Thursday, March 31, 2011

Oil's Endless Bid

I often hear the glut of housing inventory as an explanation for why house prices will continue to drop in the coming years. This Business Insider article explains that the excess inventory is keeping the pressure on house prices.

That makes sense. Too much supply puts pressure on house prices.

The question I have is why doesn't the same thinking apply to oil?

Bespoke Investment Group posted a good chart in this article last week. Check it out.

So, as the chart in the Bespoke article shows, oil inventories are sitting well above the average inventory level since 1984 yet we've got oil over $ 100 per barrel.

I've read and listened to explanations and justifications for why oil prices (and other commodities) are going up by so much (explanations not unlike those justifying high house prices that I remember hearing back in 2005). Some of these explanations may even be partially or completely correct. Obviously, monetary policy has been a big driver of the increases in commodity prices.

It's also possible that the reason has to do, in part, with what Dan Dicker (a veteran oil trader and author of the new book, Oil's Endless Bid) says in this article:

...the "financialization" of all commodity markets, but most particularly oil, has not only unnecessarily pumped up the prices that you and I pay for gasoline and corn and wheat, but has made those prices far more viciously volatile.

In a separate article, Dicker had the following to say about the cause of high oil prices:

It turns out, Dicker says, that the price has nothing to do with supply and demand for oil. It's the financial market for oil, filled with both professional speculators and amateur investors betting on poorly understood oil exchange-traded funds, who have ratcheted up the price of gas to such sky high levels.

Here is another Dan Dicker interview on what he sees as the cause of high oil prices.

It's only one individual's take but, if this is even partially true for oil, I can't see why it may not also be a factor for other commodities.

I think it's difficult to get at the root cause of something this complex but the fact is a large amount of "financialization" of commodities has occurred this past decade. When it comes to problem solving asking what has changed is usually a good place to start.

If distortions are occurring as a direct result it seems foolish for us to not address them. I know eventually prices will be sorted out by supply and demand, but eventually can be a long time. We saw what happened with housing when we juiced prices via the securitization of mortgages for years. That might have been fun on the way up but we're still feeling the economic ramifications of those inflated housing prices now. I still vividly remember experts and other serious folks making very thoughtful and sincere rationalizations of why housing prices were justified back then.

Who says what's happening now with commodities isn't a variation on a similar thing?

I'm not saying the outcome is going to be the same. I'm saying it's better to not wait to find out.

Adam

Related posts:
Ray Dalio on Stocks & Commodities
Financialization of Copper

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, March 30, 2011

Klarman: Trophy Properties vs Fixer-Uppers

Amazon (AMZN) has a great business and a great story.

Wal-Mart (WMT) also has a great business but the story's a tougher sell.

 Of course, in investing whether a story sells only matters over the short-to-intermediate term. In the long run, core economics of the business and the price you pay for it win out.

From Seth Klarman's annual letter to investors:

Price is perhaps the single most important criterion in sound investment decision making. Every security or asset is a "buy" at one price, a "hold" at a higher price, and a "sell" at some still higher price. Yet most investors in all asset classes love simplicity, rosy outlooks and the prospect of smooth sailing. They prefer what is performing well to what has recently lagged, often regardless of price. They prefer full buildings and trophy properties to fixer-uppers that need to be filled, even though empty or unloved buildings may be the far more compelling, and even safer, investments. Because investors are not usually penalized for adhering to conventional practices, doing so is the less professionally risky strategy, even though it virtually guarantees against superior performance.

Among equities right now, there are quite a few "trophy properties" that are, well, priced like trophy properties. Amazon is certainly one* but there are many others. It's not hard to find stocks with great stories selling for 50-100x earnings (and higher).

The good news is you don't have to look very far to find "fixer-uppers" selling at compelling prices. More than decent to even very good franchises selling at 7x to 12x earnings are not hard to find (many of these same businesses had an Amazon-like earnings multiple just a decade ago). Of course, most have not-so-great stories (usually "yesterday's news" or something similar) but viable businesses that, in some cases, happen to have a real but fixable problem. Dell (DELL) and Cisco (CSCO) come to mind and are certainly priced like fixer-uppers but whether they are truly fixer-uppers is debatable. Both businesses have enormous free cash flows and cash on the balance sheet that gives them quite a runway.

Now, Wal-Mart is a stock that I'm pretty sure is not a fixer-upper at all but seems priced like one.

So Wal-Mart is boring and hasn't done anything in a decade, right?

The stock? Yes.

The business? No.

As far as I can tell Wal-Mart's problem is that it's not Amazon. It's mature and boring. Amazon is not.

Some numbers.

In the past decade, Amazon has gone from losing money to making just over a $ 1.1 billion with lots of promise ahead.

From a standing start that's a good decade of work by any measure.

Amazon's Market Value = $ 80 billion

In the past decade, Wal-Mart has gone from earning $ 6.3 billion to earning $ 15.3 billion.

An incremental $ 9 billion of earning power in one decade is not so bad either considering how large Wal-Mart already was entering the decade. While not growing like Amazon, the future of Wal-Mart is not exactly dire. The company has an enormous economic moat.

Wal-Mart's Market Value = $ 185 billion

After that impressive decade of work, Amazon now earns in a year what Wal-Mart earns every 3.7 weeks. The funny thing is, even though they had a great decade, in economic terms Amazon has actually fallen further behind in earning power compared to Wal-Mart on an absolute basis.

So Wal-Mart has an extra $ 14.2 billion of demonstrated annual earnings that's still growing nicely.

That means Wal-Mart has approximately 14x more earning power than Amazon ($ 15.3 billion/$ 1.1 billion) yet only 2.3x ($ 185 billion/$ 80 billion) the market valuation.
(It's worth noting that in the past decade Amazon's shares outstanding have grown from 364 million to 456 million diluting shareholders. In contrast, Wal-Mart's shares outstanding shrunk from 4.46 billion to 3.56 over that same time frame).

So, once again, you'll hear the refrain these days that Wal-Mart has been dead money as a stock for a decade and that is true.

True, but certainly not because of Wal-Mart's business performance.

It's been dead money because a little over a decade ago Wal-Mart sold for an inflated earnings multiple much like the one Amazon has now. It took the decade for Wal-Mart's intrinsic value to catch up to price.

The price you pay matters.

As Klarman says, "perhaps the single most important criterion".

Adam

* I think there's plenty of evidence from experience that what seems like an expensive stock tends to get more expensive and will often stay that way for a very long time. Even if it is a good business like Amazon, I've never tried to predict when valuation will normalize. I just avoid all things that seem expensive. Knowing what is likely to happen is easy. Knowing when is not. The risk of missing upside is easily outweighed by the possible risk of permanent capital loss. Occasionally, something like Amazon will end up justifying the valuation and that's certainly possible in this case. Though merely justifying valuation seems hardly a huge win.  Risking capital for the privilege of seeing a company someday just fulfill its "promise" is not the path to high returns (successful speculative trades excluded).

Tuesday, March 29, 2011

Buffett: 57% Return on Equity Capital - Berkshire Shareholder Letter Highlights

Today, a long list of high return on capital businesses can be found among Berkshire's operating businesses (example: See's Candies) and in the equity portfolio things like:

Coca-Cola (KO),
Johnson & Johnson (JNJ), and
Procter & Gamble (PG).

In addition, the financial stocks in the portfolio like Wells Fargo (WFC) and American Express (AXP) are just about the highest return on equity capital businesses in the financial sector.

In the 1987 Berkshire Hathaway (BRKa) shareholder letter, Warren Buffett elaborates on the importance of high return on capital:

"...our seven largest non-financial units: Buffalo News, Fechheimer, Kirby, Nebraska Furniture Mart, Scott Fetzer Manufacturing Group, See's Candies, and World Book. In 1987, these seven business units had combined operating earnings before interest and taxes of $180 million.

By itself, this figure says nothing about economic performance. To evaluate that, we must know how much total capital - debt and equity - was needed to produce these earnings. Debt plays an insignificant role at our seven units: Their net interest expense in 1987 was only $2 million. Thus, pre-tax earnings on the equity capital employed by these businesses amounted to $178 million. And this equity - again on an historical-cost basis - was only $175 million.

If these seven business units had operated as a single company, their 1987 after-tax earnings would have been approximately $100 million - a return of about 57% on equity capital. You'll seldom see such a percentage anywhere, let alone at large, diversified companies with nominal leverage. Here's a benchmark: In its 1988 Investor's Guide issue, Fortune reported that among the 500 largest industrial companies and 500 largest service companies, only six had averaged a return on equity of over 30% during the previous decade."

Today, there are many low return on capital businesses selling for what seem to be reasonable prices but probably not as cheap as they seem:

"If the business earns 6% o­n capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% o­n capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result." - Charlie Munger at USC Business School in 1994

Buffett continues in the letter...

"Of course, the returns that Berkshire earns from these seven units are not as high as their underlying returns because, in aggregate, we bought the businesses at a substantial premium to underlying equity capital. Overall, these operations are carried on our books at about $222 million above the historical accounting values of the underlying assets."

So a business will sometimes seem a bit expensive. Yet, if that business has durable high return on capital a good result over the long haul is likely to occur.

Margin of safety remains important but the point being that purchasing a low return on capital business at what seems like a "cheap" price is no bargain.

To be continued in a follow up.

Adam

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

Monday, March 28, 2011

Barron's Interview: Donald Yacktman

Donald Yacktman co-manages two funds that have very solid long-term track records.

Yacktman Fund (YACKX)
Yacktman Focused Fund (YAFFX)

Some recent thought from him in this Barron's interview:

Barron's: Loaded for Long-Term Value

On Inexpensive High Quality Companies
"This business boils down to what you buy and what you pay for it. The market level is incidental to us."

He later added that he has to go back at least 18 years to find high-quality companies this cheap...

"But what is staggering to me is high-quality companies still selling at below-average prices on a [price/earnings multiple] basis, relative to the market.

On HP's Recent Disappointments
"That's why it is cheap, and that's why [it's of] some interest to us."

On Inflation
"A lot of people are concerned about inflation, that companies are going to have problems repricing their product...But I think the consumer-staples companies we own have pricing power."

Each fund that he co-manages has produced double-digit annualized returns over the past decade outperforming the S&P 500 by nearly 10% per year.

Read the interview in its entirety 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, March 25, 2011

Immutable Laws of Investing

In August of 2000, Fortune magazine published "10 Stocks To Last The Decade". The stocks on that list were as follows:

-Nokia (NOK)
-Nortel
-Enron
-Oracle (ORCL)
-Broadcom (BRCM)
-Viacom (VIA-B)
-Univision
-Schwab (SCHW)
-Morgan Stanley (MS)
-Genentech

The average price to earnings ratio of these ten stocks at the time?

347x.

Not surprisingly, $ 100 dollars invested equally in these stocks back then ended up being worth $ 30 a decade later.

The excerpt below is from a recent paper, The Seven Immutable Laws of Investing written by James Montier of GMO. In the paper, Montier uses the above as an example of violating Law 1 which is:

1. Always Insist on a Margin of Safety

Valuation is the closest thing to the law of gravity that we have in finance. It is the primary determinant of long-term returns. However, the objective of investment (in general) is not to buy at fair value, but to purchase with a margin of safety. This reflects that any estimate of fair value is just that: an estimate, not a precise figure, so the margin of safety provides a much-needed cushion against errors and misfortunes.

When investors violate Law 1 by investing with no margin of safety, they risk the prospect of the permanent impairment of capital. I've been waiting a decade to use Exhibit 1. It shows the performance of a $100 investment split equally among a list of stocks that Fortune Magazine put together in August 2000.
Check out the paper to get a good look at the chart. According to Montier, the Seven Immutable Laws are as follows:

1. Always insist on a margin of safety
2. This time is never different
3. Be patient and wait for the fat pitch
4. Be contrarian
5. Risk is the permanent loss of capital, never a number
6. Be leery of leverage
7. Never invest in something you don't understand

The paper goes on to elaborate on each law. Not new material necessarily for value investors but this paper does a nice job of summarizing the tendencies that get investors in trouble from time to time.

Adam

No position in stocks mentioned

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

Thursday, March 24, 2011

The Beer Industry's Bright Spot

From this recent Brewers Association press release:

Small and independent craft brewers* saw volume** increase 11 percent and retail sales dollars increase 12 percent over 2009, representing a growth of over 1 million barrels (31 gallons per U.S. barrel), equal to more than 14 million new craft cases.

The "craft brewer" designation has favorable federal excise tax implications.

Currently, a small brewer that produces less than 2 million barrels of beer per year is eligible to pay $7.00 per barrel on the first 60,000 barrels produced each year.

So remaining below the 2 million annual barrels of beer threshold has been required to gain the favorable federal tax benefits but that may be about to change.

It turns out the threshold was recently increased from 2 million to 6 million barrels by the Brewers Association. Some Senators are attempting to put that new definition in a new bill called the Brewer's Employment and Excise Relief (BEER) Act while also lowering the excise tax rates.*** 

The bill would drop the $ 7.00 tax per barrel to $ 3.50 up to 60,000 barrels. Above 60,000 barrels, it would also also drop the excise tax rate from $ 18.00 per barrel to $ 16.00 for those that meet the definition of a "craft brewer". The larger brewers pay $ 18.00 per barrel. As it stands now, above 60,000 barrels, the small brewers pay the same excise tax as the very largest brewers. 

So guess who is just about to go over 2 million barrel run rate in the next few years?

Boston Beer Company (SAM), the maker of Sam Adams and by far the most successful "craft brewer".

Over 200 million barrels of beer per year is produced in the United States.  So while Boston Beer has been extremely successful in "craft brewer" terms, it still has only a tiny fraction of the beer market.

Though still small, I find it hard to not admire what Boston Beer has accomplished.

Anheuser-Busch (BUD) has more than 50% of the U.S. beer market. MillerCoors (TAP) is the 2nd largest U.S. brewer with ~30%.

The entire craft brewing segment still acounts for less than 5% of volume.

One thing of note is how the beer brewing industry has evolved since prohibition:

Before prohibition, the number of breweries in the U.S. peaked at 1,751 breweries.

By 1980 that number had fallen to less than 100 breweries.

Where's it at now?

1,759 breweries. Quite a comeback.

CNBC article: The Beer Industry's Bright Spot

There's a good graphic on how the U.S. brewery count has changed over the long haul and more recently in the Brewers Association press release that's worth checking out.

The 10 Largest Craft Breweries in the U.S.:

1 Boston Beer 1.84 million barrels
2 Sierra Nevada Brewing 724,000 barrels
3 New Belgium Brewing 583,000 barrels
4 Spoetzl Brewery 409,000 barrels
5 Pyramid Breweries 192,000 barrels
6 Deschutes Brewery 187,000 barrels
7 Matt Brewing 172,000 barrels
8 Magic Hat Brewing 154,000 barrels
9 Boulevard Brewing 139,000 barrels
10 Harpoon Brewery 131,000 barrels

Some consolidation is already happening as Pyramid Breweries and Magic Hat Brewing were acquired by North American Breweries in August of last year.

Another 600+ new breweries are in the works so it certainly seems that the segment is thriving.

Adam

* From the Brewers Association press release: The definition of a craft brewer as stated by the Brewers Association: An American craft brewer is small, independent, and traditional. Small: Annual production of beer less than 6 million barrels. Beer production is attributed to a brewer according to the rules of alternating proprietorships. Flavored malt beverages are not considered beer for purposes of this definition. Independent: Less than 25 percent of the craft brewery is owned or controlled (or equivalent economic interest) by an alcoholic beverage industry member who is not themselves a craft brewer. Traditional: A brewer who has either an all malt flagship (the beer which represents the greatest volume among that brewers brands) or has at least 50 percent of its volume in either all malt beers or in beers which use adjuncts to enhance rather than lighten flavor. 
** From the Brewers Association press release: Volume by craft brewers represent total taxable production. 
*** It turns out a bill, the Brewer's Employment and Excise Relief (BEER) Act, was introduced by Senator John Kerry of Massachusetts (Democrat) and Senator Mike Crapo of Idaho (Republican) that would also modify the definition of a small or "craft" brewer to 6 million barrels (while also providing other federal tax advantages). They were joined by eight Republicans and nine Democrats who signed on as co-sponsors. Large brewers pay $ 18.00 per barrel.
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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, March 23, 2011

Buffett, Munger, and the 90% Tax

In the following exchange, Warren Buffett and Charlie Munger critique the investment profession. From the 2006 Berkshire Hathaway (BRKashareholder meeting:

Buffett: Most professions add value beyond what the average person can do for themselves. But in aggregate, the investment profession does not do this – despite $140 billion in total annual compensation. It's hard to think of another business like that. Can you, Charlie?

Munger: I can't think of any.

Later in the exchange Buffett continues saying...

Buffett: In the investment field, you now have large portions of investment managers that charge fees that, in aggregate, cannot work out for investors. Obviously, some [investments in high-fee managers] do [work out well]. But you can't pay 2 and 20 [2% annual management fee and 20% of the profits, standard for private-equity and hedge funds], in which you pay the manager 20% of the profits if they make money and, if they don't, they just close up and reopen later. If you charge this in an economy that's only growing a few percent a year, the math doesn't work. The question for you is how to pick out the exceptions [e.g., the managers who will outperform, even after fees]. Everyone who calls on you says they are the exceptions.*

I will bet you that if you name any 10 partnerships with over $500 million in assets and put them up against the S&P 500, they will trail the S&P, after fees, over time.

If you know enough about the person and how they've done in the past, you can occasionally find someone. But if you’re running a big pension fund, with everyone calling on you, you will likely invest in the best salespeople.

Munger: I think it ought to be a crime [for an investment manager or his agent] to entertain a state pension-fund manager, and it should be a crime for that person to accept it.

The whole concept of the house advantage is an interesting one in modern money management. The terms of the managers of the private partnerships look a lot like the take of the croupier at Monte Carlo, only greater.

Buffett: Is there anyone we've forgotten to offend? [Laughter]

2006 Berkshire Hathaway Meeting Notes

Someone who invested $ 1,000 in Berkshire Hathaway in 1965 would have just under $5,000,000 today.

Fortunately, since Buffett did not happen to charge what is now the industry standard "2 and 20 fees", that investor would have all of the $5,000,000 in his/her account.

So how much would that investor have if they had paid Buffett 2 and 20 during that time**?

Give or take roughly 1/10th that amount.

In other words, over the long haul the 2 and 20 fees amounts to a tax that transfers 90% of the wealth creation to the person managing your money. (this is easy to calculate: Buffett earned 20.2% since 1965, just subtract the 2 and 20 fees from those returns and recalculate. The power of compounding.)

And that's if the investor happens to be fortunate enough to hire someone as good as Warren Buffett.

What if that investor ends up with a mere mortal?

Adam

* Charlie Munger said this best during a speech back in 1998: "...five centuries before Christ Demosthenes noted that: 'What a man wishes, he will believe.' And in self-appraisals of prospects and talents it is the norm, as Demosthenes predicted, for people to be ridiculously over-optimistic. For instance, a careful survey in Sweden showed that 90% of automobile drivers considered themselves above average. And people who are successfully selling something, as investment counselors do, make Swedish drivers sound like depressives."

** Of course, during Buffett's partnership era, the fee structure was lucrative for him on the upside but also gave him exposure personally to losses on the downside. In fact, he could lose more money than he invested into the partnership by covering a quarter of all losses from his partners. From Alice Schroeder's book, The Snowball: "I got half the upside above a four percent threshold, and I took a quarter of the downside myself. So if I broke even, I lost money. And my obligation to pay back losses was not limited to my capital. It was unlimited." (pp. 201-202)
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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, March 22, 2011

Buffett: "Two Types of Assets"

Warren Buffett had the following to say on CNBC about buying assets that produce something versus those that do not:

So there's two types of assets to buy. One is where the asset itself delivers a return to you, such as, you know, rental properties, stocks, a farm. And then there's assets that you buy where you hope somebody else pays you more later on, but the asset itself doesn't produce anything...I regard the second game as speculation. Now there's nothing immoral or illegal or fattening about speculation, but it is an entirely different game...

Investing is about what something produces over time not the quoted price tomorrow, next week or even next year.

Speculating is about buying something you hope someone will pay you more for at a later time. 

In the most recent Berkshire Hathaway Shareholder Letter (BRKa), Buffett added the following about Coca-Cola (KO):

Coca-Cola paid us $88 million in 1995, the year after we finished purchasing the stock. Every year since, Coke has increased its dividend.In 2011, we will almost certainly receive $376 million from Coke, up $24 million from last year. Within ten years, I would expect that $376 million to double. By the end of that period, I wouldn't be surprised to see our share of Coke's annual earnings exceed 100% of what we paid for the investment. Time is the friend of the wonderful business.

If the focus is on what a quality asset is likely to produce in the future, instead of the near term price fluctuations, it should alter how an investor expends energy.

In speculation, the focus is on whether:
  • the quote on the computer screen flashes red or green tomorrow, 
  • the chart looks healthy, or 
  • a recent event impacts near term price action etc. 
In contrast, long-term owners of productive assets tend to use their energy think about things like:
  • Did I pay a fair price relative to estimated intrinsic value? 
  • In what way is the competitive position of the business under threat? 
  • Is the management team in place effective? 
  • Is capital being allocated wisely?
The focus becomes thinking through the things that any business owner needs to think about.

Coca-Cola a decade from now or so will be producing earnings (both the dividend and the undistributed earnings* portion)  at a rate that exceeds the average price Buffett paid for Coca-Cola up until a little over 15 years ago (Buffett bought the stock between 1988-1995). So even if Coca-Cola stops growing (unlikely) from that point on the earnings will return to shareholders more than 100% each year from earnings (if not in perpetuity then for a very long time). Every 1.5 years or so, the cash dividend alone paid directly into Berkshire's coffers will likely equal the full initial investment made by Buffett.

How much does the quoted price of the stock matter at that point?

While Coca-Cola is an exceptional business there are many other productive assets in the form of public companies that accomplished remarkably similar results over the same time frame. (You'll find that things like Hershey - HSY, Pepsi - PEP, and Johnson & Johnson - JNJ among others have had similar enough outcomes for decades.) So the quality assets are not entirely unique or hard to find. It's Buffett's behavior that is unique. The wisdom to buy with the intent to own for a very long time a good asset when a favorable price comes along.

What happens with these assets going forward cannot be known precisely, but odds are that gaining partial ownership of a few great franchises at a fair price will produce good results over the long haul.

Buying gold or art is about whether someone else will be there to buy it at a price you are happy with when you need to sell it.

I'll take the ownership of assets that produce something over other assets any day of the week.

Adam

Long positions in stocks mentioned with the exception of HSY

* From the Berkshire Hathaway owners manual on "look-through" earnings: "We attempt to offset the shortcomings of conventional accounting by regularly reporting "look-through" earnings...The look-through numbers include Berkshire's own reported operating earnings, excluding capital gains and purchase-accounting adjustments...plus Berkshire's share of the undistributed earnings of our major investees - amounts that are not included in Berkshire's figures under conventional accounting."

"Look-through" earnings for Berkshire Hathaway was more important when they had fewer operating businesses and an equity portfolio that represented a significant portion of intrinsic value.
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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, March 21, 2011

Is Japan a Buying Opportunity?

Recently, there have been lots of calls to buy Japan equities.

Historically, I have not found equities of businesses based in Japan to be all that attractive but there is a growing chorus of those who do.

First of all, Japan's stock market reached extreme valuations in the 1980s. It has taken the past couple decades for what were extreme price to earnings multiples back then to become more reasonable. So either companies had to grow into valuations and/or stock prices had to come down.

2nd, return on equity, which historically has been pretty dismal for Japan businesses has only begun to look respectable.

Even with these improvements in valuation and return on equity, I'm still fairly lukewarm when it comes to Japan equities. The Japanese stocks on my radar just don't seem inexpensive enough to own in lieu of reasonably priced high quality companies sold on U.S. exchanges.

Still, there are those with more enthusiasm for Japan equities that think otherwise.

Here are some more bullish points of view.

David Herro, the manager of Oakmark International recently said in this Fortune interview (the interview happened before the earthquake and tsunami) why he likes Japan equities:

...in the '80s, Japan was 60% of the international index, and I had 0% invested in Japan. They used to say, "This is very risky." And I said, "What's risky is investing in Japanese companies that are trading at 60 or 70 times earnings."

Herro points out that, back then, he was seeing average return on equity was 5% in Japan but that has started to change. He added...

Low price does not mean undervalued in our view. You have to look for companies that (a) are selling cheap but (b) are committed to value creation, to doing something with their excess cash, to building book value per share, and to getting a good return on equity. And we're able to find that for the first time ever -- at least since the mid-1980s, when I started investing.

Four of Oakmark's top five holdings are in Japan.

Geoff Gannon recently wrote this very bullish article on Japan equities.

If an investor already likes a Japanese business, an extraordinary event just makes the stocks cheaper and margin of safety -- if valuation is well-judged -- that much wider. Buffett said it's going to take some time to rebuild but it doesn't change Japan's economic future in this Reuters article published early this morning.

Buffett also said he wouldn't be selling Japanese stocks as a result of this (if he owned any).

Buffett in the past has frequently expressed enthusiasm for businesses in South Korea but not those in Japan. In the Reuters article, Buffett said he'd like to buy businesses or shares of large capitalization stocks in South Korea.

Berkshire is a shareholder in South Korean steelmaker POSCO (ADR: PKX).

While Buffett has said some bullish things on Japan, at least so far the actual money he has allocated has gone into South Korea and China (though could certainly have been buying Japan in recent weeks or be buying as I write this).

In this article from Fox Business, Buffett said they are looking for large businesses to buy in any country but most likely in the United States.

Some Japanese ADRs:
  • Canon (CAJ)
  • Hitachi (HIT)
  • Honda (HMC)
  • Kubota (KUB)
  • Kyocera (KYO)
  • Nomura (NMR)
  • NTT DOCOMO (DCM)
  • Orix (IX)
  • Panasonic (PC)
  • Sony (SNE)
  • Toyota Motor (TM)
I still find plenty of high quality investment opportunities elsewhere but, at the very least, Japan equities have started to look more competitive with other equity investment alternatives.

Adam

Small position in PKX established at much lower than recent prices; no position in other equities mentioned.

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, March 18, 2011

Wells Fargo, JP Morgan, & U.S. Bancorp Increase Dividends

Wells Fargo (WFC), J.P. Morgan (JPM), and U.S. Bancorp (USB) announced dividend increases and share repurchases today.

Here's a quick summary with excerpts from each bank's press release:

Wells Fargo - Approximate Yield 1.5%
Wells Fargo & Company (NYSE:WFC - News) today announced a special first quarter 2011 cash dividend on its common stock of $0.07 per share, which together with the $0.05 per share dividend declared on January 25, 2011, brings the total dividend declared for the first quarter to $0.12 per share. The special dividend is payable March 31, 2011, to stockholders of record on March 28, 2011.

The Board of Directors also increased the Company's authority to repurchase common stock by an additional 200 million shares. The quarterly dividend rate increase to $0.12 per share was part of the capital plan the Company submitted to the Federal Reserve Board in January 2011.

JP Morgan - Approximate Yield 2.2%
JPMorgan Chase & Co. (NYSE:JPM - News) today announced the following actions taken by its Board of Directors:
  • Declared a quarterly dividend of $0.25 per share on the corporation’s common stock, an increase of $0.20 per share. The dividend is payable on April 30, 2011 to stockholders of record at the close of business on April 6, 2011.
  • Authorized a new $15 billion multi-year common stock repurchase program, of which up to $8.0 billion of common stock repurchases is approved for 2011.
U.S. Bancorp - Approximate Yield 1.8%
The board of directors of U.S. Bancorp (NYSE:USB - News) has approved a 150 percent increase in the dividend rate on U.S. Bancorp common stock to $0.50 on an annualized basis, or $0.125 on a quarterly basis. The quarterly common stock dividend of $0.125 per common share is payable on April 15, 2011, to shareholders of record at the close of business on March 31, 2011.

Additionally, the board of directors of U.S. Bancorp today approved an authorization to repurchase up to 50 million shares of its outstanding common stock.

These relatively stronger banks are now in a position to begin paying dividends. Some others still have some mending to do.

Adam

Long position in WFC, JPM, and USB
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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.

David Herro, The Contrarian

David Herro, Morningstar's International Stock Manager of the Decade and manager of Oakmark International (OAKIX) since its founding in 1992 (returning 9% annually over the past 10 years...better than 98% of competitors), had the following to say in a recent Fortune article on emerging markets:

In the late '90s we had 20% to 30% emerging-markets exposure, and people thought we were crazy. There had just been a crash, and prices were dirt cheap. Today there's hype and over-euphoria, and we cut our investments because they're reflected in the price. One has to distinguish between attractive equities and an attractive macroeconomic situation. And investors have confused this.

On China...

...China is growing 8% to 10% a year. Do you play that by buying some state-owned enterprise that doesn't care about the shareholders, has no transparency, and is trading at 25 times earnings? Or do you play that by buying into a business that trades at less than 10 times cash flow and makes more than 30% of its profits from emerging markets and China? That's the case for companies like Danone (DANOY), Diageo (DEO), and Nestlé (NSRGY).

Herro added that he likes natural resources the least and explains his thinking.

He also explains why he likes European banks (Banco Santander: STD, Credit Suisse: CS, UBS: UBS) and, though the interview occurred before the awful earthquake and tsunami had happened, Japanese stocks like Canon (CAJ) and Toyota (TM). 

Pretty much a contrarian on most things but considering the track record it's worth listening to him. Check out the full 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.

Thursday, March 17, 2011

Buffett, Bogle, and the Invisible Foot

From Warren Buffett's 1983 Berkshire Hathaway (BRKashareholder letter:

"...consider a typical company earning, say, 12% on equity. Assume a very high turnover rate in its shares of 100% per year. If a purchase and sale of the stock each extract commissions of 1% (the rate may be much higher on low-priced stocks) and if the stock trades at book value, the owners of our hypothetical company will pay, in aggregate, 2% of the company's net worth annually for the privilege of transferring ownership. This activity does nothing for the earnings of the business, and means that 1/6 of them are lost to the owners through the 'frictional' cost of transfer. (And this calculation does not count option trading, which would increase frictional costs still further.)

All that makes for a rather expensive game of musical chairs. Can you imagine the agonized cry that would arise if a governmental unit were to impose a new 16 2/3% tax on earnings of corporations or investors? By market activity, investors can impose upon themselves the equivalent of such a tax."

Later Buffett goes on to say...

"These expensive activities may decide who eats the pie, but they don't enlarge it.

(We are aware of the pie-expanding argument that says that such activities improve the rationality of the capital allocation process. We think that this argument is specious and that, on balance, hyperactive equity markets subvert rational capital allocation and act as pie shrinkers. Adam Smith felt that all noncollusive acts in a free market were guided by an invisible hand that led an economy to maximum progress; our view is that casino-type markets and hair-trigger investment management act as an invisible foot that trips up and slows down a forward-moving economy.)"

Consider that this was written during a time when trading volumes were quaint by comparison to today (although partially offset by today's lower commission costs).

Partially.

Let's look at the trading volumes and resulting frictional costs of S&P 500 Index ETF (SPY) in our modern context. John Bogle recently pointed out the SPY turns over 10,000%/year.

"Well, the ETF has got to be one of the great marketing ideas of the recent era. I think it remains to be seen whether it’s one of the great investment ideas of the recent era. The trading volumes are astonishing. Standard & Poor’s 500 SPDR (SPY), the biggest one, turns over 10,000% a year, and I think 30% turnover is too high. What does one say about 10,000%?"

So take that turnover rate and assume a .05% average commission cost (for example: $ 10 of commissions...$ 5 for the buyer and $ 5 for the seller on a $ 20,000 average purchase amount of SPY). Using these simplistic but I think meaningful assumptions, what's the rough annualized frictional costs for the average participant in the SPY during a calender year based upon current behavior?

It comes out to a little over 5% per year plus the modest .09% fund expenses:

$ 10/trade x 10,000% percent annual turnover + $ 20,000 x .09% = $ 1,018

That's $ 1,018 of expenses per year on the $ 20,000 purchase amount or just over 5%.

In other words, if these assumptions are even close to correct, the average participant in SPY would make only 4% if the S&P 500 went up 9% per year going forward. This, of course, does not apply to participants wise enough to just buy and hold the SPY. Yet, for the average participant, 4% would in fact be the approximate per annum return (again, based upon current typical market participant behavior).

Only those involved in the hyperactive trading of SPY bear the costs. Those that buy and hold do not (they pay a mere $ 18/year on $ 20,000 invested plus a modest commission expense).

Under the above scenario, buy and hold behavior would seem to provide a 5%/year advantage over the average participant in that fund (those driving that 10,000% turnover volume).

If correct, more than half the returns of that ETF is being drained off in the form of commissions. What Jeremy Grantham calls a "raid" of the balance sheet.

Taking money that would be capital and converting it to income (in the form of salary, commissions, bonuses etc to your favorite broker).

Now, in this case the frictional costs are not being caused by raising fees but the effect is the same. Instead, the frictional cost is caused by investor behavior itself (well, actually trader behavior or whoever plays the "rather expensive game of musical chairs").

The fact is a quality ETF like the SPY (if traded minimally) can be an incredibly convenient low frictional cost way to invest.

Now, the above admittedly is a bit of a Fermi Estimate. The question: Is that estimate, at least, in the ball park of being correct? Let's look at a broader set of ETFs that were tracked by Vanguard and referenced by John Bogle in this interview:

Bogle said among the pitfalls are that ETFs "turn over at a fantastic rate and they reflect the public appetite for performance chasing."

When Vanguard tracked the returns on 175 ETFs recently, said Bogle, it found investors fell about six percent short per year of the actual index the ETFs were designed to track—adding up to a 30 percent gap over five years.

So much like my Fermi guesstimate above, it's likely that a good portion of that performance gap comes from all the frictional costs associated with trading ETFs so frequently.

Charlie Munger said the following in a 1998 speech to the Foundation Financial Officers Group:

"Human nature being what it is, most people assume away worries like those I raise. After all, five centuries before Christ Demosthenes noted that: 'What a man wishes, he will believe.' And in self-appraisals of prospects and talents it is the norm, as Demosthenes predicted, for people to be ridiculously over-optimistic. For instance, a careful survey in Sweden showed that 90% of automobile drivers considered themselves above average. And people who are successfully selling something, as investment counselors do, make Swedish drivers sound like depressives. Virtually every investment expert's public assessment is that he is above average, no matter what is the evidence to the contrary."

Just like the study of Swedish drivers, many probably think they will chase the performance of the SPY at just the right time and end up above average. The evidence suggests otherwise and by definition the total return of investors as a whole can be no larger than the total return of the fund minus frictional costs.

Newton's 4th Law.

Adam

Long BRKb

Related posts:
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
When Genius Failed...Again
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

Wednesday, March 16, 2011

Is Dell a Bargain?

Here is a GuruFocus interview with Mason Hawkins and Stanley Cates of Longleaf Partners. In the interview, Cates made the case that for Dell (DELL) as an investment.

Cates says the company sells for less than 5 times earnings. He basically thinks Dell is cheap because of a gap between what they actually do and what the perception of what they do is.

GuruFocus: Interview With Mason Hawkins And Staley Cates Of Longleaf Funds

If Dell were still just commodity desktops and notebooks this would be a different story. I am not a huge fan of the business (an industry with too much change and competition from very strong well-financed players) as a long-term investment but the valuation disconnect (at least relative to some high-flyers) seems extreme.

At current prices, Dell's business could shrink in the coming years and still produce a good return. Still, for lots of reasons, a large margin of safety makes sense.

Other value-oriented investors who owned shares in Dell at the end of 2010 include: Joel Greenblatt, Brian Rogers, Jean-marie Eveillard, Richard Pzena, Donald Yacktman, Prem Watsa, John Rogers, Arnold Schneider, Bill Nygren, and Arnold Van De Berg (though not all were adding to shares in the most recent reported quarter).

It may not make for a great "story" ( and Dell has real difficulties ahead) like some of the current high-flying stocks, but at some point valuation creates a margin of safety that's hard to ignore.

Dell has an enterprise value (market cap - net cash) that's a bit over $ 19 billion. Now, speaking of high-flyers, let's compare Dell to Salesforce.com (CRM).

It has an enterprise value a bit under $ 18 billion.

Not the same as Dell...but close.

Dell's enterprise value to forward earnings*  is ~ 5.8x ($ 19 billion divided by earnings of ~ $ 3.3 billion). This is slightly more conservative calculation than the Cates multiple from above as it does not include finance receivables.

Salesforce.com has an enterprise value to forward earnings* of  ~92x ($ 18 billion divided by earnings of ~$ 193 million).

In the late 90s, Dell was once valued at over $ 125 billion with just over $ 1.4 billion/year in earnings. So a multiple that kind of looks like Salesforce.com now.

Dell may not be capable of earning $ 3 billion plus over the long haul. The transition away from personal computers as their core business makes this difficult to predict. So it is far from an attractive business these days.

Still, investors sometimes seem willing to pay a hefty price for the hope and promise of someday earning lots more money and a whole lot less for a company that actually earns more money.

The promise of growth is worth more than growth already achieved. That's how a company like Dell can lose more than 75% of its market value over a decade plus even though the company now earns more than twice as much money.

No matter how good the story is at the time, it's tough to avoid permanent losses of capital when extreme multiples of earnings are paid.

The fact is there's just no technology business that I'm comfortable with as a long-term investment. Occasionally, some have sold at enough of a discount to be worth the trouble, but they will always remain very small positions. Most are involved in exciting, dynamic, and highly competitive industries.

That's precisely what makes them unattractive long-term investments.

No matter how good business looks today (or how high the expectations are), it's just not that easy to predict their economic prospects many years from now.

With the best businesses that's not the case.

Adam

Small long position in Dell established at lower prices

* Fiscal Year ending January 2012
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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, March 15, 2011

Ray Dalio on Stocks & Commodities

An interview with Ray Dalio of Bridgewater Associates in Barron's.

In the Barron's interview, Dalio says that China will continue the commodity-buying spree and that the commodity bubble probably goes on well into 2012.

He ultimately sees the following:

"...a seismic shift, very similar to the Bretton Woods breakup in 1971, in which linked monetary policies and linked exchange-rate policies come undone."

One of the outcomes of all this, in his view, is that China will also be buying commodity manufacturers and other companies. In other words, buy assets trusted more than bonds denominated in depreciating money.

Dalio is long gold and in the interview he explains his thinking.

Productive assets like a good business happens to be my focus so owning shares in the right stocks makes sense to me. We know that the U.S. currency lost value massively over the past century yet partial or full ownership of shares in a good business performed just fine (along with a 6-7x increase in the standard of living). I don't plan on the dollar doing that much better going forward. Fortunately it doesn't need to.

For me, a non-productive asset like gold is of little interest though I think I understand Dalio's point of view.

Gold will certainly go up from time to time and especially in periods when fear is prevalent and paper money is not trusted.

"I don't have the slightest interest in gold. I like understanding what works and what doesn't in human systems. To me that's not optional; that's a moral obligation. If you're capable of understanding the world, you have a moral obligation to become rational. And I don't see how you become rational hoarding gold. Even if it works, you're a jerk." - Charlie Munger at the University of Michigan in 2010

"...Gold is a way of going long on fear, and it has been a pretty good way of going long on fear from time to time. But you really have to hope people become more afraid in a year or two years than they are now." - Warren Buffett in a recent CNBC Interview

In the same interview Buffett also added the following...

"...If you took all the gold in the world, it would roughly make a cube 67 feet on a side…Now for that same cube of gold, it would be worth at today's market prices about $7 trillion. That's probably about a third of the value of all the stocks in the United States...Now, for $7 trillion, there are roughly a billion of farm-acres of farmland in the United States. They're valued at about $2 1/2 trillion. It's about half the continental United States, this farmland. You could have all the farmland in the United States, you could have about seven ExxonMobils (XOM), and you could have $1 trillion of walking around money." - Warren Buffett

In the interview, Dalio added the following about how printing money and currency devaluations will likely impact assets:

"Currency devaluations are good for stocks, good for commodities and good for gold. They are not good for bonds."

Makes sense.

Adam

Related posts:
Financialization of Copper

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, March 14, 2011

Buffett Uses Elephant Gun, Buys Lubrizol for $ 9 Billion in Cash

Sure didn't take long to find out what Berkshire Hathaway (BRKa) would buy next.

Even with the 28% premium to Lubrizol's closing price on Friday, it looks like Buffett paid just over 12x the previous year's earnings for the company.

A good overview of Lubrizol from WSJ's Deal Journal:

Nearly three-quarters of Lubrizol's revenue comes from its "additives" segment, which churns out goo to keep humming engine oil and fluids for passenger cars, big diesel engines, power tools, hydraulics and other working machine parts.

While certainly a large purchase, Lubrizol is relatively small compared to Berkshire Hathaway:

Lubrizol pulled in $5.4 billion in revenue for 2010, compared to Berkshire’s more than $136 billion in revenue over the same time period. Lubrizol had about 6,900 workers at the end of last year, and facilities in 27 countries around the world, many of them laboratories where it cooks up new work. Berkshire employed about 260,000 people.

Some other articles on the deal:
Buffett had the following to say in the Berkshire Hathaway News Release:

"Lubrizol is exactly the sort of company with which we love to partner – the global leader in several market applications run by a talented CEO, James Hambrick," said Warren Buffett, Berkshire Hathaway chief executive officer. "Our only instruction to James – just keep doing for us what you have done so successfully for your shareholders."

I guess now we know just how itchy that trigger finger was.

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, March 11, 2011

Wells Fargo to Devote 30% of Earnings to Dividend

In this article on Well Fargo (WFC), their CEO John Stumpf said the bank plans to use 30 percent of its earnings to fund a dividend and initiate a buyback.

According to the quarterly banking report released in February by the FDIC the banking industry has returned to significant profitability (though still far below normalized). Industry profits were $ 21.7 billion in the 4th quarter compared to $ 1.8 billion the previous year.

Banks Recovering but Need to Lend More: FDIC

The next step is more lending.

As long as 1) the yield curve doesn't get too flat and 2) balance sheets keep improving then increases in loan growth should follow and result in a decent profit cycle for the banks (especially the stronger ones).

In early 2010, Buffett commented on Wells Fargo's revenue potential and its ability to absorb losses on CNBC.

Even as the stock was being crushed during the chaos of the financial crisis Buffett remained consistent on Wells Fargo and kept buying.

In contrast, during the heat of the crisis on January 21st, 2009, FBR lowered their price target on Wells Fargo from $ 20 to $ 12.

The stock hit a low that day of $ 13.74/share and these days is selling at ~$ 32/share.

Only 18 months later, on July 22, 2010, did FBR then change its rating on WFC to "Outperform" and set a price target of $ 31/share.

Obviously, a company like Wells Fargo just does not have its intrinsic value change from $ 12/share to $ 31/share in an 18 month stretch. Seems like a bit too much focus on possible price action instead of trying to judge what a business is approximately worth intrinsically and likely to grow in worth over time.

I still consider Well Fargo to be worth quite a bit more than $32/share. For new purchases of the stock, I'd want a slightly larger margin of safety than what current market prices provide. The bank has a great capacity to grow in value over time in my view (emphasis here on growth in intrinsic value not necessarily the short to intermediate term stock price). This game of setting price targets or trying to guess what price some stock will trade at next week, month, or even 2 years from now makes little sense to me.

I happen to think that Wells Fargo has close to $ 20 billion of normalized earning power (+ or - a few billion...no false precision needed here). With a current market value of $ 168 billion (5.26 billion shares outstanding x $ 32/share) it sells for slightly more than 8x earnings.

"Our inability to pinpoint a number doesn't bother us: We would rather be approximately right than precisely wrong." - Warren Buffett in the 2010 Berkshire Hathaway Shareholder Letter

By normalized earnings I mean what Wells Fargo is likely to earn on average over a complete business cycle (use of peak earnings during boom times can easily result in the overestimation of value, while use of trough earnings during a recession can result in the opposite mistake).

Naturally, depending on the assumptions being used there will be disagreement on the normalized earning power of Wells Fargo going forward. Still, I doubt someone could come up with earnings that explains a $ 12/share value.

At the $ 12/share FBR price target, including the dilution that happened, Wells Fargo would have a market value of ~$ 67 billion (5.6 billion shares outstanding x $ 12/share). If you buy anything close to my estimate of $ 20 billion in earnings power that means Wells Fargo would have a price to earnings multiple just over 3x at that $ 12/share price.

To be fair, the unknown back then was how much dilution would occur (dilution that Buffett thought was unnecessary but nevertheless happened). Hindsight did prove Buffett to be right and the assumptions in the stress tests did underestimate the strength of Wells Fargo. Hey, no system is ever going to be perfectly fair. Still, the amount of dilution that would have to happen to justify a $ 12/share value does not seem plausible.

Back to dividends.

Something like Bank of America (BAC) will likely need to wait a while before increasing its dividend payouts.

Wells Fargo and J.P. Morgan (JPM) should get approval sooner than later.

Adam

Long position in BAC, WFC, and JPM
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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, March 10, 2011

Black-Scholes and the Flat Earth Society: 2010 Berkshire Shareholder Letter Highlights

Warren Buffett had the following to say about Black-Scholes in the most recent Berkshire Hathaway (BRKa) shareholder letter:

Both Charlie and I believe that Black-Scholes produces wildly inappropriate values when applied to long-dated options. We set out one absurd example in these pages two years ago. More tangibly, we put our money where our mouth was by entering into our equity put contracts. By doing so, we implicitly asserted that the Black-Scholes calculations used by our counterparties or their customers were faulty.

We continue, nevertheless, to use that formula in presenting our financial statements. Black-Scholes is the accepted standard for option valuation – almost all leading business schools teach it – and we would be accused of shoddy accounting if we deviated from it. Moreover, we would present our auditors with an insurmountable problem were we to do that: They have clients who are our counterparties and who use Black-Scholes values for the same contracts we hold. It would be impossible for our auditors to attest to the accuracy of both their values and ours were the two far apart.

Part of the appeal of Black-Scholes to auditors and regulators is that it produces a precise number. Charlie and I can't supply one of those. We believe the true liability of our contracts to be far lower than that calculated by Black-Scholes, but we can't come up with an exact figure – anymore than we can come up with a precise value for GEICO, BNSF, or for Berkshire Hathaway itself. Our inability to pinpoint a number doesn't bother us: We would rather be approximately right than precisely wrong.

John Kenneth Galbraith once slyly observed that economists were most economical with ideas: They made the ones learned in graduate school last a lifetime. University finance departments often behave similarly. Witness the tenacity with which almost all clung to the theory of efficient markets throughout the 1970s and 1980s, dismissively calling powerful facts that refuted it "anomalies." (I always love explanations of that kind: The Flat Earth Society probably views a ship's circling of the globe as an annoying, but inconsequential, anomaly.)

Academics' current practice of teaching Black-Scholes as revealed truth needs re-examination. For that matter, so does the academic's inclination to dwell on the valuation of options. You can be highly successful as an investor without having the slightest ability to value an option. What students should be learning is how to value a business. That's what investing is all about. - Warren Buffett

Here's a quote from Charlie Munger on the same subject from the 2003 shareholder meeting:

Black-Scholes is a know-nothing system. If you know nothing about value — only price — then Black-Scholes is a pretty good guess at what a 90-day option might be worth. But the minute you get into longer periods of time, it's crazy to get into Black-Scholes. For example, at Costco we issued stock options with strike prices of $30 and $60, and Black-Scholes valued the $60 ones higher. This is insane.

At the same meeting Buffett added the following:

Buffett: We like this kind of insanity. We will pay you real money if you deliver someone to our office who is willing to offer us three-year options that we can pick and choose from.

When I first understood how prevalent the use of Black-Scholes was to value long-dated options more than a decade ago I figured by now things would have at least changed marginally toward something more rational. Nope.

I've learned to never underestimate how sticky the entrenched use of a bad idea can be.

Adam

Long BRKb

Related posts:
-Buffett: Indebted to Academics
-Grantham on "The Greatest-Ever Failure of Economic Theory"
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.
 
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