Friday, June 28, 2013

Ignore the Noise: John Bogle on Market Fluctuations

John Bogle offered the following during this recent interview with Morningstar's Christine Benz:

"Well, we have to get investors everywhere, and not just retirement plan investors, [onto] the idea that these daily leaps and plummets in the stock market are meaningless. As I've said in more occasions than I care to count, Christine, the stock market is a giant distraction to the business of investing. Because investing is owning corporations that provide goods and services, hopefully more and more efficiently to lower prices, and that's capitalism at work. … They make earnings, they reinvest, pay dividends, reinvest the rest to build the business, that's classic capitalism. That's what I call investment return, dividends and earnings growth..." 

He later added this on the importance of ignoring short-term market price action:

"So, we've got to get people away from looking at the market, and one of my investment rules, as you well know, is don't peak. Don't look at your retirement plan accumulations. If you don't do it for 50 years, you will be thunderstruck with the amount you have when you open that final statement. You won't even believe it. It will be sensational. By looking, all it does is distract you and get you to take action where none should normally be taken."

Underlying fundamentals don't change nearly as much as the daily fluctuations might seems to indicate: 

"And stocks go up and down every day, not based on a change in the fundamentals, because the fundamentals don't change every day for heaven's sake. 

So, we're our own worst enemies. So we want to get a little better investor behavior..."

At a minimum, learn to ignore near-term market fluctuations. Better yet, allow its tendency to misprice assets to serve.

"Mr. Market is there to serve you, not to guide you." - Warren Buffett in the 1987 Berkshire Hathaway (BRKa) Shareholder Letter

In many fields success depends on lots of action. Investment is quite different from that. There's a bunch of hard work involved but it has nothing to do with trading market action; it has to do with understanding what something is worth now and judging how much it is likely to change -- within a range -- over longer time frames. That's hard enough to do well. It's decisively buying what you understand well and being disciplined about allowing for sufficient margin of safety. It's knowing what you don't know. It's about owning sound assets, bought at fair or better prices, while minimizing frictional costs and mistakes.

For most, the index fund bought (not traded) for the long haul consistently over time is a very convenient way to accomplish this. Whether indexation, the purchase of individual marketable stocks, or some combination makes sense as an investment approach is necessarily unique to each investor. Still, no matter what the circumstances, it makes sense to reduce frictional costs and limit trading activity.

Remember that each portfolio move is not only a chance to enhance returns, it's an opportunity to incur additional frictional costs and make additional mistakes.

Respect the illusion of control.

Some underestimate this a great deal and that can be costly.

Of course, none of this applies to someone with a short time horizon but, otherwise, developing the habit and temperament to at least ignore market fluctuations and, if anything, allow market action to serve is a generally good one.

The more confident one is the quality of what they own and what it is worth, the more they should embrace a drop in price. If something was bought at a discount to intrinsic value in the first place why be bothered if the discount temporarily gets even bigger?*

A good test as to whether one is involved in speculation or investment is in their reaction to a drop in price.

Lots of productive assets -- things like private businesses, farms, real estate -- are fine investments but have no quoted market value. The owners of these businesses don't constantly check to see for how much they could sell their ownership position to someone else. Well, it's best treat common stocks -- or the index fund that is holding common stocks -- in a similar fashion.
(The fact that part ownership of a fine business that's reasonably -- or even better than reasonably -- priced can be established very easily and at low transaction costs should be an advantage. It makes no sense to turn it into a disadvantage by constantly trying to buy and sell. Just consider how much more the transaction costs are for the purchase of productive assets other than stocks.)

So, as long as per share intrinsic value gets judged reasonably well, and especially if a discount to that value was paid, a long-term investor should logically like the idea of a drop in price.**

That's the case even if the drop occurs post initial purchase. At the very least, the long-term investor should be neutral toward price drops.

A speculator, understandably, likely will not feel the same way.

Speculation may provide more excitement, at least in the eyes of some, but the evidence more than suggests -- between the mistakes made and the unnecessary frictional costs -- most won't do well who attempt to play that game.

Investment has as its emphasis what an asset can produce over a very long time frame. Speculation has as its emphasis market price action and how to profit from it. Naturally, there's nothing wrong with speculation but it is much less similar to investment than some seem to think.
(No doubt their are individuals who are capable speculators, of course.)

Finally, no matter what investment vehicle(s) makes sense for an individual (again, that's necessarily unique to each person and the circumstances) it's foolish to not allow the magic of compounding to work.

As John Bogle said in this Frontline report earlier this year:

"What happens in the fund business is the magic of compound returns is overwhelmed by the tyranny of compounding cost. It's a mathematical fact. There's no getting around it. The fact that we don't look at it, too bad for us." - John Bogle

It also makes no sense to be held back by "the tyranny of compounding cost".

Otherwise, investing well means mostly just getting out of the way while consistently making wise purchases along the way.

Ignore the noise.

Adam

* The investor can buy more at a bigger discount as can the company itself via buybacks.
** If business value was misjudged then a price drop is a real problem. The emphasis should be on intrinsic business values not market price action. Business prospects change and sometimes it's for the worse. The price paid relative to value matters, of course, but durable high quality business economics are what matters even if some choose to instead focus on exciting growth prospects. 
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

Wednesday, June 26, 2013

Buffett and Munger on See's Candies, Part II

A follow up to this post. Roughly two years ago, Charlie Munger said the following about what he and Warren Buffett learned from buying See's Candies:*

"When we bought See's Candies, we didn't know the power of a good brand. Over time we just discovered that we could raise prices 10% a year and no one cared. Learning that changed Berkshire. It was really important.

You have to be a lifelong learner to appreciate this stuff. We think of it as a moral duty."

Buffett said something very similar in this more recent article:

"We have made a lot more money out of See's than shows from the earnings of See's, just by the fact that it's educated me, and I'm sure it's educated Charlie too."

As always, the price paid relative to value -- paying a plain discount to conservative per share intrinsic value -- matters a whole lot when it comes to reducing risk while increasing potential reward for the long-term investor.**  Otherwise, attractive risk-adjusted returns come from owning a business (or part of a business via marketable common stocks) with characteristics that lead to attractive and durable return on capital.

Well, it's having sustainable pricing power (and a commodity that's in high demand/in short supply doesn't qualify) that is often a key driver of return on capital. Possession of a great brand -- what Buffett calls "share of mind" -- can provide an ongoing source of sustainable pricing power.
(Even if, as in the case of See's, it happens to be primarily regional brand strength developed over many years.)

In the prior post I noted the following:

...if a business can raise price a certain percentage each year and it mostly sticks (i.e. there's no real hit to volume), the increase all falls to the bottom line after taxation. If that same business instead had a similar percentage increase in revenue via greater unit volume, there inevitably has to be an incremental cost -- sometimes significant -- associated with each additional unit. The result being -- at least when there's real pricing power -- not as much of an equivalent increase in revenue actually falls to the bottom line.***

A price increase requires no additional capital and has no incremental cost. What matters is whether price can be increased in a way that doesn't significantly impact volume. Here's what Warren Buffett said at the 2005 Berkshire Hathaway (BRKashareholder meeting:

"We like buying businesses with some untapped pricing power. When we bought See's for $25 million, I asked myself, 'If we raised prices by 10 cents per pound, would sales fall off a cliff?' The answer was obviously no. You can determine the strength of a business over time by the amount of agony they go through in raising prices." 

In contrast, what it takes to support the added unit volume certainly creates additional operating costs and might even require more capital to be employed.

Either way, that means reduced return on capital for similar incremental growth.

Growth, in itself, can be an overrated. Well, at least it can be when it comes to generating attractive risk adjusted shareholder returns. At a minimum, there's a great tendency to overpay for it.

During this interview with the Financial Crisis Inquiry Commission (FCIC), Warren Buffett had the following to say about the importance of pricing power when evaluating a business:

"...the single most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you've got a terrible business."

It also helps if the business requires little in the way of capital to maintain or even strengthen its advantages.

See's may, in the very long run, attempt to expand beyond its mostly regional footprint (in fact, there's for the first time some at least limited indication they may) but that will make sense only if they can develop the "share of mind" where they move to next.

Some might wonder why they didn't expand sooner. That takes patience, time, and it's not inevitable that it will work. Enduring some pain in the near-term or longer, the willingness to forgo returns early on to gain a foothold -- what Tom Russo calls the "capacity to suffer" -- can make a lot of sense. Many of the great global consumer franchises do just that but it depends on the specific circumstances. When it comes to the "capacity to suffer", Russo also emphasizes the importance of first mover advantage. Well, one of the reasons See's may not want to move into a new region is the existence of already entrenched brands. The lack of first mover advantage could mean the returns on the incremental capital invested turn out to be unattractive.

The good news is that there's often nothing wrong with striving for more modest growth prospects while using the excess capital wisely elsewhere. That's essentially what Berkshire has been doing with See's for more than 40 years. It depends not just on first mover advantage but also on the competitive landscape more generally (and many other factors, of course).

Those that push for growth -- too often blindly in the context of the capital requirements -- sometimes underestimate this. Exciting growth prospects need to be fully understood in the context of the incremental capital investment. Will it actually be of the high return variety? Could that capital be put to use elsewhere at higher returns and less risk?

High return growth is not a given. Some treat all forms of growth as a good thing or, at least, assume the growth will be high return in nature.

From the 1992 Berkshire Hathaway shareholder letter:

"Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive."

Remember, for example, that airlines grew for a long time at impressive rates. Saying the returns from all that capital investment have been poor for those who held common stock in airlines is more than an understatement.
(I'm writing strictly from a common shareholder perspective. Airlines and air travel clearly have been quite important and valuable to civilization in other ways.)

More from the 1992 Berkshire letter:

"...business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.

Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value."

Sometimes growth is pursued where lots of capital must be deployed -- with diminishing and even negative returns -- to continue fueling that growth.

In the short run (and sometimes even much longer), exciting growth can provide for equally exciting stock price action. That's fine, I suppose, if one likes to speculate on such things.

In the long run, investors will have quite a difficult time benefiting from behavior that amounts to growth for its own sake or growth for growth's sake.

Well, at least they will have difficulty benefiting on an intrinsic basis.

Some might decide to treat the See's example as nothing more than a merely interesting curiosity and consider its implications no further.

I happen to think that's a mistake.

To me, it's an essential business and investing lesson.

Adam

Long position in BRKb established at much lower than recent prices

Related posts:
Buffett and Munger on See's Candies - Jun 2013
Aesop's Investment Axiom - Feb 2013
Grantham: Investing in a Low-Growth World - Feb 2013
Buffett: Stocks, Bonds, and Coupons - Jan 2013
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
Buffett: What See's Taught Us - May 2011
Buffett on Coca-Cola, See's & Railroads - May 2011
Buffett on Pricing Power - Feb 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
Pricing Power - Jul 2009
The Growth Myth - Jun 2009
Buffett on Economic Goodwill - Apr 2009

* A
ccording to The Motley Fool these notes are "in Munger's own words, lightly edited and condensed for clarity."
** Note that the correlation between risk and reward need not be positively correlated.
*** Even if a modest drop in volume were to occur, the increased price may still make sense as far as total return goes. It all comes down to how much pricing power actually exists. What some might describe as being price inelastic.
---
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, June 21, 2013

Risk and Reward Revisited

From the Implications and Conclusion section of this paper, co-written by Nardin Baker and Robert A. Haugen:

"As a result of the mounting body of straightforward evidence produced by us and many serious practitioners, the basic pillar of finance, that greater risk can be expected to produce a greater reward, has fallen. It is now clear to a greater and greater number of researchers and practitioners that inside all of the stock (and even some bond) markets of the world the reward for bearing risk is negative."

Paper: Low Risk Stocks Outperform within All Observable Markets of the World

Well, according to the paper, if the "basic pillar of finance" is not necessarily valid then:

"...its invalidation carries critical implications for the theories underlying investment and corporate finance. In our view, existing textbooks on both subjects are dramatically wrong and need to be rewritten."

Buffett explained this negative correlation between risk and reward very well nearly 30 years ago in The Superinvestors of Graham-and-Doddsville.

I highlighted it in this recent post.

Buffett on Risk and Reward

"I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, 'I have here a six-shooter and I have slipped one cartridge into it. Why don't you just spin it and pull it once? If you survive, I will give you $1 million.' I would decline -- perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice -- now that would be a positive correlation between risk and reward! 

The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it's riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is." - Warren Buffett in The Superinvestors of Graham-and-Doddsville

Sometimes risk and reward is positively correlated. Sometimes it is not.

Some act as if they must always be correlated in a positive manner.

Note that, for example, the capital asset pricing model (CAPM) doesn't leave any room for the possibility that risk and reward can be correlated in a negative manner.*

Ra = Rf + β(Rm-Rf)

Ra = Expected Return
Rf = Risk Free Rate
β = Beta of the Security
Rm = Expected Market Return

I think it is fair to say that just because an equation happens to have a greek letter, is elegant in appearance, and is widely taught, it doesn't automatically qualify as some great leap of insight.

"...Berkshire's whole record has been achieved without paying one ounce of attention to the efficient market theory in its hard form. And not one ounce of attention to the descendants of that idea, which came out of academic economics and went into corporate finance and morphed into such obscenities as the capital asset pricing model, which we also paid no attention to." - Charlie Munger at UC Santa Barbara back in 2003

Efficient markets and the "descendants" is not just somewhat flawed thinking. It is, to me, worse than useless. Charlie Munger said the following later in the same speech talking about what he calls physics envy:**

"I want economics to pick up the basic ethos of hard science, the full attribution habit, but not the craving for an unattainable precision that comes from physics envy. The sort of precise reliable formula that includes Boltzmann's constant is not going to happen, by and large, in economics." - Charlie Munger at UC Santa Barbara back in 2003

These ideas have -- sometimes quietly and sometimes less so -- influenced real world behavior and system design in far from desirable ways. They continue to do so. The damage done may be subtle but it's real.

Not all flawed ideas deserve to be viewed with contempt (and even a brutal disrespect), but at least some of this stuff just might deserve such treatment.

It's not difficult to show, as Jeremy Grantham points out, that participants do not always behave in the cold, rational manner that the efficient market hypothesis relies upon.***

It's not difficult to show that market prices fluctuate far more than intrinsic business values.

It's not difficult to show that risk and reward are not always positively correlated.

It's not difficult to show that a single greek letter -- in this case β -- cannot possibly be a proxy for risk.

Systems should be designed with these realities in mind. The next generation of business leaders, finance professionals, and economists will be more effective if taught to think about the world the way it is (or, at least, as close as possible to the way it is) instead of an imaginary one built upon certain flawed models and assumptions.

In capital markets, mispricing is the norm and, as we've seen during the past decade and a half or so, sometimes that mispricing goes to extremes.

The paper ends by asking, then attempting to answer, the question "how can it be true that over the course of almost fifty years, millions of unsuspecting students have been trained by thousands of finance professors to believe" in efficient markets?
(Including the many related ideas -- the "descendants" -- that have been spun off from it.)

Well, they say it comes down to the following:

"The answer is that in all but the hardest of sciences, academic research may be influenced by other factors in addition to a pure quest for the truth."

They go on to explain this further. In a nutshell, Baker and Haugen suggest that once ideas like these obtain widespread influence in academia, it is in the interest of those involved to maintain that influence.

In any case, it's usually a good idea to never be surprised by how long it takes for widely adopted, credible sounding, but highly flawed thinking to surrender its costly influence.

Adam

Related posts:
-Efficient Markets
-Modern Portfolio Theory, Efficient Markets, and the Flat Earth Revisited
-Buffett on Risk and Reward
-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
-Buffett: Indebted to Academics
-Grantham on "The Greatest-Ever Failure of Economic Theory"
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind

* Some will rightly point out that alpha would pick this up. Well, in my view, all this does is mask the fact that risk and reward are not always positively correlated. As far as I'm concerned that makes alpha really just a fudge factor of the worst kind. A solution that's elegant in appearance, less so in fact. For this reason and others I think alpha, despite its popularity, deserves little attention or, better yet, should be ignored altogether. I'm well aware of how much alpha has become the favored way to express risk-adjusted performance; its broad acceptance in this way need not logically lead one to conclude it's based upon sound thinking or even that, while somewhat flawed, it is at least incidentally useful. Unfortunately, it's not even of incidental utility. It's worse than useless. That probably seems a bit too harsh but I think, in this case, it's appropriately harsh. It succeeds at concealing instead of revealing what's really going on in terms of risk and reward. Sometimes outperformance occurs because additional risk was taken on in a smart way leading to an even greater reward. Other times, outperformance occurs because a very low price was paid so -- as Buffett's example above of the dollar bill bought for 60 cents versus 40 cents makes clear -- less risk is taken for more reward. Alpha doesn't distinguish between the two outcomes even if they couldn't be more different. I guess greek letters have a way of creating an aura of legitimacy that makes something rather dumb seem like it must have merit. It's not the first time this has happened -- where seriously smart people become stubborn proponents of suspect ideas -- and it's likely not going to be the last time. 

If that otherwise intelligent and capable people behave in such ways seems at all surprising, check out Charlie Munger at Harvard-Westlake back in 2010 for more on this subject. Well worth reading. It applies far beyond the world of investing. Psychological factors -- various fallacies/biases/illusions both subconscious and conscious -- lead to cognitive errors that affect even the very brightest (including those who might be quite admirable in other ways). At Harvard-Westlake, Munger provided a very useful explanation why this tends to happen (and often at the major institutions no less). It's how aspects of human nature lead to less than reasonable outcomes. Too often, that's just what happens. I'm sure some will -- consciously or not -- underestimate this stuff. I happen to think that's a mistake. An awareness and understanding of these forces at least has the potential to reduce the quantity and scale one's own cognitive errors. It's worth mentioning that CAPM was expanded upon in the Fama and French three factor model. In the less elaborate CAPM, beta alone was supposed to explain portfolio returns. The expanded model adds company size and value factors (finally!) to the single risk factor of beta. So these two additional factors are an attempt to better explain portfolio returns.

Empiricists surely have the capacity to make useful contributions. No doubt the work that went into developing these models was done by smart individuals, is all very well-intentioned, and not at all simple to do. Those interested in this sort of thing should, of course, study both models as carefully as they feel is necessary. I've unfortunately taken the time to do just that (time I'd like back). To me, as far as the investment decision making process goes, things like equilibrium/asset-pricing models offer not much real world utility (and I'm being generous here). There's just far more effective ways to spend valuable time. Others may come to a more optimistic conclusion. Unfortunately, if not surprisingly, there's not just one multi-factor model. Others exist or are in the works. I suppose even more will likely follow. Ugh.
** At UC Santa Barbara back in 2003, Charlie Munger talked about nine different categories of weaknesses in economics. According to Munger, the following is the third weakness:

"The third weakness that I find in economics is what I call physics envy. And of course, that term has been borrowed from...one of the world's great idiots, Sigmund Freud. But he was very popular in his time, and the concept got a wide vogue."

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

Wednesday, June 19, 2013

Buffett and Munger on See's Candies

***Updated***

Warren Buffett writes about See's Candies -- what he calls "the prototype of a dream business" -- in the 2007 Berkshire Hathaway (BRKa) shareholder letter:

"The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn't grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See's, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry's earnings."

So, beyond See's, there just isn't much profitability to be had in the boxed-chocolates industry.

As far as volume growth goes:

- From 1972 to 2007, the growth rate of See's was roughly 2% in terms of volume.

- 16 million pounds of chocolate was being sold each year when Berkshire bought See's in 1972.

- At that 2% growth rate, volume had increased to roughly twice that amount when he wrote the 2007 letter.

So why exactly is this a "dream business?"

In a recent Fortune article, Charlie Munger highlighted some of the reasons See's has been so successful over the years:

- Sound decision-making both before and after Berkshire's purchase

- Avoiding cannibalization of its stores

- A cautious nature that led to long-term success

Warren and Charlie and the Chocolate Factory

Their cautious nature, in part, means they didn't chase low return growth for its own sake. Munger also points out that "We haven't basically touched it at all" and highlighted the importance of See's as a gift:

"Who wants to give a gift that announces 'I'm a cheap ... ' You know."

In the same article, Warren Buffett said this:

"It was sort of the first non-insurance company we bought, or non-financial type company, and so I used to spend a lot of time. I used to be able to tell you which store numbers were which stores. But that's because we didn't have any other companies. Now we have 70-something companies."

Buffett later also said this about See's:

"We almost missed it. Charlie wouldn't have missed it. I would have missed it, and I would have never known what I missed."

Still, this doesn't really quite explain what makes See's such a great business. Charlie Munger said the following about what they learned from buying See's Candies:

"When we bought See's Candies, we didn't know the power of a good brand. Over time we just discovered that we could raise prices 10% a year and no one cared. Learning that changed Berkshire. It was really important."

Essentially, See's is a great business because it has durable competitive advantages that were built up over time; advantages that led to persistent pricing power.

Put simply, it's a great regional brand with "share of mind" developed over many years, primarily in California, that provides the pricing power. It's the fact that the business can at least maintain its competitive advantages with rather modest incremental capital requirements.

Back in 1998, Warren Buffett said the following about See's at the University of Florida:

Buffett at Univerisity of Florida 1998

"We bought See's Candy in 1972, See's Candy was then selling 16 m. pounds of candy at a $1.95 a pound and it was making 2 bits a pound or $4 million pre-tax. We paid $25 million for it—6.25 x pre-tax or about 10x after-tax. It took no capital to speak of. When we looked at that business—basically, my partner, Charlie, and I—we needed to decide if there was some untapped pricing power there. Where that $1.95 box of candy could sell for $2 to $2.25. If it could sell for $2.25 or another $0.30 per pound that was $4.8 on 16 million pounds. Which on a $25 million purchase price was fine. We never hired a consultant in our lives; our idea of consulting was to go out and buy a box of candy and eat it.

What we did know was that they had share of mind in California. There was something special. Every person in California has something in mind about See's Candy and overwhelmingly it was favorable."

Buffett later added...

"I bought it in 1972, and every year I have raised prices on Dec. 26th, the day after Christmas, because we sell a lot on Christmas."

The fact is, most don't buy boxed chocolate for themselves, they buy them as gifts. Christmas is the biggest season of the year -- more than 90% of the earnings from the business back in 1998 comes from the three weeks prior to Christmas -- while Valentine's Day is the single biggest day:

"Guilt, guilt, guilt—guys are veering off the highway right and left. They won't dare go home without a box of chocolates by the time we get through with them on our radio ads. So that Valentine's Day is the biggest day.

Can you imagine going home on Valentine's Day—our See's Candy is now $11 a pound thanks to my brilliance. And let's say there is candy available at $6 a pound. Do you really want to walk in on Valentine's Day and hand—she has all these positive images of See's Candy over the years—and say, 'Honey, this year I took the low bid.' And hand her a box of candy. It just isn't going to work. So in a sense, there is untapped pricing power—it is not price dependent."

It takes some discipline to run a business where basically everything it earns happens around two holidays.

When Berkshire bought See's back in 1972, the capital required was around $ 8 million. The return on that invested capital was already very attractive (roughly 50-60% pre-tax) when they bought the business, but it has only become more so over time as they've raised prices. More from the 2007 Berkshire letter:

"Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories.

 Last year See's sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See's has given birth to multiple new streams of cash for us. (The biblical command to 'be fruitful and multiply' is one we take seriously at Berkshire.)"

All that from a business that has grown volumes just 2% annually. The key thing to consider is that if a business can raise price a certain percentage each year and it mostly sticks (i.e. there's no real hit to volume), the increase all falls to the bottom line after taxation. If that same business instead had a similar percentage increase in revenue via greater unit volume, there inevitably has to be an incremental cost -- sometimes significant -- associated with each additional unit. The result being -- at least when there's real pricing power -- not as much of an equivalent increase in revenue actually falls to the bottom line.*

In fact, the added unit volume might also require more capital to be employed.

Either way, it should mean less return on capital compared to just increasing the price of a powerful brand.

Of course, a good business might offer both opportunities to pursue high return increased pricing as well as high return incremental volume. It's just that sometimes an easier way to generate returns exists (via an increase to price), but the harder thing to do (increases to sales sometimes at reduced prices) is pursued with the justification being to grab market share or something similar.

I'm not saying it's not that it never makes sense to grab market share. I'm suggesting that, from an owner's point of view, it probably is at least worth being a little skeptical when you see this being pursued as a prolonged strategy.
(This, of course, necessarily comes down to the specifics of the competitive landscape, technology shifts, unique advantages and disadvantages of each individual business, etc.)

I'm also not saying that sometimes it makes sense to invest in a big opportunity now with a bigger payoff in mind much further down the road. It's worth mentioning that some of the best businesses can afford to forgo near-term profitability -- sometimes even for an extended period of time -- while they build out a great franchise (developing brand and distribution in a new region, for example) for the long-term. 

Tom Russo: First Mover Advantage and the "Capacity to Suffer"

The best also have the financial wherewithal and competitive strength to invest in such things.

More on See's in a follow up.

Adam

Long position in BRKb established at much lower than recent prices

Related posts:
Aesop's Investment Axiom - Feb 2013
Grantham: Investing in a Low-Growth World - Feb 2013
Buffett: Stocks, Bonds, and Coupons - Jan 2013
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
Buffett: What See's Taught Us - May 2011
Buffett on Coca-Cola, See's & Railroads - May 2011
Buffett on Pricing Power - Feb 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
Pricing Power - Jul 2009
The Growth Myth - Jun 2009
Buffett on Economic Goodwill - Apr 2009

* Even if a modest drop in volume were to occur, the increased price may still make sense as far as total return goes. It all comes down to how much pricing power actually exists. What some might describe as being price inelastic.
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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, June 14, 2013

Newton's Fourth Law

From this interview with Michael Mauboussin:

"...9% is what the market does over the long term. 7.5% is what mutual funds earn, and the difference is primarily fees that mutual fund managers charge."

Yet investors generally earn even less than that. According to Mauboussin, it's more like 60% or 70% of what the market returns.

What accounts for the difference between mutual funds returns and the returns of mutual fund investors?*

"...the answer is: Timing. Or I should say, bad timing. That is, most individuals tend to buy when things have done well and sell when things have done poorly. So they miss out on the subsequent rises when they sell, and of course the subsequent reversals when things have done very well in the past. They buy high and sell low instead of what you're supposed to do."

It turns out, somewhat oddly, that investors who buy load funds do better than no-load funds with the reason apparently being, because of the upfront cost, they are less likely to buy and sell as much.

That's, of course, not an argument for buying load funds.

It's an argument to stop attempting to time the buying and selling of marketable securities and/or funds.

It's an argument for less activity. A better solution, of course, would be to not pay those upfront load fees, trade a whole lot less, and resist the temptation to time the market action.

Reduced frictional costs. Fewer mistakes.

This gets back to the Fourth Law of Motion that Sir Isaac Newton, unfortunately, did not discover. 

"...Sir Isaac's talents didn't extend to investing: He lost a bundle in the South Sea Bubble, explaining later, 'I can calculate the movement of the stars, but not the madness of men.' If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases." - From the 2005 Berkshire Hathaway (BRKaShareholder Letter

Isaac Newton, The Investor

In the same interview, Mauboussin also points out that it's not just individual investors, it is also institutions.

"So you could understand why mom and pop mutual funds maybe would do poorly, but this pervades institutions as well. And it's interesting. The American ethic, or probably Western ethic, is hard work equates to better outcomes. So doing things tends to be a good thing.

That’s not always true in the world of investing."

This Barron's article points out that 85 percent of investor sell or exchange decisions are wrong.

The Money Paradox

So that means:

"...the investor would do better by doing nothing or going the other way that 85% of the time. Simple random decision making (with no investment knowledge) would have yielded about 50% good decisions."

It's an illusion of control.

The evidence more than just suggests that trading excessively and attempting to time the market are likely to just hurt results. Productive assets -- whether partial business ownership (marketable stocks), an entire business, a farm, or some real estate -- can do the heavy lifting as far as long-term returns go.
(Especially those that possess durable advantages.)

Trading skill and clever market timing not required.

Well, at least it is for those investors who have a long enough investment time horizon and the kind of temperament that makes them not much influenced by exuberant or fearful market action. Back in 2009, Charlie Munger said this in an interview on the BBC:

"I think it's in the nature of long term shareholding of the normal vicissitudes, in worldly outcomes, and in markets that the long-term holder has his quoted value of his stocks go down by say 50%. In fact, you can argue that if you're not willing to react with equanimity to a market price decline of 50% two or three times a century you're not fit to be a common shareholder, and you deserve the mediocre result you're going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations."

In this BBC interview with Warren Buffett, also from back in 2009, here's what he had to say about the nature of stock markets.

"The very liquidity of stock markets causes people to focus on price action. If you buy an apartment house, if you buy a farm, if you buy a MacDonald's franchise you don't think about what it's going sell for tomorrow or next week, or next month, you think about how is this business going to do. But stocks with this huge liquidity suck people in and they turn what should be an advantage into a disadvantage."

Then, later in the interview, Buffett added this:

"...you can still get in trouble if you pay too much, but you are focusing on the right thing if you look at the stream of income that the asset is going to produce over time." - Warren Buffett

Invest in what you understand.

Invest with a margin of safety. 

Trade as little as possible to minimize frictional costs and mistakes.

Ignore the near-term market price action. 

Focus on underlying value and what might change it.

Remember that the quoted price of a marketable common stock can be just about anything in the near-term or even longer. 


"...it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical." - Warren Buffett in The Superinvestors of Graham-and-Doddsville

Price action -- nonsensical or not -- doesn't change the underlying per share intrinsic value of the asset itself. Understanding per share intrinsic value is, in itself, difficult enough to do well. For investors, that's where the emphasis should be.

None of this applies if the time horizon is short, of course. Yet, for those with a long enough investing horizon, it's the underlying value that matters not what the quoted price might be at any point in time. Eventually the weighing machine overwhelms the voting machine.

So much for efficient markets.

Adam

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

Related posts:
Investor Overconfidence
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again

* In a separate study, according to Vanguard founder John Bogle, from 1984 to 2002 the average mutual fund delivered a 9.3% annual return compared to the S&P 500's return of 12.2% a year. Even worse, during that same period the average fund investor, according to DALBAR, earned just 2.6% a year. 
(The average fund investor does much worse largely due to ill-timed buy/sell decisions and fund selection. In other words, a timing penalty and a selection penalty. Bogle adds why he thinks the DALBAR study might actually overstate the annual returns. See his explanation under the Is the DALBAR Study Accurate? section for more details.)
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

Wednesday, June 12, 2013

Boring Stocks

This recent MarketWatch article notes that so-called 'boring' stocks tend to more than hold their own compared to those that provide more excitement as far as price action goes:

"...'boring' stocks — those that have exhibited the least historical volatility — on average outperform the most 'exciting' issues — those that have been the most volatile."

The article also points out that Nardin Baker, manager of global equity for Guggenheim Partners, conducted research that revealed the following:

"Consider a portfolio that invested in the 10% of U.S. stocks that had the lowest historical volatility. According to Baker, this portfolio from 1990 through 2012 did 19 percentage points a year better than the 10% of stocks with the greatest historical volatility. He says that he found nearly identical results in each of 20 developed-country stock markets outside the U.S. as well as in 12 emerging markets."

The extent of the outperformance may be somewhat surprising to some, but there happens to be at least some evidence to support the idea that these kind of companies produce very solid returns.

Of course, what really matters is what's likely to happen going forward. Still, it's worth trying to understand why the tendency has existed in past, and whether it's likely to apply in the future.

Robert A. Haugen and his former professor A. James Heins created a working paper with the title "On the Evidence Supporting the Existence of Risk Premiums in the Capital Market" back in 1972.

In the paper they conclude:

"...over the long run stock portfolios with less variance in monthly returns have experienced greater average returns than their 'riskier' counterparts."

So, even if this has been ignored by many over the years, it's not exactly a new idea. In this interview from a bit more than a year ago, Nardin Baker said the following:

"Low volatility stocks have outperformed consistently through time and across the world."

He later added...

"Essentially, the difference between high and low volatility stocks is their excitement factor. High volatility stocks are exciting and in demand. Investors, including institutional fund managers, tend to invest in exciting stocks in an attempt to outperform. So, high risk stocks have underperformed in the past because of these behavioral and agency problems.

We believe the low volatility anomaly will persist because investors and fund managers will only modify their behavior slowly, if at all."

Essentially, it's the tendency to pay too much relative to intrinsic value due to the "excitement factor".

To this I would add that some (not all, of course) of the lower volatility stocks are lower volatility in the first place simply because they are shares of higher quality businesses (durable competitive advantages, high returns on capital). Their range of outcomes are narrower and generally good or better. In other words, the potential relative performance* comes, in part, from having durable competitive advantages that lead to the business producing higher and more sustainable return on capital (and, ultimately, propels the increases to per share intrinsic value).

Whether there's more or less volatility isn't really what's important.

What's important is the fact that the underlying business has attractive core economic characteristics (and that capital is generally allocated wisely or, at a minimum, reasonably well). What's important is that, at the very least, a reasonable price was paid in the first place.

It just so happens that many higher quality businesses trade with reduced volatility. That's not a coincidence, of course, but it's the "high quality" characteristics and price paid that matters.

Over the long haul, the price paid relative to value along with attractive and sustainable returns on capital, end up being the key drivers of investor returns.**

If nothing else, that boring or defensive stocks (or whatever else one chooses to call them) tend to, in the long run, do just fine in terms of risk and reward is a subject that has been covered quite a bit over the years on this blog.

The boring companies with leading consumer brands, strong distribution, tend to experience little change. They sell nearly the same products, year after year, and can maintain their advantages. They also tend to be built to last so, combined with attractive and durable core economics, the compounded effects work to the long-term advantage of those who stick around. On the other hand, while innovation is critical for the world, picking the winning innovative companies beforehand is usually not easy. For every winner there are many losers, and avoiding the losses associated with those losers is easy only in theory. In addition, those with the most exciting prospects tend to have market valuations that seem to assume nothing can go wrong.

Well, if things do go wrong -- and the price that's paid should always assume things will -- the end result is permanent capital loss or, at least, an undesirable result in terms of risk and reward.

Picking the winners among the more boring companies is, by comparison, a whole lot less challenging.

Of course, what the higher quality boring businesses have done in the past promises nothing about the future. Even the best businesses have specific challenges going forward that are likely very different than the past.

Yet, as far as the investment process goes, the boring stuff sure doesn't seem like a bad place to start.

Over the shorter run -- less than five years or so -- anything can happen as far as price action and relative performance goes, of course. Also, the so-called boring stocks are just not likely to do particularly well in bull markets. Anyone buying them expecting to outperform during a bull market is likely to be disappointed.

That is, in part, how they have earned the reputation of being "defensive".

Yet, this defensive reputation isn't quite correct when you look at their historic returns over long enough time horizons.

It's generally when they're looked at over longer time frames -- more than a full business cycle or two -- that the picture becomes more clear.

Adam

Related posts:
Nifty Fifty - Part II - Nov 2012
Nifty Fifty - Nov 2012
The Cost of Complexity - Aug 2012
The Quality Enterprise, Part II - Aug 2012
The Quality Enterprise - Aug 2012
Consumer Staples: Long-term Performance, Part II - Dec 2011
Consumer Staples: Long-term Performance - Dec 2011
Grantham: What to Buy? - Aug 2011
Defensive Stocks Revisited - Mar 2011
KO and JNJ: Defensive Stocks? - Jan 2011
Altria Outperforms...Again - Oct 2010
Grantham on Quality Stocks Revisited - Jul 2010
Friends & Romans - May 2010
Grantham on Quality Stocks - Nov 2009
Best Performing Mutual Funds - 20 Years - May 2009
Staples vs Cyclicals - Apr 2009
Best and Worst Performing DJIA Stock - Apr 2009
Defensive Stocks? - Apr 2009

* Of course, anyone expecting stocks of the more boring variety to do well over shorter time horizons -- especially during a bull market -- will probably be disappointed (and, unfortunately, unlike a few years back shares of the highest quality businesses these days seem anything but cheap). Some will no doubt be tempted to jump in and out based upon the market environment to improve results. Well, good luck with that. It sounds reasonable enough in theory, but those extra moves create their own risks that are too often underestimated. Not impossible to do, maybe, but there are plenty of reasons to be skeptical that it will work in the real world. It's easy to overweight the upside potential of a particular move while not weighing appropriately the downside...that being things like the possibility of increased errors of omission and commission, as well as the higher frictional costs. An illusion of control at work. Obtaining part ownership of a fine business that one understands well at a great price is difficult enough -- patience, discipline, sound business judgment, and awareness of limits required. If the share price subsequently more fully reflects value the core economics of a good business are still at work for the partial owner. There's only so many industries and businesses one can develop real competency in and that is necessarily specific to each investor. If willing to sell part of one good business to buy another, the reasons ought to be very plain. Extreme overvaluation. A vastly superior and cheaper well understood alternative. Now, if business quality was misjudged or its prospects have materially and permanently changed for the worse that's another story. Investing well is not necessarily about being very smart. It's about wisely allocating limited time and an awareness of individual capabilities. 
** While trading excessively usually just adds frictional costs and mistakes. Otherwise, it's learning to ignore near-term -- and even intermediate-term -- price action once shares of a good business are bought at an attractive price. In this ethos, it is increases to per share intrinsic value of the business itself -- what it's capable of producing over time -- that primarily determines investment results. It's not unusual trading acumen.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.
 
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