Friday, March 30, 2012

Highest Paid Hedge Fund Managers

In 2010, John Paulson topped the list in hedge fund manager earnings with $ 4.9 billion.

The Advantage Plus Fund he manages returned 17% that year.

In 2011, he steered the same fund to a 51% loss.

Paulson Advantage Plus Fund Drops 51% in 'Aberrational Year'

So that means he didn't top the list in pay among hedge fund managers in 2011.

Here's who did.

The Rich List

1 Raymond Dalio (Bridgewater Associates): $ 3.9 billion
2 Carl Icahn (Icahn Capital Management): $ 2.5 billion
3 James Simons (Renaissance Technologies Corp.): $ 2.1 billion
4 Kenneth Griffin (Citadel): $ 700 million
5 Steven Cohen (SAC Capital advisors): $ 585 million

Pay For Top-Earning U.S. Hedge Fund Managers

The top 25 hedge fund managers in pay earned a combined $ 14.4 billion. So their average pay came in at $576 million per manager last year.

That's down from $883 million in 2010.

I guess that makes 2011, at least by comparison, quite a bargain.

What I'd like to focus on here is not the gains that come from the money these managers have invested in their funds (especially if those invested funds DID NOT come from accumulated fees charges in prior years) but, instead, on the money made from the hedge fund industry standard "2 and 20" compensation structure.
(This type of compensation structure includes a management fee that's 2% of assets under management. It also includes, when applicable, a performance fee for 20% of the profits -- sometimes above a certain threshold -- or some similar variation.)

A good chunk of the above earnings comes from fees though, of course, this varies greatly by fund.

There shouldn't be much ambiguity as to how I view these frictional costs based upon prior posts.

To me, the idea of paying someone even 1% to manage money seems expensive.

Frictional costs gone wild.

Adam

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

Thursday, March 29, 2012

Benjamin Graham: Margin of Safety

From Chapter 20 of Ben Graham's book, The Intelligent Investor:

"...the risk of paying too high a price for good-quality stocks—while a real one—is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions. The purchasers view the current good earnings as equivalent to "earning power" and assume that prosperity is synonymous with safety."

Graham, later in the same chapter, added the following:

"...it follows that most of the fair-weather investments, acquired at fair-weather prices, are destined to suffer disturbing price declines when the horizon clouds over—and often sooner than that. Nor can the investor count with confidence on an eventual recovery—although this does come about in some proportion of the cases—for he has never had a real safety margin to tide him through adversity."

Highly cyclical, capital intensive businesses that have what seems like manageable debt can be far riskier than they seem when a healthy economy turns south.

They'll seem cheap in the good times but those with highly variable revenues, lots of fixed costs (operating leverage), and debt (financial leverage) are sometimes deceptively expensive.

What seems like normalized earnings in an expanding economy (and especially a bubble) turn out to be far from robust in a less favorable economic environment. Lower quality businesses end up struggling to cover interest charges and often can't lower their fixed operating expenses fast enough if the recession is severe enough.

Even if current owners don't get wiped out, a business that requires capital when it's scarce and common equity prices are low isn't the best thing to own.

One benefit of the recent financial crisis for investors is that it is easy to study which businesses had the toughest time during that period of severely reduced business activity.

It may not have been anything close to the worst economic conditions that could occur but was still a pretty good test.

The bottom line is that under favorable economic conditions some lower quality businesses have a margin of safety in appearance only.

The fact that a premium to intrinsic value was actually paid may not become obvious until it's too late.

Adam

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

Wednesday, March 28, 2012

Seth Klarman: Margin of Safety

From the book Margin of Safety by Seth Klarman:

"The focus of most investors differs from that of value investors. Most investors are primarily oriented toward return, how much they can make, and pay little attention to risk, how much they can lose.

Institutional investors, in particular, are usually evaluated—and therefore measure themselves— on the basis of relative performance compared to the market as a whole, to a relevant market sector, or to their peers. 

Value investors, by contrast, have as a primary goal the preservation of their capital. It follows that value investors seek a margin of safety, allowing room for imprecision, bad luck, or analytical error in order to avoid sizable losses over time. A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes. It is adherence to the concept of a margin of safety that best distinguishes value investors from all others, who are not as concerned about loss."

When a money manager grabs a headline for spectacular returns achieved the question that follows should be:

At what risk of permanent loss of capital?

This is especially true if the returns were accomplished over a shorter time horizon. The problem is, of course, unlike returns it's not possible to precisely measure the risks that were taken to achieve returns.

It's easy to promote returns.

It's much harder to promote effective risk avoidance.

Consider two money managers:

Money Manager 1: Earns 14 percent per year for six years for investors then a bear market kicks in. The market value of the portfolio drops 30 percent in year seven.

Money Manager 2: Earns 10 percent per year for six years for investors then a bear market kicks in. The market value of the portfolio drops 10 percent in year seven.

Who had the better seven year returns?

Money Manager 2

Who's portfolio performed better on the downside during a bear market?

Money Manager 2

Who do you think attracted more investors in the first six years?

It's best to not get enamored with spectacular returns of others unless the risks taken to achieve those returns are well understood.

Downside risk is regulated by judging value well and having the discipline and patience to wait and buy only when there's a meaningful discount to that value (and selling, at times, under the opposite conditions).

Unfortunately, the evidence suggests that many do the opposite. The tendency of investors buying high when it feels safe (usually during a spectacular performance frenzy) then selling out of fear and/or disgust when it temporarily all goes south.

Those with any doubt should compare money flows into equity mutual funds in 1999 to the money flows of more recent years.

Successful value investors develop (or have) the ability to be less susceptible to this risky behavioral pattern.

This all too predictable pattern takes away the investors best possible method of reducing risk.

Price.

Paying a low price relative to value (and sound judgment of value) regulates the downside risk for an investor.

The chance to buy an investment you understand well with the largest possible margin of safety usually happens in brutal bear markets when nothing seems to be going right.

It rarely feels good at the time.

Adam

* No matter how much someone wants to believe it, academic or otherwise, there will never be a single variable that captures the risks of an investment. Beta may lend itself to neat calculations but it's worthless when it comes to gauging risk. Risk is always a bunch of mostly not quantifiable judgments.

Intro. 11-12
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Tuesday, March 27, 2012

Where The Growth Is In The Beer Industry

From this release by the Brewers Association yesterday:

Craft brewers saw volume2 rise 13 percent, with a 15 percent increase in retail sales from 2010 to 2011, representing a total barrel increase of 1.3 million.

In 2011, craft brewers represented 5.68 percent of volume of the U.S. beer market, up from 4.97 in 2010, with production reaching 11,468,152 barrels. Additionally, the BA estimates the actual dollar sales figure from craft brewers in 2011 was $8.7 billion, up from $7.6 billion in 2010.


This trend of small batch independent brewers taking market share has continued for a number of years. Consider that this is happening while the overall U.S. beer market actually saw a volumes decrease 1.32 percent in 2011.

One thing I noted in this previous post is how the beer brewing industry has evolved since prohibition:

The Beer Industries Bright Spot

Before prohibition the U.S. had 1,751 breweries.

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

Where's it at now?

It is now up to 1,989 according to this latest release by the Brewers Association.

Adam

Note: The numbers from the Brewers Association are preliminary. The Association will publish its full 2011 industry analysis in the May/June 2012 issue of The New Brewer.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, March 26, 2012

Bats IPO: A Gift to Critics of Modern Market Structure

From this Bloomberg article on the errors that forced Bats to withdraw its IPO and some of the implications of the failure:

The malfunctions will refocus scrutiny on market structure in the U.S., where two decades of government regulation have broken the grip of the biggest exchanges and left trading fragmented over as many as 50 venues. Bats, whose name stands for Better Alternative Trading System, expanded in tandem with the automated firms that now dominate the buying and selling of American equities.

The withdrawal also raises questions about the reliability of venues formed as competitors to the New York Stock Exchange and Nasdaq Stock Market since the 1990s.

Themis Trading LLC has been shedding light for some time on some of the things that led to changes in market structure. I've included excerpts from some of their prior posts and one of their white paper's:

Regulations That Contributed to Existing U.S. Market Structure
Beginning with REG ATS in the late 90′s, the SEC has had the stated goal of transparency, and equal access to pricing by all market participants. Unfortunately, with decimalization and Reg NMS, the velocity of trading has skyrocketed. While this spawned some innovative products, nevertheless it has fragmented the market place and hurt the price discovery process in an unintended way. - From Themis Trading Comments on SEC Dark Pool Proposal

Unintended Negative Consequences
To regain public trust and confidence in our equity market, the SEC must undertake major reform. Such change faces two major challenges, however. It means admitting that the past decade of regulations have had serious unintended negative consequences. And it means going up against the HFT community, which is likely to do everything in its power to slow or water down the reform process.

The HFT community will claim that if any serious reform is implemented, they will be driven out of the market, spreads will increase and liquidity will dry up. We agree that spreads will widen, but liquidity will not vanish; only HFT volume will. And if a slightly wider spread is the cost of getting our market back into the hands of the owners who are responsible for price discovery, then that is a cost that most investors will gladly pay, we believe. While explicit costs will go up, the implicit costs of reduced market confidence will plummet. - From a White Paper by Sal Arnuk and Joseph Saluzzi

Those implicit costs may be hard to measure but that doesn't make the costs of reduced market confidence any less real.

Threat to Market Stability?
The first step in fixing a problem is admitting that you have one and that is exactly what this committee did last week. The unintended consequences of Reg ATS, the Order Handling Rules, Decimalization and Reg NMS have emerged into a serious threat to the stability of our market and they need to be addressed immediately. - From Great Expectations and the Frankenstein Market

Beneficial to Capital Formation?
Were these regulations beneficial to the markets? Were they beneficial to capital formation? Which is larger today: the cash equity business (ownership in real economic corporations), or more profitable market for derivative instruments of those equities? Is today’s Frankenstein market a result of “unintended consequences”, or is this market exactly the intended plan of the insiders, given that the current market participants had literally years to tool up to prepare (and take advantage of) for that very Frankenstein market? - From The Revolving Door

What's at stake seems straightforward enough but the fix won't be easy.

Does the market structure that exists today facilitate anything near the most effective capital raising and formation capability possible?

Are participants who invest primarily with longer term economic effects in mind being pushed aside in favor of more short-term oriented insiders?

I'm pretty sure that answers aren't likely to come from those with entrenched interest in the status quo. Pressure from places with fewer conflicts obviously have the better chance of getting us closer to more a desirable outcome.

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 are never a recommendation to buy or sell anything.

Friday, March 23, 2012

North American Oil and Gas Revolution

From this CNBC article:

Increased production of energy from a number of sources including deepwater drilling, natural gas exploration and Canada's oil sands could make North America the next Middle East, according to a new report from Citigroup.

According to the report, supply will go up substantially a result of the substantial strides in natural resource extraction. In addition, demand for oil in the U.S. is down 2 million barrels per day (since the peak in 2005) and is expected to continue declining over the next decade. Some of this is the result of the 2008 recession but it is also partly a structural decline.

The article quotes Ed Morse, head of global commodities research at Citigroup. Mr. Morse says this supply and demand revolution has "potentially extraordinary" economic consequences.

The report also predicts that the U.S. could overtake both Russia and Saudi Arabia in oil production by 2020. Check out the chart in this article.

According to the article, Citigroup's analysts assert that some of the consequences for the U.S. in a "good case" scenario include:

- An increase in GDP of 2.0 to 3.3 percent
- Roughly 3.6 million new jobs by 2020
- Decreased geopolitical risks
- A decline in oil prices

In 2011, the U.S. became an exporter of refined oil for the first time since 1949 but will likely continue to be a net importer of crude oil for a very long time. The U.S. currently imports roughly 9 million barrels of crude oil per day so there's a long way to go.

There's still a ways to go but the Citigroup report suggests the U.S. could put a material dent in those 9 million barrels of daily imported crude oil in less than ten years.

From this article in The New York Times:

Across the country, the oil and gas industry is vastly increasing production, reversing two decades of decline. Using new technology and spurred by rising oil prices since the mid-2000s, the industry is extracting millions of barrels more a week, from the deepest waters of the Gulf of Mexico to the prairies of North Dakota. 

We are also using significantly less gasoline. In part due to the recession and high prices but also from driving less with more fuel-efficient machines. While our reliance on imports continues to be substantial, I doubt many would have predicted that anything like this would happen in the U.S. as recently as five or so years ago.

The question is whether there's a smart way to invest in this.

That I haven't figured out yet.

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 are never a recommendation to buy or sell anything.

Thursday, March 22, 2012

Buffett's Bet Against Hedge Funds, Part II

Yesterday's post about Buffett's bet that hedge funds (or actually funds of hedge funds selected by Protege Partners LLC) would not outperform the S&P 500 over ten years brought the following to mind:

Let's say a hypothetical hedge fund manages $ 5 billion.

That means just the annual 2 percent management fee* (the 2 percent of assets that a typical hedge fund charges investors each year) alone will cost its investors $ 100 million/year. The costs would be more, of course, since a hedge fund will also usually charge investors 20 percent of profits generated (performance fees). There would also be an additional 1.25 percent of assets and 7.5 percent of any gains charged if a fund of hedge funds is involved as noted in yesterday's post.
(As I write this I still find all these fees very hard to believe.)

Now, compare the above to Berkshire Hathaway (BRKa).**

Berkshire Hathaway's market value is $ 200 billion (it's not hard to argue the company is worth more but that's another topic).

So Berkshire is 40x bigger than the above hypothetical hedge fund but Buffett's pay has been and continues to be much more reasonable. For decades, Buffett's compensation has been the $ 100k/year he collects in salary. Buffett does also benefit from personal and home security that Berkshire pays for but otherwise no bonus, stock options, or other forms of compensation.
(Buffett's primary source of wealth has come from the shares he purchased decades ago.)

Quite a contrast and, well, quite a bargain.

What Buffett has been paid during the forty plus years as CEO added together is, in total, less than 5 percent of what the hypothetical hedge fund above would be paid in one year.

Now naturally some of the $ 100 million paid to the hedge fund goes to other operating expenses. So to be completely fair, at least some of the operating costs of Berkshire's headquarters (though much of those costs are presumably related to the operating businesses Berkshire owns outright), including the new investment managers, shouldn't be ignored. That's the only way to make this a true apples-to-apples comparison of frictional costs (though I know of no corporation Berkshire's size with such a small headquarters).

Let's not split hairs. This difference in costs, I think, speaks for itself. Precision not required. Berkshire is built to minimize frictional costs for investors like few other investment vehicles. Add the cost for Berkshire's headquarters (all 19 employees) and the total frictional costs compared to the value of the assets being managed is still lower than any fund in existence by a large margin.
(Consider I'm also ignoring the performance fees that hedge funds charge which are far from inconsequential.)

...frictional costs of all sorts may well amount to 20 percent of the earnings of American business. In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80 percent or so of what they would earn if they just sat still and listened to no one.- From the How to Minimize Investment Returns section of the 2005 Berkshire Hathaway Shareholder Letter

What if Buffett had been charging '2 and 20' fees instead all these years?

Berkshire would be a shadow of itself and its long-term investors, of which it has many, a lot less rich.

We know with Buffett in charge Berkshire has produced ~20 percent returns per year for decades. Due to its sheer size, it will almost certainly not do that well in the future whether Buffett's at the helm or not.

Having said that, the company is made up of a pretty fine set of assets that are likely to compound nicely in value over time.

I'm guessing no matter who is running Berkshire over the coming decades, even if not the compensated at a bargain $ 100k per year rate, that the frictional costs as a percent of value will continue to be lower than just about any fund in existence.

Adam

Long position in BRKb established at less than recent market prices

Related posts:
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
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

* The article mentioned in yesterday's post noted that, in addition to the '2 and 20' fees hedge funds typically charge (investors are charged 2% of the assets each year in management fees plus 20% of profits generated in performance fees), the funds of funds add another layer of fees. According to the Bloomberg article, on average this is an additional 1.25 percent of assets and 7.5 percent of any profits.
** Berkshire's not a hedge fund, of course, but I think it's worthwhile to make the comparison. Much like a hedge fund, Berkshire is an investment vehicle that attempts to generate satisfactory returns and manage risks. The investor is just charged a lot less for the privilege.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Wednesday, March 21, 2012

Buffett's Bet Against Hedge Funds

A little over 4 years ago, Warren Buffett made a $ 1 million friendly wager with Protege Partners LLC, a New York fund of hedge funds.

The bet Buffett made with Protege was that "a portfolio of funds of hedge funds" of their choosing couldn't beat the S&P 500 over a ten year period.

The winner's charity of choice is to receive the $ 1 million.

For background, here's the wording of the specific wager that was made between Buffett and Protege:

"Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S&P 500 will outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs and expenses."

So how are the funds chosen by Protege doing against a Vanguard mutual fund that tracks the S&P 500?

This article notes that the returns since the beginning of the bet have been as follows:

Vanguard S&P 500: Plus 2.2 percent return (low-cost Admiral shares)
Hedge funds: Minus 4.5 percent return

That's hardly definitive but, then again, not really surprising consider the difference in fees and other frictional costs.

Most hedge funds are compensated via the '2 and 20' fees. Investors in the fund are charged for 2 percent of the assets each year (management fees) plus 20 percent of profits generated (performance fees).

I happen to find the idea of paying that much baffling but, somewhat amazingly, the frictional costs involved go beyond those fees.

From the Bloomberg article:

In addition to the 2 percent management fee and 20 percent performance fee that hedge funds typically charge, the funds of funds add another layer of fees, on average 1.25 percent of assets and 7.5 percent of any gains, according to data compiled by Bloomberg.

To me, 1 percent seems like a lot.

Buffett and Protege present their arguments for the wager here*.

An excerpt from Buffett's argument:

...passive investors, will by definition do about average. In aggregate their positions will more or less approximate those of an index fund. Therefore the balance of the universe—the active investors—must do about average as well. However, these investors will incur far greater costs. So, on balance, their aggregate results after these costs will be worse than those of the passive investors.

Costs skyrocket when large annual fees, large performance fees, and active trading costs are all added to the active investor's equation. Funds of hedge funds accentuate this cost problem because their fees are superimposed on the large fees charged by the hedge funds in which the funds of funds are invested.

A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose...

An excerpt from Protege's argument:

Having the flexibility to invest both long and short, hedge funds do not set out to beat the market. Rather, they seek to generate positive returns over time regardless of the market environment. They think very differently than do traditional "relative-return" investors, whose primary goal is to beat the market, even when that only means losing less than the market when it falls. For hedge funds, success can mean outperforming the market in lean times, while underperforming in the best of times. Through a cycle, nevertheless, top hedge fund managers have surpassed market returns net of all fees, while assuming less risk as well. We believe such results will continue.

There is a wide gap between the returns of the best hedge funds and the average ones. This differential affords sophisticated institutional investors, among them funds of funds, an opportunity to pick strategies and managers that these investors think will outperform the averages. Funds of funds with the ability to sort the wheat from the chaff will earn returns that amply compensate for the extra layer of fees their clients pay.

According to the Bloomberg article, Buffett told Carol Loomis he thought his chance of winning was 60%. So for Buffett this is not exactly the high probability outcome he usually seems to like when putting capital at risk. I'm just guessing but this seems more about a way for Buffett to highlight the extremely high fees that are the norm in the industry.

It's certainly possible the funds that were chosen to compete with the S&P 500 by Protege may, in fact, do better over these ten years in this particular wager. To me, that would miss the primary point.

I think the more important thing to consider is that, with all those costs layered on, the probability of outperformance is not very high over the long haul. A large enough sample and enough time should reveal just that.

Certain funds will outperform, of course, but that a large percentage of funds (or funds of funds) could consistently overcome all those fees and expenses seems improbable at best.

Good luck to those trying to separate the few long-term winners from the rest.

Most investors, on average and over the long haul, will likely do better with a low-cost index fund.

Adam

Related posts:
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
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

* The site is longbets.org. Its stated purpose "is to improve long-term thinking" and is backed by the non-profit The Long Now Foundation.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Tuesday, March 20, 2012

Steve Jobs: "We've Got All This Cash, Warren...What Should We Do With It?"

Here's a follow up post to yesterday's Apple (AAPL) announcement of a quarterly dividend and share repurchase program.

In a CNBC interview back in February, Warren Buffett said that a couple years ago Steve Jobs had called and asked him what to do with all the cash Apple was accumulating.

During the interview, Buffett admitted he wished he had bought Apple's stock then described a conversation he had with Steve Jobs. Apparently, Steve Jobs called Buffett a couple years ago and asked:

"We've got all this cash, Warren...what should we do with it?"

The four alternatives that Buffett says he walked through with Steve Jobs was:

-Stock Buybacks
-Dividends
-Acquisitions
-Sitting on the Cash

Buffett said he was told by Steve Jobs that they wouldn't need lots of money for acquisitions. So here's what Buffett says he said to him:

"'...I would use it for repurchases if I thought my stock was undervalued.' And I said how do you feel about that? Stock was around 200 and something. He said, 'I think our stock's really undervalued.' I said, 'Well, you know, what better can you do with your money?' And then we talked a while, and he didn't do anything."

Buffett then added...

"I said, look, you can buy dollar bills for 80 cents or 70 cents and you know the dollar bill. I mean, it's not a counterfeit, it's your dollar bill. I said go to it, and the truth was he didn't. He just didn't want to repurchase stock. But he was certainly right about his stock being undervalued."

Well, in retrospect not acting on it at the time was costly but, considering the accomplishments of Apple, it's difficult to be critical in this case.

Few others have ever matched Apple's business performance and accomplished so much in such a short time. That, in itself, is not an excuse. My point is while Apple is a force today not long ago (late 1990s) the company was in far from great competitive or financial shape.

Now imagine you are Steve Jobs having watched Apple barely survive the late 1990s. Ten years later the feeling that the company was now a financial fortress must have been nice.

It's not hard to imagine the thought process being:

Why not let the cash build up so you feel sure to never face that again?

Instead, just focus on making Apple an increasingly great business.

Who knows what Steve Jobs was thinking but I can understand why he might have been cautious financially. It doesn't change the fact that the cautiousness was costly. There'd be many fewer shares outstanding if Apple had acted sooner. The same intrinsic value would spread across substantially less shares (bought cheap) and Apple's spectacular stock would have been more so.

The math is simple. There's no doubt that the persistent repurchase of shares would have led to lots of per share value being created.

So while it was to an extent understandable, as the late 1990s moves further into the rear-view mirror the financial caution clearly makes less sense.

The intelligent use of future cash flows and all that cash on the balance sheet will impact long-term returns substantially.

As I mentioned in the prior post, yesterday's dividend announcement by Apple was a fine step forward but, the stated primary objective of their planned share repurchase was a little disappointing. I'll be interested to see if they have the discipline to buy the stock when cheap but, more importantly, to know not buy it back if the stock happens to become expensive in the future.

"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." - Warren Buffett in the 2011 Berkshire Hathaway Shareholder Letter

Apple's a great product company. Sure they sat on the cash too long and had less than optimal capital allocation up to this point but, considering where they have come from, it's somewhat understandable.

With most companies it's best as a shareholder to be less understanding about it. As time goes on that applies to Apple no matter how good they are at what they do.

The amount of per share wealth creation for long-term investors that could be left on the table is far too great.

Adam

Long position in AAPL

Related post:
Apple Initiates Quarterly Dividend and Share Repurchase Program
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.

Monday, March 19, 2012

Apple Initiates Quarterly Dividend and Share Repurchase Program

This morning, Apple (AAPL) announced they will begin paying a quarterly dividend and initiate a share repurchase program.

The company will start paying a $ 2.65/share quarterly dividend and expects to repurchase $ 10 billion of stock over three years.

Using Friday's closing price the annual dividend yield is 1.81 %. Apple will start paying that dividend in the company's fiscal fourth quarter, which begins July 1.

With the stock now hitting all-time highs, it sure would have been nice if the share repurchases had begun much earlier.

The company said the following in their press release about the share repurchase program:

...the Company's Board of Directors has authorized a $10 billion share repurchase program commencing in the Company’s fiscal 2013, which begins on September 30, 2012. The repurchase program is expected to be executed over three years, with the primary objective of neutralizing the impact of dilution from future employee equity grants and employee stock purchase programs.

Apple's stock, even though it has run quite a bit, may not yet be overvalued but saying that the primary objective of the repurchase program is to neutralize "the impact of dilution" is revealing and seems at least poorly worded.

The purpose of a buyback should simply be to buy shares whenever they are comfortably below intrinsic value* for the benefit of long-term holders (as long as the company can easily afford it).

Consider what Apple said in the press release (that the share repurchase program has "the primary objective of neutralizing the impact of dilution") in the context of what Warren Buffett said in the most recent Berkshire Hathaway (BRKashareholder 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 [emphasis added] 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.

Apple, like any business, should buy back shares whenever both conditions are met. I think it's safe to say the company has had the first condition covered and, in recent years, it seems pretty clear they've had the second condition also covered (obviously much less so now considering the recent price action of its stock).

In the release, neutralizing share dilution is what Apple said is the primary objective but that's clearly not where the focus should be.

No share repurchase makes sense unless a clear discount to likely intrinsic value exists.

It seems obvious that true long-term investors in Apple's stock don't benefit if shares are repurchased at any cost to meet their stated primary objective. Now, make the primary objective to buy shares whenever they are selling comfortably below intrinsic value and shareholders will do just fine. To me, that's how decision-making for a share repurchase program should be guided.**

With nearly $ 100 billion of cash and investments and that pile of money growing at an extremely rapid clip, it was time for Apple to start returning cash to shareholders. The dividend seems a good start but it will be worth watching closely how their buyback decision-making plays out.

Adam

Established long positions in BRKb and AAPL at less than recent market prices

Related post:
Technology Stocks

* Obviously, intrinsic value cannot be precisely calculated. At best, it's a range that represents a company's likely value. Apple's change in intrinsic value has been unusually fast moving and hard to gauge. It continues to be difficult at best to estimate what's it's really worth and likely going to be worth down the road. The answer now seems likely to be a lot but something this dynamic by its nature has a wider range of outcomes.
** I'm guessing Apple would likely not buy back as much stock if shares became extremely expensive. It's just that the wording of their release doesn't even provide a passing mention of how price versus value impacts their decision-making. Now, if Apple's business continues to be in such good shape it will hardly be the end of the world if they don't get this exactly right. The success of their next several product launches matters a whole lot more. Yet, it is still an example of potentially less than optimal buyback decision-making and capital allocation. Something that has been prevalent with far too many public companies. Who knows, may be Apple will do a good job on this. We'll see.
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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, March 16, 2012

Wall Street Meets Casablanca

This new Barron's article explains ex-Goldman Sachs vice president Greg Smith's recent "Why I Am Leaving Goldman Sachs" op-ed with a famous scene from the movie Casablanca.

In the scene, French prefect Louis Renault expresses surprise that there's any gambling going on in Rick's Cafe then, of course, proceeds to collect his winnings.

Captain Louis Renault: "I'm shocked, shocked to find that gambling is going on in here!" 
(then a croupier hands Renault a pile of money)

I'm shocked, shocked to find that there's been less than admirable behavior on Wall Street!

The Barron's article makes the following points:

- Wall Street selling stuff that blows up isn't a new thing
- What's relatively new is trading against customers instead of mostly executing trades on behalf customers

So what's at the root of this change in behavior over the years by some Wall Street firms?

In the article, Joan McCullough of East Shore Partners explains, as she calls it, "when the whole freakin' Street went rogue."

Yet another voice that reinforces, in a compelling way, the idea that Wall Street's culture went south quite a while ago and the reasons why.

That there are excesses on Wall Street isn't exactly breaking news at this point. Just as most, including Captain Renault, were well aware of the gambling at Rick's Cafe those who've followed Wall Street's evolution know there's been some fairly egregious excesses.

Obviously, it's best to not paint with too broad a brush. Some operate more admirably than others and there are very talented and high quality people at many of these firms. Yet, there seems little doubt most Wall Street firms would be more useful to the world if some intelligent changes were made.

These days, being a trusted source for companies (new and old) to raise new capital and wisely allocate their capital takes a back seat to many less vital activities. In order to evolve back into something more useful again, aspects of the current model and culture seem to need meaningful modification.

Unfortunately, it is hard to imagine the situation changing materially for the better anytime soon.

It's a shame because there's plenty of important contributions to be made by a high quality investment bank.

Check out the Barron's article in its entirety.

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 are never a recommendation to buy or sell anything.

Thursday, March 15, 2012

Ben Graham: Better Than Average Expected Growth

From Chapter 8 of The Intelligent Investor by Benjamin Graham:

A stock does not become a sound investment merely because it can be bought at close to its asset value. The investor should demand, in addition, a satisfactory ratio of earnings to price, a sufficiently strong financial position, and the prospect that its earnings will at least be maintained over the years. This may appear like demanding a lot from a modestly priced stock, but the prescription is not hard to fill under all but dangerously high market conditions. Once the investor is willing to forgo brilliant prospects—i.e., better than average expected growth—he will have no difficulty in finding a wide selection of issues meeting these criteria.

Shares of businesses with exciting growth prospects (and usually a great story) often sell at a substantial premium to their current value.

There's always exceptions, of course, but pay for promise not yet realized and watch out below if things don't go quite as well as hoped.

Businesses with big growth opportunities attract competition* and wider range of future outcomes.

In contrast, it's usually not difficult to find publicly traded shares of a business with sound economics if unexciting growth prospects (and likely an even less exciting story) selling at an attractive price relative to current value. If shares are bought at or near the right price, satisfactory or better returns can be achieved even if nothing particularly good happens to the business.

Now, a bit of stable growth from a business with durable competitive advantages is certainly nice. It's just that getting in the habit of paying a premium for potential opens the door to an unacceptably high probability of permanent capital loss.

Graham later in the chapter added that an investor...

...can take a much more independent and detached view of stock-market fluctuations than those who have paid high multipliers of both earnings and tangible assets.

Being detached from market price action is a lot easier when shares of an enterprise are primarily owned for long run profit-producing capacity.

I'm guessing many get this at some level though it seems less practice it.

It's certainly not due to a lack of IQ. There's no shortage of informed and intelligent market participants.

Sir Isaac Newton made the case for this as well as anyone with his participation in the folly of the South Sea Bubble.

His genius did nothing to prevent him from being totally wiped out by it.

Adam

Related posts:
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009

* The tobacco industry comes to mind. Who'd want to take on the established players in the U.S. cigarette market?
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Wednesday, March 14, 2012

Banks Raise Dividends After Passing Stress Tests

The Federal Reserve released the stress test results for the 19 largest U.S. banks. From the Fed's press release:

The Federal Reserve on Tuesday announced summary results of the latest round of bank stress tests, which show that the majority of the largest U.S. banks would continue to meet supervisory expectations for capital adequacy despite large projected losses in an extremely adverse hypothetical economic scenario.

The Federal Reserve in the Comprehensive Capital Analysis and Review (CCAR) evaluates the capital planning processes and capital adequacy of the largest bank holding companies. This exercise includes a supervisory stress test to evaluate whether firms would have sufficient capital in times of severe economic and financial stress to continue to lend to households and businesses.

The nine quarter hypothetical stress scenario assumes the following:

- 13 percent peak unemployment rate

- 50 percent drop in equity prices

- 21 percent decline in housing

- 8% drop in GDP

According to the Fed 4 banks failed the test. Citigroup (C), Ally Financial, and SunTrust (STI) failed to have an adequate tier 1 common capital ratio. MetLife (MET) failed on the basis of its risk-based capital ratio being too low.

The problem for some came down to proposed plans to return capital being too aggressive. From yesterday's SunTrust press release:

The Federal Reserve review showed that SunTrust's capital exceeded requirements throughout the Supervisory Stress Test time horizon without any capital actions. As a result of this review, SunTrust will not be increasing its return of capital to shareholders at this time...

Citigroup would have met the minimum capital requirements if a more modest plan to return capital to shareholders had been submitted. The bank has already announced it will submit a new capital plan to regulators (no doubt some of the others will need to do the same). From yesterday's Citigroup press release:

...results showed that Citi exceeded the stress test requirements without the capital actions Citi proposed. However, the Federal Reserve advised Citi that it objected to Citi's proposed return of capital to shareholders. In light of the Federal Reserve's actions, Citi will submit a revised Capital Plan to the Federal Reserve later this year, as required by the applicable regulations.

Soon after the stress test results were released (and in the case of JP Morgan before the results were released), some of the healthier banks announced the dividend increases and other capital actions. All these actions had to have been, of course, accepted by the Fed:

JPMorgan (JPM) - Raised its dividend 20% from 25 cents/share to 30 cents/share and announced a $ 15 billion stock buyback.
U.S. Bancorp (USB) -  Raised its dividend 56% from 12.5 cents/share to 19.5 cents/share and plans to repurchase up to 100 million shares of stock.
Wells Fargo (WFC) - Raised its quarterly dividend 83% from 12 cents/share to 22 cents/share, an 83% increase. The banks also mentions "other capital actions" in its press release but wasn't more specific.
American Express (AXP) - Raised its quarterly dividend 11% from 18 cents/share to 20 cents/share and said it intends to buy back up to $ 4 billion of stock in 2012 and up to $ 1 billion of stock in 1Q 2013.
BB&T (BBT) - Raised its quarterly dividend 25% from 16 cents/share to 20 cents/share.
State Street (STT) - Raised its quarterly dividend 33% from 18 cents/share to 24 cents/share and a share repurchase program of up to $ 1.8 billion.

PNC (PNC) said the Federal Reserve accepted its capital plan but won't be announcing any specifics until their next board meeting.

Unfortunately, some of the above stocks are rallying this morning. If that continues some of these announced buyback plans will become less wealth enhancing for long-term shareholders.

Adam

Long JPM, USB, WFC, and AXP

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, March 13, 2012

Buffett on Errant Purchases: Why We Hold On To My Mistakes

When it comes to businesses they acquire, over the years Berkshire Hathaway (BRKa) has made it very clear they don't to sell their mistakes.

It's a principle Berkshire established a long time ago and they have stuck with it. An excerpt below from Buffett's latest letter helps explain their way of thinking on this.

The same is not true when it comes to partial ownership of businesses via the purchase of marketable securities. Buffett has said many times he prefers to hold a stock "forever". They have, in fact, owned certain shares for a very long time. Yet, they're not nearly as rigid about holding on to shares of certain stocks if better use for the capital exists elsewhere.

For starters, here's a quick overview of Berkshire's Manufacturing, Service, and Retailing Operations. Quite a few (though certainly not all) of the acquisitions by Berkshire over the years is within this group.

It is, to say the least, a highly varied mix of businesses that includes:

Acme Brick
Benjamin Moore
Borsheims (jewelry retailing)
CTB (agricultural equipment)
Dairy Queen
Fruit of the Loom (including Russell athletic apparel)
Iscar (cutting tools)
Lubrizol (lubricant additives)
Marmon (140 independently operated manufacturing and service businesses)
McLane (distributor of food products, cigarettes, candy, sundries, wine and spirits)
Nebraska Furniture Mart
Pampered Chef (direct sales of kitchen tools)
See's Candies
Shaw Industries (flooring)

...among others.

This collection of businesses earned just $ 3.04 billion dollars in 2011 or just slightly more than the $ 2.97 billion that Berkshire's railroad Burlington Northern Santa Fe (BNSF) earned by itself.
(BNSF is not part of the Manufacturing, Service, and Retailing Operations. It is listed under Regulated, Capital-Intensive Businesses.)

Buffett said the following about the Manufacturing, Service, and Retailing Operations in the latest Berkshire Hathaway shareholder letter:

Some of the businesses enjoy terrific economics, measured by earnings on unleveraged net tangible assets that run from 25% after-tax to more than 100%. Others produce good returns in the area of 12-20%. A few, however, have very poor returns, a result of some serious mistakes I made in my job of capital allocation. These errors came about because I misjudged either the competitive strength of the business being purchased or the future economics of the industry in which it operated. I try to look out ten or twenty years when making an acquisition, but sometimes my eyesight has been poor. Charlie's has been better; he voted no more than "present" on several of my errant purchases.

Berkshire's newer shareholders may be puzzled over our decision to hold on to my mistakes. After all, their earnings can never be consequential to Berkshire's valuation, and problem companies require more managerial time than winners. Any management consultant or Wall Street advisor would look at our laggards and say "dump them."

That won't happen. For 29 years, we have regularly laid out Berkshire's economic principles in these reports...and Number 11 describes our general reluctance to sell poor performers (which, in most cases, lag because of industry factors rather than managerial shortcomings). Our approach is far from Darwinian, and many of you may disapprove of it. I can understand your position. However, we have made – and continue to make – a commitment to the sellers of businesses we buy that we will retain those businesses through thick and thin.

Buffett goes on to make the following points:

- Up to now at least, the dollar cost of this commitment has not been substantial.
- The cost of laggards may be offset by the goodwill it builds among potential sellers.
- Future sellers to Berkshire know alternative buyers can't (or at least don't) make a similar promise. Commitments are measured in decades at Berkshire.

Now, though it has happened rarely, there are conditions where Berkshire will sell an acquisition. More from the 2011 letter:

If either of the failings we set forth in Rule 11 is present - if the business will likely be a cash drain over the longer term, or if labor strife is endemic - we will take prompt and decisive action. Such a situation has happened only a couple of times in our 47-year history, and none of the businesses we now own is in straits requiring us to consider disposing of it.

The principle behind this is laid out comprehensively in Rule 11 of the Berkshire Hathaway owner's manual.

You'll be looking for a long time trying to identify an acquirer with scale that takes a similar approach.

Adam

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

Monday, March 12, 2012

Credit Default Swaps: Insurance Masquerading As A Financial Product

Yesterday's Washington Post article by Barry Ritholtz provided some useful history and background on credit-default swaps (CDS).

Washington Post: Credit default swaps are insurance products. It's time we regulated them as such.

It's well worth reading and makes a strong case for regulating CDS the same way as other insurance products.

In the article, Ritholtz makes the following points:

- CDS obtained their favored status as unregulated insurance policies thanks to the Commodity Futures Modernization Act of 2000 (CFMA). They continue to be, effectively, unregulated insurance policies.

 - The act was built on the assumption that markets could self-regulate (I think it is fair to say we've learned otherwise) and, as a result, basically eliminated all relevant regulations.

 - Commodity Exchange Act of 1936 was modified so derivative transactions were exempted from regulations as "futures" and "securities" (via fed securities laws).

 - CFMA exempted credit-defaults swaps and other derivatives from regulation by state insurance regulators.

So that means...

- CDS can be traded like any financial products but is not considered a security.
- CDS can be used to hedge future prices but is not considered a futures contract.
- CDS pays in the event of a specific loss but is not considered an insurance policy.

Makes sense, right?

Well, not surprisingly this "innovation" changed behavior in the industry. The article also points out insurance companies have to typically set aside reserves to cover losses. With swaps there is no such requirement.

Ritholtz goes on to write that "they are still exempt from all insurance regulatory oversight," even though they are "thinly disguised insurance products" with the added bonus that they lack reserve requirements.

Why does this matter? Ultimately, the problem is reserves (or the lack thereof).*

If treated like the insurance products that they are, insurance regulators would impose appropriate reserve requirements. This, of course, would reassure participants that the institutions on the hook are actually capable of paying down the road. It seems fairly obvious that this would increase the health, stability, and effectiveness of the financial system.

First and foremost, the increasingly complex and vital financial system is built upon trust and confidence. If system-wide robustness is in doubt it can't function optimally. As it stands now, knowing whether there is a systemically crucial institution liable for something it's incapable of  absorbing isn't easy for anyone to judge. It opens the door for rumors and raw emotion to set the agenda in lieu of facts and rationality.

We should know from recent experience that, at least during chaotic markets, this matters a whole bunch.

The mere fact that it's so difficult to figure out who's potentially liable for what creates damaging uncertainty.

That uncertainty, during times of economic stress, potentially amplifies the size of the problem.

We've already learned that during times of financial crisis what starts as a seemingly manageable problem takes on an unpredictable life of its own.

Check out the full article.

Adam

Related prior posts:
Buffett: Credit Default Swaps Potentially "Very Anti-social" Instruments
The Bond Market Rules
Sinking Seaworthy Ships

* Lack of reserves certainly aren't the only problem with CDS. It's an established principle for an insurance company to not let someone insure something they don't own because they do not have an insurable interest. England figured out centuries ago it's a good idea to remove the ability to profit from another's loss and the possibility of misconduct associated with it. Human nature hasn't changed. Warren Buffett made this point in an interview last year on CNBC: "...you can't go out and insure my house against fire because you do not have an insurable interest, as they call it in the trade. Because once you insure my house against fire and you may decide that, you know, that maybe dropping a few matches around my lawn might be a good idea."  Yet, with credit default swaps, one can take out insurance on a bond without actually owning that bond. So someone that doesn't own an underlying corporate or sovereign bond have been able to place a bet against it via the purchase of a credit default swap then directly benefit if a default occurs. It's rather similar to being able to insure someone else's home and directly benefiting from something bad happening to it. These side bets, it seems, have the potential to be massively destabilizing though there is far from universal agreement on this. Some argue that wise limits to reign this sort of thing in is plainly needed (if not an outright ban); others argue for quite the opposite. I'll take the recently adopted outright ban on sovereign debt sooner than later. It may not be sufficient but it's a start.
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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, March 9, 2012

Assured Mediocrity

An excerpt from the now out of print book Margin of Safety written by Seth Klarman:

If interplanetary visitors landed on Earth and examined the workings of our financial markets and the behavior of financial-market participants, they would no doubt question the intelligence of the planet's inhabitants. Wall Street, the financial marketplace where capital is allocated worldwide, is in many ways just a gigantic casino. The recipient of up-front fees on every transaction, Wall Street clearly is more concerned with the volume of activity than its economic utility.

 Later in the book Klarman added...

In addition, hundreds of billions of dollars are invested in virtual or complete ignorance of underlying business fundamentals, often using indexing strategies designed to avoid significant underperformance at the cost of assured mediocrity.

It's certainly true that there are no shortcuts to understanding the fundamentals of a business. There's a fair amount of work and, at least in my case, a lot of time is required.*

Yet, it's also not as complicated as some may like to make it seem.

As far as investing goes, Jeremy Grantham said it very well in his latest letter:

"...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."

Investors with an even temperament who know their limits and stay within them, have reasonably good business judgment, and do their homework can do just fine.

Investing well starts with learning how to value something and having the discipline and patience to buy with a substantial margin of safety.

In my view, each investor needs to develop their own models of what makes a business a good long-term investment. That's one of the reasons why I'd never buy anything based upon someone else's opinion. No one should. When an investment idea is not your own, the conviction level that's required to withstand the inevitable bumps probably won't be there.

What seems cheap often first gets even cheaper after it's been bought. That's just the moody nature of Mr. Market. Higher levels of conviction lead to a higher pain thresholds. Without that higher threshold, an investor is more likely to bail on an investment that has otherwise been judged well before reaping the benefits.

Of course, those who tend to stubbornly stay with a dumb investing idea that keeps going down in price should probably hire someone else to manage their money. Trying to "prove you are right" or stay with a poorly judged underwater investment until you "get your money back" is generally not financially fattening.

Truly thinking independently and not being tempted by what other investors are buying or selling is the key. Those that can't resist listening to the specific recommendations and opinions of others aren't likely to do well.

Some underestimate how important this is.

Assured mediocrity at best.

Adam

* I start by looking at how the business performance over the past five to ten years. For me, that historical perspective is not nearly enough. I usually need to observe the performance of business for a few years before I get comfortable with it. There are exceptions, of course. Sometimes the discount to my estimate of likely value gets large enough to warrant buying the stock sooner. Price regulates risk. When a higher quality business gets cheap enough, I'll sometimes establish a meaningful position more quickly before the chance to own it closes. Occasionally, by the time I find out I like a business the price will have become too high and the chance to buy is missed entirely. That may be annoying but it's better than losing money on something not yet well understood. If nothing else, investing this past decade taught value investors the importance of patiently waiting for a good price. There were some stocks I liked in the late 1990s that didn't get cheap until the financial crisis and, as a result, I couldn't buy until then (no kidding). So obviously I don't mind waiting for a good price. 

Intro. 8
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.
 
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