Tuesday, January 29, 2013

Yacktman Funds 4Q 2012 Update

Here's the top 10 holdings of the Yacktman Fund (YACKX), according to Morningstar.com:

Yacktman Fund Top 10 Positions (as of 12/31/12)
News Corp. (NWSA)
Procter & Gamble (PG)
Pepsi (PEP)
Cisco (CSCO)
Sysco (SYY)
Viacom (VIAB)
Microsoft (MSFT)
Coca-Cola (KO)
C. R. Bard (BCR)
Stryker (SYK)

Yacktman Focused Fund (YAFFX) is very similar to the Yacktman Fund, though their are certainly some minor variations. Considering the name, it's not exactly surprisingly that the fund is somewhat more concentrated.

Yacktman Focused Fund Top 10 Positions (as of 12/31/12)
Procter & Gamble
News Corp.
Pepsi, Inc.
C.R. Bard
Clorox Company (CLX)
Johnson & Johnson (JNJ)

In fact, both portfolios are rather concentrated with the top ten making up 51% in the Yacktman Fund and 59% in the Yacktman Focused Fund.

Both funds have very low turnover by almost any standard. If nothing else that means what is owned now is likely to be in the portfolio for quite a while. Consumer stocks -- both "defensive and "cyclical" -- make up more than half of these two portfolios (with a strong tilt toward so-called "defensive"...35-40%).

The performance of these funds can be found here and at Morningstar.com.

Yacktman Fund Update

The biggest recent addition (and an entirely new position) in the fund is Dell (DELL) but is no where near a top 10 position. The stock still makes up less than 1% of the fund based upon available information. Considering where Dell was selling during the fourth quarter, that likely means -- unless the current attempts to take Dell private fail -- it will end up resulting in a nice gain but not a long-term investment.

Increases to the size of positions that were already held by Yacktman include: Stryker, Coca-Cola, and Avon Products (AVP).

Reduced positions include: H&R Block (HRB) and Research in Motion (RIMM)

Positions that were sold entirely: Liberty Ventures (LVNTA)

With Dell being the biggest change, clearly none of these moves had a huge impact on the portfolio.

Here's a new interview with Donald Yacktman in Barron's.

In the interview, Yacktman says their focus is to first protect client money, then make them money, and ultimately beat the S&P 500 over the long haul.

He also explains why Dell was to the portfolio and why they don't see Apple (AAPL) as an attractive investment (basically...the phone biz is too unpredictable). One key difference in their approach compared to many other funds these days seems to come down to time horizon. In the interview, Yacktman points out that volatility does encourage and lead to more short-term trading but...

"...short-term traders tend not to do very well over time. Most people think in terms of 10 minutes, 10 hours, 10 days, 10 weeks,10 months, but not 10 years. Most people just don't have the patience."

The difference in time horizon shows up in their 2-3% portfolio turnover. It's an approach clearly focused on long run risk-adjusted forward returns instead of chasing near-term price action.
(As the Barron's article points out, Yacktman doesn't mind at all being the "tortoise" among the many active "hares" in the market.)

The merits of their style seems unlikely to be obvious up in a bullish environment, even if extended. That's partly what inevitably tempts too many participants to trade. Yet, if their long run results are any indication, Yacktman and his team is doing something right.


Long positions in PG, PEP, CSCO, MSFT, KO, DELL, and AAPL established below recent prices and, in some cases, at much lower prices.
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, January 25, 2013

Buffett: Cigar Butts & Wonderful Businesses

Warren Buffett wrote the following in the 1989 Berkshire Hathaway (BRKashareholder letter:

"If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the 'cigar butt' approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the 'bargain purchase' will make that puff all profit.

Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original 'bargain' price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces - never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost. Time is the friend of the wonderful business, the enemy of the mediocre.

You might think this principle is obvious, but I had to learn it the hard way..."

Buffett provides one example (Hochschild Kohn, a Baltimore department store) of a bargain that turned out not to be one at all, and says he could offer more.

So, with the mediocre businesses, what seems like it's selling at a big discount at the time often proves otherwise. He then later in the letter added this:

"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner. But now, when buying companies or common stocks, we look for first-class businesses accompanied by first-class managements."

Businesses with sustainable advantages that generate high return on capital have the capacity over time to do just fine even if the investor, on occasion, mistakenly pays a price that proves to be somewhat expensive. Margin of safety is always a very important aspect of the investing process -- and an investor can't do very well if they often pay too much -- but errors in judgment about current value inevitably happen.

That wind isn't at your back in a low return business. What seems cheap at first isn't at all.


Long position n BRKb established at much lower prices
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, January 23, 2013

U.S. Railroad Earnings

Norfolk Southern (CSX) and CSX Corporation (CSX) reported earnings yesterday.

Both companies have been hurt lately by weak coal shipments.
(CSX saw volumes reduced by 19% versus the same quarter a year ago while Norfolk Southern had volumes drop by 13% versus the same quarter one year ago.)

The railroad business is, of course, rather cyclical. Railroads, by their nature, are capital-intensive and economically sensitive. Not often a great combination but, in their current form, the pricing power that U.S. railroads now have has made quite a big difference to their core economics.

Still, they'd have to be a whole lot less inherently capital intensive to be properly described as great businesses.

Stepping back a bit both of these railroads have had decent improvements to profitability over the past five years:*

2007 Earnings: $ 1.34 Billion**
2012 Earnings: $ 1.86 Billion
% Increase: 39%

Norfolk Southern
2007 Earnings: $ 1.46 Billion
2012 Earnings: $ 1.75 Billion
% Increase: 20%

Hardly spectacular but solid nonetheless. Year-over-year performance looks less impressive. Roughly flat in the case of CSX and down somewhat for Norfolk Southern.

Here's how the 2007 versus 2012 numbers look on a per share basis:

2007 EPS: $ 1.00
2012 EPS: $ 1.79
% Increase: 79%

Norfolk Southern
2007 EPS: $ 3.68
2012 EPS: $ 5.37
% Increase: 46%

A persistent buyback executed reasonably well (i.e. shares bought back were generally not expensive though when truly cheap during the crisis no buying was done) is behind the difference between earnings and EPS. CSX bought back ~19% of their shares outstanding over the past five years. Norfolk Southern bought back ~18% of their shares outstanding over those same five years.

Both have increased debt levels. Give or take, this level of borrowing seems consistent with and comfortably within their capacity to earn.

In addition, both companies have consistently increased the size of their dividends over the past five years (currently 2.7% for CSX and 3.0% for Norfolk Southern at yesterday's close).

In 2009, not surprisingly considering their cyclical nature, both of these railroad businesses had reduced full year earnings yet remained quite profitable. If nothing else, that time frame was a pretty good test of their resilience.

At that time, their stocks certainly dropped far more in percentage terms than the earnings power did. Back then, they became proper bargains compared to their per share intrinsic value and how that value was likely to increase over time.

What matters to an investor is not a snapshot of current earnings or historic earnings performance, but what it (and other things) reveals about longer run earnings power. Whether and how much per share intrinsic value is likely to continue increasing. That's rarely an easy thing to judge correctly and certainly not for something as economically sensitive as a railroad business.

For long-term investors, a temporary reduction in earnings isn't a problem. Good businesses often get more valuable during an economic downturn even if the near-term stock price action and temporarily reduced earning power seem to contradict that reality. Some prospects for the U.S. railroads might have been temporarily interrupted by the financial crisis but, otherwise, these businesses have done just fine. Here's a subset of a Warren Buffett quote I used in the prior post that seems relevant here:

"The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase - irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings..." - Warren Buffett in the 1992 Berkshire Hathaway (BRKaShareholder Letter

So some volatility in the earnings stream doesn't necessarily reduce value though it can lead to mistakes in the judgment of value. With added volatility, an investor might incorrectly consider a certain level of earnings as being indicative of normalized earnings. The greater the cyclicality, the bigger the possible misjudgment.

As always, I have no opinion or idea what any stock will do in the near-term or even longer but -- for my money -- neither of these stocks are selling at a big enough discount to my (necessarily imprecise) estimate of their intrinsic value to buy.

Shareholders with long run effects in mind (not traders) are better off with a stock staying cheap as long as the business continues increasing per share intrinsic value. That way the buybacks will be more effective and more shares can be accumulated from time to time at a nice discount to value.

Maybe -- and I certainly hope so -- shares of these will become cheap enough to buy again and they'll stay that way for a long time while the businesses continue to solidly increase per share earning power.

For the long-term investor, as explained by Buffett here, a lower stock price combined with increasing (again, even if volatile) earnings performance over time is a good thing.

This may or may not be intuitive but it's worth taking some time to appreciate.

Simple, yes, but the long run significance is not always obvious. It can reduce risk and increase returns.
(I don't expect that many traders -- or anyone who tries to profit from price action in time frames of less than five years -- will find this of any interest at all.)

Investing often involves lots of waiting for the right price, a bunch of time and energy spent figuring out what's an understandable and attractive business, then buying decisively when occasionally (sometimes rarely) cheap.

Often, that happens when economic storm clouds are front and center.
(Either company specific or something on a broader scale like the financial crisis.)

It was not difficult to see that shares of many good businesses in 2008 and 2009 (and later) were selling at huge discounts to value.

Those with enough justified confidence (I say justified since overconfidence will inevitably destroy investor returns) in their judgment of value had less trouble buying what they like then ignoring the rather ugly price action. The wrong kind of temperament, and a variety of cognitive biases, often lead to big mistakes. That includes not buying what (or enough of what) should be bought when very cheap because of real, even quite serious, near-term difficulties. When psychological factors have brought down the prices of marketable securities, but the long run prospects of the businesses themselves remain sound.

In the short run, psychology will be the driver of price action. In the long run, fundamental business economics will win.

Buying in an environment like now might feel less risky but it's not. That doesn't mean stocks won't go up from here. That doesn't mean there are no individual bargains. That also doesn't mean an investor needs to sell something (that's become somewhat expensive or, at least, is difficult to buy) they intend to own long-term that was initially bought with proper margin of safety. It does mean the investor is generally taking more risk these days when buying a shares of an attractive business. What has little risk at one price becomes increasingly risky at higher prices.
(By risk I mean the increasing possibility of permanent capital loss, not temporary paper losses, and certainly not beta.)

The time to do the bulk of the buying what you understand well is when headlines and market psychology are awful. That's when the shares of a business with durable advantages are more likely to be plainly cheap.


2007 - CSX Earnings
2012 - CSX Earnings
2007 - Norfolk Southern Earnings
2012 - Norfolk Southern Earnings

Long position in NSC established at much lower than recent market prices.

* As far as the other large U.S. railroads, Union Pacific (UNP) reports tomorrow and BNSF Railway results are reported with the rest of Berkshire's results.
** There's $ 110 million (roughly 8 cents per share) of earnings in the 2007 numbers from discontinued operations.
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, January 18, 2013

Buffett: Stocks, Bonds, and Coupons

In the 1992 Berkshire Hathaway (BRKashareholder letter, there's a condensed version of how John Burr Williams described the equation for value in his book The Theory of Investment Value back in the 1938.*

Warren Buffett explained it as follows in the letter:

"In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset."

Notably, as Buffett highlights, the formula is the same for stocks and bonds. The key difference being that bonds generally have future cash flows defined by the coupon and maturity date unless there's a default of some kind. In contrast, the equity 'coupons' have to be estimated by the investor.

"...in the case of equities, the investment analyst must himself estimate the future 'coupons.'"

The size and duration of those 'coupons' have a much wider range of possibilities. More from the letter:

"The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase - irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value. Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought.

Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite..."

It's easy to overly complicate the investment process, but it pretty much comes down to consistently paying comfortably less than the appropriately discounted present value of future cash flows. In other words, paying less than a well-judged conservative estimate of intrinsic value.**

If an investor is highly confident in their future cash flows estimate (and the appropriate interest rate to use), then a smaller discount would be necessary.

Still, requiring that an appropriate discount to value exists (margin of safety) is all-important to protect the investor against the unforeseen and unforeseeable.

Buffett's "irrespective of whether the business grows or doesn't" comment is worth noting.
(A subject I've covered quite a lot, if nothing else, on this blog.)

Some take it as a given that growth is of primary importance in investing. Well, for example, if $ 1 of earnings in perpetuity can be bought for $ 3, should the investor care if it grows? That's an extreme example, but sometimes the blind pursuit of growth leads an investor to take more risk than necessary to achieve a similar or worse result.

In fact, listen to enough commentary on investing and it seems growth dominates the conversation. That all growth is good growth is, at least, implied. I mean, how could growth not be a good thing, right? Growth is fine if it's of the high return variety and can be bought at a fair price. Unfortunately, many forms of growth do not produce attractive returns and can even destroy value. From the 2000 Berkshire Hathaway shareholder letter:

"Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years."

Attractive growth prospects usually sell for a premium. Too often -- even if growth happens to be in a potentially high return form -- the premium price paid means that permanent capital loss is more likely to occur if things do not pan out as expected.

Insufficient margin of safety.

Growth will, of course, often have a favorable impact on value. It just happens to be a mistake to think that it always has a favorable impact.

Many very fine investments have modest to no growth at all while having more predictable outcomes. Lacking excitement, they more often sell cheap. Their relative predictability also means that getting the investment analysis consistently right is more doable. In contrast, where there's high growth often invites in competition and naturally less predictable long range outcomes. With lots more competition there's usually less certainty that the economics will remain attractive during the pursuit of that growth.

So whether the investor can roughly but meaningfully estimate the coupons a business will produce over a very long time frame is far more important than growth. Buffett points out that even for very experienced and able investors, it's still easy to get the estimate of future coupons very wrong.

How does Berkshire deal with that reality? One way is that they stick to what they understand. As Buffett explains, it's easier to get the estimate of future cash flows right with businesses that are "simple and stable"  compared to those that are "complex or subject to constant change". It is not about how much an investor knows. It's about an awareness of what they don't know.

Awareness of limitations.

"An investor needs to do very few things right as long as he or she avoids big mistakes."

The other way they deal with the problem is always buying with a margin of safety. To always pay a price that is substantially lower than their own estimated value of future cash flows.

Finally, as Buffett mentions in the quote above, the current price relative to earnings or book value -- whether seemingly very high or low -- often reveals little about business value. Though, it's worth noting, Buffett has said Berkshire's book value is a rough if quite understated way to gauge the company's intrinsic value. Otherwise, sometimes what seems a low price against current earnings or book value won't turn out to be cheap at all. The opposite is, of course, also true. The price has to be considered against the discounted long run stream of cash that will be generated over time. Sometimes those future cash flows are just too difficult to estimate. In those cases, it's best to avoid the investment no matter how compelling the story is or cheap it appears.

Judging value based upon some simple snapshot measurement will often lead to very big and costly mistakes.


Long position in BRKb established at much lower than recent prices

Related posts:
Maximizing Per-Share Value - Oct 2012
Death of Equities Greatly Exaggerated - Aug 2012
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
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

* First written as a Ph.D. thesis at Harvard in 1937.
** The Berkshire Hathaway owner's manual provides a useful explanation of intrinsic value.
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, January 15, 2013

Buffett On A Depressed Stock Market

From the Berkshire Hathaway (BRKa) owner's manual:

"...a depressed stock market is likely to present us with significant advantages. For one thing, it tends to reduce the prices at which entire companies become available for purchase. Second, a depressed market makes it easier for our insurance companies to buy small pieces of wonderful businesses – including additional pieces of businesses we already own – at attractive prices. And third, some of those same wonderful businesses, such as Coca-Cola, are consistent buyers of their own shares, which means that they, and we, gain from the cheaper prices at which they can buy."

Every now and then I re-read the Berkshire owner's manual.

Bet that sounds like fun. Okay, maybe not, but there's much to be learned from it.

Whenever I do re-read it, I come away thinking how helpful it would be if more public companies had their business principles laid out in such a manner.

So it may not sound like all that much fun but it's only six pages long, it's a pretty quick read, and, at least to me, rather useful.
(It certainly requires less time and effort than a typical Berkshire shareholder letter.)

The excerpt is from number 4 of the 15 principles. Toward the end, there's also a good explanation of intrinsic value.

Well worth reading.

The above is not unlike what Warren Buffett wrote in the 1997 Berkshire Hathaway shareholder letter:

"If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices."

The typical initial reaction to a stock dropping in price is obviously a rather visceral one. So it takes some work to unlearn such an instinctive response. This may not be an easy thing to do, but it starts with having justifiably high confidence in one's own ability to judge business values consistently well, and the discipline to require an appropriate margin of safety.

Judge value well, buy cheap.

In other words, it's not possible (nor is it wise) to react favorably to a drop in price if the investor has an inflated appraisal of his/her own ability to judge intrinsic business value and they tend to pay too much.

Like many things it's an awareness of limits. Overconfidence and overestimation can be the real destroyer of long-term returns.


Long position in BRKb established at much lower than recent prices
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, January 11, 2013

Wells Fargo's 2012 Results

Prior to the financial crisis, Wells Fargo's (WFC) book value per share and earnings per share was as follows:*

Book value per share: $ 14.1
Earning per share: $ 2.47

Wells Fargo 2007 Annual Report

Those numbers reflect what was at or near the peak of the company's financial performance before the financial crisis.

So they hardly represented normalized earnings over a full business cycle.

Roughly five years later, those numbers are as follows:

Book value per share: $ 29.5
Earnings per share: $ 3.36

Wells Fargo Full Year and 4th Quarter 2012 Results

Book value per share is up 110% in five years. For many reasons, an imperfect measure of value but, within limits, still a useful proxy.**

Earning per share is up by 36% since the pre-crisis peak. Hardly explosive earnings growth over a five or six year period but, in the context of what has happened to the financial system since 2007, that's a pretty solid business performance from a bank. Of course, what matters more is what Wells Fargo does from here and the valuation.

For continuing long-term shareholders, as long as the business itself continues to perform well (that earnings continue to increase and for a very long time), the lower the normalized earnings multiple remains the better.

Other than a recession or another crisis, it'll be surprising if Wells doesn't continue to improve per share earnings. There's no way to know, of course. The next time the bank's earnings get temporarily reduced due to an economic downturn it's likely to become more valuable as a result. Much as it did in the most recent crisis.

Earnings is often temporarily and depending on the business, even substantially, reduced during a period of reduced economic activity. Stock prices, of course, usually follow. Yet, the fact is a good business often improves during an economic downturn. The strong become stronger. Intrinsic value is actually increased. So, in some cases, price will be moving precisely in the opposite direction of business value even though it doesn't seem so based upon the near-term earnings decline.

If Wells Fargo's share price were to remain near 10x normalized earnings (not peak nor crisis level earnings) or, better yet even less, any buybacks that occur should improve underlying returns nicely for continuing long-term shareholders.

Wells has had a pretty good five years or so but, like many banks, it raised capital during the financial crisis.

Unlike many banks, Wells was able to increase its per share intrinsic value despite the capital that was raised and resulting dilution. Some other banks will not equal pre-crisis per share earnings levels for a very long time, if ever.

Those capital raises certainly had an adverse impact on shareholders to the extent that the market price of common shares were sold below per share intrinsic value. Yet, the cost was modest compared to the increase in Wells Fargo's intrinsic value (and especially modest compared to what happened to some other large financial institutions). In my view, shares of Wells Fargo were sold below the bank's per share intrinsic value, but not so much so that it did huge economic damage to long-term owners. It's the shareholders of those banks that were forced to sell lots of shares (relative to existing share count) and at a very low price  that were hurt badly. Some of those same banks were also forced to sell off valuable businesses.

Sometimes a stock will drop in price because the mood has changed yet per share business value has not (or at least has not nearly as much as the price would indicate). It's psychological factors that determine near-term price action not necessarily changes to real business value.***

Sometimes a stock goes down because real business value per share has been destroyed.

When the former happens, it's a good thing as long as capital does not have to be raised while the shares are selling below intrinsic business value. That's what happened to many banks and, for many of them, it was probably more than well-deserved.

When the latter happens, the result is permanent capital loss or, at least, severe underperformance as business value "catches up" to the price paid over time.

It's not difficult to understand why those with a shorter time horizon react negatively to a drop in price. Otherwise, the reduced share price of a sound business due to primarily to near-term psychological factors is a very good thing for long-term owners.

Why Buffett Wants IBM's Shares "To Languish"

At least it is for a well-financed business with durable competitive advantages. The business with an earnings stream that's persistent (even if somewhat cyclical)  and, better yet, nicely increasing over time. The mistake of letting price action influence one's view of the underlying business is an easy one to make. Learning to ignore the daily quotes does take more than a little discipline.

It's correctly judging the underlying business prospects and whether the price paid provided a sufficient margin of safety that generally matters in the long run.


Long position in WFC established at much lower than recent market prices

* The peak book value per share number is from 2007. The bank's peak earnings of $ 2.47/share is a 2006 number.  In 2007, the bank earned $ 2.38/share. That drop was likely a small but early indication of the financial crisis yet to unfold.
** Some might prefer using tangible book value per share. On that measure, the increase in tangible book value per share has been an even greater percent over the past five years.
*** Usually grounded by real fundamental issues, but the price movements often end up being far greater, both on the upside and downside, than is warranted. Intrinsic business value just doesn't usually change all that quickly.
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, January 8, 2013

On Hedge Funds

From this The Economist article:

WHEN it comes to brainboxes, the name "Nobel" has a certain ring. But news that the Nobel Foundation plans to increase its investment in hedge funds, because years of low returns forced it to cut cash prizes in 2012, is one to leave laureates scratching their eggheads. The past year has been another mediocre one for hedge funds. The HFRX, a widely used measure of industry returns, is up by just 3%, compared with an 18% rise in the S&P 500 share index. Although it might be possible to shrug off one year's underperformance, the hedgies' problems run much deeper.

The S&P 500 has now outperformed its hedge-fund rival for ten straight years, with the exception of 2008 when both fell sharply.

The article points out a simple portfolio of 60% stocks, 40% bonds would have returned 90% this past decade. Hedge funds produced more like 17% over the same time frame.
(See chart in the article.)

The article also points out there are star performers every year but, sometimes, whoever it happens to be in any particular year doesn't necessarily repeat the performance.

...a third have lost money, including some of the stars of yesteryear: John Paulson, celebrated as an investment wizard in 2007 for having foreseen America's housing bubble, reportedly saw his flagship fund lose 17% in the first ten months of 2012, after a 51% fall in 2011.

Interestingly, John Paulson topped the list of best paid hedge fund managers in 2010 with $ 4.9 billion in pay, after being 4th on the list of highest paid managers in 2009 with $ 2.3 billion, and 2nd on the list in 2008 with $ 2.0 billion.

Not surprisingly, Paulson wasn't on the list in 2011 considering what happened to fund performance that year.
(The 2012 list will probably be out within a few months.)

Here's who was on the 2011 list.

The Rich List

Top 5 of 2011
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

Highest Paid of 2011
Highest Paid of 2010
Highest Paid of 2009

Typically, hedge fund compensation comes from the 2 and 20 fees (2% of assets and 20% of profits above a certain level or some variation of that arrangement), but also comes from increases to the value of whatever stake a manager might have in their fund(s).

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.

To keep this simple but meaningful, let's consider a hedge fund with $ 20 billion in assets under management (excluding what the fund manager has kept invested in the fund). Many of the larger hedge funds have more than that much under management -- some much more -- so it's a reasonable scenario.

Now, in a year where a hedge fund generates, let's say, a 10% return -- what is, of course, a $ 2 billion increase -- that means the frictional costs for investors in would roughly be:

2% of $ 21 billion plus = $ 420 million
(The fund would have increased from $ 20 to $ 22 billion so I've used the midpoint.)


20% of the $ 2 billion profit = $ 400 million

= $ 820 million

These rather huge frictional costs couldn't contrast more greatly with the model that exists within the Berkshire.

The above fund managers may all be excellent at what they do, but these rather huge frictional costs are quite a contrast to the $ 100,000 per year that Warren Buffett is paid (plus/minus whatever change to the substantial amount of stock he owns) and has been paid for decades. Some, at the very least, of the prevailing compensation systems in the industry seem, by comparison, more than just a bit heads I win, tails I win even more.

It's not difficult to see -- looking at the assets under management multiplied by a typical hedge fund fee arrangement -- that a large proportion of the earnings by many hedge fund managers comes from the fees themselves.

Of course, Buffett has done just fine, but his wealth has come primarily from the increase in value to the shares of Berkshire Hathaway's (BRKa) stock.

That is stock he bought decades ago with his own money. So it is Buffett's own investment in Berkshire's stock long ago that, for the most part, made him wealthy. The wealth did not come from his Berkshire compensation package.*

As a result, the frictional costs to shareholders of Berkshire has, in fact, been minimal.

If Buffett hadn't been allocating capital well all those years, he couldn't have become rich. He also couldn't have done well without other Berkshire shareholders also being rewarded.

The capital he put at risk inside Berkshire long ago is the primary basis of his substantial wealth. Crucially, his wealth is not from compensation that could have subtracted meaningfully from Berkshire's intrinsic value over time. If it had been in the form of substantial, the reduction in returns for continuing long-term Berkshire shareholders would have been substantial.

Buffett's compensation has remained modest by just about any standard over these past decades. Naturally, I think it's fair to say that expecting others to take that kind of pay cut is, other than in exceptional cases, just not very realistic. I also realize Berkshire is not a hedge fund. Still, those that are very good at capital allocation -- even if not willing to accept a paycheck reduced to the size of Buffett's -- shouldn't really mind if the prevailing compensation systems moved at least directionally toward the Berkshire model. In other words, more wealth from appreciation of their own capital (and there are certainly managers with a bunch of capital in their funds) side by side w/investors, less from fees/other forms of compensation that subtract from total return (and the capital base). Those who are very capable investors would, in the long run, still be able to do very well for themselves indeed.

Of course, the less able capital allocators might not like it a whole lot.

So Berkshire may not be a hedge fund, but the company has been built around the effective allocation of capital. Their approach has worked well over time, has proved to be adaptable, and continued working well once it had some scale (though there are certain things it cannot do due to sheer size). While the company's unique strengths can't easily be replicated by others, it's tough to see why the world wouldn't be better off if the best qualities of Berkshire (including the extremely low frictional costs) wasn't the prevailing model used by others in the business of capital allocation. Berkshire would now be a shadow of itself if Buffett had been compensated like a hedge fund manager all these years.

The Economist article points out the industry can rightly claim that certain hedge funds have performed extraordinarily well longer term. The problem for an investor is figuring out who that's going to be in the future among the 8,000 or so hedge funds that exist. Also, for even those that do well, the frictional costs are plainly still very much there.

No matter what, the Berkshire way seems by far closer to the model we'd want most allocators of capital to be emulating. Very low frictional costs combined with a greater focus on long-term effects. Above average results with less risk (that's risk of permanent capital loss...not beta).

Now this obviously isn't about to happen anytime soon. The current accepted norms and ways of doing business are far too lucrative for that to happen.

Still, some wise changes along these lines wouldn't seem to be a bad thing at all.

"If we [the investment industry] raise our fees from 0.5 percent to 1 percent, we actually raid the balance sheet. We take 0.5 per cent from what would have been savings and investment and turn it into income and GDP. In other words, you're taking money that would have become capital and chewing it up as bankers' bonuses." - Jeremy Grantham

Jeremy Grantham: 'We Add Nothing But Costs'

Well, many hedge funds are charging a whole lot more than .5 or 1 percent.

It's worth considering the compounded effect of these frictional costs on overall long run wealth creation (even if individual fund performance is exceptional) for investors as a whole. The world's not better for it. Nor is it better off with so much talent being absorbed into various aspects of money management. Talent that could potentially be rather useful elsewhere. Yet, with it being so lucrative, it's not really hard to understand why someone would make such a career move. It's the system that exists. Tough to blame the participants. They're just going where the money is.

So I doubt it changes anytime soon. That doesn't mean there aren't real long-term consequences.

"When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done." - John Maynard Keynes

Keynes The Money Manager

We're capable of creating a system of capital formation and development that better serves investors and society as a whole.


Related posts:
Highest Paid Hedge Fund Managers
Bogle: "Tyranny of Compounding Costs" - Part II
Bogle: "Tyranny of Compounding Costs"
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Munger, and the 90% Tax
Heads I Win, Tails I Win...

* In other words, compensation that would reduce Berkshire's per share intrinsic value. Beyond the salary, Buffett does have personal and home security paid for by Berkshire. Otherwise, no bonus, stock options, stock grants, and certainly not the kind of management fees charged by hedge funds. (The portfolio he manages -- not to mention the operating company -- is substantial in size compared to almost any fund.) An apples-to-apples comparison to hedge fund frictional costs would also include all the operating costs of Berkshire's corporate office (though much of those costs are presumably related to the operating businesses Berkshire owns outright) and related (including the costs associated with the two investment managers). Consider how small these costs are in the context of Berkshire's assets overall. The difference in frictional costs is still measured in orders of magnitude compared to a typical hedge fund. So let's not split hairs. This difference, I think, speaks for itself. Precision not required. Berkshire is built to minimize frictional costs for investors like few other investment vehicles. Now, during Buffett's partnership era, he was paid fees that compensated him well on the upside though also gave him exposure to losses on the downside. In fact, he could lose more money than he invested into the partnership by covering a quarter of all losses from his partners. From Alice Schroeder's book, The Snowball"I got half the upside above a four percent threshold, and I took a quarter of the downside myself. So if I broke even, I lost money. And my obligation to pay back losses was not limited to my capital. It was unlimited." (pp. 201-202)
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, January 4, 2013

Berkshire Hathaway vs S&P 500

These two articles point out that Berkshire Hathaway (BRKa) outperformed the S&P 500 this past year.

That's an awfully short time frame to judge performance. Let's look at the increases to per share book value and Class A shares of Berkshire's stock over a longer -- and likely more meaningful -- time frame. We don't know year-end 2012 book value just yet, so I'll use the last reported number of $ 111,718 per share.

3rd quarter 2012 earnings

At the end of 1999, book value was more like $ 37,987 per share.

1999 Berkshire Letter

So that makes the annualized increase since 1999 to Berkshire's book value per share roughly 8.7%.

Over that same time frame, the S&P 500 (incl. dividends) increased by roughly 1.6% per year.

The end of 1999 was not long after Warren Buffett was asked to give a speech to business leaders in Sun Valley, Idaho. In that speech, he explained why the stock market was not likely to perform anything like it had over the past 17 years*. In fact, he thought stock returns over the next 17 years were likely to be rather unimpressive.

This contrasts in a big way with how favorably he has been toward stocks in more recent years.

Warren Buffett: Why stocks beat gold and bonds

Now, book value is an imperfect measure but, as Buffett has pointed out, it is a pretty good proxy for Berkshire's intrinsic value.

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

The stock itself went from $ 56,100  to $ 134,060 per Class A share, or roughly 6.9% per year since 1999. So the stock has performed somewhat worse than the growth in book value. That's a reflection of the fact that the stock was selling for roughly 1.5x book at the end of 1999, while it was selling at more like 1.2x book at the end of 2012.

Now, that was before the bubble had burst. Let's look at the returns of S&P 500 compared to Berkshire from ten years ago -- after the bubble had burst. Again, since we don't know year-end book value for Berkshire, I'll use the last reported number of $ 111,718 per share. At the end of 2002, Berkshire's book value was $ 41,727 per share.

2002 Berkshire Letter

So that makes the annualized growth in Berkshire's book value per share roughly 10.3%.

Over that same time frame, the S&P 500 (incl. dividends) increased by about 7.0% per year.

The stock itself went from $ 72,750 to $ 134,060 or roughly 6.3% per year over the past ten years.

So, while increases to Berkshire's book value outpaced the market, the stock slightly underperformed. That, once again, is simply a reflection of the stock selling for over 1.7x book at the end of 2002 while selling at more like 1.2x book at the end of 2012. It's also a reflection of the fact that the S&P 500, even if not at all cheap at the end of 2002, had become at least more reasonably valued.

Per share book value is far from a perfect measure (of course, there's no such thing as a perfect measure of value), but I'll take it as a proxy for changes to Berkshire's intrinsic value over the market price any day.

So, whether buying a quality enterprise like Berkshire or an index that's a good representation of the market as a whole, the initial price paid will always matter.

The 1999 Sun Valley speech by Buffett that I mentioned above was covered in Chapter 2 of 'The Snowball'.

It was also covered in this 1999 Fortune article:

"Let me summarize what I've been saying about the stock market: I think it's very hard to come up with a persuasive case that equities will over the next 17 years perform anything like--anything like--they've performed in the past 17. If I had to pick the most probable return, from appreciation and dividends combined, that investors in aggregate--repeat, aggregate--would earn in a world of constant interest rates, 2% inflation, and those ever hurtful frictional costs, it would be 6%. If you strip out the inflation component from this nominal return (which you would need to do however inflation fluctuates), that's 4% in real terms."

In the speech, Buffett points out that investors were, back then, paying roughly $ 10 trillion for just $ 334 billion of profits.**

Not cheap.

A PaineWebber-Gallup poll done at that time revealed investors were expecting stocks to return something like 13-22% going forward.

I've always been somewhat amazed that so many discounted what Buffett was saying back in 1999. I've been similarly perplexed by the skepticism toward his more recent favorable views on stocks.

I mean, it's not like Buffett's giving medical advice. If there's one thing the man knows a thing or two about it is investing.

By the way, it's not that Buffett is usually correct on timing. He certainly isn't. What's cheap can, and often does, get cheaper. What's pricey does usually get even more so. Investors who buy with value in mind often buy "too early" and sell "too early". Learning to effectively judge how price compares to value -- identifying what's being mispriced -- isn't easy but doable with some work. Getting the timing consistently right is not.

Nor is it necessary.

"Picking bottoms is not our game. Pricing is our game. And that's not so difficult. Picking bottoms is, I think, impossible." - Warren Buffett back in 2009 at the Shareholder Meeting

So an investor can achieve good results if price versus value is frequently judged well (even if timing is not).

Well, at least if the investor has justifiable high levels of conviction in order to hang in there when the inevitable paper losses occur. Easier said than done. High levels of unwarranted conviction due to less than sound judgment of price versus value isn't a lucrative combination.
(Overconfidence in, and overestimation of, what the investor understands too often subtract from overall results.)

Hopefully, investors won't end up getting more comfortable with equities as they become increasingly expensive though, historically and rather unfortunately, that's what usually happens.
(It's obviously much harder to buy shares with sufficient margin of safety right now relative to not too long ago. That doesn't mean there is not some cheap individual marketable securities.)

Too often, market participants buy just when stuff starts becoming somewhat or even very expensive compared to intrinsic worth. 

Unfortunately, many will also sell (or not buy) when the headlines are awful and the chance to own part of a business is the most attractive and the lowest risk.


Long position in BRKb established at much lower than recent market prices

* The market had gone up more than 10-fold (excl. dividends...so total return was actually higher) in the prior 17 years or so (1982-1999). Stocks were extraordinarily expensive by any measure. It wasn't just tech stocks (though many of them were extremely overvalued, of course).
** Combined profits at the time for the Fortune 500 was $ 334 billion while the market value of those stocks collectively was $ 9.9 trillion.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

Wednesday, January 2, 2013

On Speculation and Investment

In The Intelligent Investor, Benjamin Graham had this to say about the difference between an investor and a speculator:

"The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements. The speculator's primary interest lies in anticipating and profiting from market fluctuations. The investor's primary interest lies in acquiring and holding suitable securities at suitable prices." - Benjamin Graham in The Intelligent Investor

Speculation is an emphasis on price action instead of what an asset can produce over time.

As John Bogle points out in this Wall Street Journal article, John Maynard Keynes held a similar view:

...Mr. Bogle cites another legendary figure, British economist John Maynard Keynes, who drew a similar distinction between investment, or "forecasting the prospective yield of [an] asset over its whole life," and speculation, or "forecasting the psychology of the markets."

Investment places an emphasis on what an asset itself can produce over time.

From this interview with Warren Buffett:

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

So, in contrast, speculation places an emphasis on near-term price action and how to profit from it. He added this in a separate interview on CNBC:

"So there's two types of assets to buy. One is where the asset itself delivers a return to you, such as, you know, rental properties, stocks, a farm. And then there's assets that you buy where you hope somebody else pays you more later on, but the asset itself doesn't produce anything. And those are two different games. I regard the second game as speculation." - Warren Buffett

By almost any measure, speculation in marketable securities and their derivatives is more popular than ever these days. Well, the problem is that achieving above average risk-adjusted returns is not a popularity contest. It's about making consistently sound judgments over time. Later in the same CNBC interview:

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

If they closed the stock market for 10 years and we owned Coca-Cola and Wells Fargo and some other businesses, it wouldn't bother me because I'm looking at what the business produces. If I buy a McDonald's stand, I don't get a quote on it every day. I look at how my business is every day. So those are the kind of assets I like to own, something that actually is going to deliver, and hopefully deliver to meet my expectations over time. A piece of art, you know, may go from $1,000 to $50 million, but it's dependent on what the next guy wants to pay me. The art itself— the painting itself is not going to dispense cash. So I have to find somebody that's going to like it more." - Warren Buffett

The Wall Street Journal article also points out that John Maynard Keynes, during his time, was concerned about speculation and its influence on the markets.

Interestingly, in his thesis as a student at Princeton back in the early 1950s, John Bogle expressed optimism about speculation losing out to investment over time. He now admits that was the wrong view and that the Keynes view was right. According to the Wall Street Journal article, Bogle predicted the following in his thesis a little over 60 years ago:

Mr. Bogle predicted a "steady, sophisticated, enlightened, and analytic" demand for securities from the growing investment-management industry—a demand based essentially on the intrinsic performance of a corporation instead of the public's opinion of the value of a share. 

 "I was wrong and he [Keynes] was right," says Mr. Bogle flatly. The "enlightened" demand for securities that he'd predicted is now in short supply, he says, while speculative demand has soared.

To me, the evidence more than just suggests market participants have an easy choice to make if they want, all risks considered, improved results. Even though speculation (the emphasis on price movements) now dominates over investment (the emphasis on returns generated via the productive capacity of the asset), an investor can choose the latter and let others incur the heavy costs.
(It matters not at all whether the asset is owned 100% or partially via marketable stocks.)

With speculation, the frictional costs (commissions, fees, taxes etc.) and the mistakes that get made* are real, but the good news is that a true investor doesn't have to foot the bill.

Gambling, even if frictional costs are ignored**, is inherently a zero-sum game. Similarly, speculative trading adds nothing in aggregate and, once all costs are taken into account, actually subtracts from returns. In contrast, investment need not be a zero-sum game (if, for example, a business with durable advantages is owned long-term and the investor generally doesn't overpay) since the intrinsic value of a productive asset can increase over time. The size of the pie is not fixed.

Ultimately, the returns for market participants as a whole is dictated by what the underlying assets produce over the long haul minus all the frictional costs.

A sound investment will increase intrinsically in value because of what the asset produces over time.

Of course, that means if an investors picks a subpar asset, the pie could also easily be shrinking.

Consider this. A market participant (with a long position) that reacts positively about prices going up in the near-term likely has a more speculative approach. A market participant (again, with a long position) that reacts positively to an asset they've already bought cheap (w/value judged correctly) getting even cheaper is clearly more investment-oriented.***

Of course, both investors and speculators eventually expect prices to be higher, but the reasons why (psychological factors versus growth in intrinsic value derived from the income produced) and the time frames couldn't be more different.

Now, there is nothing inherently wrong with speculation, of course.

In fact, speculation has its place but the proportion in markets matters. Just because a little bit of something might be a good thing doesn't make more of it even better. If the capital markets become just a giant casino they're unlikely to be operating optimally. The $ 33 trillion of annual trading compared to just $ 250 billion of actual capital raising (less than 1%) that's been noted by John Bogle seems far from optimal.

Still, my emphasis here is on what makes sense for the individual market participant, not the system-wide implications. I think it is more than fair to say that those with a long-term horizon are usually being unwise choosing the more speculative route.


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

* Buying, for example, during euphoric market environments while selling during unpleasant, sometimes quite scary, market environments. In other words, doing the opposite of what usually works well in the long run. It's quite clear that many participants make repeatedly this mistake even if they underestimate the fact that they're susceptible to it. Things like overestimating capabilities, overconfidence, and loss aversion (among others) are destroyers of long-term returns.
** Of course, frictional costs are, in many instances, far from immaterial.
*** Since more shares can be bought cheap by the investor and the company's free cash flow can be used to buy shares below intrinsic value to the benefit of continuing shareholders. Buffett provides a useful explanation of this using IBM as an example. Also, here's a prior post on the same subject:

Why Buffett Wants IBM's Shares "To Languish"

So a long-term investor shouldn't generally want shares of a sound business to go up in the near-term. It's better if it stays low. What's an exception to this? Here's one scenario to consider. Unfortunately, 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 owners are okay with the gain that will have occurred compared to the recent price action, the deal may be approved. If too few have conviction about longer run prospects, the deal may get approved. When too many 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.
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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