Thursday, June 30, 2011

Buffett on Speculation and Investment

From this CNBC interview with Warren Buffett:

"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. And those are two different games. I regard the second game as speculation." - Warren Buffett

In yesterdays post, I basically said a well-designed system to support capital development, among other things, efficiently helps money meet a good idea with minimal frictional costs.

It will also more often than not produce market prices that, at least to a reasonable extent, approximate the discounted value of the cash a business can produce over its remaining life.

In reality, financial markets will always have a tendency to be alternatively manic then depressive in nature. The mood swings in markets are not going to stop producing prices in marketable securities that vary quite a bit, on both the high and low side, around the approximate underlying value of the assets.

Yet, I think modern financial markets have developed in a way that unnecessarily amplifies this nature. It's not like we're going to create a perfect system anytime soon but we'd be better off reversing the direction we've been heading for some time.

Some of this gets back to the question of what is speculation versus what is investing. The answer is clearly not black and white but that doesn't mean the differences are unimportant or small.

Investing is the ownership of an asset, partially or entirely, with the emphasis on benefiting from what that asset can produce in value itself over an extended period of time.

Speculating is altogether different. Speculation is betting on the near or even medium term price action of marketable securities. What the asset itself can produce in value over time is of little or, in the case of increasingly popular things like high frequency trading and technical analysis, of no interest. More from the CNBC interview:

"I bought a farm 30 years ago, not far from here. I've never had a quote on it since. What I do is I look at what it produces every year, and it produces a very satisfactory amount relative to what I paid for it." - Warren Buffett

If an investor buys something hoping the price will go up in the near-term, it's speculation. Investing is not about price action, it's about what the asset can produce in the long run relative to what was paid for the asset. What the price does next week, month, or even much longer matters little.

In a separate interview, Buffett had this to say:

"Basically, it's subjective, but in investment attitude you look at the asset itself to produce the return. So if I buy a farm and I expect it to produce $80 an acre for me in terms of its revenue from corn, soybeans etc. and it cost me $600. I'm looking at the return from the farm itself. I'm not looking at the price of the farm every day or every week or every year. On the other hand if I buy a stock and I hope it goes up next week, to me that's pure speculation." - Warren Buffett

So speculating is like investing the same way a Chihuahua is like a Doberman, a horse is like a zebra, and a house cat is like a lion. These things may seem, in some ways, very much the same but that's only if your definition of being the same is rather imprecise.

The differences matter.

There is certainly nothing wrong with speculation but the proportion of market participants that are speculators isn't exactly irrelevant. If most participants are focused more on price action, less on underlying value, it seems clear that the system will work below its potential. More frequent mispricings, sometimes substantial, seem an inevitable outcome.

To me, a market dominated by those focused on price action, less by those anchored by intrinsic value (the financial markets equivalent to gravity), naturally ends up with assets mispriced (on the high and low side) more frequently and by larger amounts. The more time and distance that prices remain disconnected from underlying value means ultimately more capital gets misallocated. This misallocation has got to be costly for all over the long haul*.

In the long run, the weighing machine wins (the financial equivalent to gravity assures this so a true long-term investor in a good business will do just fine) but in the short-to-intermediate run the system is less effective at performing its primary functions.

If I bought some farmland, owned it passively and rented it out to someone over the past 40 years, I think it's fair to say that I'm not a speculator in farmland. I primary look at the rent checks I collect over time to judge how wise the investment was. 

I become a passive part owner in a restaurant with the intention to own it "forever". While I may sell someday, what it could be sold for on any given day to someone else is not my focus.  I mainly judge my investment based on my share of the income and value it produces over many years relative to the price paid for the partial ownership. It's what the business produces relative to my capital at risk. I think in that scenario it's also fair to say I'm not a speculator in restaurants. 

The same is true for a long-term investor in something like Coca-Cola (KO) or Johnson & Johnson (JNJ). An investor who bought shares of either of stock in the early-to-mid 1980s now owns an asset that earns each year roughly what was paid for the stock (they are both remarkably consistent long-term value creators). Those earnings, of course, continue to grow. The dividend checks alone now easily produce a 40% return per year on the original capital invested (dividends that naturally also continue to grow). The dividend income stream alone represents a nice return even if those shares of Coca-Cola or Johnson & Johnson end up never being sold. Besides, selling means giving up the ownership of a proven productive asset and creates a new problem.

Finding another one.

If the market did not produce another quote on either Coca-Cola or Johnson & Johnson for a decade, the owner of shares would do just fine. The portion of the earnings that are not paid out as dividends, if management does its job, is invested in a manner that should create even more wealth for owners down the road.

I'm guessing, even if not quite as spectacular, someone who invests in these businesses now will not regret it in 25 years.

I'm not saying 25 or 30 years is somehow required to be considered an investment but a longer time frame helps make the point. There is room for speculators in any market. Yet, with the average holding period of stocks now standing at less than 3 months**, I think the proportion of participants in the market who think and behave like owners has clearly got to be too low (with prices more likely to swing wildly above and below the approximate intrinsic value of underlying assets).

When returns are primarily driven by well-timed trades around price action, it's speculating.

When returns are primarily driven by what the underlying asset produces in value over a long period of time, it's investing.

In reality, there's often a bit of each in any transaction but an emphasis more on the latter in the markets these days would be welcome.

Adam

Long stocks mentioned

Related posts:
Buffett on Gambling and Speculation (follow-up)
Buffett on Speculation and Investment - Part II (follow-up)

* Costly in terms of some opportunities getting undercapitalized while others end up swimming in capital who have questionable prospects or maybe don't even need the funds. Many good businesses were created in the late 1990s. At the same time many not even remotely viable businesses chewed up capital that could have been put to use elsewhere. The widespread mispricing (on the high side) of internet related businesses made it seem like easy money. Meanwhile, at the time, it's almost certain something non-internet related but more viable couldn't even get a return call from the distracted investment bankers and venture capitalists. That's why widespread mispricing in the capital markets makes bubbles so expensive and painful economically. Money gets burned up on bad investments while others are starved for capital. It may seem like a big party at the time but it is, in fact, very costly.
** Historically, the norm has been much longer.
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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, June 29, 2011

Buffett, Bogle, and the "Invisible Foot" Revisited

"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." - Warren Buffett in the 1983 Berkshire Hathaway (BRKaShareholder Letter

The casino-type markets Buffett was referring to back in 1983 seem quaint in size and complexity compared to now.

With Buffett's "invisible foot" in mind, consider this interview with John Bogle from earlier this year where he provided some thoughts on the frenetic turnover of ETFs:

"'Spiders,' the S&P 500 ETF [SPY], turns over 10,000% a year. That's a lot of turnover. And even the big emerging market ETFs are turning over, I think at around 3,000% a year. And even the more cautious funds are turning over at 2-300% a year...And we know in fact that if you look at all of the ETFs that are out there--there are about 175 of them that have been out there for five years--and you calculate the returns as it happens in that particular five-year period, the average returns of all of those indexes together that they were tracking is about +3% a year, and the returns of the investors in those ETFs was -3% a year."

Compounded that costs investors 30% or so over five years. A well-designed system of capital formation/allocation efficiently helps money meet a good idea with minimal frictional costs. We've steadily gone backwards in this regard in my view*.  In recent years, the lower costs per transaction have been much more than offset by the increased costs of hyperactive trading.

In the past few decades, the average holding period of marketable securities has gone from being measured in years to a few months. One big equity rental system.

Related post: Buffett, Bogle, and the Invisible Foot

Q: "So who's watching the governance practices of the business? Is the business being well run? Are resources being intelligently allocated?"

A: "Who cares, I'm only going to own shares in the company for 15 minutes."

There may not be a precise number that you can put on what it costs (in potential wealth creation not realized) to have most owners of equity uninterested in the long run performance of the actual business itself. That doesn't mean there are not some very real, terribly important, and hard to quantify costs beyond the explicit ones Bogle notes above.

"You've got a complex system and it spews out a lot of wonderful numbers that enable you to measure some factors. But there are other factors that are terribly important, [yet] there's no precise numbering you can put to these factors. You know they're important, but you don't have the numbers. Well practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that." - Charlie Munger in this speech at UC Santa Barbara

Well, just because you can't put numbers on wealth not created or destroyed resulting from a system increasingly oriented toward share-renters over share-owners doesn't make the costs less real. Maybe a few less corporate scandals this past decade would have occurred if the owners were keeping a closer eye on who was minding the store. You can't quantify precisely but you know those scandals had real costs.

A short-term renter doesn't lose much sleep over how well the caretakers of the underlying asset are looking out for its long run future.

Seriously, how carefully did you drive your last rental car? It's a completely different context but worry much about the underlying asset? Short-term renting changes behavior whether it's a car or a business.

Equity shares aren't trading cards. They're partial ownership of some mostly rather useful assets. For those that think these costs don't reduce value (wealth) because they happen to be tough to quantify I have a nice, well-maintained, rental car to sell them.

"Not everything that counts can be counted, and not everything that can be counted counts." - Sign hanging in Albert Einstein's office at Princeton

Now, getting back to the easier to quantify explicit frictional costs. Jeremy Grantham made the point that frictional costs like this actually "raid the balance sheet" of investors.

Now, in this case the frictional costs** are not driven by raising fees but the effect is the same. Instead, the additional frictional costs come from investor behavior itself (well, actually trader behavior). Taking money that would be capital and converting it to income (in the form of salary, commissions, bonuses etc). Potential investment dollars becomes mostly consumption.

I prefer to own equities directly, but a quality ETF can be an incredibly convenient low frictional cost way to invest.

That doesn't mean trading them excessively makes sense.

Adam

Long BRKb

Related posts:
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again

* Despite the lower per transaction cost (some would say because of the lower per transaction cost). Take the 10,000% turnover rate that Bogle mentions above for the "Spiders" (SPY), 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%. A bit of a Fermi Estimate but not far from the actual performance gap, noted by Bogle above, experienced by investors in those 175 ETFs. So it's not hard to see what drives most of the underperformance...excessive trading costs.
** These dollars don't disappear, of course. After sloshing around the economy for a while some will eventually become savings and investment again. It's just seems an expensive and inefficient way to go about capital development.
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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.

Tuesday, June 28, 2011

The Best Use of Corporate Cash: Acquisitions, Buybacks, Debt Reduction or Dividends?

"When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases." - Warren Buffett in the 1984 Berkshire Hathaway (BRKaShareholder Letter

Buybacks, if pursued with discipline in the manner Buffett describes, can work out very well for shareholders.

Unfortunately, in practice, buybacks don't always work out as well as they ought to for shareholders.

The reasons? Too often executives end up buying shares back, if not high, certainly not cheap. Alternatively, an expensive acquisition will be chosen when the company's own stock is right there available to be bought on the cheap.

Weak execution and the misalignment of owners (shareholders) and management objectives is sometimes the culprit.

Plenty of evidence supports this unfortunate reality.

Now, a senior management team doesn't generally come forward and say they behaved in ways contrary to shareholder interests. Management actions, examined objectively, in time reveal the real story.

Here's what Jason Trennert had to say in this Barron's article:

...buybacks may just "enhance the reputation of corporate treasurers as poor market timers," at a time when market cycles are growing shorter.

How management should allocate excess cash on balance sheet and future free cash flow for things like acquisitions, debt reduction, buybacks, and dividends is specific to each company. Of course, things like increases to capex/R&D/other expenses, in order to pursue organic business growth opportunities, is also an option when the risk-reward is clearly favorable.

The list of possible scenarios is long. Some companies have lots of debt to pay down. Others, little in the way of attractive internal investments yet otherwise strong businesses (See's Candies comes to mind if it were a stand alone public company). Alternatively, certain technology businesses can appear to have sound economics now but have to deal with a difficult to predict, fast changing, competitive landscape. For these businesses, holding excess cash might offer a bit of protection against a future fundamental shift that impacts core economics in a negative way.

Naturally, there are many other scenarios. One size does not fit all in capital allocation decision-making.

Having said that, buying back your own company's stock when it's clearly cheap is sometimes a great low risk way to create shareholder value.

"When companies purchase their own stock, they often find it easy to get $2 of present value for $1. Corporate acquisition programs almost never do as well and, in a discouragingly large number of cases, fail to get anything close to $1 of value for each $1 expended." - Warren Buffett in the 1984 Berkshire Hathaway Shareholder Letter

Unfortunately, the track record is spotty at best as this Barron's article from earlier this year points out:

Beware The Buyback Craze

Buffett has said stock buybacks makes sense when they're selling below intrinsic value (calculated conservatively) and if the business and balance sheet are strong enough.

So not all buybacks work out for investors. Those one's that do not are mostly the result of ineptly buying high. When executed intelligently, buybacks work very well and also reveal that management actions are driven by shareholder wealth creation.

"By making repurchases when a company's market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management's domain but that do nothing for (or even harm) shareholders." - Warren Buffett in the 1984 Berkshire Hathaway Shareholder Letter

What's a good recent example of the expansion of domain if not necessarily shareholder wealth? The following may fit the bill. Check out this Barron's article on Sanofi's (SNY) offer for Genzyme. Here's what CEO Chris Viehbacher had to say when asked about buybacks on a conference call:

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

That acquisition may work out but that doesn't make this flawed thinking any less an issue for investors. The ignorance of basic math may seem puzzling but there is no shortage of CEOs that will let math get in the way of the desire to grow the empire even if it may cost the owners some wealth.

When a CEO is justifying the price paid and merit of a deal sometimes shareholders need to read between the lines.

My only somewhat sarcastic view is that the words strategic and/or synergistic used in the context of justifying the high price paid by the acquiring company for its target should be considered code for the following:

I'm going to overpay for an acquisition to grow this company at shareholders expense.

In too many cases, a company's own stock is selling below intrinsic value and could easily have been bought instead.

A straightforward, low risk, way to create per share value is available.

Yet the riskier voyage is chosen.

Personally, if I couldn't find a plane and needed to get across the ocean I'd take a ship. All too often, choosing an acquisition over a buyback seems the equivalent of attempting to get across on the back of a sailfish when a perfectly good ship is available.*

"Smart people aren't exempt from professional disasters from overconfidence. Often, they just run aground in the more difficult voyages they choose..." - Charlie Munger in a speech to the Foundation Financial Officers Group

You just need a management team in place that knows how and when to allocate capital wisely with increasing shareholder value its real first priority.

Adam

Long BRKb

Related posts:
Buffett on Stock Buybacks - Part II
Buffett on Stock Buybacks
Sanofi-Aventis: How Not to Spend $ 18.5 Billion
Buy a Stock...Hope the Price Drops?

Apparently, the sailfish can hit 68 mph for shorter periods of time. That's quicker than any other fish. So someone could, at least theoretically, get to their destination more quickly than on a ship. Obviously, that doesn't make it a brilliant alternative means of transport.
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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, June 27, 2011

Are Large Cap Stocks on Sale?

A follow up to this post:

Buffett: Waiting For The Fat Pitch

If not quite fat pitches yet, many big cap stocks seem not at all expensive.

Last week I noted that many stocks among the Dow 30 are, on the surface, very reasonably valued.

Some, of course, more than others. I'm wary of businesses that may be benefiting from cyclical tailwinds that make them look cheap now but on a normalized long-term basis they end up not such a bargain.

In general, I wouldn't take the bat off the shoulder for most commodity businesses unless they have a clearly sustainable low cost advantage, a conservative balance sheet, selling at a price that reflects a weak business outlook. In other words, a much larger than average margin of safety is needed.

In fact, I wouldn't go near something like Alcoa (AA) no matter how inexpensive it was.

For most businesses, especially the capital intensive/cyclical ones, current earnings doesn't help much in estimating intrinsic value. Cyclical stocks often look cheap when they are most expensive. The use of what ends up being near peak earnings to value a cyclical business, a common mistake, can be very costly*.

In my view, earnings produced on average over at least a full business cycle (much longer if recent bubble conditions have caused distortions) must be used with quality of earnings carefully checked.

To me, this is not the case for the great consumer franchises. For those businesses, recent annual earnings is usually sufficient given the resilience of their earning power.

Dow 30
3M (MMM), AT&T (T), Alcoa (AA), American Express (AXP), Bank of America (BAC), Boeing Co (BA), Caterpillar Inc (CAT), Chevron Corp (CVX), Cisco Systems (CSCO), Coca-Cola (KO), Disney (DIS), Du Pont (DD), Exxon Mobil (XOM), General Electric (GE), Hewlett-Packard (HPQ), Home Depot Inc (HD), IBM (IBM), Intel (INTC), Johnson & Johnson (JNJ), Kraft Food Inc (KFT), McDonalds (MCD), Merck (MRK), Microsoft (MSFT), J.P. Morgan (JPM), Pfizer (PFE), Procter & Gamble (PG), Travelers (TRV), United Technologies (UTX), Verizon (VZ), Wal-Mart Stores (WMT)

The focus here is always on purchasing shares of good businesses, with an appropriate margin of safety, then allowing the economics of the business itself, the drivers of growth in intrinsic value, to do the heavy lifting over a long period of time. No special ability to trade or time the market required.
(I never have an opinion when it comes to the trading of any stock. Fortunately, nor is some unusual talent for trading required if price vs value is frequently judged well.)

Many large tech stocks, pharma stocks, and integrated energy stocks currently sell at single digit price to earnings ratios. A low multiple isn't enough. Ultimately, what matters is whether the business has durable competitive advantages that allow it to produce a high return on capital** over a very long period of time. Durable high return on capital is useful for gauging 
how intrinsic value may grow over time (though there is no precise method to predict long-term growth in value, of course).

Again, the durable high return on capital is what drives long-term investment returns not some kind of superior trading skills.

It's often better to pay a slightly greater multiple (maybe more than slight) for a business that's positioned to produce a high return on capital for years to come.

Return on capital for tech stocks often looks pretty solid but the question is not usually how attractive current or near term return on capital happens to be for most tech stocks.  The question is how sustainable those seemingly favorable economics will be in a constantly changing competitive landscape with evolving future threats. That's why I'm not comfortable with most tech stock investments unless the discount to likely value is very large.

The single digit multiples found among some of the above stocks appear to be pricing in a future not likely to happen. I have no idea what the stocks will do in the short-to-intermediate run but, for me, quite a few of these do have a decent margin of safety. 


They seem as strangely cheap today as they were strangely expensive roughly a decade ago. Yet, I wouldn't describe any as being along the lines of what Buffett calls a fat pitch.

A decade ago prices reflected a rosy future that didn't happen. For many of the better businesses here with prices that reflect a lousy expected future, I suspect things will end up being a bit better than lousy and long-term investors will do okay.

Most big banks also sell at a single digit multiple of likely normalized earnings (some are already at single digit multiples even with earnings depressed well below potential).

As far as banks go, for me, something like Wells Fargo (WFC) still looks very reasonable even if the regulatory and systemic risks remain significant. The long-term economics of Wells is exceptional. Even as the rules of the banking game change I'm of the opinion they will continue to have an advantage.

I may, of course, be proven wrong about Wells. The question is whether any bank is worth the trouble when considering all the other reasonably valued assets available. Many things can go wrong for a bank, some beyond its control, that simply cannot for other businesses.

As always, some of this comes down to how comfortable an individual investor is with the inherent risks of one asset versus another asset. Buy an asset where you don't understand the inherent risks and potential and the conviction required to hang in there if the market price starts to break down probably will not be there.

For my money, adjusted for risk the best businesses to own long-term remain the great franchises (Diageo: DEO, and Pepsi: PEP and Johnson & Johnson: JNJ among many others) when bought at the right price. These all have huge and durable economic moats. The durability of their economics come primarily from a combination of strong product, brands, distribution, and scale. Each are very difficult to dislodge from their unique positions of strength and have proven economics to back it up.

These stocks may lack characteristics that those involved in hyperactive trading are looking for but the merits of their long-term effects, especially on a risk/reward basis and when bought at the right price, are real.

"...why should such an owner care if at any time most other investors are faring somewhat better or worse. And particularly so when he rationally believes, like Berkshire, that his long-term results will be superior by reason of his lower costs, required emphasis on long-term effects, and concentration in his most preferred choices." - Charlie Munger in a speech to the Foundation Financial Officers Group

The problem is most of these are not particularly inexpensive (though certainly not overvalued) at this time so some patience is required.

Adam

Accumulating, or planning to accumulate, long positions in some of the above stocks as they hopefully drop further in value. Previously have established long-term positions in KO, PEP, DEO, PG, JNJ, AXP, and WFC. Many of these were established at much lower prices. Technology positions require a larger margin of safety.

* That it was bought near the cyclical peak of earnings is often only obvious after the fact...when it's already too late to sell.
** Return on capital measures how well a company employs its resources to generate profits. The best business has durable competitive advantages yet needs little capital relative to the profits it produces. The durability characteristics make it likely that not only can a business earn a nice return now, but that those favorable economics are sustainable for a long time. A business that needs modest capital compared to earnings power (whether financed by equity, debt or the future free cash generated) has lots of options that benefit shareholders. Capable management can either return excess cash to shareholders (dividends or buybacks depending on attractiveness of the share price) or use it to produce high returns on capital when the opportunity to deploy incremental capital presents itself. The problem for shareholders begin when management uses capital to pursue growth for its own sake regardless of return. 
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, June 24, 2011

Buffett: Waiting For The Fat Pitch - Berkshire Shareholder Letter Highlights

From Warren Buffett's 1997 Berkshire Hathaway (BRKashareholder letter:

"In his book The Science of Hitting, Ted explains that he carved the strike zone into 77 cells, each the size of a baseball. Swinging only at balls in his 'best' cell, he knew, would allow him to bat .400; reaching for balls in his "worst" spot, the low outside corner of the strike zone, would reduce him to .230. In other words, waiting for the fat pitch would mean a trip to the Hall of Fame; swinging indiscriminately would mean a ticket to the minors.

If they are in the strike zone at all, the business 'pitches' we now see are just catching the lower outside corner. If we swing, we will be locked into low returns. But if we let all of today's balls go by, there can be no assurance that the next ones we see will be more to our liking. Perhaps the attractive prices of the past were the aberrations, not the full prices of today. Unlike Ted, we can't be called out if we resist three pitches that are barely in the strike zone; nevertheless, just standing there, day after day, with my bat on my shoulder is not my idea of fun."

When the above was written, the party that ultimately led to the tech bubble era valuations* had already begun in the equity markets.

Overvaluation, in some cases extreme, became the norm.

A field day for those speculating on price action yet not so amusing for those in the business of estimating current value, likely future value, and trying to buy things at a sufficient discount.

So, at the time, marketable securities became increasingly decoupled from the economic forces that determine value. The financial equivalent of ignoring Sir Isaac Newton's law of universal gravitation.

Now, gravity and, more specifically, a so-called zero gravity flight provides a useful way to think about what happens in markets from time to time.

For a brief period measured in 20 or 30 seconds, a zero gravity flight can, in fact, simulate weightlessness and make it seem to passengers like there's no gravity. Yet, while a zero gravity flight can make it seem there are negligible gravitational forces at work for a short time, eventually the plane will leave the zero gravity phase -- the parabolic arc -- and the fact that gravity is still very much there becomes front and center again to the passengers.

An easy to understand temporary illusion.

A similarly easy to understand temporary illusion happened in the late 1990s in the equity markets.

In the long run it is intrinsic value** -- the discounted value of all cash that can be taken out of a business during its remaining life -- that anchors market prices the same way gravity keeps us firmly planted on terra firma.

In the long run.

In the short-to-intermediate run it's a very different story.

Markets do occasionally enter a period analogous to a zero gravity flight. It may be for a period greater than 20-30 seconds, but basically that's what happens. Consider the late 1990s. For several years the passengers (i.e. market participants) were stuck in the zero gravity phase of the financial flight, where it seemed that the market's equivalent to gravity (i.e. intrinsic value) was no longer at work, but some made the mistake of thinking it somehow was not just an illusion.

The zero gravity phase for the equity markets ended when the dot com bubble burst.

So, in 1997, market prices had already begun decoupling from economic reality. After a while enough market participants believed the illusion was real (others saw it for what it was but likely believed they'd be able to find a chair when the music stopped). It was not a fun time if, like Buffett, buying shares of a good business (or, in his case, sometimes, an entire business) at a meaningful discount to their intrinsic value was your game.

Even though market prices got even sillier a few years later (the decoupled getting even more decoupled), it was already difficult in 1997 to find shares of a good business selling at prices that offered a substantial margin of safety to the investor.

Today, the investing landscape is very different in my view. On the surface, the market as a whole is not exceptionally cheap.

Yet, below that surface I happen to think we find ourselves in an investing universe that, while not containing an overwhelming number of fat pitches, there's certainly enough to occasionally take the bat off the shoulder.

Adam

Long BRKb

* I've said previously, it was not just the tech and internet stocks though that is certainly where valuations became the most extreme.
** From the Berkshire owner's manual"Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life." Of course, there is no perfect estimate of what the cash that can be taken out of a business during its remaining life will be. Yet, despite the zero gravity illusion -- or, at least, the equity markets equivalent -- stock prices should to an extent be anchored by intrinsic value within some plausible range. Still, expect the alternately manic-then-depressed nature of markets to reinforce the illusion. Short run -- and even longer run -- price action will sometimes completely decouple from the intrinsic value anchor.
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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.

Thursday, June 23, 2011

Buffett on "The Inevitables": Berkshire Shareholder Letter Highlights

From Warren Buffett's 1996 Berkshire Hathaway (BRKashareholder letter:

I was recently studying the 1896 report of Coke (and you think that you are behind in your reading!). At that time Coke, though it was already the leading soft drink, had been around for only a decade. But its blueprint for the next 100 years was already drawn. Reporting sales of $148,000 that year, Asa Candler, the company's president, said: "We have not lagged in our efforts to go into all the world teaching that Coca-Cola is the article, par excellence, for the health and good feeling of all people." Though "health" may have been a reach, I love the fact that Coke still relies on Candler's basic theme today - a century later. Candler went on to say, just as Roberto could now, "No article of like character has ever so firmly entrenched itself in public favor." Sales of syrup that year, incidentally, were 116,492 gallons versus about 3.2 billion in 1996.

I can't resist one more Candler quote: "Beginning this year about March 1st . . . we employed ten traveling salesmen by means of which, with systematic correspondence from the office, we covered almost the territory of the Union." That's my kind of sales force.

Companies such as Coca-Cola and Gillette might well be labeled "The Inevitables." Forecasters may differ a bit in their predictions of exactly how much soft drink or shaving-equipment business these companies will be doing in ten or twenty years. Nor is our talk of inevitability meant to play down the vital work that these companies must continue to carry out, in such areas as manufacturing, distribution, packaging and product innovation. In the end, however, no sensible observer - not even these companies' most vigorous competitors, assuming they are assessing the matter honestly - questions that Coke and Gillette will dominate their fields worldwide for an investment lifetime. Indeed, their dominance will probably strengthen. Both companies have significantly expanded their already huge shares of market during the past ten years, and all signs point to their repeating that performance in the next decade.

In the letter, Buffett mentions that the stock prices of businesses like Coca-Cola (KO) and Gillette (now part of Procter & Gamble: PG) end up out of line with value. He also says that even outstanding businesses have historically been susceptible to management that become distracted and unfocused from time to time.

You can, of course, pay too much for even the best of businesses. The overpayment risk surfaces periodically and, in our opinion, may now be quite high for the purchasers of virtually all stocks, The Inevitables included. Investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid.

A far more serious problem occurs when the management of a great company gets sidetracked and neglects its wonderful base business while purchasing other businesses that are so-so or worse. When that happens, the suffering of investors is often prolonged. Unfortunately, that is precisely what transpired years ago at both Coke and Gillette. (Would you believe that a few decades back they were growing shrimp at Coke and exploring for oil at Gillette?) Loss of focus is what most worries Charlie and me when we contemplate investing in businesses that in general look outstanding. All too often, we've seen value stagnate in the presence of hubris or of boredom that caused the attention of managers to wander.

Around the time that letter was written, stocks like Coca-Cola were beginning to sell at multiples of earnings that made little sense. Even an outstanding business like Coca-Cola, if bought at 40-50x earnings, almost guarantees the investor a stagnant or worse decade ahead (in terms of stock performance) as the intrinsic value* of the business catches up to market price (or market price falls more in line with current value).

These are value creating machines but paying too much in anticipation of future worth will naturally damage investor returns.

Many stocks, of course, would go on to get even more expensive after he wrote that letter and it certainly was not just the tech stocks.

These days, Wal-Mart (WMT) is often cited as a stock that has gone nowhere in the past decade. The listless performance has more to do with the price paid by market participants for Wal-Mart's stock, especially in the 1st half of the past decade, not business performance over that time.

The business itself did just fine.

Over that time the Wal-Mart's business more than tripled its earning power. Not a bad decade of work especially for a company that size.

A decade ago market participants were willing to pay around forty dollars for every dollar of Wal-Mart's earnings. Now, investors are paying less than 12 dollars for every dollar of earnings.

Unless something material is going to happen to Wal-Mart's moat, at current market price the next decade should be a much different story as far as that stock goes.

Adam

Long all stocks mentioned

* From the Berkshire Hathaway owner's manual:
"Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.

The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are 5 revised. Two people looking at the same set of facts, moreover – and this would apply even to Charlie and me – will almost inevitably come up with at least slightly different intrinsic value figures."
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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, June 22, 2011

Charlie Munger: Two Kinds of Businesses - Part II

A follow up to this previous post.

With the following thought from Charlie Munger in mind...

"There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there's never any cash. It reminds me of the guy who looks at all of his equipment and says, 'There's all of my profit.' We hate that kind of business."

...consider a typical automobile manufacturer.

Occasionally, though for some not very often*, an automaker will actually have some earnings. The problem is much (if not all of it) will go toward:
- helping fund the creation of the next generation vehicles, and
- absorbing the nearly certain future operating losses (during the next meaningful economic downturn).

In my view, you can't look at price to current earnings to gain any meaningful insight with most automobile manufacturers. In fact, if you look at many of the automakers over a few business cycles, there's not all that much in the way of normalized earnings. It's especially ugly for investors when viewed in the context of the amount of capital that is being employed to produce the rather meager (or nonexistent) earnings.

So what seem like earnings are, in fact, mostly illusory. Return on capital ends up being subpar or much worse. For many auto manufacturers, their earnings are a necessary and useful fuel for staying in the game. Yet, the last time I checked, effective investing doesn't involve putting capital at risk just so a business can survive while ultimately generating unsatisfactory or negative returns. (An FDIC insured bank account provides a much safer way to produce modest returns with essentially no risk of negative returns.) It's about getting much more out, commensurate with the risks taken, primarily through the increases of a businesses earning power per share over time.

It's pretty simple. A business that needs most (or all) of its earnings just to stay remain a viable going concern cannot produce satisfactory economic returns for investors.

Any automaker that invests insufficiently or ineffectively in the next generation of products has a high probability of being on the ropes once the inevitable next recession hits. It takes little time for the current generation of vehicle to lose competitiveness in the marketplace.

Still, even those that survive are not likely to produce much in the way of returns for shareholders. Let's say someone buys the following two stocks in the late 1950s and reinvests the dividends over the next fifty years.

$ 10,000 invested in General Motors (GM) stock in the late 1950s, even before it went bankrupt, had not produced much shareholder value fifty years later (considering the time frame). Of course, ultimately the stock was worth nothing. First of all, investors in an inherently weaker business like GM would have been better off if those dividends were not reinvested. Actually, considering the challenges (its capital intensiveness and brutal competition led to low return on capital and reduced business durability) that was facing an enterprise like General Motors, better to not invest at all.

In contrast, over the same fifty year period, $ 10,000 invested in Philip Morris/Altria (MO) grew to over $ 80 million (incl. reinvested dividends).

Philip Morris/Altria generated an annual return of nearly 20% during that time frame.

An asset that returns that much annually left to the magic of compounding turns $ 10,000 into $ 80 million in 50 years.

That means a roughly 6x increase in value has been a typical decade for MO. Some of this came about as a result of a consistently low stock price. The threat of legal liabilities and that some investors don't want anything to do with a business that sells tobacco products meant the shares were often cheap. The fact that it is a business with high return on capital and the dividends could be used to buy shares consistently cheap were key factors in generating high long-term returns. This works with buybacks as well even if the tax implications, depending on the type of account, are generally not the same

Excluding the tax differences, buybacks and dividend reinvestments -- implemented at reasonable or better valuation levels (i.e. discount to intrinsic value) -- similarly benefit long-term owners; the former reduces overall share count, while the latter increases the number of shares owned.

Odds are pretty good that both MO, and the spin-off Philip Morris International (PM), will continue to do just fine as investments though, I think it's fair to assume, they're not likely to generate anything close to those spectacular returns going forward.
(Now, if it turns out to be better than expected there'll surely be no complaints.)

In any case, all else equal, they'll be even better long-term investments if the shares consistently remain rather cheap.

Imagine having $ 10,000 laying around back in the 1950s and not being sure whether to make a long-term investment in GM or MO. I'm guessing most investors back then thought of GM as an unstoppable business juggernaut while MO was a company heading into uncertain legal liabilities and reduced demand for their products.

Occasionally, a well run automaker will do better than GM and maybe even make more than modest returns for investors. So theoretically there are exceptions.

The problem is you have to pick the right one.

Unfortunately, the right one in the auto industry will probably do worse for investors than a laggard in some other field. In certain industries, the leader will produce excellent return but even the laggards produce good results for investors.

The cereal business come to mind. More from Charlie Munger:

"If it's a pure commodity like airline seats, you can understand why no one makes any money....Yet, in other fields—like cereals, for example—almost all the big boys make out. If you're some kind of a medium grade cereal maker, you might make 15% on your capital. And if you're really good, you might make 40%."

It's easier to pick a needle out of a stack on needles.

Yet, the generally subpar long-term returns produced by automotive manufacturers are not simply the result of weak management. For an investor, I think the problem goes deeper than that. These are fundamentally difficult businesses with almost no chance of producing a high return on capital for investors. A well run auto manufacturer is, in most cases, just going to be the best house in a bad neighborhood.

So that mean, even with the best, an investor takes on more risk for lower returns versus many alternative investments.

Think about how much Ford (F), GM and other major automakers have had to spend on new car models over the past 30 years. Yet, even with all that money put to work, there is still no real moat protecting the future economics of these businesses. They are only as secure as the competitiveness of the next models that they produce. Underinvest or misfire on key new product launches and it won't take much time for any automaker to be in some trouble.

A good business that invests heavily in its future over time should also be able to build some kind of an economic moat. Something that protects the economics of a business for an extended period into the future against competition (some combination of brand strength, a cost advantage, broader distribution etc). Automakers have a very tough time doing this.

In contrast, how much has someone like Wrigley had to spend producing its next generation pack of gum over the past 30 years?

Here's how Munger looks at it:

"If I go to some remote place, I may see Wrigley chewing gum alongside Glotz's chewing gum. Well, I know that Wrigley is a satisfactory product, whereas I don't know anything about Glotz's. So if one is 40 cents and the other is 30 cents, am I going to take something I don't know and put it in my mouth which is a pretty personal place, after all for a lousy dime?"

So Wrigley has little difficulty charging something like 33% more in price for essentially the same product because of the trust and familiarity of the brand. What would an automaker have to put into one of it's machines to get a customer to pony up 33% more dollars. Yes, brand matters in the auto business but even the better ones would struggle to charge a higher price without more...more...more. More options, more horsepower, more engineering etc.

Meanwhile, Wrigley sells variations of gum and other candies, with updated packaging of some kind every now and then, and gets to charge a nice premium. I'm not saying that running Wrigley's well is easy. Yet, I'd bet if there was not a single update to that pack of gum over the next decade they'd still basically have a pretty good business.

That's the best evidence of Wrigley's moat. They'd still make a nice living even if they stopped innovating tomorrow (though they may miss a whole lot of upside).

Not true for automakers.

Some of this comes down to being a small ticket item instead of a big ticket item relative to an individual's average annual budget. If you are about to spend $ 100 on groceries no one is going to sweat ten cents more for the pack of gum that you like and trust.

Not so for a big ticket item like a car.

I realize producing automobiles for a living is probably a lot of fun but, from an investors point of view, which kind of business would you rather own?**

In lower quality businesses like automobile manufacturing, the problem is that the basic alternatives for management are unattractive:
-stay competitive by making the investments in new technology while producing lousy shareholder returns (not necessarily zero or negative, but certainly not great long-term relative to alternatives given the risks)
-do not make those investments, lose competitiveness, and watch earning power shrink over time (as competitors adopt the new technology) while producing even crappier returns

Durable competitive advantage, pricing power, and modest capital requirements are found among the better businesses. Selling a desirable small ticket item doesn't hurt.

Pretty much the opposite of almost all auto manufacturers.

The better businesses have earnings that are truly free to benefit shareholders (i.e. not continuously needed to shore up business competitiveness).

Earnings that are either available to be distributed to shareholders or can be used for incremental investments that ultimately produce even higher future returns for shareholders.

Investing is not about earning or earnings growth in a vacuum; it's about return on capital. What matters is the earnings that can be produced relative to the capital that is employed. Well, many high quality businesses -- those that produce terrific and durable returns on capital in their current form -- often have limited opportunities to deploy incremental capital at a high rate of return.***

Some businesses may be growing earnings fast but require the deployment of capital at an even faster rate. Investors may chase that sort of growth but simple arithmetic gets in the way of shareholder returns in the long run.
(It's another story for traders, of course.)

Return on capital mostly dictates long-term overall returns. An investor can't escape the long run gravitational force that causes returns to converge on what a business can generate in earnings relative to the capital employed. 

Bottom line: buy quality businesses at the right price and the rest should take care of itself over the long-term.

Adam

Long position in MO and PM

Related prior post:
Charlie Munger: Two Kinds of Businesses

* As an example, if you add up the earnings from each of the past ten years, Ford Motor Company's losses were more than $ 20 billion.
** I'm not making a judgment on the merits of trading any automaker's stock here. I am looking at how much intrinsic value a business creates in the long run. The stock may end up working just fine as a trading vehicle over a business cycle. I have no useful skills or opinions regarding that sort of thing.
*** Both incremental capital and ongoing capital that's needed to maintain or even improve the existing "machinery". In other words, the investments necessary to fortify the important existing physical and intangible assets already in place. Capital that at least maintains but ideally improves (widening the moat) a firm's competitive position. It's generally when incremental capital gets deployed at low returns, in the blind pursuit of growth, where long-term investors end up getting hurt.
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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, June 21, 2011

Charlie Munger: Two Kinds of Businesses

Some businesses must utilize almost all of its earnings (or what seems like earnings) just to remain competitive.

To some extent, this was covered in my previous post.

Airlines and automakers come to mind as good examples.

Those businesses tend to have earnings more in an accounting sense but less so in a real economic sense.
(If earnings need to be reinvested in the asset just to survive, they can hardly be considered useful economically to owners. It's the investment equivalent of running to stay in place.)

The very best investments require modest amounts of capital to deliver a steady or increasing stream of excess cash. If most, or all, of the cash earned needs to be plowed back into a business just to remain competitive, shareholders cannot do well in the long run.

Investing is about buying an asset at a price that allows the excess cash produced to provide a sufficient return considering the risks being taken and the total capital that's employed (over the full life cycle of the investment).

Businesses like Pepsi (PEP), Heinz (HNZ), Johnson & Johnson (JNJ), and Kellogg (K) among others generally produce lots of excess cash earnings that can be distributed to shareholders or used for incremental investments that ultimately benefit shareholders at a later time.

Each needs modest capital to remain competitive.

Each requires little in the way of capital relative to the cash produced.

At least that's been the case historically. The question is, as always, whether that'll change. In the previous post I mentioned the following quote by Charlie Munger:

"There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there's never any cash. It reminds me of the guy who looks at all of his equipment and says, 'There's all of my profit.' We hate that kind of business."

Pepsi, of course, is an example the first kind of business while things like airlines generally represent the second kind.*

Here is another variation of this idea that Munger presented during this 1994 talk at USC:

"The great lesson in microeconomics is to discriminate between when technology is going to help you and when it's going to kill you. And most people do not get this straight in their heads. But a fellow like Buffett does.

For example, when we were in the textile business, which is a terrible commodity business, we were making low-end textiles—which are a real commodity product. And one day, the people came to Warren and said, 'They've invented a new loom that we think will do twice as much work as our old ones.'

And Warren said, 'Gee, I hope this doesn't work because if it does, I'm going to close the mill.' And he meant it.

What was he thinking? He was thinking, 'It's a lousy business. We're earning substandard returns and keeping it open just to be nice to the elderly workers. But we're not going to put huge amounts of new capital into a lousy business.'

And he knew that the huge productivity increases that would come from a better machine introduced into the production of a commodity product would all go to the benefit of the buyers of the textiles. Nothing was going to stick to our ribs as owners.

That's such an obvious concept—that there are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that's still going to be lousy. The money still won't come to you. All of the advantages from great improvements are going to flow through to the customers."

So, once again, what seems like earnings is actually of the poor quality variety. Those earnings are an illusion. They are there up until the point that shareholders would like to benefit from them.

The earnings exist, for the most part, in an accounting sense only. They are effectively good 'til needed by the owners, I guess. Like a fruit that's rotten before it is even ripe.

The result?

Earnings that are not available as dividends (or buybacks).

Earnings that cannot be used to fund future investments that will produce an attractive return.

Why? They mostly get used up just keeping the existing business alive.

Running in place.

Adam

Long PEP and JNJ

Related post:
Charlie Munger: Two Kinds of Businesses - Part II (follow-up)

* Pepsi is just one good example among many. It is both able to pay cash dividends to shareholders, make investments in new products, distribution etc. at a high rate of return to produce future streams of cash, while remaining competitive in its existing business. Favorable returns can also come from something like See's Candies: a business that has little need for capital yet reliably produces a growing stream of cash. If See's were a separate public company, a nice dividend, buyback (if shares were cheap enough), or smart acquisitions would be in order since there aren't many high return investment opportunities within the business. In other words, the incremental capital that can be put to work internally is limited (even if the capital that it does employ generates very attractive returns). So the excess capital needs to be intelligently redeployed by competent management.
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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, June 20, 2011

Stocks Cheapest in 26 Years

At least that's what this Bloomberg article suggests.

Bloomberg: Stocks Cheapest in 26 Years as S&P Falls, Profit Rises

Valuations do seem not at all expensive for some stocks. The Dow Industrials, for example, at this time offer a number of examples of stocks selling near or even below 10 times earnings.

Obviously, the earnings expectations could prove to be optimistic. We could be heading into a soft patch (or worse) that ultimately make those earnings look more than a bit inflated.

Still, with the earnings yields (inverse pricing to earnings) in the 8% to 10% range, valuations do seem reasonable even if earnings growth turns out to be modest. Some of these franchises -- though, of course, not all -- even have somewhat better than modest earnings growth prospects. The better ones produce lots of excess cash that'll be available for distribution to shareholders. What does get reinvested can produce attractive returns that also ultimately benefit shareholders. In fact, just a little bit of growth on top of an 8% to 10% earnings yield (as long as earnings are of the high quality variety and capital allocation is sound) quickly becomes above market returns.

Will capital will be allocated reasonably well? Do current earnings roughly reflect normalized free cash flow (i.e. not at a cyclical peak and not needed to maintain business competitiveness)?

That's what'll matter in the long run.

The key thing is that earnings are 1) free to be distributed to shareholders and/or 2) can be used for incremental investments that ultimately produce high returns for long-term shareholders. Some businesses need to use just about all their earnings (or what seems like earnings) to remain competitive. Many airlines and some automakers come to mind. Those companies only have earnings in an accounting sense but less so in an economic sense. Here's how Charlie Munger looks at it:

"There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there's never any cash. It reminds me of the guy who looks at all of his equipment and says, 'There's all of my profit.' We hate that kind of business."

Speculators can try to jump in and out the second kind of businesses if they want.

Most investors, it would seem, have better things to do with their money.

The risk of poor near term price action after buying shares of even the very best business "too early" is very real. Yet missing the chance to benefit from potential favorable long run economics of a franchise can be just as costly (errors of omission).

Warren Buffett has pointed out how costly errors of omission can be:

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

Investing well is not about successfully buying at the lows. That's effectively impossible and, in fact, the attempt to do so creates its own problems. Investing is about buying something understandable at a discount (to intrinsic value). In fact, attempting to time things perfectly might result in missing the chance to buy something at a sensible price.
(Near-term price action is inherently unpredictable....in BOTH directions. When the focus is on judging how price compares to value and long-term effects, the price action tends to end up mattering much less than some seem to think.)

The key question is the sustainability of each franchise. It's about whether the long run economics are likely to remain in tact. The focus should always be, at least for long-term owners, on price paid relative to a conservative estimate of value. In fact, if the price drops further it sometimes can create an opportunity.
(By offering the chance to buy shares of a good business at a discount via incremental purchases, buybacks, and dividend reinvestments.)

10-year Treasuries yielding less than 3% seem, by comparison, very unattractive.

Those 10-year Treasuries probably feel safer to some investors in the short run but that doesn't mean they are actually safer when all risks are considered.

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, June 17, 2011

For Big Cap Tech, Cash is King

At the end of the most recent quarter, net cash and investments (cash and investments minus debt) on the balance sheet of Microsoft (MSFT, Cisco (CSCO), Google (GOOG), and Apple (AAPL) combined was over $ 160 billion.

AAPL   |  $ 65 billion
MSFT   |  $ 38 billion
GOOG   |  $ 31 billion
CSCO    |  $ 28 billion

Together, these four businesses add to that pile of cash at a near $ 60 billion annualized rate. So they will soon have over $ 200 billion combined unless one or more of them has an extremely large acquisition or buyback in the works.

So cash rich, yes, but will the money be put to good use? Tougher call.

I'm guessing most chief financial officers in corporate america would trade places in a heartbeat to have that much financial flexibility.

It's not just these 4 companies that are sitting on lots of cash....

From this Jason Zweig article:

All told, the companies in the Standard & Poor's 500-stock index are sitting on more than $960 billion in cash, a record.

What's unusual is that not only are companies sitting on more cash than ever before, they are paying out much less of it as a proportion of earnings than they have historically.

Meanwhile, the payout ratio—the proportion of earnings paid out as dividend income to shareholders—fell to 28.9% for the past four quarters. That, says S&P senior index analyst Howard Silverblatt, is the lowest level since 1936. Dividends are going up—Intel, UnitedHealth Group and WellPoint have recently raised them—but cash is still piling up far faster than most industrial giants can possibly find a prudent use for it.

Consider that the combined market cap of the four above tech companies is approximately $ 750 billion. Subtract the $ 160 billion in net cash and you are paying ~ $ 590 billion for around $ 60 billion in free cash flow.

Adam

Long MSFT, CSCO, GOOG, and AAPL

Related post:
Technology Stocks

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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