Friday, December 28, 2012

Quotes of 2012

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

Bogle on Speculation
"The thing that has always bothered me about gold is it has no value-creating unit. Underlying common stocks are earnings and dividends. Underlying bond returns are interest coupons. Underlying gold returns are nothing. There's nothing -- there's no there there. So it's a complete speculation on price." - John Bogle

Buffett: The Long Run Trumps Quick Returns
"If somebody bought Berkshire Hathaway in 1965 and they held it, they made a great investment — and their broker would have starved to death." - Warren Buffett

John Bogle: The Clash of the Cultures
"The issue that concerns me is, simply put, today's ascendance of speculation over investment in our financial markets; or, if you will, the ascen­dance of the culture of science -- of instant measurement and quantification -- over the culture of the humanities of steady reason and rationality." - John Bogle

Tom Russo: First Mover Advantage and the "Capacity to Suffer"
"The three prongs that I look for when investing in a business are: the fifty cent dollar bill, the capacity to reinvest in great brands and the 'capacity to suffer.' The 'capacity to suffer' is key because often the initial spending to build on these great brands in new markets has no initial return." - Tom Russo

Charlie Munger On "Rapid Trading By The Computer Geniuses"
"...take the rapid trading by the computer geniuses with the computer algorithms. Those people have all the social utility of a bunch of rats admitted to a granary. I never would have allowed the rats to get in the granary. I don't want the brilliant young men of America doting their lives at being rats in somebody else's granary. That's not my idea of the right way to run the republic. And if you let me write the laws, it wouldn't happen. But of course, nobody's going to do that." - Charlie Munger

Buffett & Munger on Gold
"...I think civilized people don't buy gold, they invest in productive businesses." - Charlie Munger

Assured Mediocrity
"...if you have patience, a decent pain threshold, an ability to withstand herd mentality, perhaps one credit of college level math, and a reputation for common sense, then go for it. In my opinion, you hold enough cards and will beat most professionals (which is sadly, but realistically, a relatively modest hurdle) and may even do very well indeed." - Jeremy Grantham

Why Buffett Wants IBM's Shares "To Languish"
"If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day's supply.

Charlie and I don't expect to win many of you over to our way of thinking – we've observed enough human behavior to know the futility of that – but we do want you to be aware of our personal calculus." - Warren Buffett

Buffett on Productive Assets: Businesses, Farms, & Real Estate
"Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See's peanut brittle." - Warren Buffett

"Berkshire's goal will be to increase its ownership of first-class businesses. Our first choice will be to own them in their entirety -- but we will also be owners by way of holding sizable amounts of marketable stocks. I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three* we've examined. More important, it will be by far the safest." - Warren Buffett

Happy New Year,

Adam

Long position in Coca-Cola (KO) established at much lower prices

Quotes of 2011

* The three are currency-based investments (i.e. money-market funds, bonds, mortgages, deposits etc.), nonproductive assets (i.e. gold), and productive assets (i.e. businesses or shares of businesses, farms, and real estate).

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

Wednesday, December 26, 2012

Enterprise Value to Free Cash Flow

From this Barron's article:

Four Stocks Gushing Free Cash Flow

On Microsoft (MSFT):

"Its net cash balance, combined with yearly free cash flow, works out to enough money to buy the entire company over the next six or seven years."

Now, if that free cash flow (FCF) is about to drop off in a big way, then the valuation is actually a whole lot less cheap than it seems. Microsoft isn't the only tech company with both lots of cash on the balance sheet and free cash flow relative to its total market value.

Yet it is certainly as good an example as any right now.

The first thing I hear when the subject of Microsoft's stock comes up. "The stock has done nothing for a decade plus" or something similar. That's certainly correct, but it's worth taking a bit closer look for context.

December 24th, 2002*
Closing Price: $ 26.91
Shares Outstanding: 10.9 billion
Market Cap: $ 294 billion
FCF: $ 8.1 billion
Price/FCF: 36x
Dividend Yield: N/A

Accounting for the net cash and investments, the enterprise value (EV)** to FCF was more like 30x.
(~ 30 years to produce enough money to, along with the cash and investments on the balance sheet, buy the entire company.

Now, ten years later...

December 24th, 2012
Closing Price: $ 27.06
Shares Outstanding: 8.5 billion
Market Cap: $ 230 billion
FCF: $ 23.8 billion (incl. goodwill impairment)
Price/FCF: 9.7x
Dividend Yield: 3.4%

Latest 10-K
Latest 10-Q

Just about a tripling of FCF and a 22% drop in share count puts EV to FCF at roughly 7x.

In late 2002, investors were willing to pay ~ 30 dollars of EV for every dollar of FCF or a roughly 3.3% FCF yield.
(This FCF yield reflects the market value that's not backed by a dollar of cash and investments on the balance sheet. The yield would naturally be lower based purely on market value.)

That relatively small FCF yield was little wind at an investors back.

So, of course, growth was crucial.

These days, investors in Microsoft will only pay ~ 7 dollars of EV for every dollar of free cash flow.

A 14.3% FCF yield.

That 14.3% FCF yield, in contrast, is quite a wind at the investors back even without growth. All that's needed is that the cash is put to reasonably intelligent use or returned, where appropriate, to shareholders via buybacks or dividends (though that the cash will be allocated in a smart way can hardly be considered a given). Well, that and, once again, for free cash flow to not meaningfully drop off.

Those willing to pay that kind of multiple back in 2002 had to take the financial hit of a contracting multiple even though the company actually did just fine.
(Tripling free cash flow over a decade and shrinking the share count 22% isn't a bad decade of work. Imagine the position those investors would be in if the company had produced more modest business growth.)

Investors, at least for now, simply want to pay less than a quarter as much enterprise value for every dollar of earnings. The reasons can be debated but that's the current reality.

So the same company (though not necessarily the same prospects, of course) is being valued, right or wrong, very differently just one decade later.
(Maybe today's price appropriately reflects value. Maybe not. Obviously, more than a few investors were quite comfortable in paying the then prevailing higher multiple of FCF for shares of Microsoft a decade ago. Having produced very poor returns, that price a decade ago with the benefit of hindsight seems, if not necessarily "wrong", far from "correct". Who says today's price somehow reflects more enlightened views?)

What if a similar attitude or mood adjustment occurs (based upon changes to a company's real or perceived prospects) with respect to valuation, for some of today's high fliers? If so, those who pay today's exceptionally high FCF multiples might similarly have to take the financial hit.

The solution seems simple enough. Pay a low enough price so attractive returns can occur without getting an exceptional price when it comes time to sell. Pay a price that doesn't depend upon exceptional business performance.

In other words, buy at a price so if things don't go quite as hoped, the investor will still be compensated well for the risk.
(If there's little or no growth and no expansion in the multiple where does the return come from? Well, in this example, it's the 14.3% FCF yield put to good use...ideally mostly in the form of buybacks and dividends.)

Expecting a not so great price at the end of an investing horizon imposes discipline on what one is willing to pay now. Some might think it's not possible to achieve attractive returns this way. Well, it is if the investor buys at the right price in the first place.

"...Mr. Market suffers from some rather incurable emotional problems; you see, he is very temperamental. When Mr. Market is overcome by boundless optimism or bottomless pessimism, he will quote you a price that seems to you a little short of silly." - Benjamin Graham in The Intelligent Investor

This requires investing over longer time horizons -- and lots of patience -- but is more than doable. Of course, selling in a euphoric market with lofty prices is preferred, but an investor should not (and doesn't have to) pay a price that depends on it. Also, when the price paid is a low multiple and a substantial discount to value, the near-term price action becomes inconsequential and mostly just a head I win, tails I win situation. This seems underappreciated.***

If, at the end of the investing horizon, a good sale price does end up being a available to the owner, there will obviously be no complaints.

Investors have control over what they're willing to pay upfront for an asset. They don't have control over what prevailing market prices will be down the road. They also don't have much influence over future business performance (unless, maybe, a capable activist with enough shares). Well, that means those who pay a high multiple of earnings become heavily dependent on two things they don't generally have control over: business performance and market prices.

Future business performance is unpredictable. So is the ability and willingness of others to buy at an attractive valuation many years from now. Buying with a clear margin of safety is protection against those things that are not controlled by the investor.

Microsoft's current prospects (or perceived prospects) has led to a low EV to FCF multiple. That, combined with the high multiple paid a decade ago, means investors in the stock haven't done well this past decade. Fortunately, the growth in earnings and buybacks at least offset some of the potential damage. That won't always be the case for those who are willing to pay a high multiple for a particular stock.

I'm not suggesting it's never wise to pay a high multiple. Yet, when an investor pays something like a 30x multiple of FCF (and in many other real world examples, much more), there's obviously a lot of growth expectations built into that price. There's little margin of safety to protect against what might go wrong. Not much wind at an investors back (3.3% FCF yield isn't much if unexpectedly the growth happens to disappear or worse) without that growth. If those expectations don't pan out, it will be costly. So those that do pay high multiples (for what often are the most exciting business stories) had better be very good at judging the future prospects correctly a very high percentage of the time. One big loser can easily undermine the compounding effects of many winners. Some seem to underestimate the incremental risk they're taking on.

Figuring out prospectively whether huge expected growth will eventually become reality -- and paying up for it -- seems difficult at best to get right consistently.

A different approach is to assume that, at least most of the time especially in highly dynamic industries, the future is just too unpredictable and unknowable. Too many opportunities to make mistakes. So, instead, rarely if ever pay a premium price for a promising future. Pay a price where nothing exceptional has to happen to yield a more than satisfactory long-term result. Pay a price that assumes one's own ability to correctly predict future outcomes is unlikely to be reliably correct.

It's just often less difficult to find an undervalued security that will produce attractive risk-adjusted returns despite unexciting growth prospects (or maybe because of real -- even serious -- but in the long run fixable business difficulties). The key is to not buy what seems cheap but has it's core business franchise under some kind of meaningful threat.

Occasionally, with this approach, something good actually ends up happening (consider it a bonus) but exceptional foresight was not required. Many overestimate or are overconfident in their ability to have consistently good foresight. Instead, pay a price that doesn't require it and then end up, on a few occasions, being pleasantly surprised.

What doesn't work out in weeks or months may work quite well, on a risk-adjusted return basis, over many years. If bought cheap enough, a small misjudgment can be erased in short order if the sheer size of per share FCF is substantial compared to the price paid. Pay a high multiple of per share FCF and a similar misjudgment might require decades to overcome.

Think of it this way. A 7x multiple stock that drops 50% can, without growth, buy back all shares outstanding in 3.5 years at that reduced price. Practically speaking, that means it will not be long -- at least in the context of investing if not trading -- before the substantial amount of FCF relative to market value puts, sooner than later (short of it going private), meaningful pressure upward on the stock price. Of course, it's possible those in charge will figure out ways to burn some of the cash instead of using it to buyback shares at what would be a 28.6% FCF yield. Otherwise, that's what I meant above when I said it's head I win, tails I win situation. A stock selling for 30x earnings that drops 50% still needs another 15 years unless lots of growth materializes. If not, the upward pressure from buybacks might not be obvious for a very long time.

So not all 50% drops in price pose equal long run risks of permanent capital loss. In the case of a stock with lots of net cash and investments, it takes less than a 50% drop in the stock to result in a 50% drop in enterprise value. As an example, Microsoft's stock price -- because of its net cash and investments position -- would actually only have to drop roughly 35-40% for its enterprise value per share to be cut in half.
(The math is straightforward if not initially intuitive. The cash is a reverse lever.)

Warren Buffett's "first law of capital allocation", as articulated in the 2011 Berkshire Hathaway (BRKa) shareholder letter, seems relevant here:

"..,what is smart at one price is dumb at another." 

The inherent risk of an investment can't be viewed in a vacuum. The price paid relative to a conservative estimate of intrinsic value dictates the risk being taken.

This post certainly is not intended to be about the merits of Microsoft as an investment. In fact, though I have a stake, I'm not the biggest fan of the company's shares as a long-term investment. Too many capable well-financed competitors. Too much unpredictable technological change. As I've explained previously here and on other occasions, there's just no technology business that I'm comfortable with as a long-term investment. They generally have been and likely will continue to be, at most, smaller positions. Tech businesses with seemingly attractive economics today too often prove that those economics aren't sustainable down the road.

The best businesses have durable economic characteristics. They have attractive core business economics (high return on capital) that can be expected to last a very long time. They sometimes benefit from technology and innovation but rarely do they compete in such a dynamic realm.

When an investor pays a premium for the promise of exceptional growth prospects that don't materialize, the end result is often permanent capital loss. The investor who never pays a premium price -- and, instead, always buys at a plain discount -- is less likely to be exposed to costly disappointments. The price paid should merely require decent business performance to get a good investment result.
(Of course, it'll be hardly a problem if a good unforeseen thing does end up happening. The important thing is to not be dependent on it as an investor.)

Intrinsic business value, in general, comes mostly from the excess cash that a business will produce for as long as it exists.
(Discounted at an appropriate rate.)

The problem for investors is that there's no way to know precisely the amount of cash flow over time. Also, when it comes time to sell, there's no way to know what the prevailing multiples might be. Now, an investor can decide to wait for a price that represents intrinsic value more closely, but it's better to assume that won't be possible. Knowing these things should make an investor want to build in a substantial margin of safety into their investing process.

Risk is reduced substantially when valuation is based upon modest or no growth assumptions. Some might be concerned about missing the "next big thing" and decide to pay whatever the necessary premium happens to be in the market.

Eventually, that might lead to some very costly mistakes.

Adam

Long position in Microsoft

Related post:

Technology Stocks

 * The stock was already down more than 50% from its peak. Closing price is split-adjusted. Split-adjusted shares outstanding is based upon what was reported in the latest 10-Q at that time. Net cash on the balance sheet (used for calculating enterprise value (EV)) and free cash flow (Net Income + Amortization & Depreciation - CapEx) is from what was at that time the latest 10-K. Also, the initial Microsoft dividend was yet to be announced.
** Market cap minus net cash and investments on the balance sheet.
*** Paying an extreme valuation leads to legit concerns over price action since so little intrinsic value underpins the shares. A huge proportion of price is promise that's yet to be backed substantively. Anything that threatens that promise -- or perceived promise -- becomes a huge problem that increases the risk of not just temporary but permanent capital loss.
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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, December 21, 2012

Bogle on the Financial System

From this interview with John "Jack" Bogle on CNBC:

"...the role of the financial side of our society -- the financial system if you will -- is to direct capital to its highest and best and most profitable uses."

During the interview, Bogle pointed out that companies raise about $ 250 billion a year in financing through IPOs and other equity capital offerings. Yet there's something like $ 33 trillion or so of trading going on. So less than 1 percent of the activity is actually about helping capital get to where it is needed.
(Bogle has mentioned this on prior occasions using slightly different numbers.)

So what would he do about it?

- A transaction tax on trades. Very small but enough to slow things down.
- A tax on very short-term capital gains. Bogle added a twist. He thinks the tax should apply to tax exempt institutions and taxable investors (He points out that a bit less than 70% of stock in the U.S. is held by financial institutions.)
- A federal statute for the fiduciary duty of money managers. It would require them to emphasize long-term investing, low turnover, and low costs. Putting the interest of clients first. Anything but the norm these days.

He also said to remember that the financial system is a drag on market return. Trades don't happen outside of the system. One side wins, the other side loses. Well, except for whoever is in the middle of the transaction. By definition, a net reduction in returns for investors as a whole.

Bogle also added this on gold:

"The thing that has always bothered me about gold is it has no value-creating unit. Underlying common stocks are earnings and dividends. Underlying bond returns are interest coupons. Underlying gold returns are nothing. There's nothing -- there's no there there. So it's a complete speculation on price."

He also said that he's "well aware of the monetary hazards" that exist but it obviously hasn't impacted his view of gold.

Check out the full interview.

Adam

Related posts:
Graham on Investment: "Most Intelligent When It Is Most Businesslike"
John Bogle on Speculation & Capitalism's "Pathological Mutation"
Bogle: Back to the Basics - Speculation Dwarfing Investment
Buffett on Gambling and Speculation
Buffett on Speculation and Investment - Part II
Buffett on Speculation and Investment - Part I

Related article:
Market Speculation Is a Bigger Threat Than 'Cliff': Bogle

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

Tuesday, December 18, 2012

Viacom's Buyback

In this prior post, I noted that Viacom (VIAB) was in Barron's Favorite Stocks for 2013.

It's also a small holding in the Berkshire Hathaway (BRKa) equity portfolio.
(Likely bought by Ted Weschler.)

I noted that Viacom expects to buyback $ 2.5 billion of stock over the next year in the prior post. This is similar to Viacom's buyback levels over the past two years.

The earnings multiple is certainly not high and seems backed by solid free cash flow. The recent and planned buybacks, at roughly 10% of market value, is fairly aggressive. Debt levels, though growing somewhat in recent years, seem quite manageable. It's in the Berkshire equity portfolio. What's not to like?

Well, I'll let others -- those who know how to value Viacom's business -- decide whether these buybacks will be lucrative for continuing long-term shareholders. In general, I view stock buybacks that are consistently done below a company's intrinsic value to be a very good thing. The key thing is to have at least having a rough idea what the intrinsic value actually is. As I said in the prior post, any investment comes down to knowing when you really have a handle on a company's future prospects and the range of possible outcomes.*

With Viacom, I don't.

I'd have to understand how the emergence of alternative ways for content to be consumed and distributed will impact Viacom's future business economics. This may be less of a long-term threat than it seems, but that's why it's best to invest only in what you feel you truly understand. I just don't know how their pricing power will change over the very long run. Few things are more important than that. They may be able to maintain lots of pricing power but I just don't have a feel for why that's assured (or, at least, very likely).

Basically, it's difficult, at best, for me to assess the strength and sustainability of Viacom's economic moat. Is it persistent? Others may have a great handle on this. Those that do are better candidates to own part of this business.

What other threats is Viacom vulnerable to over the longer run? If I don't have any feel for that (and I certainly don't), I'm not going to risk any capital. So I'm doing what makes sense...avoiding what might be a perfectly good business in light of my own lack of knowledge and insight. Under these circumstances, investing in Viacom would be a dumb thing for me to do.

As is always the case, it's not about what Viacom is earning today or even the next couple of years. It's about what it can produce over the very long haul. Of course, as the price gets lower and the margin of safety increases, it may eventually provide protection against all but the worst possible outcomes.**

From the most recent Berkshire Hathaway Shareholder Letter:

"The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another." 

Buffett wrote that in the context of acquisitions and share repurchases but, of course, logically applies to buying small pieces of a business as well.

So Viacom may turn out to be a great investment (I certainly won't be surprised if the stock does quite well) but I'm no where near interested in owning any shares. It's a reflection of my own limitations. No one gets to invest with the benefit of hindsight. Until that changes, I'll never mind missing it or any opportunity like it.

If the company continues to allocate capital the way they have been, and especially if the business is better than I realize, continuing shareholders will probably not be in bad shape at all. Maybe the company will even avoid chasing expensive growth through acquisitions. All too often, a poor use of capital.

The size of the buyback that, as of now, looks like it can be comfortably funded, and the not very high earnings multiple makes me want to keep an eye on it. Maybe, over some number of years, I'll eventually even understand the business well enough to invest. Better yet, maybe it will even get very cheap to provide an extreme margin of safety. In the real world it's a good bet that neither will happen. I'll either never figure it out or do so too late.

It's the nature of the investing process. An investor can only understand a small fraction of the businesses that exist. The best thing about investing is that you can take a pass on whatever you want to pass on.

Lots of homework, lots of waiting, then acting decisively those rare times a really good understandable investing idea comes across the radar. It's much easier to take decisive action when a justifiably high level of confidence in a company's prospects has been developed. It's easier to act when the discount to per-share intrinsic value is obvious to the investor. It takes patience, discipline, and awareness of limits.

Buy what's not well understand and eventually big mistakes are likely to occur.

In fact, as I've said, the initial success achieved buying what's not well understood might lead to even more substantial permanent loss of capital due to unwarranted overconfidence.

Sometimes, the most important thing in investing is knowing what not to buy; knowing when it's best to "miss" something (and not forget Richard Feynman's quote.)

When the price action eventually goes the wrong way (possibly for an extended time), the investor that lacks conviction is unlikely to be able to hang in there long enough. Also, the investor that lacks conviction likely won't be buying even more shares as the discount to business value becomes even greater.

Of course, this only works if intrinsic business value has been judged well in the first place.

The high level of conviction must be justified.

Adam

No long position in VIAB

* To figure out what the business is conservatively worth per share, and what price represents a sufficient discount to value considering the specific risks.
** Eventually a business gets cheap enough to account for all but earnings falling off a cliff. Basically, it gets to the point where you are purely buying the cash flow the business produces -- even if declining -- extremely cheap. It's buying a dollar of cheap cash and cash flow for 50 cents (or less) on the basis that it will be put to reasonably good -- even if not brilliant -- use. Of course, even if there is a big margin of safety, you still have to watch out for the really dumb capital allocators. So there are subpar businesses that I'll own shares of (and do own shares of) if I feel I understand the flaws (likely downside) well enough and the price represents a huge discount to just the discounted value of the cash.
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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, December 14, 2012

Buffett on Buybacks, Book Value, and Intrinsic Value

Looks like any recent purchases of Berkshire Hathaway's (BRKa) stock was a smart move as far as Warren Buffett and Charlie Munger are concerned.

News Release: Berkshire Repurchases 9,200 Class A shares

On Wednesday, the company bought back $ 1.2 billion in stock at $ 131,000 per Class A share (~ $ 87 per Class B share). More interestingly, they raised the buyback threshold to 120% of book value, up from 110% of book value. So, if nothing else, Buffett has made it easy to know when he thinks the shares are selling at an attractive discount to intrinsic value.

Berkshire's book value as of last quarter was ~ $ 111,700.

That means, based on the $ 111,700 book value, they are willing to buy the stock at or below ~ $ 134,000 per Class A share (~ $ 89 per Class B share). Buffett and the Board of Directors have said before that Berkshire is intrinsically worth quite a bit more than its book value in the past.
(And, of course, it would make no sense to buyback the stock if that weren't the case.)

Below, I've collected some relevant buyback-related excerpts from Buffett's shareholder letters over the years. It's a quick tour of what he has said on the subject though far from comprehensive. I'll begin with a couple excerpts from the latest Berkshire Hathaway shareholder letter:

Charlie and I measure our performance by the rate of gain in Berkshire's per-share intrinsic business value. If our gain over time outstrips the performance of the S&P 500, we have earned our paychecks. If it doesn't, we are overpaid at any price.

We have no way to pinpoint intrinsic value. But we do have a useful, though considerably understated, proxy for it: per-share book value. This yardstick is meaningless at most companies. At Berkshire, however, book value very roughly tracks business values. - 2011 Berkshire Hathaway Shareholder Letter

The reason is straightforward enough. The publicly traded investment portfolio is carried at market value. While market prices are frequently not equal to per-share intrinsic value (in fact, often far from it), that's not the main source of the discrepancy long-term. The real discrepancy comes from the wholly owned operating companies that Berkshire controls. These businesses are often intrinsically worth far more than their carrying value on the books.*

Even if far from being a perfect reflection of value, the appreciation of the marketable securities owned by Berkshire, over the long haul, is largely taken into account. That's will continue to be far from the case with the operating businesses Berkshire controls. More from the latest letter:

Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company's intrinsic business value, conservatively calculated.

We have witnessed many bouts of repurchasing that failed our second test. Sometimes, of course, infractions – even serious ones – are innocent; many CEOs never stop believing their stock is cheap. In other instances, a less benign conclusion seems warranted. It doesn't suffice to say that repurchases are being made to offset the dilution from stock issuances or simply because a company has excess cash. Continuing shareholders are hurt unless shares are purchased below intrinsic value. The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another. - 2011 Berkshire Hathaway Shareholder Letter

Buffett has covered the subject of share repurchases and intrinsic value in many of his letters. Here are some of the noteworthy excerpts:

...if a fine business is selling in the market place for far less than intrinsic value, what more certain or more profitable utilization of capital can there be than significant enlargement of the interests of all owners at that bargain price? - 1980 Berkshire Hathaway Shareholder Letter

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. - 1984 Berkshire Hathaway Shareholder Letter

...major repurchases at prices well below per-share intrinsic business value immediately increase, in a highly significant way, that 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.

The other benefit of repurchases is less subject to precise measurement but can be fully as important over time. 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. - 1984 Berkshire Hathaway Shareholder Letter

When Coca-Cola (KO) uses retained earnings to repurchase its shares, the company increases our percentage ownership in what I regard to be the most valuable franchise in the world. (Coke also, of course, uses retained earnings in many other value-enhancing ways.) Instead of repurchasing stock, Coca-Cola could pay those funds to us in dividends, which we could then use to purchase more Coke shares. That would be a less efficient scenario: Because of taxes we would pay on dividend income, we would not be able to increase our proportionate ownership to the degree that Coke can, acting for us. - 1990 Berkshire Hathaway Shareholder Letter

Most high-return businesses need relatively little capital. Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases. - 1992 Berkshire Hathaway Shareholder Letter

Understanding intrinsic value is as important for managers as it is for investors. When managers are making capital allocation decisions - including decisions to repurchase shares - it's vital that they act in ways that increase per-share intrinsic value and avoid moves that decrease it. This principle may seem obvious but we constantly see it violated. - 1994 Berkshire Hathaway Shareholder Letter

The 1999 letter provides probably the most comprehensive explanation of when Buffett thinks stock should and should not be repurchased.

There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds -- cash plus sensible borrowing capacity -- beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated. To this we add a caveat: Shareholders should have been supplied all the information they need for estimating that value. Otherwise, insiders could take advantage of their uninformed partners and buy out their interests at a fraction of true worth. We have, on rare occasions, seen that happen. Usually, of course, chicanery is employed to drive stock prices up, not down.

The business "needs" that I speak of are of two kinds: First, expenditures that a company must make to maintain its competitive position (e.g., the remodeling of stores at Helzberg's) and, second, optional outlays, aimed at business growth, that management expects will produce more than a dollar of value for each dollar spent (R. C. Willey's expansion into Idaho).** - 1999 Berkshire Hathaway Shareholder Letter

In the 1999 letter, he also admits to missing the chance on prior occasions to repurchase Berkshire's stock when it was a good buy.

The latest letter has a couple of good sections that are well worth reading. Check out the Intrinsic Business Value and Share Repurchases sections.

In addition, pages 99-100 of the 2011 annual report and the owner's manual have useful explanations of intrinsic value.

Maybe a very large and attractive acquisition will come along that uses a good chunk of Berkshire's cash.

If not, the best case for long-term Berkshire shareholders is for the shares to remain cheap so Buffett can use some of Berkshire's capital for repurchases. Those who want to sell Berkshire's shares near-term will rightfully want the market price to be as high as possible. Otherwise, those that have a longer term horizon should be hoping for just the opposite.

Berkshire's book value should increase at a nice clip -- not every quarter or even every year but over time -- so the maximum price for repurchasing shares is generally a moving target to the upside.

Adam

Long position in BRKb established at much lower than recent prices

Some related posts:
Stock as a Currency
Buffett on Teledyne's Henry Singleton
Berkshire's Book Value, & Intrinsic Value
Buffett: Intrinsic Value vs Book Value - Part II
Buffett: Intrinsic Value vs Book Value
Why Buffett Want IBM's Shares "To Languish"
Buffett: The Berkshire Hathaway Buybacks Have Begun
Berkshire Hathaway Authorizes Share Repurchase
Buffett: When it's Advisable for a Company to Repurchase Shares
Should Berkshire Repurchase Its Own Stock?
Buffett & Munger on Berkshire's Stock
The Best Use of Corporate Cash
Buffett on Stock Buybacks - Part II
Buffett on Stock Buybacks
Discount Rate
Buy a Stock...Hope the Price Drops?

Some related articles:
Reuters
Bloomberg
Wall Street Journal
Barron's
Morningstar

* In the short run or even longer, the market price is not the same as per share intrinsic value, of course, but the "weighing machine" doesn't work too badly in the long run. Eventually, the market prices will adjust upward to at least mostly reflect the appreciation in intrinsic value. Certainly it's a better reflection of economic value than the way businesses Berkshire controls are carried on its books. Most of the wholly owned businesses are given a value on the books that's equal to what the company paid (and maybe less since some assets are adjusted downward in book value over time via amortization or depreciation). So value isn't generally adjusted upward to reflect the current economics until something is sold. Well, since Berkshire doesn't like to sell the businesses (see Business Principle # 11 in the owner's manual) it owns, the divergence is destined to be persistent. Purely a limitation of accounting but, with a little work, easily adjusted into something economically meaningful.
** The expenditures at Helzberg and R.C. Willey are explained in more detail earlier in the 1999 letter.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Tuesday, December 11, 2012

Barron's 10 Favorite Stocks for 2013

This past weekend, Barron's released their favorite stocks for 2013.

Barron's 10 Favorite Stocks for 2013

Apple (AAPL)
Barnes & Noble (BKS)
BlackRock (BLK)
General Dynamics (GD)
JP Morgan Chase (JPM)
Marathon Petroleum (MPC)
Novartis (NVS)
Royal Dutch (RDS.A)
Viacom (VIAB)
Western Digital (WDC)

Chart: Apple, Barnes & Noble, Blackrock, General Dynamics
Chart: Marathon, Novartis, Royal Dutch, Viacom, Western Digital

Best case, a list like this can be a starting point for one's own research on a particular stock.

I'll focus a bit on just one of them.

Viacom.

Some things worth noting:

- The company plans to continue buying back its stock and rather aggressively.
- Roughly 10% of its stock was bought back in the fiscal year that just ended in September.
- More of the same is planned this year.
- The earnings multiple is ~ 11-12x.
- The shares happen to be a smaller position in the Berkshire Hathaway (BRKa) equity portfolio.
(Though not necessarily small compared to the funds managed by his two investment managers.)

This article provides a summary of which Berkshire equity investments are likely the work of Warren Buffett's two investment managers: Ted Weschler and Todd Combs. According to the article, Viacom was likely purchased by Ted Weschler.

Generally, it is only the very largest equity positions -- usually several billion dollars or more -- that are investments by Warren Buffett himself. These days, his focus is much more on buying entire businesses and, as Buffett said here, continuing to build Berkshire as a business.

Viacom expects to buyback $ 2.5 billion of stock over the next year. It's not just similar to Viacom's buyback levels this past year, where the company bought back $ 2.8 billion.

In the fiscal year before that, it was $ 2.45 billion.*

The amount they plan to buyback this year is consistent with recent behavior. Buyback levels slightly exceed free cash flow (after dividends) so the company took on some debt to make up the difference. It's at least worth noting (though total debt is hardly alarming at current levels) that some modest additional debt has partially funded, along with free cash flow, the recent buybacks.

Bloomberg: Fitch Rates Viacom's Note Offering 'BBB+'

Of course, a buyback is no good unless the shares are bought below intrinsic value (and ideally comfortably below). As I mentioned, the stock currently sells for roughly 11-12x earnings. On the surface, maybe not expensive, but I'll let those who know how to confidently estimate Viacom's per-share intrinsic business value decide whether a sufficient discount exists. I'll also let those who really understand the business figure out how lucrative these buybacks will be for continuing long-term shareholders.

Any investment comes down to knowing whether you really have a handle on a company's future prospects and range of possible outcomes.
(To figure out what the business is conservatively worth per share, and a price that represents a sufficient discount to value considering the specific risks.)

With Viacom, I don't.

A good business selling at a material discount to intrinsic value, with plenty of available funds (cash on hand, free cash flow, borrowing capacity) to:

- meet operational & liquidity needs,
- maintain/increase competitiveness (incl. the flexibility to pursue optional value creating business expansion),

that also has an aggressive buyback plan will usually be of considerable interest.

Unfortunately, Viacom is just not something that I understand sufficiently well to make a sound judgment about the quality of the business or what it is intrinsically worth.
(I understand neither the downside risks nor the favorable prospects, if any, to the upside.)

So Viacom could end up being a great investment but that doesn't matter.

I simply won't buy shares of a business with long run prospects and risks that I don't understand well.**

"The first principle is that you must not fool yourself, and you are the easiest person to fool." - Richard Feynman

Buying shares of a business (with the intent to own long-term) requires more than just a superficial insight (or a good "story"). High levels of justified conviction need to be behind the action.

Knowing what not to be buying -- something that's necessarily different for each investor -- seems a sometimes underappreciated investing discipline.***

Ignore this and, eventually, some pretty big mistakes are likely to be made. In fact, early successes achieved might lead to even bigger permanent losses of capital later on due to unwarranted overconfidence.

I'll follow up on this in a separate post at some point.

Adam

Long position in JPM and AAPL established at much lower than recent prices

* In each of the past two fiscal years, the net amount bought back is slightly less when you include the effects from the exercise of stock options.
** Viacom may have more strengths than it's getting credit for here. In other words, it might be a much better business than I realize. The free cash flow and how they are using it is certainly attractive, but how the core economics are going to change as content is consumed in increasingly varied ways over time is hard for me to gauge. That view is just as likely (if not more likely) to be a reflection of my limitations as it is Viacom's. Still, business models in the media sector seem to be changing awfully fast. Now, eventually a business gets cheap enough to account for all but earning falling off a cliff. Basically, it gets to the point where you are purely buying the cash flow the business produces -- even if declining -- extremely cheap. It's buying a dollar of cheap cash and cash flow for 50 cents (or less) on the basis that it will be put to reasonably good (if not brilliant) use. Of course, even if there is a big margin of safety, you still have to watch out for the really dumb capital allocators. So there are subpar businesses that I'll own shares of (and do own shares of) if I feel I understand the flaws (likely downside) well enough and the price represents a huge discount to just the discounted value of the cash.
*** It's knowing one's own limitations and capabilities. Investing in areas where sound judgment is lacking and a high level of conviction isn't there beforehand is trouble. An investor is likely to make big mistakes and will be unlikely to hang in there when required (if a cheap stock gets even cheaper). Sometimes, an investment might even produce a good result yet still shouldn't have been purchased in the first place. Why? The insight and conviction wasn't there. It was more good fortune than sound judgment that led to the results. Luck mistakenly interpreted as skill. Not a good thing if achieving satisfactory risk-adjusted long-term returns is the objective.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational and educational use and the opinions found here should not be treated as specific individualized investment advice. 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.

Friday, December 7, 2012

Buffett: The Long Run Trumps Quick Returns

From this recent article by Andrew Ross Sorkin:

"If somebody bought Berkshire Hathaway in 1965 and they held it, they made a great investment — and their broker would have starved to death." - Warren Buffett

For Buffett, the Long Run Still Trumps the Quick Return

Sorkin sat down with Warren Buffett and journalist Carol Loomis last week for lunch right before the two were about to do an interview on "The Daily Show With John Stewart."

Buffett and Loomis on "The Daily Show" - Part I
Buffett and Loomis on "The Daily Show" - Part II

Buffett is well known for buying businesses (or pieces of businesses via marketable stocks) with the idea of owning them for the long run. Not surprisingly, he sees the increased emphasis on trading these days as being unfortunate. More from the article:

The argument that the markets are better off today because of the enormous amount of liquidity in the stock market, a function of quick flipping and electronic trading, is a fallacy, he said.

He also said that the high volume turnover in stocks and liquidity in the markets "means that to a great extent, it's a casino game..."

Buffett and Loomis have been doing a series of interviews to discuss the new book, Tap Dancing to Work.

Tap Dancing to Work by Carol Loomis

They were both recently also on Charlie Rose, CNBC, and other media outlets.

Buffett and Loomis on Charlie Rose
Buffett and Loomis on CNBC - Part I
Buffett and Loomis on CNBC - Part II

Buffett was asked if there was anyone in the private equity business that he admired.

...he flatly replied: "No."

Buffett also added that but generally thinks the investor class of this generation is less capable:

"They're not as good as the old ones generally. The field has gotten swamped..."

He doesn't seem to think much of most hedge fund managers, but did say he liked Seth Klarman.

The article also covers Buffett's thoughts on:
- Hedge fund compensation
- Why shorting stocks is "too hard"
- Pension fund performance

These days, Warren Buffett thinks of himself as just as much a business manager as an investor. He's focused on building the business and spends less time on purely investing.

Yet, though too few seem to do so, many of the principles and ideas behind his investing success can be learned and put to effective use by those willing to do the necessary work.

In her new book, Carol Loomis points out Berkshire's stock was selling for $ 22/share in 1966, the first time she mentioned Buffett's name in Fortune (and spelled his name incorrectly). The stock is selling for roughly $ 131,000/share as write this.

A more than 20% annualized return -- and just under a 600,000% cumulative return -- over a 46 year or so period.

To get these results, there was no clever trading of Berkshire's stock required. In fact, as is pointed out in the quote at the beginning of this post, not trading the stock eliminated the associated frictional costs. It also eliminated the possibility of making dumb (and expensive) trades along the way.

When an investor finds attractively valued shares of a good business*, trading it is likely to just hurt long-term performance. That was true many years ago. It remains true today.

I don't expect a significant proportion of market participants to be convinced of this anytime soon.

Instead of putting sound long-term investing principles to work, many still try to get results by actively trading whatever is on their radar. They do this despite overwhelming evidence that a highly active approach is unlikely to produce satisfactory long run results.

Somewhat amazing, but an opportunity for anyone who's willing to adopt a more sensible long-term investing approach, and lucky enough to have a long investing horizon.

Check out the article in its entirety.

Adam

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

Tuesday, December 4, 2012

Stock as a Currency

In 1998, Berkshire Hathaway (BRKa) had its per-share book value increase by 48.3%.

Must have been a good year, right?

Warren Buffett explains why it was less so than it seemed in the 1998 Berkshire Hathaway shareholder letter:

Normally, a gain of 48.3% would call for handsprings -- but not this year. Remember Wagner, whose music has been described as better than it sounds? Well, Berkshire's progress in 1998 -- though more than satisfactory -- was not as good as it looks. That's because most of that 48.3% gain came from our issuing shares in acquisitions.

To explain: Our stock sells at a large premium over book value, which means that any issuing of shares we do -- whether for cash or as consideration in a merger -- instantly increases our per-share book-value figure, even though we've earned not a dime. What happens is that we get more per-share book value in such transactions than we give up. These transactions, however, do not deliver us any immediate gain in per-share intrinsic value, because in this respect what we give and what we get are roughly equal. And, as Charlie Munger, Berkshire's Vice Chairman and my partner, and I can't tell you too often (though you may feel that we try), it's the per-share gain in intrinsic value that counts rather than the per-share gain in book value. Though Berkshire's intrinsic value grew very substantially in 1998, the gain fell well short of the 48.3% recorded for book value. Nevertheless, intrinsic value still far exceeds book value. 

Back in the mid-to-late 1990s, Berkshire was selling, at times, at 200% to 300% of book value.

At that kind of valuation*, I think it is fair to say that Berkshire's shares were anything but cheap and that made the stock useful as currency for acquisitions. Use of a company's stock as a currency for acquisitions is, as I noted in this recent post, something Henry Singleton did effectively during his time at Teledyne. Earlier this year, Singleton's approach was highlighted in a Bloomberg article:

...Henry Singleton, made acquisitions using the company's stock when its price was high. When the share price went down, Singleton bought back shares repeatedly.

So he was savvy about using the company's stock, when pricey, as a currency for acquisitions. If a high-priced stock** (high relative to its intrinsic value) is used to acquire generally sound businesses selling for cheap, good things are likely to happen over the long haul. Henry Singleton was just as smart about buying back Teledyne's shares when it was cheap. According to John Train's book The Money Masters, Buffett once said this about Singleton:

"Henry Singleton of Teledyne has the best operating and capital deployment record in American business."

The Bloomberg article noted that, starting in 1968, Teledyne's stock generated a 23 percent annualized return over the next two decades.

In contrast to the 1990s, Berkshire's book value sat at roughly $ 111,700 per Class A share at the end of the most recent quarter. As I write this, the Class A shares are selling for $ 131,022.

A premium of 17% or so over that last reported per-share book value.
(or 117% of book value)

Berkshire announced last year that the company will repurchase shares at a 10% (or less) premium over the book value:***

In the opinion of our Board and management, the underlying businesses of Berkshire are worth considerably more than this amount, though any such estimate is necessarily imprecise. If we are correct in our opinion, repurchases will enhance the per-share intrinsic value of Berkshire shares, benefiting shareholders who retain their interest.

Buffett explained this further in the most recent Berkshire Hathaway shareholder letter. At that small premium...

...repurchases clearly increase Berkshire's per-share intrinsic value. And the more and the cheaper we buy, the greater the gain for continuing shareholders. Therefore, if given the opportunity, we will likely repurchase stock aggressively at our price limit or lower.

As I've said before, it's worth reading the Intrinsic Business Value and Share Repurchases sections in the latest letter for more of Warren Buffett's and Charlie Munger's thinking on this.

Check out pages 99-100 of the 2011 annual report and pages 4-5 of the owner's manual for good explanations of how they view intrinsic value. At a minimum, as the share price approaches that 10% premium over the book value, Buffett has made it easy to know when he thinks the shares are selling at an attractive discount to intrinsic value.

Also, unless something very large and attractive comes along, I'm guessing Buffett would rather not use Berkshire's stock as a currency anytime soon.

Adam

Long position in BRKb established at much lower than recent prices

Related posts:
Berkshire Hathaway's 3rd Quarter 2012 Earnings
Berkshire's Book Value & Intrinsic Value
Buffett: Intrinsic Value vs Book Value - Part II
Buffett: Intrinsic Value vs Book Value
Berkshire Hathaway Authorizes Share Repurchase
Should Berkshire Hathaway Repurchase Its Own Stock?

* Price to book value is an imperfect way to judge how cheap a stock is but, as Buffett has explained, it works okay, within limitations, as a rough measure for Berkshire Hathaway. From the Berkshire owner's manual:
Inadequate though they are in telling the story, we give you Berkshire's book-value figures because they today serve as a rough, albeit significantly understated, tracking measure for Berkshire's intrinsic value. In other words, the percentage change in book value in any given year is likely to be reasonably close to that year's change in intrinsic value.
In the Intrinsic Business Value section of the most recent shareholder letter, Buffett also explains why book-value -- a meaningless measure for most companies -- is a useful if understated proxy for Berkshire Hathaway's intrinsic value.
** When Teledyne stock was expensive -- 40, 50, or even 60 times earnings -- it was used as a currency to buy cheap assets. See page 48 of this Forbes article for more details. For the economic system as a whole, I happen to think if market prices generally fluctuated in a narrower range around intrinsic value, there would be less capital misallocation (even if it would make life harder for an executive like Singleton and those attempting to profit from mispriced securities) and, in the long run, the economy would be served better (but that's a subject for another day).
*** 10% premium over the book value or 110% of the book value. It's been described both ways in different publications.
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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, November 30, 2012

High Quality Global Businesses Selling Lower-Ticket Consumer Products

Jeff Auxier, manager of the Auxier Focus Fund (AUXFX), was interviewed a few months back by GuruFocus.

From the interview:

"I like products that people buy frequently that are lower ticket, especially in tough economic times. The global population recently surpassed 7 billion. Most people just want to get through their day with a little pleasure. They want a cup of coffee, a bite of chocolate, a cigarette, a beer, a Coke, whatever, a little boost to get them through. So we like the fact that people are going to buy that product every day, by their choice."

Some of the best businesses in the world sell the stuff that's consumed everyday by the global middle class (according to Auxier the global middle class is ~1.8 billion and growing by ~150 million/year). Things like snacks, beverages, tobacco, and other lower ticket branded consumer products. Compared to just about anything else, many of the great global franchises have very significant and durable competitive advantages. As a result, the best among them tend to have relatively predictable, attractive long-term business economics and prospects. More from the interview:

"Recently throughout Asia and China, there is a movement away from the cheap knockoffs and a push for higher quality, especially with regard to food. They want the real thing. People want to buy quality Western brands. The disclosure provided by the internet is driving envy. People want to live better. I look at what people are using by their choice, what they like to do every day, and that source of demand. We have $400 billion a year in housing subsidies. How do you figure out the real supply demand there? Russians are going crazy over Doritos because they love the taste."

And big scale matters...

"If you look at the demographics related to food in Asia – the rapid urbanization – the thing is you need scale to hit that market. You can't do it as a small company."

Basically, the producers of things like snacks, beverages, and cigarettes with some scale are the exact opposite of technology businesses.

The difficulty with most tech companies isn't understanding what their business economics look like now.

The problem is understanding what those economics will look like in 10 or 20 years.

Not an easy thing to do. Tech businesses reside in environments that are fast changing and unpredictable. There is a wide range of possible outcomes and, as a result, they require a much larger margin of safety. 

Mostly, they are not worth the trouble unless extremely cheap to protect against the worst possible outcomes. With technology businesses, too often the storm clouds don't emerge with enough warning. Cheap is often not cheap enough. I realize some are very good at identifying the next big winner in technology, but that's a tough thing to do consistently well. Besides, potential big winners often reside in the same neighborhood as potential big losers and sometimes they're difficult to tell apart. 

Avoid the big losses and the returns usually follow.

As I explained here and on other occasions, there's just no technology business that I'm comfortable with as a long-term investment. 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. Occasionally, certain tech stocks have sold at enough of a discount that it made me willing to own some shares. Even then I'm only willing to slowly accumulate very limited amounts. They've always been and always will be, at most, very small positions. To be worth the bother, the shares must sell at an extremely low multiple of free cash flow and, even if lacking growth prospects, have cash generating capabilities unlikely to fall off a cliff.*

In other words, I'm not exactly trying to anticipate the next big thing in tech. I'll let others try to figure that sort of thing out. It's buying inexpensive cash flow and, in some cases, lots of net cash on the balance sheet. Cash that, even if not put to brilliant use, just needs to not be allocated in very dumb ways. (Though it's better to assume that some poor capital allocation will happen then end up pleasantly surprised. The price paid should reflect that assumption.) The margin of safety must be large enough that nothing great has to happen to get, over several years, a good investment result. It must also be substantial enough to protect against all but the very worst unforeseeable rather bad tech business outcomes.

Tech businesses, in general, are involved in exciting, dynamic, and highly competitive businesses. That's precisely what makes them unattractive long-term investments. 

I'd buy more shares of my favorite businesses (some are in Stocks to Watch and the Six Stock Portfolio), with the intent to hold them indefinitely, if they were selling at just a nice (but not extreme) discount to intrinsic value. In contrast, even if bought extremely cheap, most tech stocks are just not for the long haul in my view.**

So, if there's a very large margin of safety, I'll consider some limited technology exposure but that's it. Well, at least until that margin of safety shrinks a bit. In general, they'll always play a small supporting role.

Jeff Auxier later added this in the interview:

"If the food dynamics are growing 2 to 3 times faster than the economy, who's going to do it? It's going to be like a Tesco, and a Pepsi and a Wal-Mart."

The portfolio he manages is certainly consistent with his thinking. 

Here's the top ten positions in the Auxier Focus Fund:

PepsiCo (PEP)
Molson Coors (TAP)
Tesco PLC (TSCDY)
Philip Morris International (PM)
Merck (MRK)
Microsoft (MSFT)
Procter & Gamble (PG)
Wal-Mart (WMT)
Medtronic (MDT)
Hospira (HSP)

According to Morningstar the annual portfolio turnover is 8%. So what's in the portfolio is generally held for quite a while. The top 10 make up roughly 21% of the portfolio.

The problem is getting shares of the great franchises when they're truly cheap. Unfortunately, it happens too rarely and most are not at all inexpensive right now. 

In fact, the financial crisis provided the first window in quite a while to buy shares of the best businesses at big discounts to intrinsic value (conservatively estimated). These days, most of them are much tougher to buy. They remain fine businesses but there's, by definition, lower returns at more risk if bought at these higher prices.

Unfortunately, the window that opened -- as a result of the financial crisis -- to buy shares of higher quality businesses at very attractive valuations has mostly closed.

Check out part I and part II of the interview.

Adam

Long positions in PEP, PM, MSFT, PG, and WMT established at lower prices (in some cases much lower). Also, very small long position in TSCDY.

* Though I actually do prefer that the share price falls even further in the short-to-medium term. That way the cash generating abilities can be used to buyback shares at an increasingly large discount to value. I'm perfectly happy to see a stock I've already bought temporarily go down further if I think management will use the opportunity buyback in a smart way.
** I rarely invest in anything -- and that includes tech stocks -- unless I'm willing to own the shares for several years or even longer. Frequent traders might consider several years to be long-term, but I consider that time frame really the bare minimum for almost any investment. The difficulties that have caused a security to be cheap and mispriced are unlikely to be sorted out in less time than that (though I realize several years is hardly a trade). To me, a long-term investment is something that can be owned indefinitely and deliver good results. (Indefinitely, unless there's damage to the economic moat, valuation become extreme on the high side, or opportunity costs are high.) 

Generally speaking, that's just not possible with tech stocks. 

So investing in tech stocks is a much different investing model than what I traditionally favor but worth the trouble if the mispricing is substantial. My preferred investing model is to own shares of good businesses indefinitely. Even when bought at just a fair price, the high quality enterprises tend to produce very satisfactory long-term returns with much less risk of permanent loss of capital.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
 
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