Wednesday, February 29, 2012

Jeremy Grantham's 4Q 2011 Letter

From the latest quarterly letter by Jeremy Grantham:

Grantham's 4Q 2011 Letter

"To be at all effective investing as an individual, it is utterly imperative that you know your limitations as well as your strengths and weaknesses. If you can be patient and ignore the crowd, you will likely win. But to imagine you can, and to then adopt a flawed approach that allows you to be seduced or intimidated by the crowd into jumping in late or getting out early is to guarantee a pure disaster. You must know your pain and patience thresholds accurately and not play over your head. If you cannot resist temptation, you absolutely MUST NOT manage your own money. There are no Investors Anonymous meetings to attend."

Later he adds...

"On the other hand, 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."

Understanding more than a little bit about business certainly helps. Otherwise, investing well requires an even temperament, discipline, patience, and awareness of one's limits more so than sheer brainpower.

If it was mostly about brains, Isaac Newton and John Meriwether (founder of Long-Term Capital Management) would have had more investing success.

Isaac Newton, The Investor

Clearly investing success isn't primarily about having superior intellect. Smart people are not at all immune from doing very dumb things when it comes to putting capital at risk.

"A lot of people with high IQs are terrible investors because they've got terrible temperaments." - Charlie Munger in Kiplinger's

Long-Term Capital Management (LTCM)* back in 1998, the first of many more recent debacles, serves as a good modern example among many:

"...the hedge fund known as 'Long-Term Capital Management' recently collapsed, through overconfidence in its highly leveraged methods, despite I.Q's of its principals that must have averaged 160. Smart, hard-working people aren't exempted from professional disasters from overconfidence. Often, they just go aground in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods." - Charlie Munger in a speech to the Foundation Financial Officers Group

In both of these spectacular investing failures**, Isaac Newton's and John Meriwether's LTCM, there was no shortage of IQ. Yet, obviously, some of the other necessary characteristics of investing success weren't there.

"A money manager with an IQ of 160 and thinks it's 180 will kill you...Going with a money manager with an IQ of 130 who thinks its 125 could serve you well." - Charlie Munger in San Francisco Business Times

The aspects of human nature that leads to costly misjudgments hasn't changed since Newton was wiped out a little less than 300 years ago.

It certainly doesn't hurt to have some awareness of what causes even relatively smart and informed investors to go off the rails.

Adam

Related posts:
Munger on LTCM and Overconfidence
When Genius Failed...Again

* Actually, not so long-term. Could a more perfectly wrong name have been chosen? It lasted all of four years before it needed to be bailed out to prevent a more widespread financial markets collapse. So the poor judgment of one highly leveraged fund had created serious monetary and systemic implications. 
** These two failures are very different, of course. Newton's folly hurt only himself. Merriwether lost money for others while threatening the stability of the global financial system. In fact, as these two articles point out, Merriwether has lost money for investors more than once:
John Meriwether, the Wile E. Coyote of Hedge Funds 
Meriwether: Fool Me Once, Shame On You. Fool Me Twice, Shame on Me
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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, February 27, 2012

Why Buffett Wants IBM's Shares "To Languish"

In this previous post back in 2009 and later in some others, I've covered why it makes little sense for a long-term investor to hope a stock will perform well just after it has been purchased.

In fact, unless someone is primarily involved in trading near-term stock price action (all too many market participants these days), those with a long horizon should hope the shares they buy underperform in the days, weeks, and even years that follow while the business itself does well.*

Warren Buffett wrote some excellent material on this subject in the 2011 Berkshire Hathaway (BRKa) shareholder letter that was released over this past weekend.

It's the best explanation I've read yet.

Now, it's understandable that an investor will feel pretty unlucky for having bought shares at a price higher than what becomes available soon after. Yet, while that stock price drop after purchase may seem annoying, it obviously allows the long-term investor to accumulate more shares. The key is that the shares are bought at a discount to per share intrinsic value in the first place.

If shares are actually purchased at a discount, there should be no complaints if they temporarily sell at an even greater discount. In other words, a discount can be a very good thing -- even if it lasts for many years -- for long-term owners provided that business value was judged reasonably well in the first place.

The lower price naturally also benefits long-term owners if free cash flow (in combination with cash on the balance sheet and, in some cases, debt issuance) is persistent and used intelligently to buy back cheap shares over time.

If done in a smart way the compounded benefits for continuing long-term shareholders is not at all small.

This generally only works if the buybacks are done comfortably below (ideally, well below) a conservative estimate of intrinsic value -- too often with buybacks this is not the case -- and the investor has a long time horizon.

A price that offers an appropriate margin of safety protects the investor from the unforeseen and, maybe, the unforeseeable -- what cannot necessarily be known beforehand -- as well as the inevitable mistakes.

This applies whether the investor is accumulating shares or the company is repurchasing stock.

Uncertainty is a given. The price paid should reflect this reality.

Overconfidence in future outcomes can destroy returns.

Of course, the business itself must have a strong balance sheet and plenty of free cash flow that's at least sustainable and, ideally, increasing somewhat over time; it must also have enough financial flexibility to carry out the buyback without damaging the moat, adversely affecting operations, and making other important investments.**

Here's how Buffett explained it in the letter:

"When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well. A corollary to this second point: 'Talking our book' about a stock we own – were that to be effective – would actually be harmful to Berkshire, not helpful as commentators customarily assume."

Buffett continues by focusing in on IBM's financial management (some might call it "financial engineering"):

"Indeed, I can think of no major company that has had better financial management, a skill that has materially increased the gains enjoyed by IBM shareholders. The company has used debt wisely, made value-adding acquisitions almost exclusively for cash and aggressively repurchased its own stock."

He later added...

"Naturally, what happens to the company's earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period?

I won't keep you in suspense. We should wish for IBM's stock price to languish throughout the five years."

Buffett then walks through some of the math:

"If IBM's stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%. 

If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the 'disappointing' scenario..."

He concludes by saying:

"The logic is simple: 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."

Many buyers of stock like to see it go up after purchase but the high price actually does reduce long-term returns. I understand that seeing a stock sell below the price paid, especially if it is for an extended period, is difficult for most investors to tolerate. Quite a few end up bailing out before the compounded benefits of shares bought at cheap prices has really had an impact.

Loss aversion is a powerful force but it's possible to develop a more rational response. The long-term investor should hope the stock performs poorly in the near-term and, in fact, for even much longer.
(It's not at all hard to see why this way of thinking might not be particularly popular. That is especially true in an environment where the focus is on profiting from near-term price action instead of long run investment outcomes. What's popular is often very different from what's sensible.)

If shares of a good business are bought consistently below intrinsic value it has powerful long-term effects (especially in terms of risk-reward). This can work whether it is the individual investor -- through additional share purchases or dividend reinvestments -- or the company itself that is doing the buying.
(Other than the tax considerations, share repurchases and dividend reinvestments -- implemented when shares are selling at reasonable or, better yet, cheap valuation levels -- similarly benefit long-term owners; the former reduces overall share count, while the latter increases the number of shares owned. Repurchases, depending on the type of account, are generally more tax efficient.)

One of the keys, again, is a truly long-term investing horizon.

Here's another important thing to consider: the business itself can (and likely will) experience difficulties from time to time. Even the best of them usually do.
(Some might, as a result, be tempted to jump in and out at just the right time. That's usually a better idea in theory than in reality.)

Despite the inevitable business challenges, what really matters is whether the core business economics remain mostly intact once most of the problems are solved. Well, whether IBM's competitive position in the longer run will remain strong seems, at the very least, not the easiest thing to figure out. That's just the nature of technology businesses. To me, at a minimum, this means a larger margin of safety is required.

I'd add that businesses with the most exciting growth will often get their fair share of attention (along with a premium market price). Well, while it's crucial that returns on capital are both durable and attractive, growth actually need not be all that impressive if the price is right.

So growth can be a fine thing, of course, it's just not inevitably a wonderful thing. The price that's paid and whether a business will still be producing attractive returns on capital in 20-30 years (or longer) is what's all-important.***

The fact is, while growth can be an important contributor to long-term returns, it need not be.

I write this because some seem to assume (and behave as if) all growth is good growth.

It's just not.

Buffett's thinking on share repurchases begins at the bottom of page 6 of the letter.

Well worth reading.

As is the rest of the letter.

Adam

Long position in BRKb established at lower than recent prices. No position in IBM at this time.

Related posts:
Buffett on IBM: Berkshire Buys "Big Blue"
Buffett: When it's Advisable for a Company to Repurchase Shares
The Best Use of Corporate Cash
Technology Stocks
Buffett on Stock Buybacks - Part II
Buffett on Stock Buybacks
Buy a Stock...Hope the Price Drops?

* Naturally, in the longer run, an investor will wants the stock price to at least roughly track the increases to per share intrinsic value.
** The business must have plentiful funds available for operational liquidity needs while not underinvesting in crucial assets that widen the economic moat and provide competitive advantages. So, in general, a long-term investor logically should not want shares of a sound business to go up in the near-term or even longer. What's an exception to this? Here's one scenario to consider. Unfortunately, at least for some businesses, there's the very real risk that a buyout offer comes in at a premium to market value but a discount to intrinsic value. If enough short-term oriented owners are okay with the gain (and, of course, enough board members) that will have occurred compared to the recent price action, the deal may be approved. Also, if too few have conviction about longer run prospects, the deal may get approved. When a large proportion of owners of shares are in it for the short-term or, at least, primarily to profit from price action, the chance of this happening increases. Well, those that became owners because of the plain discount to intrinsic value and the company's long run prospects will likely get hurt in this scenario. It's worth mentioning that, considering its market capitalization, IBM is not exactly a likely candidate but it can and does happen to public companies of lesser size. So picking co-owners wisely matters (as much as that is possible). Some public companies certainly have more long-term oriented owners than others. 
*** What a business will look like many years from now is, in most cases, not at all easy to figure out. Neither is whether the expected exciting growth will be sustained and the high return variety (in order to justify what is often a premium price).
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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.

Friday, February 24, 2012

Buffett on Stock Valuations

On quite a few occasions in recent years, Warren Buffett has made it clear that he is having no trouble finding attractively priced stocks.

With that in mind, consider what he was saying about equity prices during the early 2000s.

What follows is just a few samples (among many) of what he was saying back then about stock valuations.

Here's what Buffett wrote in the 2001 Berkshire Hathaway shareholder letter:

Charlie and I believe that American business will do fine over time but think that today's equity prices presage only moderate returns for investors. The market outperformed business for a very long period, and that phenomenon had to end. A market that no more than parallels business progress, however, is likely to leave many investors disappointed, particularly those relatively new to the game.

He added the following in the 2002 letter:

Despite three years of falling prices, which have significantly improved the attractiveness of common stocks, we still find very few that even mildly interest us. That dismal fact is testimony to the insanity of valuations reached during The Great Bubble. Unfortunately, the hangover may prove to be proportional to the binge.

The aversion to equities that Charlie and I exhibit today is far from congenital. We love owning common stocks – if they can be purchased at attractive prices. In my 61 years of investing, 50 or so years have offered that kind of opportunity. There will be years like that again. Unless, however, we see a very high probability of at least 10% pre-tax returns (which translate to 6½-7% after corporate tax), we will sit on the sidelines. With short-term money returning less than 1% after-tax, sitting it out is no fun. But occasionally successful investing requires inactivity.

And in the 2003 letter...

We are neither enthusiastic nor negative about the portfolio we hold.  We own pieces of excellent businesses – all of which had good gains in intrinsic value last year – but their current prices reflect their excellence.  The unpleasant corollary to this conclusion is that I made a big mistake in not selling several of our larger holdings during The Great Bubble.  If these stocks are fully priced now, you may wonder what I was thinking four years ago when their intrinsic value was lower and their prices far higher.  So do I.

Quite a contrast to Buffett's bullishness in recent years when it comes to equities. As far as returns go the decade or so that followed the above comments was, of course, a very tough one.

Here's just one example of his favorable view of stock valuations. Buffett said the following back in 2010:

It's quite clear that stocks are cheaper than bonds. I can't imagine anybody having bonds in their portfolio when they can own equities, a diversified group of equities. But people do because they, the lack of confidence. But that's what makes for the attractive prices. If they had their confidence back, they wouldn't be selling at these prices. And believe me, it will come back over time.

Long periods of inactivity is a required part of the investing process. So patience is necessary but, these days, it's not difficult to find shares of quality businesses selling at prices that provide a decent or better margin of safety.

Who knows how stock prices will fluctuate in the next week, month, or even a few years but at least now it's much easier to buy shares of businesses below intrinsic value.

For investors in common stocks, the probability of above average long-term returns seems substantially better now than it was in the early 2000s.

When quality finally sells at a comfortable discount to value my preference is to buy meaningful amounts. I do that with an understanding that it's essentially impossible to gauge the near term stock price movements. In other words, I know the stock may get even cheaper but attempting to time things perfectly leads to errors of omission.

Better to focus on price versus value and ignore the market noise.

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.

Thursday, February 23, 2012

SEC May Ticket High Speed Traders

Apparently, the Securities and Exchange Commission (SEC) may start charging fees to curb high frequency trading. In this Wall Street Journal article, Mary Schapiro said the following:

...a large portion of equities trading has little to do with "the fundamentals of the company that's being traded." She said it had more to do with "the minuscule aberrational price move" that computer-assisted traders with direct connections to the exchange can "jump on" in fractions of a second.

In addition to forcing traders to pay for cancelled trades (it turns out cancelled trades make up something like 95 to 98% of orders by high-frequency traders), the SEC may impose a requirement on high-speed participants to maintain competitive buy and sell orders throughout most of the trading day.

According to this article, Schapiro's concerns were sparked by the "flash crash" back in May of 2010.

That article points out that the SEC's mission is to "maintain fair, orderly and efficient markets" and to "facilitate capital formation." It seems to me that most high-frequency trading activity adds little value to the capital formation process and, if anything, might be one of the reasons we've seen record volatility. 

In it's current form, whether high-frequency trading somehow helps "maintain fair, orderly and efficient markets" seems at least debatable.

The article points out the crash is a challenge to the SEC's stated mission.

...to "maintain fair, orderly and efficient markets" and to "facilitate capital formation." If investors are afraid of a market crash, in other words, they won't provide the capital that public companies need to expand their businesses.

According to Schapiro, the SEC has implemented some fixes since the flash crash including:

-Circuit breakers for stocks that have large moves in a short period of time.

-A ban on stub quotes (offering to buy/sell far from what most investors are willing to pay...a contributor the the flash crash).

Some questions come to mind:

Will the fees on cancelled trades be substantial enough to actually change high-speed trading behavior?

Will the requirement to maintain competitive buy and sell orders for a certain percentage of the trading day change behavior?

In what time frame will the changes be implemented?

Are other solutions being considering to curb the influence of high frequency trading?

Just a guess but those involved in high frequency trading will likely not think these fees and other changes under consideration are such great ideas since, of course, they'll have adverse effects on "liquidity".

Well, I think we can stand for a bit less liquidity and a bit more actual investing. Charlie Munger said it best. He doesn't see much benefit to the massive amount of trading between computers that goes on. He also doesn't seem to think the energy expended and talent utilized writing algorithms (that ultimately the rest of us pay for) provides much social contribution.

"...why should we want to encourage our brightest minds to do what amounts to code-breaking and electronic trading? No I think the whole system is stark-raving mad. Why should we want 25% of our graduating engineers going into finance?" - Charlie Munger

Munger: Cut Banking Sector 80%

The economics of high frequency trading will have to be fundamentally changed for this to work in the long run.

It's not like this is static.

In other words, adjustments by high-speed traders will naturally be made to try and thrive under whatever the new rules end up being.

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, February 22, 2012

Buffett on Productive Assets: Businesses, Farms, & Real Estate

More from a column recently written by Warren Buffett in Fortune.

Warren Buffett: Why stocks beat gold and bonds

In the column, which is an adaptation from his upcoming shareholder letter, Buffett talks about what he describes as the three major categories of investments. The first two categories were currency-based investments  and nonproductive assets like gold.

Here's the third major category.

Category III: Productive Assets

Buffett calls the 1) ability to maintain "purchasing-power value" and 2) requiring minimal new capital investment the "double-barreled test". What meets that test?

According to Buffett:

- Businesses -- or partial ownership of businesses via marketable stocks -- like Coca-Cola (KO), IBM (IBM), and See's Candies
- Farms
- Real Estate

Other businesses, like regulated utilities, fail the test because of  heavy capital requirements. Yet Buffett adds they will still likely be better than nonproductive assets and currency-based assets.

"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."

The best businesses pass the "double-barreled test". While it's certainly smart to buy shares of those kinds of businesses cheap, the fact that durable superior economics are in place is more important than an extremely low initial purchase price.

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

That's not an invitation to overpay. Margin of safety still matters a whole lot as protection against the unforeseeable. It's just that, when an investor has strong conviction that a business can earn high return on capital for a very long time, it allows for greater flexibility to pay a somewhat higher price.

So, while it's always smart to buy with the largest margin of safety possible, sustained high return on capital over two or three decades eventually can make an initially somewhat expensive looking price make sense. In the very long run, results tend to be drawn like a magnet toward the return on capital earned by the business.*

Not all capital intensive businesses are lousy but some earn a very low return on their capital.  Businesses like that, even if shares are selling at a low multiple of earnings, aren't actually the bargain they initially seem to be (though some of the better ones will still beat nonproductive or currency-based assets). They can be owned until what seems a near term valuation gap closes but, over a longer investing horizon, results will ultimately be influenced most by the low return on capital.

In the article, Buffett goes on to say that Berkshire will continue to own entire businesses and be part owners of businesses via shares of stock:

"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."

The thinking that shares of a good business, especially if bought at a reasonable valuation, is somehow more risky than cash is flawed.

Check out the full Fortune Magazine column for Buffett's thoughts on the other two major investment categories.

Adam

Related posts:
-Buffett: Why Stocks Beat Gold
-Buffett: Why Stocks Beat Bonds
-Buffett on Gold, Farms, and Businesses
-Beta, Risk, & the Inconvenient Real World Special Case
-Howard Marks: The Two Main Risks in the Investment World
-Black-Scholes and the Flat Earth Society
-Edison on Gold: Fictitious Value & Superstition
-Munger on Buying Gold
-Thomas Edison on Gold
-Grantham on Gold: The "Faith-based Metal"
-Buffett: Forget Gold, Buy Stocks
-Gold vs Productive Assets
-Buffett: Indebted to Academics
-Grantham on "The Greatest-Ever Failure of Economic Theory"
-Grantham: Gold is "Last Refuge of the Desperate"
-Friends & Romans
-Why Buffett's Not a Big Fan of Gold
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind

* I consider this very different from paying a very high multiple for some newer, unproven, but fast-growing business where it's hard to foresee what will happen in three years never mind three decades.

CNBC - Warren Buffett: Stocks Will Outperform Gold and Bonds...and They're Safer 'By Far'

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, February 21, 2012

Walter Schloss, "Superinvestor" Praised by Buffett, Dies at 95

Walter Schloss, one of the original disciples of Benjamin Graham, died over the weekend at the age of 95.

Warren Buffett, in a know well-known 1984 speech at Columbia Business School, described Schloss as one of the "superinvestors".

From 1955 to 2002, Schloss earned 16% per year after fees.

The S&P 500 returned 10% over the same period of time.

That kind of outperformance over 47 years turns $ 10 thousand into $ 10 million.

From this Omaho World-Herald article published today:

"Walter Schloss was a very close friend for 61 years," Buffett said Monday from his office in Omaha. "He had an extraordinary investment record, but even more important, he set an example for integrity in investment management. Walter never made a dime off of his investors unless they themselves made significant money. 

He charged no fixed fee at all and merely shared in their profits. His fiduciary sense was every bit the equal of his investment skills."

In this article, based upon the aforementioned 1984 speech, The Superinvestors of Graham-and-Doddsville, Buffett said the following about Walter Schloss:

Walter has diversified enormously, owning well over 100 stocks currently. He knows how to identify securities that sell at considerably less than their value to a private owner. And that's all he does...He simply says, if a business is worth a dollar and I can buy it for 40 cents, something good may happen to me. And he does it over and over and over again. He owns many more stocks than I do -- and is far less interested in the underlying nature of the business; I don't seem to have very much influence on Walter. That's one of his strengths; no one has much influence on him.

More recently, in 2006 Berkshire Hathaway Shareholder Letter, Warren Buffett also added this about Schloss:

Walter managed a remarkably successful investment partnership, from which he took not a dime unless his investors made money. My admiration for Walter, it should be noted, is not based on hindsight. A full fifty years ago, Walter was my sole recommendation to a St. Louis family who wanted an honest and able investment manager.

Walter did not go to business school, or for that matter, college. His office contained one file cabinet in 1956; the number mushroomed to four by 2002.

Buffett later continued with the following...

Following a strategy that involved no real risk – defined as permanent loss of capital – Walter produced results over his 47 partnership years that dramatically surpassed those of the S&P 500...There is simply no possibility that what Walter achieved over 47 years was due to chance.

I first publicly discussed Walter's remarkable record in 1984. At that time "efficient market theory" (EMT) was the centerpiece of investment instruction at most major business schools. This theory, as then most commonly taught, held that the price of any stock at any moment is not demonstrably mispriced, which means that no investor can be expected to overperform the stock market averages using only publicly-available information (though some will do so by luck). When I talked about Walter 23 years ago, his record forcefully contradicted this dogma.

And what did members of the academic community do when they were exposed to this new and important evidence? Unfortunately, they reacted in all-too-human fashion: Rather than opening their minds, they closed their eyes. To my knowledge no business school teaching EMT made any attempt to study Walter's performance and what it meant for the school's cherished theory.

Instead, the faculties of the schools went merrily on their way presenting EMT as having the certainty of scripture. Typically, a finance instructor who had the nerve to question EMT had about as much chance of major promotion as Galileo had of being named Pope.

Tens of thousands of students were therefore sent out into life believing that on every day the price of every stock was "right" (or, more accurately, not demonstrably wrong) and that attempts to evaluate businesses – that is, stocks – were useless. Walter meanwhile went on overperforming, his job made easier by the misguided instructions that had been given to those young minds. After all, if you are in the shipping business, it's helpful to have all of your potential competitors be taught that the earth is flat.

Maybe it was a good thing for his investors that Walter didn't go to college.

There are now quite a few examples of investors, each applying variations of Graham and Dodd, with excellent long-term performance.

What they have in common is not just superior long-term returns. It's also about how risk is defined and measured.

To them, risk cannot be measured by beta.

Risk is measured, rather imprecisely I might add, by the likelihood of a permanent loss of capital. It's about two variables, price versus value, and correctly judging what's an appropriate margin of safety for a specific investment.

The imprecision, when combined with one's own unique limits, means necessarily that no margin of safety (discount to conservatively calculated value) for some investment opportunities will be large enough.

"The essence of portfolio management is the management of risks, not the management of returns." - Benjamin Graham

So invest within your limits, be wary of false precision (roughly right is better than precisely wrong), and buy when a plain discount to intrinsic value exists. Sounds easy, right?

Spectacular returns can't be looked at in a vacuum though they'll generally get the headlines (try to write a good headline on the exceptional management of risk). I'll take the portfolio manager who routinely employs a substantial margin of safety and outperforms over another who tends to push the limits and outperforms.

A long track record of outperformance is at least an indication that the manager can handle all kinds of investing environments.

Of course, it's not possible to find many with a track record as long as Walter Schloss.

I just tend to be skeptical of headline grabbing returns in any given year (or actually even much longer for that matter. Better to judge returns in the context of risk (permanent capital loss) and length of track record.

The best managers know that returns will follow if permanent capital loss is avoided. Unfortunately, the inferior management of risk often only becomes obvious after the next unforeseen crisis.

Adam

Related posts:
Graham-and-Doddsville
Superinvestors: Gallileo vs The Flat Earth
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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.

Friday, February 17, 2012

Donald Yacktman On Stocks

Below is the 10-year performance through 12/31/11 of the funds that Donald Yacktman and his team manage:

The Yacktman Fund (YACKX) had a cumulative 10-year return of 174.52%.*

The Yacktman Focused Fund (YAFFX) did even better returning a cumulative 194.07% over the past 10 years.

For a comparison, the S&P 500 was up 33.35% over the same time frame.

From the latest letter:

Old Tech
Last year, the shares of many more established technology companies were out of favor, allowing us to increase our weighting to a group which we call "old tech". At the end of 2011, Microsoft and Cisco were our largest "old tech" positions...

Consumer Staples
These businesses tend to be fairly stable and predictable, with a strong ability to handle uncertain economic periods. We reduced our weightings in Coca‐Cola and Clorox during the year due to their strong price performance.   

Consuelo Mack recently interviewed Donald Yacktman. Some excerpts from that interview:

High Quality, Profitable Businesses
I've been doing this for over 40 years, and I can't remember another period of time where I've seen so many high-quality, profitable businesses selling at prices relative to the market this cheaply.

Behaving Like a Bond Buyer
...what we're seeing now is, in effect, the so-called AAAs of equity, things like Coke and Pepsi and things like that, have these very high returns, relative to other things. And so, why would one go to lower grades when they can stay with these so-called AAA-type bonds? Only they're really equities.

Beach Balls Pushed Underwater
Conceptually, what we're doing is buying beach balls being pushed underwater, and the water level is rising. And so, if one has the patience to stay with that, then eventually the pressure will come off, and the longer it takes, because the water level's rising, the more the bounce will be. 

The full interview with Donald Yacktman is certainly worth checking out.

The top holdings in the funds managed by Yacktman at year-end include Pepsi (PEP), News Corp (NWSA), Procter & Gamble (PG), Microsoft (MSFT), and Cisco (CSCO).

Adam

* From the letter: The performance data quoted for The Yacktman Fund and The Yacktman Focused Fund represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that the investor's shares, when redeemed, may be worth more or less than their original cost. The current performance may be higher or lower than the performance data quoted.

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

Thursday, February 16, 2012

Facebook, Google, or Apple?

From this Barron's article that looks at Facebook as an investment:

The best businesses can be poor investments, if you pay the wrong price.

It's easy to understand the excitement around Facebook.

Yet, it's not like competitors have lousy prospects. The article points out Facebook will probably sell for 100x earnings when it initially goes public. Google (ticker: GOOG) and Apple (AAPL) sell at much lower multiples of earnings and both are solid (or better) growth companies.

As the article points out, Google and Apple have much more net cash and investments while Facebook's valuation implies hyper-growth.

As Google demonstrates, it's tough to sustain hyper-growth, and that's what Facebook's likely price implies. 

It's certainly possible, even likely in the longer run, that Facebook may grow into its valuation but, excluding net cash and investments, Google's forward P/E is ~12x while Apple's is less than 8x.

Even the very best businesses have risks and uncertainties. The only protection for an investor is to pay a price that doesn't reflect high hopes and rosy expectations.*

Facebook, Google, and Apple all certainly seem to have very good prospects. Yet, all tech businesses compete in dynamic industry environments that are highly unpredictable. Each clearly has a unique set of risks, uncertainties, and challenges.

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.

Every time capital is put at risk, there ought to be a high probability of being compensated with an appropriate return for the trouble.

Pay too much and, even if things work out reasonably well for the business itself, the reward may end up being too small compared to lower risk alternatives.

Adam

Long positions in AAPL and GOOG established at much lower than recent prices

Related post:
Technology Stocks

* Quite a few stocks have run up an awful lot in price lately. There are exceptions, of course, but I won't be buying much of anything in the near term until something sours the market mood a bit. The time to buy is when the headlines are awful.  Stocks with momentum inevitably attracts bandwagon "owners". I'd rather buy when something has scared some of them off the bandwagon. I understand some like to trade the hot stock of the moment with a great story. For those involved in that sort of thing, I have no particular skills or opinion whatsoever.
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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.

Wednesday, February 15, 2012

Berkshire Hathaway 4th Quarter 2011 13F-HR

The Berkshire Hathaway (BRKa4th Quarter 2011 13F-HR was released yesterday.

For comparison purposes here's the 3rd Quarter 2011 13F-HR.

This quarter some new positions were added while they continued to build upon several existing positions.

There also was a bit of selling.

This post summarizes the changes made in the previous Berkshire Hathaway 13F-HR.

Here's what changed during the 4th quarter:*

New Positions
DaVita (DVA): Bought 1.7 million shares worth $ 145 million
Liberty Media (LMCA): 2.7 million shares worth $ 227 million

Added to Existing Positions
IBM (IBM): Bought 6.6 million shares worth $ 1.3 billion (11% increase), total stake $ 12.3 billion
DirecTV (DTV): 16.1 million shares worth $ 738 million (379% increase), total stake $ 933.2 million
Wells Fargo (WFC): 22.3 million shares worth $ 679 million (6% increase), total stake $ 11.7 billion
Visa, Inc. (V): 573 thousand shares worth $ 215 million (25% increase), total stake $ 329.5 million
CVS (CVS): 1.4 million shares worth $ 63 million (26% increase), total stake $ 308.3 million
Intel (INTC): 2.2 million shares worth $ 58 million (23% increase), total stake $ 307.8 million
General Dynamics (GD): 813 thousand shares worth $ 57 million (27% increase), total stake $ 272 million
Verisk (VRSK):  1.3 million shares worth $ 55 million (64% increase), total stake now $ 140 million

In my previous summary, I mentioned some Berkshire 13F filings have the following statement:

"Confidential information has been omitted from the Form 13F and filed separately with the Commission."

Not this one.

From time to time, the SEC allows Berkshire Hathaway to keep certain moves in the portfolio confidential. The permission is granted by the SEC when a case can be made that the disclosure may cause buyers to drive up the price before Berkshire makes its additional purchases.

Reduced Positions
Kraft (KFT): sold 2.7 million shares worth $ 104 million (3% decrease), total stake now $ 3.3 billion
Johnson & Johnson (JNJ): 8.4 million shares worth $ 544 million (23% decrease), total stake now $ 1.9 billion

Sold Positions
Exxon Mobil (XOM) was sold outright.

The small positions are likely not the work of Buffett himself. Both Todd Combs, hired in 2010 and Ted Weschler, hired last year and expected to join in early 2012, are responsible for a portion of Berkshire's portfolio. So expect any changes involving the small positions to generally be the work of the new portfolio managers.

Top Five Holdings
After the changes, Berkshire Hathaway's portfolio of equity securities is made up of ~ 34% consumer goods, 31% financials, 18% technology, 7% consumer services, and 4% healthcare. The remainder is primarily spread across industrials and energy.

1. Coca-Cola (KO) = $ 13.8 billion
2. IBM (IBM) = $ 12.7 billion
3. Wells Fargo (WFC) = $ 11.7 billion
4. American Express (AXP) = $ 7.9 billion
5. Procter and Gamble (PG) = $ 4.9 billion

As is almost always the case it's a very concentrated portfolio.

The top five often represent 60-70 percent and, at times, even more of the equity portfolio. In addition, Berkshire owns equity securities listed on exchanges outside the U.S.**, plus cash and cash equivalents, fixed income, and other investments. The entire portfolio is currently worth more than $ 150 billion.

The portfolio, of course, excludes all the operating businesses that Berkshire owns outright.

Here are some examples of the non-insurance businesses:

MidAmerican Energy, Burlington Northern Santa Fe, McLane Company, The Marmon Group, Shaw Industries, Benjamin Moore, Johns Manville, Acme Building, MiTek, Fruit of the Loom, Russell Athletic Apparel, NetJets, Nebraska Furniture Mart, See's Candies, Dairy Queen, The Pampered Chef, Business Wire, Iscar Metalworking, and Lubrizol among others.

In addition, the insurance businesses (BH Reinsurance, General Re, GEICO etc.) owned by Berkshire have naturally provided plenty of "float" for their investments over time and continue to do so.

See page 106 of the annual report for a full list of Berkshire's businesses.

There'll be more details on all the above in Berkshire's annual report which is to be released later this month.

Adam

Long positions in BRKb, KO, WFC, AXP, PG, KFT, JNJ, and INTC established at lower than recent market prices.

* All values based upon yesterday's closing price. Naturally, what was actually paid can't be known from the information disclosed.
** Berkshire Hathaway's holdings of ADRs are included in the 13F-HR. What is not included are the shares listed on exchanges outside the United States. The status of those shares (BYD, POSCO, Sanofi, Tesco PLC etc.) are updated in the annual letter. Last month, Berkshire disclosed a substantial increase to their position in Britain's dominant supermarket chain, Tesco PLC (TSCDY). So even if that increase had occurred in 4Q 2011, stocks like Tesco PLC are not covered in the 13F-HR unless Berkshire happens to buy the ADR. Investments in things like preferred shares (and related warrants) are also not included in the 13F-HR.
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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, February 14, 2012

Buffett: Why Stocks Beat Gold

Some thoughts from Warren Buffett on gold from his recent Fortune Magazine column.

Warren Buffett: Why stocks beat gold and bonds

In the column, Buffett talks about what he describes as the three major categories of investments. The first category he covered was currency-based investments. That category includes money-market funds, bonds, mortgages, and bank deposits among other things.

In a nutshell, his view of currency-based investments pretty much came down to this:

They are anything but safe over the long haul.

Here's the next major category.

Category II: Nonproductive Assets Like Gold

Buffett points out that all the gold in the world forms a cube of 68 feet per side and is worth roughly $ 9.6 trillion.

"For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world's most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money..."

In a century, the 400 million acres farmland will produce lots of corn and other crops and still be capable of doing so. In a century, Exxon Mobil (XOM) will have delivered trillions of dollars to owners and still have valuable assets. Over that time frame, in contrast, all that gold will be no bigger and still unproductive. 

In fact, it costs real money to protect.

In a typical year, the 16 Exxon Mobils and U.S. cropland shouldn't have much trouble putting $ 500-700 billion of earnings in the owners pocket.

That's year after year.

So these productive assets will likely earn every 12-15 years the entire current value of a gold. During that time and thereafter, the gold will produce nothing. In contrast, whatever the oil and crop bounty happens to be during the first 12-15 years, the productive assets will continue to benefit owner and society thereafter.

With technological advancements and mostly self-funded further investments, there'll likely be quite a bounty of crops and energy resources for a very long time coming from these assets.

Gold will produce nothing and is only worth what the next buyer will pay (if you couldn't find a buyer for Exxon Mobil or the U.S. cropland you'd still collect the income stream). In fact, gold costs an owner money to store, protect, and insure (negative carry). A good business has the capacity to fund those costs from operations and still generate income for owners.

Now, the stream of income produced by productive assets has more than decent odds of growing over time. Year in and year out, the additional income could be wisely invested by the owner into more productive assets.

Let the compounding effects begin.

The growing earnings stream from the Exxon Mobils and the U.S. cropland, even as the inevitable degradation in currency value proceeds, has a very good chance of compensating the owner at least enough to maintain purchasing power. There's also a high probability that the earnings stream, as the value of it is reinvested and allowed to compound, will actually increase purchasing power.

The only problem with commodity businesses is, as a currency is debased, knowing how the price of each individual commodity will change over time to compensate for the debasement isn't always predictable. In a commodity business the owner frequently has little control over price in the long run (there are some obvious exceptions, of course).

That's where pricing power comes in.

Now, imagine owning a business with actual pricing power. As a currency is debased, the management of a good business with pricing power has little trouble adjusting the price to compensate.

I'd still rather own a productive asset like an oil company or cropland than a nonproductive one like gold but it's just that better alternatives exist.

Finally, don't forget about that other $ 1 trillion of walking-around money Buffett mentions above. Those dollars can also be put to productive use.

Still want the gold?

Check out the full Fortune Magazine column for Buffett's thoughts on the other two major investment categories.

Adam

Related posts:
-Buffett on Productive Assets
-Buffett: Why Stocks Beat Bonds
-Buffett on Gold, Farms, and Businesses
-Beta, Risk, & the Inconvenient Real World Special Case
-Howard Marks: The Two Main Risks in the Investment World
-Black-Scholes and the Flat Earth Society
-Edison on Gold: Fictitious Value & Superstition
-Munger on Buying Gold
-Thomas Edison on Gold
-Grantham on Gold: The "Faith-based Metal"
-Buffett: Forget Gold, Buy Stocks
-Gold vs Productive Assets
-Buffett: Indebted to Academics
-Grantham on "The Greatest-Ever Failure of Economic Theory"
-Grantham: Gold is "Last Refuge of the Desperate"
-Friends & Romans
-Why Buffett's Not a Big Fan of Gold
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind

Related article:
CNBC - Warren Buffett: Stocks Will Outperform Gold and Bonds..and They're Safer 'By Far'

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.

Daily Journal Corp. - Investment Portfolio Equals Nearly 80% of Market Capitalization

A follow up to this post. Daily Journal Coporation (DJCO), a publisher that relies on Chairman Charlie Munger when selecting investments, has substantially expanded its investment portfolio over the past five years.

The investment portfolio value is now nearly 80% of market capitalization (the company currently has no debt). As I'll cover below, subtract the portfolio's value from market capitalization and the business itself sells for roughly 3x earnings.

Daily Journal Expands Investment Portfolio

As I mentioned in the prior post, the company took what was roughly $ 12 million in net cash and investments back in 2006, combined it with free cash flow from the core business, then wisely reallocated into marketable securities -- mostly common stocks -- when prices were low. The latest 10-Q filing reveals that the portfolio has increased to just over $ 79 million.
(Now, the marketable securities didn't go up in value nearly seven-fold, it was the combination of capital appreciation and five years of free cash flow invested wisely.)

As far as allocation goes, the portfolio has moved from being 100% in cash, U.S. Treasury notes and bills in December of 2006 to now being almost entirely in marketable securities. The company's most recent 10-Q shows that 96% of the portfolio is now in marketable securities (primarily common stocks).

As recently as December of 2008, the portfolio continued to have zero common stock exposure.

Basically, leading up to the financial crisis the portfolio was well-positioned to act when attractive opportunities to invest became available.

Then, in early 2009, at the height of the crisis, the portfolio allocation was completely transformed.

Common stocks were purchased aggressively and have been held or added to since that time.

The company's 10-Q filing this past Friday outlined some of their moves into marketable securities in recent years. The filing also revealed a recent purchase "of common stock of another Fortune 200 company."

From the latest 10-Q of Daily Journal:

In February 2009, the Company purchased shares of common stock of two Fortune 200 companies and certain bonds of a third, and during the second and the third quarters of fiscal 2011, the Company bought shares of common stock of two foreign manufacturing companies. During the first quarter of fiscal 2012, the Company bought shares of common stock of another Fortune 200 company. The investments in marketable securities, which cost approximately $45,166,000 and had a market value of about $76,213,000 at December 31, 2011...

The rest of the portfolio is made up of $ 3.1 million in U.S. Treasury bills, cash and cash equivalents. So, in total, the portfolio was valued at $ 79.3 million at the end of the quarter (and probably more than that now considering the recent rally).

The past five years is a great example of building up capital and waiting patiently for attractive investments (something Munger has emphasized on many occasions) to emerge.

Let's compare, in some more detail, the situation now to where the company was just five years ago.

At the end of December 2006, Daily Journal's cash and investments in total were worth $ 16.54 million.

Debt was $ 4.16 million.

So net cash and investments (cash and investments minus debt) = $ 12.4 million.

Market Capitalization = ~$ 61 million.

Enterprise Value (EV = market capitalization minus cash and investments) = ~$ 49 million.

Average earnings over the previous five years (2002-2006) =  $ 2.8 million.

EV/Avg Earnings = 17.5x

Back then, investor's were willing to pay slightly more than 17.5x for the prior five years average earnings. If for some reason earnings capacity became compromised, there was little value in the investment portfolio compared to the market capitalization at that time.

Let's look at the business the same way today. At the end of December 2011, the Daily Journal's cash and investments in total were worth $ 79.3 million.

There's no debt now so, of course, net cash and investments also equals $ 79.3 million.

Market Capitalization = ~$ 101 million (based on yesterday's close)

Enterprise Value (EV) = ~$ 22 million

Average earnings over the past five years (2007-2011) = $ 7.2 million

EV/Avg Earnings = ~3x

Investor's are now willing to pay roughly 3x for what the business itself earned on average over the prior five years. Of course, what matters is what the company will earn going forward.
(The forward multiple is likely to be higher. Earnings were $ 7.9 million in its most recent fiscal year but seems poised to decline from here. Earnings were actually boosted by increases in foreclosures in recent years. Public notice advertising for foreclosures is mandated by law in California and Arizona. This most recent quarter saw earnings drop to just $ 1.70 million down from 2.18 million in the same quarter a year ago.)

The stock is up more than 70% since December of 2006 (share count shrunk somewhat so the per share price is up more than the % gain in market cap). Even with that rise in price, the enterprise value to earnings has dropped from 20x to 3x.

So, even if earnings drops substantially going forward, there's now plenty of value in the portfolio to support much of the market capitalization (since the portfolio equals nearly 80% of market capitalization). We don't know the specific holdings but odds are pretty good that, at least with Charlie Munger involved, the holdings are not exactly speculative. The portfolio is also likely to made up of shares in businesses with the capacity to increase intrinsic value over time.

More from the latest 10-Q of the Daily Journal:

The Company's Chairman of the Board, Charles Munger, is also the vice chairman of Berkshire Hathaway Inc., which maintains a substantial investment portfolio. The Company's Board of Directors has utilized his judgment and suggestions, as well as those of J.P. Guerin, the Company's vice chairman, when selecting investments, and both of them will continue to play an important role in monitoring existing investments and selecting any future investments.

In just five years, the net portfolio value has increased from under $ 12.4 million to $ 79.3 million using only the cash generation capacity of the business itself and some wise allocation.

It's a business that may have hard to predict long-term prospects but, since the traditional business needs little incremental capital, with smart allocation of funds value has been created.*

Even if the traditional business is in steady decline, since it doesn't consume much capital, the somewhat reduced earnings levels can continue to be deployed into other attractive investments. This works, of course, only as long as the core business can produce a positive even if somewhat reduced stream of earnings (a sudden sharp decline in earnings would be much more troublesome).

Some questions come to mind:

Will Daily Journal's core business remain profitable, even if somewhat less so than recent levels, for a very long time?

If so, then valuation seems very low. When you combine the value of the new cash earnings that will be coming in each year, potential intrinsic value growth over time of the existing portfolio, and who'll be allocating capital the recent market price seems a nice discount to intrinsic value. In fact, the stock wouldn't be expensive at even half recent profitability levels as long as those lower levels were sustainable long-term.
(Oh, and though it now seems unlikely, if there ended up being any sustained growth whatsoever in earnings then the stock would be truly cheap.)

Are much larger declines in profitability more imminent?

If that's the case then the current market price makes more sense. Under this scenario returns may not be great but the downside still appears somewhat limited by the investment portfolio's value as a percent of market cap.
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I think knowing how long the core business will maintain favorable economics is a tough call but, as a result of smart capital allocation, risks have been managed very well (it helps to have a business that requires little capital).

The question is what level of revenues and profits can be considered normalized. A good answer to that question would make the shares quite a bit more attractive.

In recent years, unusually high levels of foreclosures in California and Arizona have temporarily boosted earnings but clearly aren't sustainable. Foreclosure notices decreased by 26% in the most recent quarter compared to the prior year period. The recent trends for their other key sources of revenues are also not particularly great. The company is expecting revenues to decline in 2012 and that would appear likely to continue.

So it's best to assume earnings in recent years were much stronger than they will be going forward (nothing wrong with expecting lower levels and being pleasantly surprised). The investment portfolio performance, effective allocation of future free cash flow, and the sustainability of the traditional business (even if at a lower level of free cash flow) remains the key to value creation at Daily Journal.
(Obviously at some point they could acquire a business with their capital instead of buying marketable securities.  My view is, at least at their current size, why bother when shares of many publicly traded attractive businesses are selling below intrinsic value.)

I still think it is fair to say not much right has to happen at the current valuation.  A sudden sharp decline in earnings and possibly a costly wind down of the business down is a risk. Otherwise, considering the balance sheet strength and who's involved in allocating capital, the margin of safety isn't too bad.

Keep in mind that insiders own a bunch of the stock and shares trade in an extremely illiquid fashion. Anyone interested in the shares had better avoid market orders.

Adam

No position in DJCO

I wouldn't equate the Daily Journal with Blue Chip Stamps but the redeployment of capital from a source with less attractive prospects toward something with more attractive prospects is familiar territory for Charlie Munger. The float from Blue Chip Stamps, a doomed business long ago, was intelligently used to buy See's Candies (among other things), a business that has created lots of value for Berkshire Hathaway over the years. In the case of Daily Journal, instead of float it is free cash flow but still a matter of allocating capital effectively. It would seem that Daily Journal has more favorable business prospects than Blue Chip Stamps but that's a separate question altogether.
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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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