Monday, April 28, 2014

The Illusion of Consensus

From this CNBC interview of Warren Buffett by CNBC's Becky Quick. In it, Buffett gives a rather blunt description of how boards tend to behave when it comes to compensation:

"I've been on boards for 55 years— 19 public boards— I've never heard of a vote against the compensation plan voted by compensation committee. What happens in a board, I— I think people sometimes have a mistaken notion of how boards act. But— the compensation com— committee comes in, they've worked for a few hours, maybe a few days, they've had consultants. And— and they say, 'We've approved this plan.' I've never yet heard at any of the 19 boards I was on, anybody say in the meeting they were against it. And I've had— heard a few say it outside of the meeting. But— but taking on a committee that's reported, you've assigned— the job to the committee, and they — taking them on it is— is— is a little bit like belching at the dinner table. I mean, you can't do it too often. (LAUGH) If you do, you find you're eating in the kitchen pretty soon."

When asked if he had ever voted yes on something he didn't agree with his reply was "sure".

Some were a bit astonished by these comments. Yet, on some level, this was Buffett describing how group behavior -- even among smart and very capable individuals -- too often is not how we'd all like to imagine it is. Disappointing to some, no doubt, but it's a reminder how hard it can be to combat the tendency.

In a perfect world, I'd like to have heard something more forceful on this subject from Warren Buffett. One reason I'd like to see more is his unique well-earned stature among business leaders and investors. Another reason is that he has offered, on a number of prior occasions, his own critical views in this arena.

This, at least so far, seems a missed opportunity yet, of course, we all must choose our battles. Time will tell how this all plays out.

Still, how this plays out over time deserves great interest from long-term investors (and beyond). Well thought out compensation systems can have a great influence on how competently valuable resources are allocated. These resources are, ultimately, great contributors to living standards. So senior execs have the chance to allocate some rather important resources in a way that, over one or two generations, can lead to vastly different outcomes in terms of living standards per capita and per share wealth.

Pay them well when their actions have materially beneficial long-term effects.

It is the huge rewards for subpar (or worse) and very short-term outcomes that needs to be reined in.

To expand this group behavior tendency just a bit more broadly and beyond compensation, consider the following comments by Professor Robert Shiller during an interview back in 2012. In the interview, he explains why a serious discussion of asset bubbles and the associated systemic risks did NOT come up during Federal Open Market Committee meetings (according to minutes) prior to 2007 and leading up to the financial crisis.

"It is due to 'groupthink', which psychologist, Irving Janis led research on in the 1970s. It refers to how expert groups come together and interact and Janis argued that experts in a group like that are vulnerable to self-censorship – they are all harbouring doubts about a decision that is about to be reached, but view the doubts as something that they cannot articulate in a suitably professional way, so they quiet themselves and it creates an illusion of consensus. I once served on the Federal Reserve Bank of New York advisory committee and I know exactly the feeling. The discourse is at a high and professional level. I tried to bring up my concerns about bubbles. There were no minutes of our meetings but I found it difficult internally – it’s like bringing up astrology at an astronomer's convention."

Shiller goes on to say:

"People should read Janis's book and think about the vulnerability and their moral commitment to stand up and say things..."


"If people are aware of the problem, that goes a long way towards reducing it."

The dynamic among experts one might expect to exist is very different from the one that does exist.*

Committees and boards -- a relatively small group -- behave in less than optimal ways at least often enough to matter. The bubbles** themselves -- involving naturally a much larger number of participants -- is another case of less than optimal group behavior.

With bubbles, the group behavior might be of another sort, on a much broader scale, and with entirely different causes, but the expectation or assumption that groups by and large act in sensible ways seems all too easy to disprove.

Shiller actually warned of the stock market bubble in early 2000 and of the housing bubble back in 2005.

Generally, as prior posts have made clear, I'm skeptical of bold macro predictions and near-term market forecasts but that, to me, is very different from pointing out a situation where extreme valuations prevail and the possible consequences.

In addition, Shiller just might separate himself, at least in part, from some other prognosticators via the following:

"I don't have any certainty," he said. "I have a lot of humility" about any prediction.

Some in the prediction business seem to possess too much of the former and too little of the latter.

From this interview with Charlie Munger:

"Warren and I have not made our way in life by making successful macroeconomic predictions and betting on our conclusions.

Our system is to swim as competently as we can and sometimes the tide will be with us and sometimes it will be against us. But by and large we don't much bother with trying to predict the tides because we plan to play the game for a long time.

I recommend to all of you exactly the same attitude.

It's kind of a snare and a delusion to outguess macroeconomic cycles...very few people do it successfully and some of them do it by accident. When the game is that tough, why not adopt the other system of swimming as competently as you can and figuring that over a long life you'll have your share of good tides and bad tides?"

Economic forecasts are just generally, as Buffett has said, "an expensive distraction" that should be ignored.

Making a judgment call on how prices compare to intrinsic business values is one thing; attempting to guess short or even intermediate term stock price action then mostly timing it right, well, that's another thing altogether. 

Buffett also once said:

"...the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children."

Figuring out how price compares to value, and whether it will likely offer an attractive return over a longer time frame, isn't easy but at least -- with some work, sound judgment, and limits correctly considered -- is doable. Timing things -- especially the short-term price moves -- consistently well just isn't. 

Shiller explains that "bubbles are essentially social-psychological phenomena".

He also says that bubbles should be thought of as "speculative epidemics" and adds:

"We know from influenza that a new epidemic can suddenly appear just as an older one is fading, if a new form of the virus appears, or if some environmental factor increases the contagion rate. Similarly, a new speculative bubble can appear anywhere if a new story about the economy appears, and if it has enough narrative strength to spark a new contagion of investor thinking.

This is what happened in the bull market of the 1920's in the US..."

The fact that much of modern finance and economics is built upon an underlying assumption that we're mostly cold, rational actors would be quite comical if it weren't so costly.

Humans are, especially in groups, psychologically speaking rather very much not the creature that some theorists have imagined.


Related articles:
Nobel Laureate Bob Shiller on Why the Fed Can't Say There's a Housing Bubble
Central bankers need to address problem of 'groupthink', says Shiller

* It's interesting to note that Professor Shiller served on the economic advisory panel to the Federal Reserve Bank of New York from 1990-2004. Well, in this article Shiller explains his behavior while serving on the panel in the following manner: "In my position on the panel, I felt the need to use restraint. While I warned about the bubbles I believed were developing in the stock and housing markets, I did so very gently, and felt vulnerable expressing such quirky views. Deviating too far from consensus leaves one feeling potentially ostracized from the group, with the risk that one may be ostracized from the group..." So even when one has an awareness of this kind of group dynamic -- which Professor Shiller I think it's fair to say clearly does -- there's still great susceptibility to it.

** At least if you agree that bubbles even exist. From this interview with Eugene Fama: "I don't know what a credit bubble means. I don't even know what a bubble means. These words have become popular. I don't think they have any meaning."
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, April 21, 2014

Intrinsic Value - Part II

A follow up to this post. In it, the more quantifiable aspects of intrinsic value were covered while noting that meaningful estimates of value must go beyond what can easily be quantified.

In fact, I chose to use an example outside of the investment discipline -- Lord Kelvin's error in estimating the earth's age -- in an attempt to illustrate the point.

Berkshire's insurance 'float' is one example of a tough to quantify but important contributor to value.

The Insurance section of Warren Buffett's latest Berkshire Hathaway (BRKa) shareholder letter explains the following:

"So how does our float affect intrinsic value? When Berkshire's book value is calculated, the full amount of our float is deducted as a liability, just as if we had to pay it out tomorrow and could not replenish it. But to think of float as strictly a liability is incorrect; it should instead be viewed as a revolving fund."

He goes on to say:

"If our revolving float is both costless and long-enduring, which I believe it will be, the true value of this liability is dramatically less than the accounting liability."

And later adds:

"A counterpart to this overstated liability is $15.5 billion of 'goodwill' that is attributable to our insurance companies and included in book value as an asset. In very large part, this goodwill represents the price we paid for the float-generating capabilities of our insurance operations. The cost of the goodwill, however, has no bearing on its true value. For example, if an insurance business sustains large and prolonged underwriting losses, any goodwill asset carried on the books should be deemed valueless, whatever its original cost.

Fortunately, that does not describe Berkshire. Charlie and I believe the true economic value of our insurance goodwill – what we would happily pay to purchase an insurance operation possessing float of similar quality to that we have – to be far in excess of its historic carrying value. The value of our float is one reason – a huge reason – why we believe Berkshire's intrinsic business value substantially exceeds its book value."

Deferred taxes are worth mentioning in this context. As the Berkshire owner's manual explains (under principle number 7), deferred taxes have much in common with insurance 'float' in terms of advantages to the long-term investor:

"...Berkshire has access to two low-cost, non-perilous sources of leverage that allow us to safely own far more assets than our equity capital alone would permit: deferred taxes and 'float,' the funds of others that our insurance business holds because it receives premiums before needing to pay out losses."

Buffett then adds the following:

"Better yet, this funding to date has often been cost-free. Deferred tax liabilities bear no interest. And as long as we can break even in our insurance underwriting the cost of the float developed from that operation is zero. Neither item, of course, is equity; these are real liabilities. But they are liabilities without covenants or due dates attached to them. In effect, they give us the benefit of debt – an ability to have more assets working for us – but saddle us with none of its drawbacks."

Well, consider that, while most of us would find it difficult (at the very least) to gain access to high quality 'float' from insurance underwriting, just about anyone can benefit from the interest-free 'loan' that is deferred taxes.

Charlie Munger wrote the following in the 1998 Wesco letter:*

"Of course, so long as Wesco does not liquidate, and does not sell any appreciated assets, it has, in effect, an interest-free 'loan' from the government equal to its deferred income taxes on the unrealized gains, subtracted in determining its net worth. This interest-free 'loan' from the government is at this moment working for Wesco shareholders..."

The interest-free 'loan' to Wesco at the time was about $127 per Wesco share. However, since the 'loan' must be paid back someday as assets are sold, Munger thought at that time the value of the interest-free loan was probably more like $30 per Wesco share -- or less than one quarter of the 'loan'. Now, his estimate should necessarily come down to the specific situation. In other words, the estimated value should reflect a best judgment about how soon the appreciated assets might be sold. Munger's estimate likely took this into account.
(In fact, Wesco did sell shares in the years that followed. Their sale of Freddie Mac shares -- and its substantial capital appreciation -- was mostly responsible for what became a much reduced interest-free 'loan'. So it seems likely that Munger's estimate of value reflected at least some expectation that appreciated assets would be sold sooner than later.)

In contrast, if the appreciated assets are expected to be held longer -- especially if most are closer to indefinite holdings than not -- then the estimated value as a proportion of the interest-free 'loan' should, all things being equal, be larger. This estimate of value can't be known precisely but should at least be roughly meaningful.

Munger went on to explain the impact of the interest-free 'loan' on Wesco's intrinsic value per share:

"After the value of...the interest-free 'loan' is estimated, a reasonable approximation can be made of Wesco's intrinsic value per share. This approximation is made by simply adding (1) the value of the advantage from the interest-free 'loan' per Wesco share and (2) liquidating value per Wesco share. Others may think differently, but the foregoing approach seems reasonable to the writer as a way of estimating intrinsic value per Wesco share."

Naturally, this means of valuation is specific to Wesco.**

In any case, when one chooses to trade marketable stocks in a hyperactive fashion, they forgo access to such a low, or actually, no cost loan.

In the short run, such a loan does not have a big impact; in the long run, it very much does have an impact on value.

The power of compounding.

Finally, there's the "'what will they do with the-money' factor".  It's an element of value that's necessarily the most difficult to quantify.

From page 110 of the annual report:

"This 'what-will-they-do-with-the-money' factor must always be evaluated along with the 'what-do-we-have-now' calculation in order for us, or anybody, to arrive at a sensible estimate of a company’s intrinsic value. That’s because an outside investor stands by helplessly as management reinvests his share of the company's earnings. If a CEO can be expected to do this job well, the reinvestment prospects add to the company’s current value; if the CEO's talents or motives are suspect, today's value must be discounted. The difference in outcome can be huge. A dollar of then-value in the hands of Sears Roebuck's or Montgomery Ward’s CEOs in the late 1960s had a far different destiny than did a dollar entrusted to Sam Walton."

There are certainly stocks that are more straightforward than Berkshire as far as estimating per share intrinsic value.

That being said, some of the lessons that come out of learning how to estimate Berkshire's value, can be applied to other investments.


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

Some related posts:
Asset Growth & Stock Returns, Part II - March 2014
Intrinsic Value - March 2014
Berkshire Hathaway's Second Quarter 2013 Results - August 2013
Berkshire's Manufacturing, Service and Retail Operations - April 2013
Berkshire's Regulated, Capital Intensive Businesses - April 2013
Buffett on Buybacks, Book Value, and Intrinsic Value - December 2012
Berkshire's Book Value & Intrinsic Value - May 2012
Buffett: Intrinsic Value vs Book Value - Part II - May 2012
Buffett: Intrinsic Value vs Book Value - April 2012
Discount Rate - August 2009

* Also mentioned in other Wesco letters.
** Munger in the same letter added the following: "Wesco is not an equally-good-but-smaller version of Berkshire Hathaway, better because its small size makes growth easier. Instead, each dollar of book value at Wesco continues plainly to provide much less intrinsic value than a similar dollar of book value at Berkshire Hathaway. Moreover, the quality disparity in book value's intrinsic merits has, in recent years, been widening in favor of Berkshire Hathaway." Buffett has said that book-value -- which is a meaningless measure for most other businesses -- is a useful if understated proxy for Berkshire Hathaway's intrinsic value. From the 2011 Berkshire letter: "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." So it's a convenient proxy but I think it's important to consider all the elements that contribute to Berkshire's value for it to become well understood. That way one can draw conclusions as to what it's worth using their own assumptions and making their own judgments. The proxy -- multiplied by the factor that the investor believes reasonably well represents the current relationship between Berkshire's book value and intrinsic value, of course -- is, to me, at best useful as a quick check after the other work has been done. Well, in order to figure out the relationship between book value and intrinsic value, it requires that the necessary work gets done in the first place. That work itself needs to be done by whoever is putting the capital at risk. Using someone else's judgments and assumptions is likely to lead to future mistakes. If nothing else, the conviction level just isn't going to be there when needed. In other words, when difficulties or uncertainties, from time to time, inevitably emerge.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, April 14, 2014

Six Stock Portfolio Performance: Five Years Later

It has now been five years since I first mentioned the Six Stock Portfolio. At that time, I considered those stocks attractive long-term investments, if bought at the then-prevailing price levels, for my own portfolio.*

Back then I felt that the share price of each represented a very nice discount to likely intrinsic value a few years out (and beyond) and said as much. No estimate of value can be perfect, of course, but each seemed oddly cheap back then compared to even the most conservative estimate of their intrinsic worth.

None are now selling at much, if any, discount to my judgment of their value.

To me, at the very least, the margin of safety is now insufficient.

As a group, the six stocks have obviously done just fine since they were first mentioned.

Stock                                 Price                      Price                         Total
                                        |Apr. 9, 2009     |Apr. 9, 2014        |Return**
Wells Fargo (WFC)               19.61                    49.10                  174%
Diageo (DEO)                         45.54                  126.89                 225%
Philip Morris (PM)                37.71                   83.88                 173%
Pepsi (PEP)                              52.10                    83.91                  87%
Lowe's (LOW)                         20.32                   47.40                 157%
AmEx (AXP)                            18.83                   88.72                410%

Since April of 2009, the combined total return is 204 percent (incl. dividends) for these six stocks while the SPDR S&P 500 (SPY) returned 141 percent (also incl. dividends).

Though intrinsic value has increased meaningfully since five years ago, the market returns were far greater than that increase. The optimistic view is that the market returns reflected intrinsic value changes plus a closing of the discount to value gap. In other words, they were just very undervalued at the time and the market returns so far reflect a "catching up". It's inevitable that forward returns will be much more modest.
(Though, over many years, per share intrinsic value should increase at a solid rate and might even do just fine on a relative basis.)

A less optimistic way of looking at it is that it's tough to buy these now with a sufficient margin of safety.

In any case, those five year returns are certainly not an indication of how much per share intrinsic value has increased.

So these six stocks now have a nice performance advantage achieved over the five years with no portfolio turnover and little, if any, trading abilities required (well, actually none). The process always demands paying a price that's comfortably below my best estimate of intrinsic value (necessarily more of a range of values than a precise number, of course).

The fact that shares of good businesses like these were that inexpensive back in April of 2009 still seems amazing. Decisive action required an awareness of that valuation disconnect, an ability to ignore most of the many scary headlines, along with some discipline and patience.

What Daily Journal (DJCO) was able to accomplish this past decade or so is as good an example of this as any that I know (no doubt other good examples exist). The company's portfolio remained 100% in cash and U.S. Treasuries in the years that preceded the financial crisis. Then, beginning in early 2009 at the height of the financial crisis, they decisively moved much of those funds into a concentrated portfolio of what, at the time, were heavily discounted marketable securities (mostly common stocks). Some follow on common stock purchases were also made in fiscal 2011 and 2012. The portfolio remains mostly in common stocks at least based upon what's been disclosed. A great example of discipline and patience followed by decisive action when the opportunity emerges.
(The specifics of their purchases were not disclosed until much later. In fact, they didn't provide specific common stock names until earlier this year. Based upon their latest filing, it appears they've pretty much remained in these same marketable securities since they were first purchased.)

Of course, it's not like buying an S&P 500 index fund back then would have worked out too badly. In other words, many things were rather cheap back in early 2009.

The real test of relative and absolute performance will come when some future crisis leads to a big drop in the market or, at the very least, after a couple more business cycles.

Since none of the six stocks are particularly cheap (nor are they outrageously expensive) at this point, some might ask why not switch from these somewhat expensive stocks (or, at least, a whole lot less cheap) into something a bit cheaper.

I have said before that, on rare occasions, I might consider a switch if valuation becomes extreme on the high side, I've lost confidence in/significantly misjudged the long-term prospects of the business, or I understand an equal or better quality alternative investment pretty much as well that is clearly very much cheaper.
(Something that is just plainly a superior investment alternative. I mean, it has to be very obvious to me.)

Otherwise, I'm just not that smart. Each move is just another chance to make a mistake. Buying and selling isn't just a chance to improve results, it's a chance to hinder them. It's all too easy to overweight the likelihood that a move will improve portfolio performance while not considering the possibility it might do just the opposite. It's an illusion of control. Of course, each move also creates unnecessary frictional costs.

I own these six stocks because my judgment is that they have durable advantages that support attractive business economics and it was, at one time, possible to buy the shares comfortably below my conservative estimate of intrinsic value. Once I own shares of a good business at the right price (at least those that I understand), my bias is to not sell for a very long time. That means sometimes holding onto shares of a business I like even if, due to increased market prices, the stock might temporarily no longer be a bargain relative to current estimated per share intrinsic value.
(As long as my expectation is that per share intrinsic value will still increase over the long haul at an attractive rate.)

I don't necessarily expect most to adopt this way of thinking (and, more importantly, apply it in their own way) but it's, if nothing else, a recognition of my own limits. We'll see how these six perform over many years compared to the S&P 500. If I'm an idiot it will clear over time.

The blog is here to make sure of that.

This rather concentrated portfolio is meant to be an example of how attractive results can be accomplished with minimal to no trading. I'd imagine it takes a fair amount of energy to learn trading techniques and become proficient (though I don't plan to find out). My interests lie elsewhere. Instead, my energy and focus has always been on judging business quality and value, being disciplined about buying shares at a substantial discount to that value, and minimizing frictional costs of all kinds. In other words, the emphasis is on sound principles and process; it is not on attempting to predict future outcomes.

Returns will be driven by the core economics of each business and always buying with a margin of safety, not some unusual talent for trading. A modest multiple of, conservatively estimated, future per share normalized earning power -- at least 7-10 years down the road and, ideally, even much longer -- should be all that's required, considering risks and alternatives, for a nice overall investment result.

So the price paid now compared to a modest multiple of those future earnings should yield a good result. Otherwise, find something else to invest in.

"If you don't feel comfortable making a rough estimate of the asset's future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility. But omniscience isn't necessary; you only need to understand the actions you undertake." - Warren Buffett in his latest letter

Inevitably, unexpected things will happen; things that can't be foreseen. That's where margin of safety comes in.

Trying to guess what those things might be and when they'll occur is futile.

There'll no doubt be both good and bad surprises ahead.

Expect as much.

None of that can be controlled.

All one can hope to do is improve the likelihood of good results over the long haul with a thoughtful approach.

Figuring out how price compares to per share intrinsic value is difficult enough to do consistently well. Attempts to correctly time individual stock price (or market) moves and carefully consider macro views, even if well-intentioned, likely just distracts and leads to mistakes that need not be made.

"Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important." - Warren Buffett in his latest letter

Buying a stock that leads to a permanent -- not temporary -- capital loss is a costly mistake. Well, not owning shares of an understandable business with good prospects that was once cheap -- but now isn't because it rallied instead -- is also a costly mistake.

That's a risk that's too often ignored.

Permanent losses are unacceptable.

Temporary paper losses are inevitable.
(Well, at least that's generally the case with common stocks.)

In other words, the attempt to both time things well and price things well can lead to this expensive outcome. For most of us, there are only so many things that can be understood well enough to be bought with conviction. The possibility of not owning (or not owning enough of) something, at a good price, that is otherwise perfectly sensible to own because it possibly hasn't quite bottomed just yet is a risk that can be underappreciated.

"Picking bottoms is not our game. Pricing is our game. And that's not so difficult. Picking bottoms is, I think, impossible." - From this interview with Warren Buffett

There is a real cost to not acting decisively when action is warranted.

There's a real cost to mistakes or errors of omission even if those costs are harder to measure.

The right price and right time to buy might often coincide, but, in my view, the focus needs to be on how price compares to value and never on timing. Inevitably, what was bought cheap will get even cheaper (and, with inherently emotional markets, the opposite plainly also occurs) but, if ultimately the investor has paid far less than per share intrinsic value, the weighing machine generally sorts at least most of this out down the road. In the short run psychology moves prices. In the long run core business economics becomes the dominant factor. Learning to ignore short and even intermediate term quoted prices isn't a bad habit to develop.

Price action will, at times, go the wrong way near-term but shouldn't matter much in the long run if value has been judged well and the right price was paid.

The emphasis should be whether the price paid today will sufficiently compensate the investor based upon a conservative estimate of likely per share intrinsic value many years from now.

A good investment outcome should never depend on getting a premium valuation. Good results should need no more than a more moderate valuation environment if and when it comes time to sell.

There'll be no complaints if premium prices happen to prevail.

Now it's certainly true that many investors -- depending on the circumstances -- will want or need to own more than six stocks but portfolio concentration can make sense.***

At least for me, it's just not possible to get a good understanding of 50-100 businesses.

Some may be able to do just that, but I can't.

I suspect there are a few who are kidding themselves that they understand so many businesses well enough to risk their capital.

So I think attractive results can be achieved without some unusual acuity for trading but, instead, via paying the right price per share for good businesses with sound economics and owning them for a very long time.

Considering both the quality of these businesses and their rather cheap stock prices back in April of 2009, I'd expect this portfolio's overall results to be just fine over the very long haul.

Yet, at some point, I won't be surprised if at least some of these businesses (and their stocks) do not perform well for a time. Even very good businesses eventually experience their fair share of challenges. To me, this means it's wise to expect that performance in any given one to three year stretch -- and maybe even somewhat longer -- will almost certainly be subpar. Those who judge investment performance over such short time frames are choosing what's measurable over what's meaningful.

I'd add that five years is just barely long enough to make a meaningful judgment on performance. So whether the relative performance of these six stocks against the S&P 500 means much, if anything, is a reasonable debate. In fact, I'm not convinced it means a whole lot. I'm just convinced that these six stocks made sense for my portfolio as prices got near the levels that they did back in April of 2009.

Of course, as noted above, if my view of future prospects were to materially change then action might be necessary. For example, if the economic moat of one of these businesses became materially impaired (or if capital allocation decision-making by management became a serious concern), I will certainly consider switching one of these out. On the other hand, I would NOT consider selling if one of these runs into some kind of temporary but fixable problem.

It's probably obvious for those who've read some of my previous posts that I don't view it as a good thing this portfolio has increased in value so quickly. Right now, I am comfortable owning these six stocks long-term but, at current prices, neither I (nor these companies via buybacks) can acquire shares at a sufficient discount to value. For a business with durable advantages, it is the paying of meaningful discounts to value over time that improves the balance of risk versus reward.

In the long run, as Buffett pointed out using the IBM example in the 2011 Berkshire letter, the elevated prices will only reduce returns for long-term owners. So it makes no sense for an investor to be happy these stocks have run up this much.

It does, in fact, actually hurt relative and absolute long-term performance.

The performance of the six stocks over these five years just isn't sustainable on an economic basis. If this were to continue, then price action is certain to significantly outrun increases to intrinsic value. Not a good thing for the investor (traders, of course, surely view this differently). It also seems rather improbable at best that these stocks will expand the performance gap over the S&P 500 at such a rate over the longer haul.

These are six good businesses, in my view, but their capacity to increase per-share intrinsic value is far more modest than what the above performance would otherwise suggest.

In other words, though I never have a view as to how price action might play out, it seems likely more modest performance should at least be expected and for maybe even an extended period of time. I certainly hope so. In fact, a nice drop in prices would be a welcome development.
(Those looking to profit from price action must necessarily think differently than those investing long-term in a business they like and understand. Those in it for the long haul should logically want prices to not run well ahead of intrinsic values; they should hope for the return of big discounts to value. It's only when it comes time to sell that one should hope prices at least fully reflect value.)

It's difficult enough to find a good understandable business that can be bought well. If shares of that business become materially overvalued then it begs for an alternative to be found. That may work out well, but also opens up the possibility that an unnecessary error is made. The long-term investor is hurt, in terms of the balance between risk and reward, when the discount to value disappears or, worse yet, prices get ahead of per share intrinsic value.
(Naturally, those selling soon will welcome that premium to value. In addition, if a stock sells at a huge premium to value while something else understood well stays very cheap eventually a move is warranted. It's just wise to not try and trade around more modest valuation discrepancies once something attractive has been bought at a good price.)

So, while I'm not surprised that these six stocks are doing well compared to a broad-based index (and might even look very solid over a 10-20 year and longer horizon), continued performance similar to these past years simply is not likely at all. In fact, I'd expect that a less ebullient market than the current one -- or, better yet, significant broad-based caution to return -- would improve on relative performance.

If these stocks do produce nice risk-adjusted returns over the very long haul, it will because these six enterprises continued to have sound core business economics and were bought at a discount to per share value in the first place.

It's all too easy to look back at what else could have been purchased ("woulda, coulda, shoulda") that would have performed even better; it's easy to compare what actually happened to theoretical alternative outcomes. It's much more difficult to act decisively beforehand in way that the investor actually benefits from the mispricing. Well, in order to act decisively beforehand, lots of warranted conviction is required. The only way I know of to acquire that kind of conviction starts with buying only what is truly well understood (necessarily unique for each investor); where, through careful evaluation, the investor concludes something possesses attractive long-term prospects.
(This is one of the reasons why I think it never makes sense for an investor to invest in something that someone else happens to like.)

Lacking that kind of conviction means that the "noise" -- possibly including lots of fear inducing headlines and stories -- will likely have too much influence on investment decision-making. Buy what someone else likes and the conviction needed isn't likely to be there when it counts.

By building the necessary conviction during the years that preceded the financial crisis, decisive action on the six stocks above was possible when the mispricings emerged. It was the preparation beforehand, over a number of years in fact so patience certainly was required, that made it less difficult to act decisively when needed than it otherwise would be.

Preparing in the coming years in order that similar decisive action (even if not necessarily the same marketable stocks) can be taken if/when another such opportunity arises likely isn't a bad idea.

Some might reasonably wonder what can be bought now that has a similar risk and reward profile to those six stocks in early 2009.

Well, if there is something with that kind of profile -- and there just might be -- it's irrelevant since I surely don't understand it.

Nothing today strikes me as being even close to the mispricings back then. A big part of the investment process comes down to figuring out at what price it makes sense to buy something -- building the necessary level of justified conviction -- then waiting until the opportunity to buy at the right price arises.

This generally involves much reading and thinking over many years and, well, sometimes the wait for the right price will require many years. This takes patience, discipline and, yes, maybe quite a lot of work.

What it doesn't necessarily require is brilliance.

Things like sound business judgment, persistence, discipline, patience, and knowing limits matters more.

Now, though there are surely flaws, I'm comfortable with this particular approach for my own investments compared to alternatives. It's built on solid set of principles, yet remains flexible enough to respond to uncertain world.

Still, improvements will always be sought.

An investor doesn't controls what ultimately happens, but does control the approach.

The most one can hope for is to improve the likelihood that good things happen down the road.

Finally, it's worth closing with the thought that time and energy spent seeking evidence that I'm wrong about an investment beats time and energy spent confirming I'm right.

"To kill an error is as good a service as, and sometimes even better than, the establishing of a new truth or fact." - Charles Darwin

My guess is this habit alone helps me to eliminate unnecessary errors as much as anything else. Darwin may not have asserted the above in the context of investing, but it certainly applies.

"...Warren and I are better at tuning out the standard stupidities. We've left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error." - Charlie Munger in Stanford Lawyer

While some market participants are busy trying to discover beforehand what's going to be the next big thing, they're missing the chance to improve results simply through the elimination of error.


Long positions in WFC, DEO, PM, PEP, LOW, and AXP established at very much lower than recent market prices. No position in DJCO.

* 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 are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to be long the positions noted unless they sell significantly above intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
** Total return includes dividends and based upon closing price on April 9th, 2009 compared to the April 9th, 2014 closing price. 
*** It comes down to reliably judging business economics. Index funds will be, of course, the more logical alternative for many investors. Portfolio concentration is a disaster waiting to happen for anyone not able to reliably judge business economics or buys what they don't really understand. As always, awareness of individual limits is key.

Monday, April 7, 2014

When Mutual Funds Outperform Their Investors

From this MarketWatch article:

"...the typical investor booked a 4.8% annualized gain over the last decade, while the typical fund gained an average of 7.3% a year.

The same article goes on to point out the following based upon research by Morningstar:

"...investors do a good job of picking mutual funds, but a poor job in timing their moves between asset classes."

Russel Kinnel of Morningstar explained, as one recent example, that, in terms of fund flows, mutual fund investors "were going in all the wrong directions entering 2013."

Basically, they were buying mutual funds that allocate capital into bonds and selling those that are focused on U.S. stocks.* They did this at a time when doing roughly the opposite (or nothing at all) would likely have served them better. This is not an argument to get the timing right; this is an argument to not try to time such things in the first place.

This Barron's article from last month added the following:

"Individual investors have long been accused of being a lagging indicator, pouring money into areas of the market after they've seen their biggest run-ups. But that's a mistake not limited to just retail investors, but also often made by pensions and endowments managing much larger pools of money, according to insiders."

One of the major reasons for the underperformance is "that few investors sit tight in a fund" along with, once again, poorly executed attempts at timing the market.

"...the gap in returns is exacerbated by big pivot years for the market, when investors appear to have especially bad timing."

The Barron's article also notes that investors were mostly getting out of equities in 2009 while moving assets into things like bonds and commodities. Once again, not exactly the best time to be doing such things even if it probably felt like the right thing to do. The equity markets have, give or take, roughly doubled -- even if the investor didn't buy at the most opportune moments that year -- since 2009. With no doubt good intentions, investors too often do just about the opposite of what would improve returns. Influenced too much by what they've experienced recently -- what's in the rear-view mirror -- they tend to take actions that are detrimental even though, at the time, it might have felt like the right thing to do.

Benjamin Graham: Timing vs Pricing Stocks

Investors are just too often their own worst enemies. There's just no need to pick market bottoms nor is it really possible to do so consistently well. More generally, it's just not wise to make big timing calls a central aspect of the process.

"Picking bottoms is not our game. Pricing is our game. And that's not so difficult. Picking bottoms is, I think, impossible." - From this interview with Warren Buffett

The focus needs to be, or should be, on how price compares to well-judged per share intrinsic value.

Now, sometimes the right time to buy might happen to coincide with the right price, but price versus value should still be the emphasis. Good things are just more likely to happen in the long run -- even if far from a certainty -- when always buying at a plain discount to value is a central principle. There's nearly no doubt that price action might get ugly -- at the very least from time to time -- in the near and intermediate term. Expect it and, well, learn mostly ignore it. If all buying is truly at a discount to value, the price action in the early years should become increasingly irrelevant over the long haul.** Timing will inevitably end up being off; what is truly cheap becomes even cheaper due to psychological and other factors (the same, of course, can be true in the opposite direction). Yet it's easy to forget the risk of NOT owning something understandable that's become sensibly priced (in the context of long-term investment) due to fears it will temporarily get even cheaper.

In other words, attempts to get both pricing and timing right invites errors that need not be made by those who have a long-term investment horizon.

The reality is that getting the price versus value judgment right is hard enough to do consistently well without adding timing to the equation.

So it's learning to ignore price action, judging the value of what's understandable frequently well, then developing the patience and discipline to buy when there's a discount.

The most attractive discounts usually prevail when a recent or ongoing economic storm -- and the associated painful losses -- dominate the psychology of those involved.

Participants who buy when the outlook is rosy aren't likely to get great long-term results. Ditto for those who tend to sell when the outlook feels uncertain and, well, maybe even a bit scary.

In fact, the opposite behavior has a much better likelihood of being rewarded.

None of the above is necessarily easy to do well. Then again, it's also hardly impossible with the right level of energy and focus in combination with an real awareness of abilities and limits.

Overconfidence destroys results.

It's worth highlighting that, as the Barron's article notes, it's not like the investment pros -- what some might consider the "smart money" -- aren't susceptible to making the same kind of mistakes as the non-professionals.

"Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 percent to 90 percent of managers fail to match their benchmarks." - Jack Meyer, former head of Harvard's endowment, commenting on investment managers

In other words, we might be looking at a more generalized element of human nature that, to be successful, must be tamed by the market participant no matter what the level of knowledge and expertise happens to be.


Related posts:
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
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
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
When Genius Failed...Again

* Apparently, investors were also buying lots of emerging markets funds at a rather inopportune time.
** In fact, prices that remain persistently at a discount can benefit the long-term investor, and it's not just because it allows that investor to accumulate more shares; it's because the company can use excess capital to do the same.
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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