Thursday, December 31, 2009

Quotes of 2009

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

"A light-weight vehicle with a small carbon footprint using alternative energy and renewable resources to operate in a sustainable way– When I was a kid, we called it a Schwinn." - P.J O'Rourke Speaking at the Cato Forum

"What Wall Street does is package luck and sell it as skill." - Dan Solin on CNBC

"There's no reason to have a system where every young man has $8 billion to play with and buy whatever he wants. It's incredibly stupid. It's absolutely crazy. If I were in charge, I'd take away everything from banks that wasn't boring. Completely shut down [credit default swaps] 100%. What's the harm in this? The world worked just fine without them. We don't need an economy that resembles a vast poker tournament." - Charlie Munger at the 2009 Wesco Meeting

"A man does not deserve huge amounts of pay for creating tiny spreads on huge amounts of money. Any idiot can do it. And, as a matter of fact, many idiots do it." - Charlie Munger at the 2009 Wesco Meeting

"I remember the $0.05 hamburger and a $0.40-per-hour minimum wage, so I've seen a tremendous amount of inflation in my lifetime. Did it ruin the investment climate? I think not." - Charlie Munger at the 2009 Wesco Meeting

"The world will adapt to higher oil prices, because it has to. It won't be the end of the world. Even at $200 a barrel, we'd be fine. People would adapt. We have an enormous power to adapt." - Charlie Munger at the 2009 Wesco Meeting

"I can't tell you how surprised, even embarrassed I was to get the Nobel Prize in chemistry. Yes, I had passed the dreaded chemistry A-level for 18-year-olds back in England in 1958. But did they realize it was my third attempt? And, yes, I will take this honor as encouragement to do some serious thinking on the topic. I will also invest the award to help save the planet. Perhaps that was really the Nobel Committee’s sneaky motive, since there are regrettably no green awards yet. Still, all in all, it didn't seem deserved." - Jeremy Grantham in the 3Q09 Letter

"Rational expectations and the efficient market hypothesis are as dead as dodos, yet their baleful and painful influence lives on..." - Jeremy Grantham in the 3Q09 Letter

"Yes, of course every country needs a basic financial system to function effectively with letters of credit, deposits, and check writing facilities, etc. But as you move beyond that it is worth remembering that every valued job created by financial complexity is paid for by the rest of the real economy, and talent is displaced from real production, as symbolized by all of the nuclear physicists on prop trading desks." - Jeremy Grantham in the 3Q09 Letter

"Our model is a seamless web of trust that's deserved on both sides. That's what we're aiming for. The Hollywood model where everyone has a contract and no trust is deserved on either side is not what we want at all." - Charlie Munger at the 2009 Berkshire Hathaway Meeting

"We don’t want relationships that are based on contracts. I can’t really think of a formal contract that we have. We have understandings about bonus arrangements with various managers. We have different arrangements because all the businesses are different. We don’t try to hold people by contracts and it wouldn't work. We basically don't like engaging in them." - Warren Buffett at the 2009 Berkshire Hathaway 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 Meeting

"We don't try to pick bottoms. To sit around and not do something sensible because you think there might be something better…. doesn't make sense. Picking bottoms is not our game. Pricing is our game. And that's not so difficult. Picking bottoms is, I think, impossible." - Warren Buffett at the 2009 Berkshire Hathaway Meeting


Happy New Year,

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, December 30, 2009

Behavioral Bias

Here is a good post summarizing some of the many forms of behavioral bias. The biases covered include:
  • Overconfidence
  • Hindsight Bias
  • Loss aversion
  • Regret
  • Anchoring
Among others.

An excerpt:

"Unfortunately academic approaches which aim to replicate market behavior by tweaking efficient market models often don't translate well to the harsh, Darwinian world of real finance where people need to use these ideas to make money. Typically the models work right up to the point they don't, when they fail catastrophically."

This stuff is useful beyond improving investing results.

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.

Monday, December 28, 2009

Highly Probables: Berkshire Shareholder Letter Highlights

Warren Buffett wrote the following in the 1996 Berkshire Hathaway (BRKa) shareholder letter:

Of course, Charlie and I can identify only a few inevitables, even after a lifetime of looking for them. Leadership alone provides no certainties: Witness the shocks some years back at General Motors, IBM and Sears, all of which had enjoyed long periods of seeming invincibility. Though some industries or lines of business exhibit characteristics that endow leaders with virtually insurmountable advantages, and that tend to establish Survival of the Fattest as almost a natural law, most do not. Thus, for every inevitable, there are dozens of impostors, companies now riding high but vulnerable to competitive attacks. Considering what it takes to be an inevitable, Charlie and I recognize that we will never be able to come up with a Nifty Fifty or even a Twinkling Twenty. To the inevitables in our portfolio, therefore, we add a few "highly probables."

In the letter, he refers to Coca-Cola (KO) and Gillette (now part of Procter & Gamble:PG) as "The Inevitables".

Adam

Long BRKb, KO, and PG
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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.

Saturday, December 26, 2009

The Daily Journal

Charlie Munger has been Chairman of The Daily Journal (DJCO) since 1977 and his legal firm controls 41% of the company. It is thinly traded but is one of the few profitable news organizations. This article in TheStreet.com gives a quick overview of DJCO's success.

The Daily Journal has avoided the problems afflicting other news organizations by targeting niches, such as lawyers and readers in small communities in California. This tactic has lead to a profitable mix that capitalizes on the weak coverage of local news on the Web. The company also provides specialized information and software to courts.

The company's operating results have been phenomenal. Its return on equity of 28% and net margin of 22% leave the New York Times and Washington Post in the dust.
- TheStreet.com

Daily Journal Prints Cash: Under the Radar

So the business is doing well. At least it is in the context of that industry's troubles. What I find even more interesting is that at the start of this year the company had around $ 22 million of cash and equivalents (mostly in US Treasuries). In fact, for most of the past decade the company had remained cautiously positioned with investments. Around March, approximately $ 20 million of those investments in US Treasuries were converted to common stocks. Those equity investments are now worth $ 54 million with another $ 8 million of cash on the balance sheet...and still no debt (~$ 6 million of the $ 8 million of cash currently on the balance sheet as of 9/30/09 is from FCF generated this year). So as of 9/30/09 approximately $ 62 million of the company's $ 80 million market value is represented by cash and stocks.

One could easily argue that of the great investors who've been around a while Charlie and the DJCO team have had the best year.

Also, if you think DJCO has a decent future right now...that $ 5 million+ in FCF DJCO is generating can be bought for around $ 18 million ($ 80 million market value minus $ 62 million in cash and stocks).

Slightly more than 3.5 Price/FCF. I'm guessing that the portfolio is a pretty sound one considering who is in charge. Whether the business has good future prospects is not as clear but the margin of safety appears to be there.

Adam

No position in DJCO
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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.

Thursday, December 17, 2009

"Stock-Renters"

"...we have this huge amount of investors in the market or, rent-a-stock, stock-renters in the market compared to stock owners." - John Bogle on CNBC

Yesterday morning on CNBC, John Bogle referred to the following quote from John Maynard Keynes:

"Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done." - John Maynard Keynes in Chapter 12 of The General Theory of Employment, Interest and Money

Bogle went on to say that one of the biggest risks going forward is what he sees as the unfortunate, and in his view very damaging triumph of speculation over investing. In the video, he goes on to say that the problem is the ongoing trend toward speculators in the market (what he calls the "stock-renters") and away from owners with long-term returns in mind (Bogle points out that the amount of speculative activity is measurably higher now than it was even in 1929).

To me, it makes sense that you end up with more price distortions in the market like we've had this past decade with so many "renters" participating. An owner of something is more likely to be grounded by intrinsic value. A renter will naturally focus on short term price movement even if that price is extremely decoupled from reality.

"Long ago, Ben Graham taught me that 'Price is what you pay; value is what you get.'"  - Warren Buffett in the 2008 Berkshire Hathaway Shareholder Letter

If a larger and larger percent of market participants are not grounded in value, and instead focused on price action, doesn't it seem probable that the result will be more stocks becoming mispriced relative to intrinsic value? Would GE and Coca Cola have been selling at 50+ times earnings in the late 90's or Cisco at 100x during the internet bubble (never mind all the internet bubble stocks that made even Cisco at 100x earnings look cheap) if fewer participants were in the "stock-renting" business?

The emergence of the market technicians could be seen as cause or symptom depending on your point of view. Either way, technicians do not see any point to fundamental analysis. It's all in the charts (technical analysis is not new but it is certainly prevalent). Algorithms that are designed to profit from "ownership" of a stock for mere seconds care nothing about value. With fewer participants focused upon value the frequent and widespread mispricing of assets seems inevitable.

In Bogle's book, The Battle for the Soul of Capitalism, he said the following:

"When we should be teaching young students about long-term investing and the magic of compound interest, the stock-picking contests offered by our schools are in fact teaching them about short-term speculation."

Charlie Munger has expressed similar views.

"There's no reason to have a system where every young man has $ 8 billion to play with and buy whatever he wants. It's incredibly stupid. It's absolutely crazy. If I were in charge, I'd take away everything from banks that wasn't boring. Completely shut down [credit default swaps] 100%. What's the harm in this? The world worked just fine without them. We don't need an economy that resembles a vast poker tournament." - Charlie Munger at the 2009 Wesco Shareholder Meeting

For me, large price distortions in the stock market has got to hurt the real economy. Some may ask when Coca-Cola* was selling at 50+ times earnings in the late 90's what's the harm? Well, significant mispricings can lead to distortions in the capital allocation process. Mispriced assets leading to misallocated capital. This might prevent, or at least delay, capital from getting somewhere else where it'd be more useful for economic development. Those misallocated dollars in Coca-Cola (or Cisco, GE, and just about any internet stock at the time), for example, might instead be used to help some entrepreneur get a good idea, in a timely way, off the ground that ultimately would create wealth and jobs.

Obviously, the problem is not that the money disappears in this example. Someone's is always on the other side of the trade. It's just a very inefficient way to do the business of capital allocation and development. You end up with certain industries overcapitalized -- maybe resulting in overcapacity/excess supply -- while others with merit don't get off the ground or are delayed.

 The process becomes truly destructive is when lots of fresh capital goes into a bunch of internet startups with little merit while more useful things don't get funded sufficiently or at all.

In the late 1990s, plenty of market participants, professional or not, were buying overvalued shares of Coca-Cola, GE, Cisco. Even worse, some were buying things like Pets.com. We've also just recently experienced an enormous speculative housing bubble followed by a commodity bubble.

The markets have always been a bit manic in nature. It swings -- more than occasionally -- from excessive exuberance to excessive fear. That's not going to change. 


It's just that, in its current form, it seems designed to amplify that tendency. 

Adam


Long stocks mentioned

* Coca-Cola was most certainly overpriced -- selling at a price that far exceeded per share intrinsic value -- in the late 1990s. Today, at the very least Coca-Cola's intrinsic value has, give or take, caught up to its stock price.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Stocks to Watch

Here is an update of stocks I like* for my own portfolio at the right price.

Those under the dashed line are businesses I like but prevailing prices have become too expensive. Some are just barely above but the objective should be, of course to buy them well below.

Unfortunately, most of the stocks are now below that line.

Kraft (KFT) continues to be held back by it's bid for Cadbury (CBY) so it's price has remained reasonable.

I've added NSC and MCD to the list. Neither are great bargains right now but NSC is a good alternative to BNI and MCD is one of the great global franchises. I've removed BNI from the list due to Berkshire Hathaway's pending acquisition.

As always, the stocks in bold have two things in common. They are:

1) currently owned by Berkshire Hathaway (as of 9/30/09) and,
2) selling below the price that Warren Buffett paid in the past few years.

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

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

Stock/Max Price I'd Pay/Recent Price (12-16-09)
JNJ/65.00/64.80 - Buffett paid ~$ 62
KFT/30.00/27.15 - Buffett paid ~$ 33
USB/24.00/22.09 - Buffett paid ~$ 31
WFC/28.00/25.84 - Buffett paid ~$ 32
MCD/63.00/62.42
NSC/54.00/52.86
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COP/50.00/50.86 - Buffett paid ~$ 82...sold some shares at a loss
MHK/45.00/47.37
PG/60.00/62.16
PEP/60.00/60.68
KO/55.00/58.42
AXP/35.00/41.27
ADP/37.00/42.89
DEO/60.00/68.88
PM/45.00/50.08
BRKb/3000/3309
MO/16.00/19.63
LOW/19.00/23.69
HANS/30.00/36.33
PKX/80.00/128.24
RMCF/6.00/8.02
(Splits, spinoffs, and similar actions inevitably will occur going forward. Will adjust as necessary to make meaningful comparisons.)

Stocks removed from list:
  • BNI - I liked purchasing BNI up to $ 80/share. It was bought out by Berkshire Hathaway for $ 100/share in late 2009. Deal should close early 2010.
The max price I'd pay takes into account an acceptable margin of safety**. That margin of safety differs for each company.

In other words, I believe these are intrinsically worth quite a bit more than the max price I've indicated in this post and in prior Stocks to Watch posts. I also believe most of these companies generally have favorable long-term economics (i.e. the best of them have high and durable ROC) and, as a result, intrinsic values will increase over time. Of course, I may be wrong about the core economics and that margin of safety could provide insufficient protection against a loss. Still, a year from now I would expect to be willing to pay more for many of these based upon each company's intrinsic value growth over that time frame.

Some of these stocks have rallied quite a bit compared to not too long ago. So they're more difficult to buy with a sufficient margin of safety. Still, that doesn't mean the risk of missing something you like when a fair price is available (error of omission) won't ultimately 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 a perfect solution with your best long-term investment ideas.

To me, if an investment was 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 a real one (error of commission).

There is no perfect answer to this problem. 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.

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.
** The required margin of safety is naturally larger for a bank than for something like KO. When I make a mistake and misjudge a company's economics in a major way, the margin of safety may still not be sufficient. Judging the durability of the economics correctly matters most. If the economics remain intact but the stock goes down that is a very good thing in the long run.

Wednesday, December 16, 2009

Airlines: A Tough Business

Airlines have had a fairly brutal half century or so. It has just been a difficult business to be in for a whole bunch of reasons. Here are just some of the many problems:
  • Capital intensiveness
  • High fixed costs resulting in excessive operating leverage
  • Unpredictable fuel expenses that airlines have little control over
  • Fuel expenses typically make up a substantial portion (~20-30%) of an airline's cost structure with potential spikes beyond that level
  • Minimal to no pricing power
  • Overcapacity
  • Excessive debt (financial leverage)
A business with both high operating leverage and financial leverage will have net income (in the case of airlines mostly net losses) that is highly volatile. Generally, if you are in an industry that has inherently high operating leverage (like an airline) use of debt should be kept to a minimum. With both types of leverage in place net income becomes very sensitive to even small changes in revenues. When revenues are going up it's great but when they reverse profitability disappears quickly. Add in the unpredictability of fuel costs and a lack of pricing power and you have just about everything you don't want in a business.

From an article in The Onion:

In its ongoing effort to cut transportation costs and boost profits, United Airlines announced Tuesday that it was exploring the feasibility of herding them into planes and stacking them like cordwood from floor to ceiling.

"After much trial and error, we've found the most efficient way to stack them is to start with a base of large ones, then put down a layer of medium ones, then fill up all the holes with the smaller ones," operations manager Gary Brown said. "The really tiny ones are great for cramming up in the corners."

That's, at the very least, a novel approach to solving a difficult problem.

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, December 11, 2009

AOL Goes Public...Again

A little less than 10 years ago AOL's market value was, unbelievably, over $ 160 billion. Once combined with Time Warner the market value of the 2 companies was over $ 300 billion.

AOL went public again today and is trading at around $ 23/share. At that price the company is currently valued at $ 2.4 billion...a 98.5% drop in value since back when it acquired Time Warner.

The funny thing is AOL may finally be fairly valued now though I certainly wouldn't touch it (At today's price AOL is probably selling at 5-6x current earnings...whether just a fraction of those earning will be around in 5 years is the question). So best case it's a cigar butt.

What a difference a decade makes.

When AOL bid to buy Time Warner who in either boardroom or within the senior leadership was thinking about Google?

From this MarketWatch article:

...few were even aware that a 70-person startup called Google had set out to show small advertisements alongside Internet search results. Just five years later, Google Inc. itself had become a heavyweight on the scene and it purchased a 5% stake in AOL from Time Warner, at a price of $1 billion. Four years after that, however, Google sold the stake back to a chastened Time Warner for $283 million, while maintaining control of the inner workings of AOL's search engine through a partnership.

Back in 2000 when AOL was valued at over $ 160 billion the company was earning approximately $ 1 billion per year giving it a PE of ~160. So, as an investor, you were paying $ 160 to buy $ 1 of earnings for a company with a suspect economic moat.

The contrast of AOL at the time with Google today is significant. Google will earn over $ 7 billion this year and is in a position to grow that substantially in coming years. So while Google's $185 billion market value is slightly higher than AOL's at the time, it's earning capacity is already 7x higher and looks more durable. It also has $ 22 billion of cash with no debt. Now that may not be cheap...but a case can certainly be made for that price in my view.

Most importantly, at least for now, Google appears to have a wide economic moat. Now whether that moat will become wider or shrink over time is much more difficult to judge considering how fast the world they operate in changes. Still, I wouldn't bet against them over the short to medium run.

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.

Thursday, December 10, 2009

$ 2 Million -----> $ 2 Trillion

The following are excerpts from Charlie Munger's Turning $ 2 Million into $ 2 Trillion.

It is 1884 in Atlanta. You are brought, along with twenty others like you, before a rich and eccentric Atlanta citizen named Glotz.

Effectively, it is an explanation of psychological factors and other forces that helped to make the Coca-Cola Company what it is.

Glotz offers to invest $2 million, yet take only half the equity, for a Glotz charitable foundation, in a new corporation organized to go into the non-alcoholic beverage business and remain in that business only, forever. Glotz wants to use a name that has somehow charmed him: Coca-Cola.

The other half of the new corporation's equity will go to the man who most plausibly demonstrates that his business plan will cause Glotz's foundation to be worth a trillion dollars 150 years later, in the money of that later time, 2034, despite paying out a large part of its earnings each year as a dividend. This will make the whole new corporation worth $2 trillion, even after paying out many billions of dollars in dividends.

You have fifteen minutes to make your pitch. What do you say to Glotz?

And here is my solution, my pitch to Glotz, using only the helpful notions and what every bright college sophomore should know.

Check out the full post to see Charlie's approach.

Adam

Munger: Practical Thought About Practical Thought?

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, December 9, 2009

Ackman on McDonald's

One of the great global franchise businesses is McDonald's (MCD). Yesterday, they reported some disappointing same store sales results for November. While that indicates some problems in the short run, I don't think it changes the long-term attractiveness of the business (though the news has the potential to bring the stock into a more attractive valuation range).

MCD has solid returns on capital that will likely improve over time and a durable wide moat.

Below is an excerpt of Bill Ackman's (Pershing Square Capital Management) recent take on MCD from his 2Q09 letter:

McDonald's makes money in principally two ways: first, by collecting an approximate 14%+ share of its franchisees' revenues for the use of McDonald’s brand...and second, by generating operating profits from a portfolio of company-operated stores.

Then later added...

McDonald's brand royalty business is one of the greatest businesses in the world because it generates an annuity-like revenue stream which can grow without the requirement for meaningful investment of capital from the company. Because the company's revenue share comes from more than 32,000 different stores spread around the globe, it is an inherently stable, currency-hedged, inflation-protected stream of cash flow. 

Despite its business quality and dominant global market position, McDonald's stock trades at only about 13 times multiple of 2010 earnings, a price which we believe does not adequately reflect the company’s fair value.

MCD has attractive long-term prospects and a reasonable valuation (reasonable but certainly not cheap). It's currently selling at around $ 60/share and should earn at least $ 4.30/share in 2010. As far as global franchises go I still prefer the likes of Coca-Cola, Pepsi and Diageo but McDonald's should do very well in the coming decades.

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.

Thursday, December 3, 2009

Investor Intelligence

Good post on two studies that reveal patterns of poor decision-making by what would generally be considered intelligent and informed investors.

The title of the post: Intelligence Can Seriously Damage Your Wealth

From the post:
"An eye-opening study on how investors choose index funds – Why Does The Law of One Price Fail? – selected a bunch of exceedingly bright people as its subjects, most being in the 98th and 99th percentiles of US SAT scores: to summarise, these people are pretty damn smart by normal standards. Moreover the participants were also decently incentivised to succeed at the investment task – which was to select the highest performing portfolio of S&P500 index funds.

Now, a moment's consideration will show that the only real differences between one S&P500 index tracker and another are the fees they charge. Therefore the optimum portfolio choice should be one that selects the minimum fee fund. It's simply not that tricky a decision. Anyway, as you can guess, the ├╝ber-smart respondents conclusively proved that being the brightest of the brightest is no defence
..."

The post also added this:

"The dumber investors did better than the smarter ones because they didn't understand enough about what they were doing to be fooled into doing completely the wrong thing. Brain hurting yet?"


And in a separate study...

Doran, Peterson and Wright carried out a study on finance professors, looking at their investment behaviour.

Obviously we're talking here about a group of people who should have a decent understanding of the way markets work and of the theories behind them. What we find, however, is the usual mix of confusion between ostensible beliefs and actual behaviour: basically as a group the professors behave in much same behaviourally muddled way as everyone else.


When it comes to the investment process, the right temperament and an awareness of limits matters more than extraordinary intelligence.

I think the example of Isaac Newton and the South Sea Bubble makes that pretty clear.

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, December 2, 2009

Psychology of Human Misjudgment

This is from a talk given by Munger at Harvard in 1995 on the subject of human misjudgment and the system of psychology that Munger came up with to better understand it.

Not a short or easy read but worth it.

Excerpt:
Although I am very interested in the subject of human misjudgment - and lord knows I've created a good bit of it - I don't think I've created my full statistical share, and I think that o­ne of the reasons why I tried to do something about this terrible ignorance I left the Harvard Law School with.

When I saw this patterned irrationality, which was so extreme, and I had no theory or anything to deal with it, but I could see that it was extreme, and I could see that it was patterned, I just started to create my own system of psychology, partly by casual reading, but largely from personal experience, and I used that pattern to help me get through life. Fairly late in life I stumbled into this book, Influence, by a psychologist named Bob Cialdini.... Well, it's an academic book aimed at a popular audience that filled in a lot of holes in my crude system. In those holes it filled in, I thought I had a system that was a good-working tool, and I'd like to share that o­ne with you.

And I came here because of behavioral economics. How could economics not be behavioral? If it isn't behavioral, what the hell is it? And I think it's fairly clear that all reality has to respect all other reality. If you come to inconsistencies, they have to be resolved, and so if there's anything valid in psychology, economics has to recognize it, and vice versa. So I think the people that are working o­n this fringe between economics and psychology are absolutely right to be there, and I think there's been plenty wrong over the years.


In this talk Charlie Munger goes through more than 20 different standard causes of human misjudgment. He updated them in Poor Charlie's Almanac. The update is organized around 25 different psychology-based tendencies.

Considering the length of the original talk I happened to choose an excerpt from the 5th standard cause:

Where you see in business just perfectly horrible results from psychologically-rooted tendencies is in accounting. If you take Westinghouse, which blew, what, two or three billion dollars pre-tax at least loaning developers to build hotels, and virtually 100% loans? Now you say any idiot knows that if there's o­ne thing you don't like it's a developer, and another you don't like it's a hotel. And to make a 100% loan to a developer who's going to build a hotel...[Laughter] But this guy, he probably was an engineer or something, and he didn't take psychology any more than I did, and he got out there in the hands of these salesmen operating under their version of incentive-caused bias*, where any damned way of getting Westinghouse to do it was considered normal business, and they just blew it.

That would never have been possible if the accounting system hadn't been such but for the initial phase of every transaction it showed wonderful financial results. So people who have loose accounting standards are just inviting perfectly horrible behavior in other people. And it's a sin, it's an absolute sin. If you carry bushel baskets full of money through the ghetto, and made it easy to steal, that would be a considerable human sin, because you'd be causing a lot of bad behavior, and the bad behavior would spread. Similarly an institution that gets sloppy accounting commits a real human sin, and it's also a dumb way to do business, as Westinghouse has so wonderfully proved.

Oddly enough nobody mentions, at least nobody I've seen, what happened with Joe Jett and Kidder Peabody. The truth of the matter is the accounting system was such that by punching a few buttons, the Joe Jetts of the world could show profits, and profits that showed up in things that resulted in rewards and esteem and every other thing... Well the Joe Jetts are always with us, and they're not really to blame, in my judgment at least. But that bastard who created that foolish accounting system who, so far as I know, has not been flayed alive, ought to be.


The updated written version found in Poor Charlie's Almanac is also called The Psychology of Human Misjudgment. It is much more formal and organized than the original talk.

Adam

* Incentive-Caused Bias is the title of another one of the standard causes of human misjudgment covered in another section of his talk...these psychological tendencies all interact.
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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, December 1, 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|+50.1%
DEO|+48.5%
PM  |+25.4%
PEP |+18.6%
LOW|+8.2%
AXP|+137.0%

Total return for the six stocks combined is 48.03% (excluding dividends) since April 9th. The S&P 500 is up 29.95% 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 here is not to measure returns over short time frames. It's meant to be an easy to verify working example of Newton's 4th Law.

Many equity investors would get improved long-term returns, at lower risk, if they: 1) bought (at fair or better than fair prices) shares in 5-10 great businesses, 2) avoided the hyperactive trading ethos that is so popular these days to minimize mistakes & frictional costs, and 3) sold shares in these businesses only if the core long-term economics become impaired or opportunity costs are extremely high.

A six stock portfolio is very concentrated but vast diversification isn't always needed. I've noted this in a previous post.

"We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it." - Warren Buffett in the 1993 Berkshire Hathaway Shareholder Letter

Having said that...the less experienced you are as an investor the more diversification may be a necessity. Those that fall into this group probably need to diversify holdings more but still keep trading and frictional costs to a minimum. Index funds may make more sense than buying individual stocks. It's important to know which camp you fall into before investing a penny.

The above concentrated portfolio of six stocks won't outperform in every period. In the long run it has a reasonable probability of doing well compared to the S&P 500 due to lower frictional costs and the quality of the businesses. The growth in value comes from the intrinsic value created by the businesses themselves...not some special aptitude for trading or timing the market. It probably won't outperform the very best portfolio managers but should do very well against many mutual funds** over a period of 10 years or longer.

In any case, this simple experiment is designed so it's easy for anyone to check the results. If this six stock portfolio*** isn't performing well against the S&P 500 (it'll take a few years, at least, to meaningfully start judging performance) it will be obvious.

Finally, an opportunity may come along where the capital from one of these stocks is needed.

My view is under such a scenario the threshold for making changes needs to be high. That hypothetical new investment must have clearly superior economics.

In addition, if something appears to fundamentally threaten the moat (ie. the effect of the internet on the newspaper biz) of one of these businesses a change may also be warranted.

So I may rarely add or switch some of the stocks in this portfolio but I will only make a change if the situation described above exists (ie. if the core long-term economics of one of these stocks become impaired or opportunity costs are extremely high).

Adam

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

* As of 11/30/09.
** 
There's no shortage of evidence that many actively managed equity mutual funds underperform the S&P 500. Also, DALBAR's Quantitative Analysis of Investor Behavior (QAIB) study released in March 2009 revealed that over the past 20 years investors in stock mutual funds have underperformed the S&P 500 by 6.5% a year (8.35% vs. 1.87%). Beyond the performance of the funds themselves, it shows that much of these poor returns come down to investor behavior. The tendency of investors to buy the hot mutual fund that has been going up while selling when the market is going down out of panic or fear (the same is true for stocks).
*** 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. At any moment, there is always something better to own in theory but I don't think you can invest that way (as if stocks are baseball cards) and have consistent success. So there are certainly quite a few other shares in 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.

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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 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.
 
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