Wednesday, September 29, 2010

The Dividend Matters

Why dividends (especially when reinvested) are a much bigger deal than some realize...

Reinvested dividends actually make up almost the entire total return in the long run. This Barron's article points out:

Since 1929, $ 100 invested in the S&P 500 would be worth $117,774. Out of that $117,774 only $4,989, or 4.2%, came from capital appreciation. That means 95.8% of the total return was dividends and the reinvestment of those dividends.

Here's a more recent example.

Today, Coca-Cola pays $ 1.76/share in dividends...roughly half what it earns. 25 years ago it was selling at ~$ 2.90/share. What probably looked like a modest dividend back in 1985 has grown to what is now a roughly 60% annualized dividend on the $ 2.90/share an investor paid back then. So every two years the rate of cash dividends being received by a 1985 buy-and-hold investor exceeds the amount originally paid for the stock.

That dividend, of course, should continue to grow.

If those future dividends are reinvested, 25 years from now that original $ 2.90/share price paid is likely to seem like a small fraction of an afterthought.

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.

Tuesday, September 28, 2010

Buffett: Regenerative Capacity of Capitalism

Warren Buffett thinks the "normal regenerative capacity of American capitalism" trumps fiscal and monetary policy in the long run. From this CNBC article:

"...we had many recessions in the history of this country when nobody even heard of fiscal policy or monetary policy. The country always comes back.

There are 309 million people out there that are trying to improve their lot in life. And we've got a system that allows them to do it. It doesn't allow things to get changed overnight, though. And...it's important to have the right monetary policy. It's important for-- to have the right fiscal policy. But it's nowhere near as important as just the normal regenerative capacity of American capitalism." - Warren Buffett


Some seem to underestimate (or ignore) the factors that allow our economic system to recover from the excesses and imbalances that inevitably occur from time to time.

Check out the complete article.

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, September 27, 2010

The Public-Utility Function

There are some comments of note by Michael Lewitt on the financial system in this Barron's article:

Among other things, he says that the financial system and its public-utility function has not been favored enough.

He argues for a balance more in favor of that function.

The reason? For society and our economy, capital is the lifeblood.

I'm realistic about whether the most logical financial system changes will happen.

Entrenched interests will, understandably, resist reigning in some of their speculative but highly profitable activities.

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, September 24, 2010

John Bogle: Capitalism & Casinoism

An interview with John Bogle on CNBC.

In the interview, Bogle is asked how he defines capitalism now:

"The only way I can define capitalism right now is casinoism!"

"The rampant trading that goes on is just foolish and creates no value for both the buyer and seller combined."

"...if you can avoid getting sucked into this vortex you will actually do better than if you did get sucked into it. Wherever the stock market is a decade from now, it's not going to have anything to do with the stupidity of today or tomorrow."


Later  in the interview he was asked about the oft-repeated phrase that "buy and hold is dead".

His response: "I say they don't understand. It's dumb."

Check out the full  interview.

Adam

HT: Gaurang Sathaye

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.

Peter Lynch: Temperament vs Intelligence

"Everyone has the brainpower to make money in stocks. Not everyone has the stomach. If you are susceptible to selling everything in a panic, you ought to avoid stocks and stock mutual funds altogether." - Peter Lynch

Thursday, September 23, 2010

Munger: Changing the Power Source

More from the University of Michigan interview with Charlie Munger. In this part of the interview he talks about the idea of "Changing the power source for mankind in a really massive way."

Charlie's not a fan of Al Gore.

Excerpts:

"If you asked what I would do if I were the benevolent despot of the United States. I would have the biggest infrastructure program you ever saw to go to power from renewable sources."

"The idea of rapidly going to the sun basically and creating a vast infrastructure that will do it is a thoroughly sound idea. And we now know how to do everything that we need to know how to do. And I think the country would get behind it."

Munger thinks the country should concentrate its intellectual and financial capital on a vast program to develop an alternative energy infrastructure.

"...we had a chance to turn our lemon into lemonade and we still have it. If I were running the world I'd be playing that card hard."

"I think it would be a net plus if we were plainly doing the right thing if we borrowed the money and created the infrastructure. I think when we just borrow the money and shovel it at people it's dangerous but I think it is less dangerous when there is something really meritorious you're doing with the money."

"I think all of this stuff is coming, I just wish it had come faster with more rationality.

I think we have been distracted a lot by people who bleeded about their own things. I'm not sure somebody as technologically ignorant as Al Gore is entitled to speak on the subject. I think you should have punched your ticket in a few better places before you open your mouth."

Interestingly, Munger wants us as a country to invest big in something that happens to be environmentally friendly yet he comes at it from a completely different point of view. An emphasis less on the environmental benefits but instead the social and economic benefits.

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, September 22, 2010

Buffett: The 'Disguised Bond'

In this 2001 Fortune article, Warren Buffett elaborates on how he never knows what any stock will do in a short time frame like 2-3 years.

This is at least mildly interesting since the average holding period for stocks from the early 1930s to late 1970s was 4-8 years. Then in the 1980s it dropped below that range and now has fallen to more like 6 months. Much less than than the time frame Buffett thinks it's possible to reliably know how a stock will perform.

Buffett also essentially says that it's not necessary to know what a stock is going to do in the short run to be successful in investing. Forecasting near-term movements may be impossible, but it is possible figure out, within a range, what a stock is likely to be worth over the longer term.

He also explains why a basket of stocks like the Dow, for example, can be thought of as a 'disguised bond'.

From the article:

"Let me explain what I mean by...'disguised bond.' A bond, as most of you know, comes with a certain maturity and with a string of little coupons. A 6% bond, for example, pays a 3% coupon every six months.

A stock, in contrast, is a financial instrument that has a claim on future distributions made by a given business, whether they are paid out as dividends or to repurchase stock or to settle up after sale or liquidation. These payments are in effect 'coupons.' The set of owners getting them will change as shareholders come and go. But the financial outcome for the business' owners as a whole will be determined by the size and timing of these coupons. Estimating those particulars is what investment analysis is all about."

Buffett then adds, at least when it comes to individual stocks, the real challenging part is figuring out what those 'coupons' are going to be.

Considering this challenge, the fact that so many market participants focus on the short-term -- what James Montier calls the "investment equivalent of attention deficit hyperactivity disorder" -- seems like a rather unfortunate use of time and energy.

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.

Tuesday, September 21, 2010

Salesforce.com's Valuation

The list of stocks with price to earnings of 50x and higher has become pretty long. One example among many is Salesforce.com (CRM).

The market value of Salesforce.com at the recent ~$ 123/share is $ 16 billion.

In the fiscal year ended January 2010 Salesforce.com earned just over $ 80 million.

In the first 2 quarters of this fiscal year the company earned $ 32.5 million.

They are growing revenues and earnings fast and expected to earn ~$ 150-160 million in the fiscal year ended January 2011.

Let's assume Salesforce.com will successfully execute 800% earnings growth in the next 3-4 years and the stock price stays the same. Even if that aggressive assumption becomes real, Salesforce.com's price to earnings multiple would actually still be higher than that of Apple (AAPL) right now.
(Apple is actually a moving target considering its own growth.)

Using the most recent 4 quarters of earnings for both companies:

AAPL: Price $ 283/share, Market Cap $ 259 billion, Earnings: $ 12.23 billion, PE = 21
CRM: Price, $ 123/share, Market Cap $ 16 billion, Earnings $ 73.6 million, PE = 217

So clearly even the 800% growth isn't enough.

I mention Apple, not to compare the two businesses (clearly they are very different), only to give that Salesforce.com valuation some perspective.* Having said that, it seems that some stocks with valuations like Salesforce.com have a tendency to go from what already seems expensive to even more so.

In many instances, the high flyers are transformational businesses with a great story. Some do actually end up justifying the seemingly high valuations in the long run.** I'm not smart enough to get that right very often so, in my case, the losses would almost surely be offset by the gains. It's very likely quite a few folks know how to effectively invest this way but I'm not one of them. Just a completely different game. For me, finding businesses with proven durable competitive advantages and buying them when there is a significant margin of safety is what works.

Salesforce.com may be the making of a great franchise. I've no doubt that there is a great story behind it. The question is:

What are you willing to pay for promise versus what's proven?

Adam

Long position in AAPL

* I'm not a huge proponent of Apple's stock but it looks even cheaper if you take into account the $ 50/share of net cash and marketable securities (nearly 18% of the Apple's market value) it has on the balance sheet. Salesforce.com has less than 2% cash as a percent of market value. In fact, as long-term investments, I happen to be no fan of most tech stocks unless the price compared to a conservative estimate of intrinsic value represents a very substantial margin of safety (i.e. very little has to go right). With too many tech stocks, the problem is that it seems nearly impossible -- using reasonable assumptions -- to create even a very rough estimate of intrinsic value. The range of future outcomes is often just too wide. What today looks like sound core economics often gets destroyed by technological shifts as well as new, very capable, competitors who emerge, sometimes, seemingly out of nowhere. In contrast, the very best businesses have plain durable advantages and a technological/competitive landscape that changes little. When it does change, more often than not, it occurs in a manageable manner; it occurs in a way that the core economics aren't severely damaged.
** Though often the valuations of these businesses disconnect from any kind of likely future economic reality.
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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, September 20, 2010

Large Cap Tech

Here's a Barron's article on how one analyst, Tavis McCourt of Morgan Keegan, thinks tech companies should allocate the enormous cash they have on their balance sheets. In addition to excellent FCF, many tech companies have cash on the balance sheet equal to 1/5 or more of total market capitalization.

McCourt recommends boosting the dividend payout ratio to as much as 70% of earnings.

Not sure if that makes sense but valuations are attractive. Some of these are selling at 10x earnings or less. If technology CEO's do end up effectively allocating their excess capital, near recent prices, there seems to be very good risk/reward with some of the companies listed in the article.

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.

Grantham: "Decline in Standards"

From Jeremy Grantham's Summer Essays:

"...how little our side of the industry did to move its business to the more ethical firms and to make a fuss about conflicted or unethical behavior. Had a number of us moved our business, we might have slowed or even stopped the 30-year slide in conflicted, unethical behavior that we have experienced. I, for one, regret the modest nature of our moves. We all could have done more. We have tolerated a pretty nasty decline in standards. Shame on us." - Jeremy Grantham

Grantham tells it like it is.

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, September 17, 2010

Charlie Munger: Snare and a Delusion

From an interview with Charlie Munger at the University of Michigan Ross School of Business. For a couple of hours, Munger talks in front of a large audience to Becky Quick of CNBC then takes questions from students and faculty.

Becky began the interview by asking Charlie for his thoughts on the economy.

"Warren and I have not made our way in life by making successful macroeconomic predictions and betting on our conclusions.

Our system is to swim as competently as we can and sometimes the tide will be with us and sometimes it will be against us. But by and large we don't much bother with trying to predict the tides because we plan to play the game for a long time.

I recommend to all of you exactly the same attitude.

It's kind of a snare and a delusion to outguess macroeconomic cycles...very few people do it successfully and some of them do it by accident. When the game is that tough, why not adopt the other system of swimming as competently as you can and figuring that over a long life you'll have your share of good tides and bad tides?"

Check out the full interview.

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, September 15, 2010

Microsoft: An Underleveraged, Low P/E Stock

Late on Monday Microsoft (MSFT) announced it is planning to issue more debt.

Two articles from Barron's:
Microsoft, like many other large tech companies these days, seems hardly expensive and has quite a balance sheet. In an environment with extremely low borrowing costs, issuing some debt looks like a smart way to utilize that exceptional balance sheet (and hopefully avoid using the cash on pricey acquisitions).

Microsoft has 8.9 billion shares outstanding and, at the current price of $ 25/share, a market cap of ~$ 223 billion. Prior to the debt offering, Microsoft had over 30 billion of net cash (cash of $ 36.7 billion minus debt of $ 6 billion) giving it an enterprise value (EV) of:

EV = market cap - net cash = $ 223 billion - $ 30.7 billion = ~ $ 192 billion

That $ 192 billion buys a company with $ 19.4 billion of free cash flow (FCF = Net Income+Depreciation+Amortization-CapEx) this past year for a EV/FCF of ~ 10x (and obviously a free cash flow yield of 10%).

A franchise with very high returns on capital and ~ 30% net margins selling at a 10x multiple? The threats to Microsoft are far more difficult to assess than Coca-Cola but few businesses generate so much excess cash while requiring so little capital.

Is there a plausible thesis describing how Microsoft's competitive advantages will become materially impaired? Will capital be used for expensive acquisitions? As always, those are the crucial judgments that need to be made but near current prices it doesn't seem expensive even with little or no growth prospects.

The company can easily borrow money for ten years at less than 5.0%* (so after tax cost would be more like 3.5%) and the stock generates a greater than 10% free cash flow yield. So, unless a material decline in earning power is in the cards, the buyback should directly benefit continuing long-term shareholders.

Microsoft's cash on the balance sheet (earning essentially nothing) could also be used to buy back shares. That cash pile is growing at a $ 5 billion clip each quarter.

What a difference a decade makes when it comes to tech stock valuations.

Adam

Long position in MSFT

* Microsoft is one of the four remaining publicly traded U.S. companies with a credit rating of triple-A. The others are Johnson & Johnson, ADP, and Exxon. Current 10-year triple-A bond rates remain on the rather low side. Johnson & Johnson recently sold 10-year bonds with a nominal interest rate of 2.95%.
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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, September 14, 2010

Buffett: Prospects for a Double-Dip Recession

Buffett spoke yesterday on the performance of the broader economy. Obviously, there's been a bit of a media obsession with the possibility of a double-dip recession in recent months. Some examples:
Buffett's comments from this Bloomberg article:

"I am a huge bull on this country...We will not have a double-dip recession at all. I see our businesses coming back almost across the board."

Later in the article he also said while sentiment turned sour in the media but he's not seeing it in the businesses Berkshire Hathaway owns. He thinks they'll be employing more people than in the past couple months or so.

Finally, Buffett added it was "night and day" from a year/year and a half ago.

It will be tough to convince some of this until the financial crisis moves further into the rear-view mirror.

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, September 13, 2010

Johnson & Johnson: An Underleveraged Stock

An article that summarizes thoughts from Whitney Tilson on why Johnson & Johnson (JNJ) should cut the dividend and take on debt to finance a large buy back of its stock.

Tilson asks you to imagine what would happen if Johnson and Johnson cut the dividend in half and used the $3 billion to issue 30-year debt. Assuming a 5% interest rate, $3 billion pays the interest on $60 billion of debt (note that last month Johnson and Johnson issued $1.1 billion of debt, half 10 year at 2.95% and half 30 year at 4.5%).

The $60 billion of debt proceeds could be used to buy back 36% of the current Johnson and Johnson shares outstanding at the current market price. After subtracting the interest payments (partially reduced by income tax savings), Johnson and Johnson's earnings per share would increase 38% assuming no increase in net income.


Personally, I would be in favor of less extreme leveraging but the point being made is a useful one. The scenario described above also works for many other companies right now. Microsoft (MSFT) is an example that comes to mind. The opportunity to do so is directly related to a combination of high FCF yield, an underleveraged balance sheet, and cheap borrowing costs.

When a durable and underleveraged franchise can access low cost financing* then use those funds to buy an 8-10% earnings yield (one that might even grow a bit over time), the difference is to the benefit of continuing long-term shareholders.

This is all in stark contrast to the post on The Danger of Short-Term Debt.

We have a situation now where, at one extreme, there are many sovereign countries and financial institutions that have seemingly too much leverage while, at the other extreme, some very good companies are underleveraged.

Some are even reasonably cheap.

Adam

Long JNJ and MSFT

* The four remaining publicly traded U.S. companies with a credit rating of triple-A are Microsoft, ADP, Johnson & Johnson, and Exxon. Johnson & Johnson recently sold 10-year bonds with a nominal interest rate of 2.95%.
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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.

The Danger of Short-Term Debt

Jason Trennert's column in the Wall Street Journal last Friday points out 60% of America's debt matures in three years or less.

Recently, we've seen the kind of crisis that occurs when leveraged institutions can't "roll over" debt. I can think of a few that seemed just fine under this kind of financing arrangement for many years until hitting the wall in 2008.

There are huge differences, of course. The U.S. has huge advantages having all its debt in its own reserve currency. That's not a small differentiator. Nor is how productive the country is.

As a reserve currency, the financial flexibility of the U.S. cannot be compared to a large financial institution or some other financially weaker sovereign nations. That doesn't make the excessive use of short-term funding wise. The U.S. has the flexibility now -- and just might be better off -- to move toward more long-term borrowing. From the column:

...it might be wise to remember Hemingway's Mike Campbell from "The Sun Also Rises," who, when asked how he went bankrupt, responded, "Gradually, then suddenly."

Too much short-term financing can unexpectedly lead to serious problems down the road. It seems to work (maybe for decades) just fine until it doesn't.

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, September 10, 2010

Work Horses & Race Horses

From an interview in Graham & Doddsville with Glenn Greenberg this past spring:

"...it is not necessarily that the boring company with a double-digit cash flow yield has got some major trick up its sleeve; it just gets recognized as mispriced relative to the market."

Then Greenberg later added...

"That is what we focus on and if you can load your portfolio with those kinds of investments, I think you will do quite well. Then occasionally, you hope to find a real race horse, a company with a huge opportunity and you invest heavily in it. But, they are not easy to find. Those investments may be what really give you the excess returns; but, it is basically loading your portfolio with work-horses where the risks are low and you will be okay."

Check out the entire interview.

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, September 9, 2010

Klarman: Intelligence vs Human nature

"So the question is not, are people smart, are people sophisticated, do they have clever ways of looking at things, are they looking in the right areas? The question is, are there periods when none of that matters because their human natures get the best of them?" - Seth Klarman

Starved For Capital

More from the Barron's interview with Michael Lewitt.

For Chastened Investors, Capital Ideas

"What got us into this mess was raw speculation and its offspring, a sustained misallocation of capital."

In the interview, Lewitt notes there are examples of private-equity improving companies. Yet, he says that in the last cycle substitution of too much debt for equity at times ruined the balance sheet of the target. The result being they now can't compete and are starved for capital and R&D.

According to him, private-equity chose generating fees over building and improving businesses.

Private-equity can be a useful force in business but too often these days it's about financial engineering and fee generation. Check out the full interview.

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, September 8, 2010

Sanofi-Aventis: How Not to Spend $18.5 Billion

Here's a Barron's article from this past weekend on the Sanofi-Aventis (SNY) attempt to acquire Genzyme (GENZ). Sanofi is paying 36 times Genzyme's 2010 estimated profits and 20 times 2011 estimated profits.

Sure seems like more than a full price. Sanofi is selling at 7-8x earnings these days. With its ~$ 10 billion/year of FCF it could quickly add to existing shareholder value by simply buying shares at current market prices (or even higher).

The article makes the point that the $ 18.5 billion (Sanofi's market value: $ 78 billion.) could be used instead to buy back stock. It would be meaningfully accretive to earnings per share and Sanofi's shares would naturally trade at something like six times earnings at the same price.

Sanofi does have a difficult patent expiration problem in the coming years but the buyback math still works. Corporations like Sanofi with healthy FCF can borrow these days at low cost and take that money to buy their own 12-14% earnings yield. The difference goes into remaining shareholder pockets at relatively low risk. Better yet, don't borrow that much and just rely on the company's FCF to buy back as long as the shares are cheap or until a more favorably priced acquisition comes along. Even if Sanofi has to shrink its size somewhat in the coming years before resuming growth it works out pretty well for shareholders. This can be a bit counterintuitive (and I'm well aware that this way of thinking can be anathema to many investors). Pursuit of growth is fine but it has to make sense relative to the capital being allocated.

To me, the question is whether your goal is to quickly build a business (or in Sanofi's case quickly offset the expiration of key drugs) even if it is at a high cost to shareholders or whether you want to transition steadily over time through prudent capital allocation. Sometimes that means allowing a company to initially become a bit smaller while pursuing more capital friendly growth and higher overall returns for shareholders.
(ie. if Sanofi shrinks for a few years that doesn't have to be the permanent trajectory. Capable management can eventually build the company off of that smaller base while wisely allocating capital throughout the transition process)

Instead, CEO's often impatiently buy something for "strategic" reasons burning up capital in the process. The company does end up bigger but the shareholders end up poorer than they would otherwise ex-acquisition. Pursuit of growth for its own sake at a high cost to shareholders happens frequently. It's not an easy sell (and certainly does not feed one's ego) to say "We will use excess capital to buy our undervalued stock in order to increase per share value until a shareholder friendly deal comes along". Comes across as lacking ambition. A tough sell for a CEO but often the right thing to do.

What concerns me is the Sanofi CEO Chris Viehbacher's view of corporate buybacks more than the specifics of the Genzyme deal itself. According to the article, when asked on a conference call about buybacks he blasted analysts and said:

"I personally don't believe that buybacks add any shareholder value."

The article provided a quote from one big investor who was critical of drug-company CEOs:

"For these types, buybacks are a pejorative, a 'going out of business strategy' equated with no growth or ambition. Of course, the ambition to grow value per share instead of all the other stuff seems to escape many of them. I wonder how it's possible that so many well-educated people can be so ignorant of some pretty basic math."

That Viebacher thinks this way may seem somewhat amazing but unfortunately his view is not uncommon enough among CEO's. Here's a quick revisit of Buffett's take on buybacks from the 1980 shareholder letter (included in this recent post):

One usage of retained earnings we often greet with special enthusiasm when practiced by companies in which we have an investment interest is repurchase of their own shares. The reasoning is simple: if a fine business is selling in the market place for far less than intrinsic value, what more certain or more profitable utilization of capital can there be than significant enlargement of the interests of all owners at that bargain price? The competitive nature of corporate acquisition activity almost guarantees the payment of a full - frequently more than full price when a company buys the entire ownership of another enterprise.

Quite the contrast with Sanofi's CEO. It's too bad that so many CEO's see buybacks as "a perjorative" left only to those with not enough ambition.

Considering that Berkshire Hathaway owned ~$ 2 billion of Sanofi Aventis at the beginning of this year it makes you wonder whether Buffett is actually the "one big investor" quoted in the article. Who knows.

He was quite vocal in his dislike of the Kraft's (KFT) deal to buy Cadbury and this one looks much more expensive.

Adam

Long SNY and KFT

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, September 7, 2010

Buffett on Derivatives

A significant amount of noise in the reported quarterly results is created by Berkshire Hathaway's (BRKa) derivatives portfolio.

Headlines from media coverage only add to the confusion. Derivatives tend to wreak havoc on reported results.

Some things to consider when evaluating Berkshire Hathaway's quarterly report:
  1. Are the risks from derivatives understandable and well managed?
  2. Are the contracts priced in such a way that the "float" provided will favorably impact long-term value creation for shareholders?
If the risks are being well managed and shareholder value is being created that additional quarterly accounting noise is merely annoying.

Understanding the risks within a derivatives portfolio for any financial institution is not easy these days. Here is what Warren Buffett had to say in the derivatives section of the 2008 Berkshire Hathaway shareholder letter (it starts on page 16):

Derivatives are dangerous. They have dramatically increased the leverage and risks in our financial system. They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks.

Later in the section he explains...

I believe each contract we own was mispriced at inception, sometimes dramatically so. I both initiated these positions and monitor them, a set of responsibilities consistent with my belief that the CEO of any large financial organization must be the Chief Risk Officer as well. If we lose money on our derivatives, it will be my fault.

Our derivatives dealings require our counterparties to make payments to us when contracts are initiated. Berkshire therefore always holds the money, which leaves us assuming no meaningful counterparty risk. As of yearend, the payments made to us less losses we have paid – our derivatives "float," so to speak – totaled $8.1 billion. This float is similar to insurance float: If we break even on an underlying transaction, we will have enjoyed the use of free money for a long time. Our expectation, though it is far from a sure thing, is that we will do better than break even and that the substantial investment income we earn on the funds will be frosting on the cake.

Only a small percentage of our contracts call for any posting of collateral when the market moves against us. Even under the chaotic conditions existing in last year's fourth quarter, we had to post less than 1% of our securities portfolio.


And finally he explains the "equity put" portfolio, the largest of Berkshire's four types of derivatives contracts (~60% of the derivatives "float"):

For us to lose the full $37.1 billion we have at risk, all stocks in all four indices would have to go to zero on their various termination dates. If, however – as an example – all indices fell 25% from their value at the inception of each contract, and foreign-exchange rates remained as they are today, we would owe about $9 billion, payable between 2019 and 2028. Between the inception of the contract and those dates, we would have held the $4.9 billion premium and earned investment income on it.

Looking at the above numbers keep in mind that Berkshire has the following resources to cover the above potential losses:
1) Berkshire Hathaway's operating companies earn $ 8 billion/year in a bad year (ie. Berkshire will conservatively earn ~$ 150-200 billion in cash between now and when all the contracts expire even if Berkshire does not grow...which it will),
2) Berkshire basically never has less than $ 20 billion in cash on hand and another $ 35 billion of relatively easy to sell bonds (and of course another $ 60 billion in equities that you can just ignore as those may not be easy to sell in a major collapse),
3) even if the stock market did happen to go to zero on those termination dates (The way these contracts are structured what matters is the market value on those termination dates, not any date between now and then) Berkshire actually could still afford it.

Considering what it would take to make stocks go to zero, I'm pretty sure things like derivatives contracts will not seem all that important under those circumstances.

Still, no matter how much disclosure he (or any financial institution) provides you still are betting on the judgement of the risk officer/CEO. I think it's unfortunate this amount of complexity has become part of the system (it's well known that Munger wants them banned 100%). Not that long ago you could look at a financial institutions 10-Q or 10-K and not have to wonder about how many ways these things can blow up. It makes all investing in modern financial institutions too much of a leap of faith.

Like most things he does, Buffett doesn't just give derivatives a cursory treatment in the letter. Other bank CEOs should take the time to do the same.

Adam

Long BRKb
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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.

Bonds vs Stocks

More comments from Ron Muhlenkamp:

So, anytime we look at a company, we look at the bonds and we look at the stock. Now in the early '80s prospect of returns on bonds were as high as stocks, from '81 to '93 I was a third in bonds, because the numbers were there.

Today, there is an unusually wide spread between interest rate returns and prospective returns when I look at what the company is earning and their return on equity stands, so what I'm paying for stocks look much cheaper than bonds in here. So we always look at one versus the other.


He makes the point that if a company is generating cash and they don't pour it "down a rat hole" shareholders get value for that. He later added...

So, we found a long time ago that if we allow the numbers to tell us where to go, they do a pretty good job of it. And then you do your homework to be sure that the numbers are believable, and after that it's just a stomach problem. Is your stomach good enough to live through the--because the only time you can buy a good company cheap is when somebody didn't like it."

If you can take the emotion out of the equation it's a whole lot easier. Check out the rest of his comments here.

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, September 3, 2010

Strangest Currency

That award goes to...
On the island of Yap in the Solomon Islands, you'll find the world's largest and strangest form of currency: the rai stone. Forget pocket change: these limestone discs with the hole in the center can run 12 feet in diameter and weigh up to eight tons.
Because Yap lacks the proper limestone for rai stones, the villagers would risk their lives to paddle their ocean-going canoes to Palau, where they would carve these behemoths from a mountainside and row them back to the island.

"Part of the value is size, but the real value lies in what it took to get it there, the number of people who died bringing it back," [David] Doty explains.

As for its monetary use, the stones typically remain in place; only the ownership changes.

"Once it gets there, these things can't be moved, but everybody on the island knows who owns which stones, and transfer is done in a public ceremony," says Doty. "But how different is that really from moving bits around in a computer? I mean, do the bits really move, or do you just change the association of the name in the bank account?" The Yap government has banned export of rai stones. One of the few on display resides in the lobby of the Bank of Canada in Ottawa.

Excellent.

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, September 2, 2010

Buffett on the Competitive Nature of Corporate Acquisitions: Berkshire Shareholder Letter Highlights

In the 1980 Berkshire Hathaway (BRKa) shareholder letter, Warren Buffett explains the potential advantages of buying a partial interest in an enterprise through common stock vs outright ownership of an enterprise. To place 30 year old commentary on corporate acquisitions into a more recent context, I think the following provides some insight into why Buffett was less than enthusiastic with the purchase by Kraft of Cadbury.

From the 1980 letter:

The value to Berkshire Hathaway of retained earnings is not determined by whether we own 100%, 50%, 20% or 1% of the businesses in which they reside. Rather, the value of those retained earnings is determined by the use to which they are put and the subsequent level of earnings produced by that usage. This is true whether we determine the usage, or whether managers we did not hire - but did elect to join - determine that usage. (It's the act that counts, not the actors.) And the value is in no way affected by the inclusion or non-inclusion of those retained earnings in our own reported operating earnings. If a tree grows in a forest partially owned by us, but we don't record the growth in our financial statements, we still own part of the tree.

Our view, we warn you, is non-conventional. But we would rather have earnings for which we did not get accounting credit put to good use in a 10%-owned company by a management we did not personally hire, than have earnings for which we did get credit put into projects of more dubious potential by another management - even if we are that management.

(We can't resist pausing here for a short commercial. One usage of retained earnings we often greet with special enthusiasm when practiced by companies in which we have an investment interest is repurchase of their own shares. The reasoning is simple: if a fine business is selling in the market place for far less than intrinsic value, what more certain or more profitable utilization of capital can there be than significant enlargement of the interests of all owners at that bargain price? The competitive nature of corporate acquisition activity almost guarantees the payment of a full - frequently more than full price when a company buys the entire ownership of another enterprise. But the auction nature of security markets often allows finely-run companies the opportunity to purchase portions of their own businesses at a price under 50% of that needed to acquire the same earning power through the negotiated acquisition of another enterprise.)


The competitive nature of an outright acquisition more often than not results in more than full price being paid. I've certainly seen it happen.

Too often, it's detrimental to the shareholders of the acquiring company.

In corporate acquisitions overpayment is the rule. You will be given many articulate explanations and impressive presentations by senior management why it is they are not, in fact, overpaying. Just keep in mind that when you hear the words "strategic" being used a lot to justify that premium price, expect the premium to end up in the pockets of shareholders in the acquired company and the investment banks that help facilitate the deal.

When it comes time for Berkshire Hathaway to purchase an entire business Buffett has said: "we don't do deals when we're ready to buy, but rather, when a company is ready to sell." When someone sells their business to Berkshire Hathaway they are likely trading off getting the max price with the benefits of a unique corporate culture and an owner who doesn't meddle very much.

Overpaying for a business will happen less often if you don't make getting a controlling interest in that business the priority. You just need the patience to wait for the market to serve you.

Favorable mispricings tend to occur when buying small portions of a business in a stock market environment.

Adam

Long BRKb
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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, September 1, 2010

Whitney Tilson: Undervalued Blue Chip Equities

From CNBC this morning. In the interview, Tilson talks about J&J, Microsoft, Berkshire Hathaway and more generally on the current valuations of equities vs bonds. He was asked the inevitable question of what he thinks will happen to the market short-term and wisely said essentially "who knows".

Tilson is smart and experienced enough to know what you can't know. Why business journalists still ask that question is beyond me.

Tilson did have the following to say:

"We are seeing some of the best opportunities we've ever seen in big cap high quality blue chip equities."

"We think there is a bubble in blue chip bonds."

"The single biggest mistake investors make...they invest looking in the rear-view mirror not through the windshield."

"Ten years ago there was a bubble in blue chip quality stocks...they were trading at 30x earnings."

"JNJ at 12x earnings is a very different proposition over the next 10 years than 10 years ago JNJ at 30x earnings."
In the interview, he also points out that Microsoft is very cheap selling at 9.3x trailing earnings (excluding net cash on the balance sheet) and explains why he thinks Berkshire Hathaway is still undervalued.

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.

Misallocation of Capital

In this recent Barron's interview, Michael Lewitt makes the following points:

For Chastened Investors, Capital Ideas

- There has been a misallocation of capital for years. Speculative activities have been favored over productive activities.

- He also added that 95% of credit default swaps are not used for hedging but instead speculation on price action. As a result, much intellectual and financial capital is wasted instead of being used to enhance growth.

There's no question that speculation needs to be reigned in. Check out the full  interview.

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.

World's Safest Banks 2010

Here is the 19th annual list from Global Finance of the "World's 50 Safest Banks".

According to the list, most of the safest banks are not located in the United States. Here are the only 4 from the U.S. that make the list:
  • BNY Mellon (#30)
  • JPMorgan Chase (#40)
  • Wells Fargo (#43)
  • U.S. Bancorp (#48)
None in the U.S. reside anywhere near the top of the list.

The number 1 bank on the list is Caisse des Depots et Consignations (CDC) located in France.

Banks from Germany held 4 of the top 10 positions.

Netherlands had 3 of the top 10.

Here are the rankings from last year.

Adam

Long Wells Fargo and U.S. Bancorp

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.

Investing Models

Below are some thoughts from Glenn Greenberg and Charlie Munger on the various investing models they have used over time. Obviously, there is no one best model...just build on those that resonate in some way.

In my case, one of the most effective is simply the great brands combined with powerful distribution (Diageo, Philip Morris International, Altria, Coca-Cola, Pepsi etc.) model. The fact that it is so simple I'm guessing is one of the reasons it gets underutilized*. The combination of scale advantages and psychological factors that result in repeat behavior produces pricing power. It's a reliably useful model. I know of nothing else that produces so many examples of wide moats and durable high returns on capital. There may be but I just don't know of it. If bought with an appropriate margin of safety, the above tend to provide attractive risk-adjusted returns (what Grantham calls "the one free lunch").

"In the long run, quality stocks have proven to be the one free lunch: you simply have not had to pay for the privilege of owning the great safe companies, as plain logic and established theory would both suggest." - Jeremy Grantham

Another model I like is the consolidation of a fragmented industry around 1-2 powerful competitors (Mohawk Industries or Home Depot are examples). The cost advantages of the bigger competitors tend to provide at least a decent moat.

So the above are just two examples of models that can be used but clearly there are many others.

In this Charlie Munger speech, he describes some of the investing models that he and Warren Buffett use.

Munger on Investing Models

Here is an example of one:

"GEICO is a very interesting model. It's another one of the 100 or so models you ought to have in your head. I've had many friends in the sick business fix up game over a long lifetime. And they practically all use the following formula I call it the cancer surgery formula:

They look at this mess. And they figure out if there's anything sound left that can live on its own if they cut away everything else. And if they find anything sound, they just cut away everything else. Of course, if that doesn't work, they liquidate the business. But it frequently does work.

And GEICO had a perfectly magnificent business - submerged in a mess, but still working. Misled by success, GEICO had done some foolish things. They got to thinking that, because they were making a lot of money, they knew everything. And they suffered huge losses.

All they had to do was to cut out all the folly and go back to the perfectly wonderful business that was lying there. And when you think about it, that's a very simple model. And it's repeated over and over again.

And, in GEICO's case, think about all the money we passively made....It was a wonderful business combined with a bunch of foolishness that could easily be cut out. And people were coming in who were temperamentally and intellectually designed so they were going to cut it out. That is a model you want to look for. - Charlie Munger


Here is an excerpt of what Greenberg had to say:

I have been in the business since 1973, so I have been looking at companies for a long time. There are a lot of things in my head. There are a number of different models of the kinds of business or situations that can work. It may be the local monopoly concept, the low-cost commodity producer concept, the consolidated industry that has come down to a few competitors, a basic essential service that isn't going to stop growing, or an industry that may be growing too slowly to attract any competition. So, there are a lot of different models - Glenn Greenberg.

Over time, I have learned those that work most effectively for me. Some don't. For example, I doubt I will ever be able to gain the insights necessary to find the next Google (there are obviously those who have models of some kind that help them identify that sort of thing).

Improve on the one's that have worked and hopefully add some new one's over time.

Adam

* Some expect shares of companies like this to have more modest returns than the market. They are often treated as defensive (and in the short run, they are) but they can be more long-term offensive than many think.

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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