone thinks it's the case it won't stand the test of analysis."

Long-term returns come down to durable high ROC and the price you pay relative to intrinsic value....not necessarily growth.

Adam

Related post:
The Growth Myth - Jun 2009
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Sunday, July 12, 2009

"For Trading, Not Eating"

From an older post by Jeffrey Saut, Raymond James Chief Investment Strategist.

While gold was first discovered in Alaska during the 1870s, the 1890s have come to be known as the Yukon-Klondike Gold Rush days, as thousands of rugged individuals swarmed to the northern climes to find fortune and glory. Unsurprisingly, during the winter of 1896-97 the Alaskan ports were frozen solid and therefore closed to all shipping traffic. Food became very scarce and very expensive since new supplies had to be brought in over land at great hardship. Reportedly, a can of sardines that had cost $0.10 in New York could be priced at 10 times that amount by the time it reached the gold miners in Alaska. Still, there was great demand even at such inflated prices. For instance, in one remote mining town the price of a can of sardines was sold at rapidly escalating prices from $10.00, to $30.00, then $50.00. Finally, one desperately hungry miner paid $100.00 for a can of the highly sought after sardines. He took it back to his room to eat. He opened it. To his amazement he discovered the sardines were rotten. Angered, he found the person who sold him the tin and confronted him with the rotten evidence. The seller was amazed and shouted, 'You mean you actually opened that can of sardines? You fool; those were trading sardines, NOT eating sardines!'

Many stocks back in 2000 were definitely not for eating.

Adam

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

Friday, July 10, 2009

Smart Money?

Is it reasonable to assume that, by and large, those who manage large sums of money (bank execs, fund managers etc.) possess above average judgment in financial matters?

Generally speaking, according to John Kenneth Galbraith the answer is no.


In his book, A Short History of Financial Euphoria, Galbraith says, in fact, no such dependable relationship exists. 

"...in a world where for many the acquisition of money is difficult and the resulting sums palpably insufficient, the possession of it in large amount seems a miracle. Accordingly, possession must be associated with some special genius." - John Kenneth Galbraith in A Short History of Financial Euphoria (Page 14)

Galbraith later adds:

"In fact, such reverence for the possession of money again indicates the shortness of memory, the ignorance of history, and the consequent capacity for self- and popular delusion..." - John Kenneth Galbraith in A Short History of Financial Euphoria (Page 14)

Financial memory, according to Galbraith, turns out to be rather short as he explains later in the book.* 

During periods of speculative excess poor judgment by what are supposed to be the best financial minds is the norm...not the exception. The financial heroes or geniuses before a bubble bursts become (often most deservedly) the villains after the crash. So the so-called "smart money" during speculative episodes proves to be rather not so smart:

"...we compulsively associate unusual intelligence with the leadership of the great financial institutions-- the large banking, investment-banking, insurance, and brokerage houses." - John Kenneth Galbraith in A Short History of Financial Euphoria (Page 15)

Galbraith explains this tendency as follows:

"...the investing public is fascinated and captured by the great financial mind. That fascination derives, in turn, from the scale of the financial operations and the feeling that, with so much money involved, the mental resources behind them cannot be less.

Only after the speculative collapse does the truth emerge. What was thought to be unusual acuity turns out to be only a fortuitous and unfortunate association with the assets. Over the long years of history, the result for those who have been thus misjudged (including, invariably, by themselves) has been opprobrium followed by personal disgrace or a retreat into the deeper folds of obscurity. Or it has been exile, suicide, or, in modern times, at least moderately uncomfortable confinement. The rule will often be here reiterated: financial genius is before the fall."
- John Kenneth Galbraith in A Short History of Financial Euphoria (Page 17)

Note: What the great investors with long track records of success seem to have in common is that they do not rely on so-called financial genius. For most, it was working and thinking hard to gain insights on a quality business, buying it at a fair price, then allowing the superior economics of the business itself to compound over time. It was about making smart long-term investments while employing only modest amounts of debt.

From my viewpoint, the term financial genius is too often just code for someone taking excess risk with other peoples money under the guise of some supposedly new innovation.

That innovation is almost always just some new form of leverage.

"...financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design, one that owes its distinctive character to the aforementioned brevity of financial memory. The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets." - John Kenneth Galbraith in A Short History of Financial Euphoria (Page 19)

Leverage that works great until it doesn't.

Adam

Related post: 
The Madness of Crowds

"...for practical purposes, the financial memory should be assumed to last, at a maximum, no more than 20 years. This is normally the time it takes for the recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind. It is also the time generally required for a new generation to enter the scene, impressed, as had been its predecessors, with its own innovative genius." - John Kenneth Galbraith in A Short History of Financial Euphoria (Page 87)
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Wednesday, July 8, 2009

The Madness of Crowds

The recent Rolling Stone article, "The Great American Bubble Machine", had good insights but was simplistic. Wall Street no doubt operates well below its potential; too often more of a tax on the system than facilitator of value creation.

Yet blaming the excesses 100% on Goldman and Wall Street is a stretch. There were other contributing factors (and not just things like the Federal Reserve and policymakers).

According to Charles Mackay, author of Extraordinary Popular Delusions and the Madness of Crowds (1841)*, the cause of bubbles is much broader than that.

In the book, Mackay says it is common after an episode of financial euphoria to place blame on those in power (execs, directors, politicians etc). That makes sense. Yet, he makes the point that "nobody seemed to imagine that the nation itself was as culpable" (John Kenneth Galbraith made a similar point about the Crash of 1929 and other episodes of financial euphoria).

Here is a more complete version of the quote from Mackay. In describing the aftermath of the South Sea Bubble, he said:

"Public meetings were held in every considerable town of the empire, at which petitions were adopted, praying the vengeance of the legislature upon South Sea directors, who, by their fraudulent practices, had brought the nation to the brink of ruin. Nobody seemed to imagine that the nation itself was as culpable as the South Sea company. Nobody blamed the credulity and avarice of the people-the degrading lust of gain...or the infatuation which had made the multitude run their heads with such frantic eagerness into the net held out for them by scheming projectors. These things were never mentioned."

The above doesn't seem much different than the more recent housing and internet bubbles.

An inevitable painful economic contraction followed the South Sea Company bubble. As a result of the excesses, Parliament banned trading public companies for decades. Yet England's economy grew just fine in the following decades without any publicly traded shares.

"The people who are in the business of prospering because there's a lot of stock being traded in casino-like frenzy wouldn't like this example if they studied it enough. It didn't ruin England to have a long period when they didn't have publicly traded shares." - Charlie Munger in this UC Santa Barbara Speech

History repeats frequently when it comes to financial euphoria. If the seemingly obvious lessons from these episodes going back almost 400 years haven't been learned yet, chances are it isn't going to be any different the next time.

Galbraith explains why these bubbles recur so often with what he calls "financial memory" (or the lack thereof). Basically every 20 years the new players involved in the financial system, the so-called smart money**, become convinced "it's different this time" because of some new innovation, financial or otherwise (ie. The Joint Stock Corporation in the 1700's, holding companies in the 1920's, junk bonds in the 1980's, internet stocks in the late 90's, derivatives like CDO, CDS etc more recently). Here are some relevant excerpts from John Kenneth Galbraith's book, A Short History of Financial Euphoria:

"The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets." - John Kenneth Galbraith in A Short History of Financial Euphoria (Page 19)

"All [financial] crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment." - John Kenneth Galbraith 
in A Short History of Financial Euphoria (Page 20)

"Let it be emphasized once more, and especially to anyone inclined to a personally rewarding skepticism in these matters: for practical purposes, the financial memory should be assumed to last, at a maximum, no more than 20 years. This is normally the time it takes for the recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind. It is also the time generally required for a new generation to enter the scene, impressed, as had been its predecessors, with its own innovative genius." - John Kenneth Galbraith in A Short History of Financial Euphoria (Page 87)

One of the common elements in these episodes is the use of debt to finance speculation.

Historically, the so-called financial innovations from these episodes of euphoria have just been leverage in a different guise.

Adam

Three chapters of that book describe bubbles as far back as the Mississippi Company bubble in the 1700's, the South Sea Company bubble in 1700's, and the Dutch tulip mania in the 1600's.

** There is a natural tendency for the investing public to believe that those who have/manage lots of money must be the "smart money".

In reality, Galbraith says no such correlation exists if you pay attention to history. Financial heroes or geniuses before a bubble bursts become the villains after the crash. Those that are supposed to be the "smart money" seem to often get it very wrong.

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

Tuesday, July 7, 2009

Kurt Gödel & Orson Welles

Kurt Gödel (Austrian-American mathematician) showed that all but the most trivial systems capable of arithmetic must always be either inconsistent or incomplete.

One of his incompleteness theorems is related to the liar paradox.

The liar paradox is as follows: 

"This sentence is false."

The sentence cannot be true, since then it is false.

It also cannot be be false, since then it is true.

In a previous post, I mentioned Charlie Munger's observation that: "if the mathematicians can't get the paradox out of their system when they're creating it themselves, the poor economists are never going to get rid of paradoxes, nor are the rest of us."

Expect to run into to some paradox and messiness during the investment process. Sometimes useful insights reside near where there's incompleteness and inconsistency; they reside where something  just doesn't quite fit. Munger also said:

"When I run into a paradox I think either I'm a total horse's ass to have gotten to this point, or I'm fruitfully near the edge of my discipline. It adds excitement to life to wonder which it is."

So what does this have to do with Orson Welles?

There's a scene in the 1949 movie, The Third Man, where Welles delivers a pivotal monologue.

Here's a good setup from filmsite.org for the monologue by Welles:

With murderous fluency, he [Harry Lime played by Welles] contemplates the greater productivity of a warring, strife-ridden culture and civilization that is plagued by warfare and violence, versus a peaceful one. The corruptible Lime cynically justifies his black market criminal activities by recognizing that despite appearances, good and evil (black and white, peace and war, up and down, etc.) are complementary concepts.

...and a key part of the monologue as delivered by Welles (with a smug grin):

"In Italy for thirty years under the Borgias, they had warfare, terror, murder, bloodshed - but they produced Michelangelo, Leonardo Da Vinci, and the Renaissance. In Switzerland they had brotherly love, 500 years of democracy and peace, and what did they produce? The Cuckoo Clock."

Unlike Citizen Kane (1941), the movie was not written by Orson Welles but, apparently, he did come up with that monologue.

Adam

* The actors in this scene [Joseph Cotton and Orson Welles] both first appeared together in Citizen Kane.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, July 6, 2009

Dick Bove on CNBC

"In the 1st quarter of this year the 8426 banks in the US generated $ 80 billion in pre-tax cash profit. That was the highest number that this industry has generated ever." - Dick Bove on CNBC (June 26, 2009)

Doesn't seem to get much coverage. The current cash earning power of banks right now remains extremely strong.

There will be large write-offs for the banks over the next couple of years but the system continues to have significant capacity to absorb those write-offs and build capital through earnings over time.

During a downturn, the short run earnings are often understated while banks are booking loan loss provisions to build reserves in anticipation of future losses. Non-cash expenses in GAAP* can easily be misunderstood. What they mean in the long-term may be far less significant than they seem in the near-term. Getting the interpretation mostly right and understanding the inherent limits of accounting is key.

For any bank it comes down to sound assets, smart credit analysis and underwriting, reasonable leverage/capital levels, sufficient liquidity and, ultimately, the quality of earnings. A bank with the lowest cost deposits has a huge advantage in the long run. Current GAAP earnings alone do not tell you very much about the dynamics of a bank.

Where investing in banks gets tricky is when they are required by regulators to raise capital to meet capital requirements when the stock price happens to be low. When this happens, it may not make sense (or even be fair) economically but as Clint Eastwood said in the movie Unforgiven: "Deserve's got nothin' to do with it."

Fair or not, the dilution still has a very real negative impact on investor returns.

A lot of pain lies ahead for the banks but the survivors should turn into solid long-term investments. Those that buy a high quality bank now -- and have the stomach to ride out the storm -- will likely do just fine over the next 10 years even if some dilution occurs.

Adam

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

Saturday, July 4, 2009

Wall Street Journal - July 4th, 1930

Here are two interesting July 4, 1930 Wall Street Journal headlines.

On competitive threats to Gillette:

WSJ - Gillette Safety Razor plunged to lowest level since 1925 on concerns of increasing competition, good report from competitor AutoStrop Safety Razor.

Procter and Gamble bought Gillette in 2005 for $ 57 billion so I guess those competitive threat concerns were a bit overblown.

Not sure what happened to AutoStrop.

The other headline that caught my attention was:

WSJ - Current depression doesn't appear that serious: number of shareholders of major corporations continues to grow; gasoline demand is up; Treasury is running a surplus; mass transit and auto traffic continues high; dividend and interest payments will not be far off record 1929 levels. Prevailing opinion is that “stocks cannot be forced much below current levels.”

The stock market had only fallen 30% at that point. It would go on to fall almost 90% peak to trough over the next two years.

Adam

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

Thursday, July 2, 2009

Six Stock Portfolio Update

Portfolio performance since mentioning on April 9, 2009 that I like these six stocks as long-term investments if bought near prevailing prices at that time (or lower, of course).

While I never make stock recommendations each of these, at the right price, are what I consider attractive long-term investments for my own capital.

Stock|% Change*
WFC|+29.8%
DEO|+25.6%
PM  |+13.7%
PEP |+4.7%
LOW|-3.7%
AXP|+31.9%

Total return for the six stocks combined is 17.0% (excluding dividends) since April 9th. The S&P 500 is up 9.0% since that date. This is a conservative calculation of returns based upon the average price of each security on the date mentioned. Better market prices were available in subsequent days so total returns could have been improved with some careful accumulation.

The purpose is not to measure returns over such a short time frame. It's meant to be, in part, an easy to verify working example of Newton's 4th Law.

Above market long-term returns can be achieved if you buy 5-10 good businesses and hold them for a very long time.

Less activity generally produces higher long-term returns for most investors.

The hyperactive trading ethos in vogue is nonsense.

This portfolio certainly won't outperform in every period but in the long run it has a reasonable probability of beating the S&P 500. It will probably not outperform the very best portfolio managers but should do very well against many mutual funds over a period of 10 years or longer with lower risk.

The professional money management business is lucrative whether they perform or not. Few (if any) industries pay so well for below par performance. (Charlie Munger calls them febezzlers)

In any case, this simple experiment is designed so it's easy for anyone to check the results. So if it isn't working (it'll take a few years, at least, to meaningfully start judging performance) it will be obvious.

I don't think these are necessarily the six best businesses in the world, but I believe they are all very good businesses*** that were selling at reasonable prices on April 9th, 2009. At any moment, there is always something better to own in theory but I don't think you can't invest that way (as if stocks are baseball cards) and have consistent success.

I plan to occasionally (though rarely) add or switch some of the stocks in this portfolio but generally will make only minor changes.

Adam

Long position in DEO, AXP, PEP, PM, WFC, and LOW

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 are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to be long the positions noted unless they sell significantly above intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
** As of 6/30/09.
*** There are certainly quite a few other businesses that would be good alternatives to these six. The point is for me to get a handful of them at a fair price and then let time work.

Wednesday, July 1, 2009

Pricing Power

"We like buying businesses with some untapped pricing power. When we bought See's for $25 million, I asked myself, 'If we raised prices by 10 cents per pound, would sales fall off a cliff?' The answer was obviously no. You can determine the strength of a business over time by the amount of agony they go through in raising prices. 

A good example is newspapers. The local daily paper controlled the market and every year they raised the ad rates and circulation prices – it was almost a big yawn. They didn't worry about losing big advertisers like Sears, J.C. Penney or Wal-Mart, or losing subscribers. They increased prices whether the price of newsprint went up or down. 

Now, they agonize over price increases because they worry about driving people to other media. That world has changed." - Warren Buffett at the 2005 Berkshire Hathaway Annual Shareholder Meeting

Collectively, the earnings of the companies in the S&P 500 will be down 30-40% compared to the peak in 2006. As a group, the earnings of the companies in the S&P 500 is slightly down (5-15% depending on estimates) compared to 5 year ago.

It's a different story for those companies that have pricing power.

Consider the following.

We are in a severe recession yet the earnings of KO, PEP, JNJ will still be -- give or take -- basically flat compared to a year ago. No real earnings erosion in an environment like this? A more than slight decline in such an environment would be completely acceptable, yet these businesses are so good that they can still grind out similar earnings year over year. What's possibly a bit underappreciated though is that while the aggregate earnings of the companies in the S&P 500 is down a bit compared to five years ago, all three of these company's earnings this year will be 50% higher compared to five years ago.

This earnings resilience comes from the pricing power of each company's high quality brand portfolio, distribution strength, and the stability of demand for their products.

The earnings of all three should also continue increasing solidly over time.

Great franchises produce above average returns on capital through pricing power.

They are price setters not price takers.

Price setters
are those companies that dictate the price its customers pay for goods and services.
Price
takers are those companies that cannot dictate their prices. Their prices are dependent on the supply and demand within the market (commodities).

If a business doesn't have pricing power, it consistently has to be the low cost producer in the industry to get above average returns.

Adam

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