Friday, May 30, 2014

Buffett on Farms, Real Estate, and Stocks - Part II

A follow up to this post. In the 2013 Berkshire Hathaway (BRKa) shareholder letter, Warren Buffett describes two of his small investments -- a Nebraska farm and a New York retail property -- to help illustrate some important investing fundamentals.

This was covered in the previous post.

In the letter, after using the two small investments to illustrate those investing fundamentals, Buffett goes on to say the following:

"There is one major difference between my two small investments and an investment in stocks. Stocks provide you minute-to-minute valuations for your holdings whereas I have yet to see a quotation for either my farm or the New York real estate.

It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings – and for some investors, it is. After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his – and those prices varied widely over short periods of time depending on his mental state – how in the world could I be other than benefited by his erratic behavior? If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.

Owners of stocks, however, too often let the capricious and often irrational behavior of their fellow owners cause them to behave irrationally as well. Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits – and, worse yet, important to consider acting upon their comments.

Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of 'Don't just sit there, do something.' For these investors, liquidity is transformed from the unqualified benefit it should be to a curse."

Many participants turn what should be an inherent advantage into a disadvantage. Excessive trading is likely to be unproductive or worse. It likely leads to a bunch of unforced and costly errors.

The result? A less favorable balance between risk and reward for a whole lot time and energy not well spent.

What Buffett describes above is a very sensible way to go about the business of investing. It's certainly not complicated nor is it particularly difficult to understand. Yet the noise distracts. The apparent simplicity masks the fact that the job is a whole lot more difficult to do consistently well than it appears. The merits of the approach becomes lost in a sea of opinions, breaking news, economic reports, and stock quotations.

Psychological factors get in the way.

Compounding effects over a long time horizon -- increases to intrinsic value -- should do the heavy lifting when it comes to generating returns. Yet the incredible low cost convenience of buying and selling in modern equity markets leads some (many?) to a kind of destructive hyperactivity. The equity markets potential strength is converted to a weakness. At least it is for those who choose to trade so often.

I think that Morgan Housel said it very well earlier this year:

"I think the single biggest risk you face as an investor is that you'll try to be a trader. It's the financial equivalent of drunk driving -- recklessness blinded by false confidence. 'Benign neglect, bordering on sloth, remains the hallmark of our investment process,' Warren Buffett once said. It probably should be yours, too."

Sometimes, the biggest challenge is knowing when to -- after doing sensible things around one's own very best ideas -- just get out of the way. Invest in what's sound and understandable. Buy only if attractively priced. Be positioned to act decisively when emotions are running high; when, most likely, the uncertainty or euphoria seem to be at or near its highest. Allow other to lose their composure during the a crisis. Allow others to get caught up in the excitement of seemingly endless and rapid rising prices. Study businesses and learn to judge their long run prospects well. Those prospects may change (or be misjudged), of course, and appropriate action will need to be taken. Serious and permanent damage to the economic moat of a business (i.e. not temporary even if very real difficulties) may warrant action, for example. Extreme overvaluation may warrant action. The opportunity to buy something else that's plainly superior may also warrant action.

All of this is easier said than done.

Otherwise, it generally makes no sense to transact frenetically once something of quality has been bought well in the first place.

Attempts to jump in and out of assets at just the right time is folly.

Such behavior not only adds frictional costs, but likely also increases the chance to that mistakes will be made. When someone buys or sells something in their portfolio, it's naturally done with the idea that it will lead to a favorable result. I mean, pretty much no is going to make a portfolio move unless they expect that move will improve future outcomes. Otherwise, they wouldn't make the move. Yet the evidence suggests just the opposite is likely to happen; it suggests portfolio actions generally reduce returns.

More effort; less reward. That may not be intuitive but, at least, deserves some thoughtful consideration. Some will discount this as just an odd anomaly. Some will choose to ignore it.

That's probably a mistake.

Most participants would benefit from fewer thoughtful moves and by considering how their best ideas are likely to play out over longer time horizons. It's just very easy to be overly confident that each short-term action will result in something fruitful.

I mean, most of us mortals have only so many good ideas. Well, those who are trading all the time seem almost certain to be eventually acting on something that is much further down the list of their best ideas.

Also, frenetic trading means attempting to predict the mostly unpredictable:

That is, near-term price action.

It's important to think of stocks as part ownership of a business because, well, that's of course what they actually happen to be. More from the Berkshire letter:

"When Charlie and I buy stocks – which we think of as small portions of businesses – our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out, or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings – which is usually the case – we simply move on to other prospects. In the 54 years we have worked together, we have never foregone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions.

It's vital, however, that we recognize the perimeter of our 'circle of competence' and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses."

Some will be comfortable judging an individual businesses long-term prospects, estimating its value, deciding on the appropriate margin of safety against that value -- to, at least in part, improve risk versus reward* -- while carefully considering the opportunity costs. If these things are not in one's comfort zone then, well, stay away from stocks.

Some fine low cost index fund alternatives exist and, in any case, it's NOT like most active market participants -- professional or not -- end up doing better than a broad-based index.

Either way, whether stocks or low cost index funds make sense, frequent trading is generally unwise.
(There are, no doubt, exceptions to this but a plan built around being one of the exceptions seems like no plan at all.)

So investing well requires tuning out the noise, an emphasis on reducing errors where possible, and an understanding of how and why certain psychological biases create trouble that can be costly.

Like many things, this naturally also requires a realistic assessment of one's own abilities and limits.

Tuning out the noise means mostly ignoring the near-term quoted prices. The inevitable wild fluctuations will be mostly driven by changes to market participant psychology -- and maybe a build up of leverage that, when prices go the wrong way, results in forced transactions to meet margin calls -- instead of changes to intrinsic business value.

For good businesses -- and even some of less quality -- those quoted price fluctuations will inevitably be much greater than changes to underlying per share value.

Make that an advantage.


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

* The price paid for an asset can serve to improve risk versus reward but only up to a point. In other words, there are limits to how much a reduced price can be used to manage risks. Sometimes, for example, no price is low enough because the low end of estimated intrinsic business value is too difficult to judge.

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

Friday, May 23, 2014

Buffett and Munger Talk Retail Businesses, Nebraska Furniture Mart, and Amazon

Warren Buffett and Charlie Munger talked about retail businesses more generally, as well as Nebraska Furninture Mart, and Amazon (AMZN) specifically, in this recent CNBC interview:

MUNGER: I think Warren and I can match anybody's failures in retail.

BUFFETT: Yeah, we have a really bad record, starting in 1966. We bought what we thought was a second-rate department store in Baltimore at a third-rate price, but we found out very quickly that we bought a fourth-rate department store at a third-rate price. And we failed at it, and we failed...

MUNGER: Quickly.

BUFFETT: Yeah, quickly. That's true. We failed other times in retailing. Retailing is a tough, tough business, partly because your competitors are always attempting and very frequently successfully attempting to copy anything you do that's working. And so the world keeps moving. It's hard to establish a permanent moat that your competitor can't cross. And you've seen the giants of retail...a lot of giants have been toppled.

MUNGER: Most of the giants of yesteryear are done.

They go on to talk about a very successful retail business Berkshire's owned since the early 1980s:

BUFFETT: Nobody is going to be able to compete with the Nebraska Furniture Mart. I mean, this store does more home furnishing business than any store in the country. And what are we in, I don't know, the 50th market in the country? This store does $450 million annually. It's doing $40 million during the Berkshire shareholders week. But there's no store that remotely can offer the variety. There's no store that can undersell us. But to achieve that kind of dominance, you can't do it with a chain of stores in Canada when you're competing with Wal-Mart up there and a whole bunch of other people.

Buffett and Munger both share a very favorable view of Amazon.* Here's what they had to say when asked about the company's business model:

MUNGER: Well, I think it's very disruptive compared to everybody else, I think it's a formidable model that is going to change America.

BUFFETT: I agree. It's one of the most powerful models that I've seen in a lifetime, and it's being run by a fellow that has had a very clear view of what he wants to do, and does it every day when he goes to work, and is not hampered by external factors like people telling him what he should earn quarterly or something of the sort. And ungodly smart, focused. He's really got a powerful business, and he's got satisfied customers. That's hugely important.

This certainly isn't the first time accolades have been directed at Jeff Bezos by Buffett.

In fact, last year Buffett said that he was "the ablest CEO in America."

Still, retailing certainly is a tough business.

Figuring out whether a moat can be built and sustained is tough to do but it sure helps to have exceptionally talented leadership.

Of course, these days Amazon has moved beyond strictly being a retailer.

Now, whether Amazon ends up being a great investment is another question altogether.

To me, the respect and admiration for Amazon has been well-earned as noted in prior posts.
(Some concerns and criticisms have also been previously highlighted.)

My main problem has always been valuation. More specifically, I've just never understood how to value the business within an acceptably narrow range.

Tough to value is very different than being overvalued.

Based upon price to earnings the company naturally appears quite overvalued and very well may even be. Yet this company -- almost uniquely -- invests with a long view in mind, often executes very well, and makes brilliant use of its working capital. With this in mind, it seems foolish to underestimate Amazon.

Amazon's business is likely intrinsically worth a lot as of now. How much?

I have no idea.

It also has seems to have a reasonable chance of being worth a whole lot more down the road. How much?

Again, I just have no idea.

In both cases, I'm NOT referring to market capitalization; I'm referring to a rough but meaningful estimate of intrinsic value based upon defensible assumptions and sound logic. If what something is roughly worth -- within a narrow enough range -- isn't clear, it's naturally just not possible to judge what an appropriate margin of safety might be.
(The price paid should be a nice discount to estimated value and protect the investor sufficiently against things not going quite as well as expected.)

This simply means, when it comes to Amazon, I can't figure out whether the returns are likely to be sufficient considering the risks and compared to investment alternatives.

Alternatives that I understand better.

Others may have a way to figure out Amazon's value with enough confidence. Those that can are far better candidates to invest long-term in the company.**

The biggest reason I still always pay attention to Amazon is their ability to potentially disrupt (or damage the economic moat of) some other business or industry. Just because the company doesn't compete directly against someone now, doesn't mean it won't down the road.

In other words, what appear to be solid business economics today, end up being badly eroded down the road.

Clearly, certain businesses and industries are more likely to be challenged some day by Amazon than others.

Though I'm not sure ten years ago many would have imagined or anticipated all the moves that Amazon has made since that time.


No position in AMZN

Related posts:
Washington Post Sold To Jeff Bezos
Amazon, Apple, and Intrinsic Value - Part II
Amazon, Apple, and Intrinsic Value
Negative Working-Capital Cycle
Amazon, Apple, and Margin of Safety
Amazing Amazon
Barron's on Bezos: Time to Reign in Amazon's CEO?
Amazon's Jeff Bezos On Inventing & Disrupting
Amazon Sells Kindle Fire Below Cost
Technology Stocks

* Keep in mind they are commenting on Amazon's business NOT necessarily the stock.
** Someone else might find Amazon's intrinsic value easier to estimate, of course. As always, it's knowing what's understandable to you and only investing in those things. This is necessarily unique to each investor. When you stick to what you know fewer errors are likely to be made.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, May 16, 2014

Berkshire Hathaway 1st Quarter 2014 13F-HR

The Berkshire Hathaway (BRKa) 1st Quarter 13F-HR was released yesterday. Below is a summary of the changes that were made to the Berkshire equity portfolio during that quarter.
(For a convenient comparison, here's a post from last quarter that summarizes Berkshire's 4th Quarter 13F-HR.)

There was plenty of buying and selling during the quarter. Here's a quick summary of the changes:*

New Positions
Verizon (VZ): Bought 11.0 million shares worth $ 529 million
Liberty Global Class C (LBTYK): 7.35 million shares worth $ 306 million

The above new position in Liberty Global is at least mostly -- though likely entirely -- related to this announcement. Berkshire received a stock dividend of one Liberty Global Class C ordinary share for each Liberty Global Class A (LBTYA) ordinary share they owned (some of which, as shown below, were purchased during the 1st quarter).

Further information on this can be found here.

Berkshire's latest filing did not indicate any activity was kept confidential. Occasionally, the SEC allows Berkshire to keep certain moves in the portfolio confidential. The permission is granted by the SEC when a case can be made that the disclosure may cause buyers to drive up the price before Berkshire makes its additional purchases.

Added to Existing Positions
IBM (IBM): 233 thousand shares worth $ 43.5 million, total stake $ 12.7 billion
Wal-Mart (WMT): 8.57 million shares worth $ 658 million, total stake $ 4.46 billion
U.S. Bancorp (USB): 706 thousand shares worth $ 28.6 million, total stake $ 3.25 billion
DaVita (DVA): 1.16 million shares worth $ 78.6 million, total stake $ 2.55 billion
Verisign (VRSN): 724 thousand shares worth $ 35 million, total stake $ 566 million
Liberty Global Class A (LBTYA): 4.40 million shares worth $ 192 million, total stake $ 321 million

Reduced Positions
DirecTV (DTV): 2.0 million shares worth $ 170 million, total stake $ 2.94 billion
General Motors (GM): 10.0 million shares worth $ 344 million, total stake $ 1.03 billion
Phillips 66 (PSX): 17.4 million shares worth $ 1.43 billion, total stake $ 799 million
Starz (STRZA): 2.62 million shares worth $ 77.7 million, total stake $ 56.9 million

The reduction in shares of Phillips 66 came about as a result of this deal.

Todd Combs and Ted Weschler are responsible for an increasingly large number of the moves in the Berkshire equity portfolio, even if they still manage a small percentage of the overall portfolio.

These days, any changes involving smaller positions will generally be the work of the two portfolio managers.
(Though some of the holdings they're responsible for have become more substantial over time.)

Top Five Holdings
After the changes, Berkshire Hathaway's portfolio of equity securities remains mostly made up of financial, consumer and, to a lesser extent, technology stocks (mostly IBM).

1. Wells Fargo (WFC) = $ 22.7 billion
2. Coca-Cola (KO) = $ 16.2 billion
3. American Express (AXP) = $ 13.3 billion
4. IBM (IBM) = $ 12.7 billion
5. Wal-Mart (WMT) = $ 4.46 billion

The additional purchases of Wal-Mart shares moved the position into the top five in place of Procter & Gamble (PG).

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

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

According to their latest filing, the combined portfolio value (equities, cash, bonds, and other investments) at the end of the most recent quarter was ~ $ 227 billion (including the investment in Heinz).

The portfolio, of course, excludes all the operating businesses that Berkshire owns outright with, according to the latest letter, a bit more than 330,000 employees combined.

Here are some examples of the non-insurance businesses:

MidAmerican Energy, Burlington Northern Santa Fe, McLane Company, The Marmon Group, Shaw Industries, Benjamin Moore, Johns Manville, Acme Building, MiTek, Fruit of the Loom, Russell Athletic Apparel, NetJets, Nebraska Furniture Mart, See's Candies, Dairy Queen, The Pampered Chef, Business Wire, Iscar, Lubrizol, Oriental Trading Company, as well as 50% of Heinz.
(Among others.)

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

See page 111 of the annual report for a full list of Berkshire's businesses.


Long positions in BRKb, KO, WFC, AXP, PG, USB, WMT, DTV and PSX established at much lower than recent market prices. Also, small long position in IBM established at slightly less than recent market prices.

* All values shown are based upon Thursday's closing price.
** Berkshire Hathaway's holdings of ADRs are included in the 13F-HR. What is not included are the shares listed on exchanges outside the United States. The status of those shares are updated in the annual letter. So the only way any of the stocks listed on exchanges outside the U.S. will show up in the 13F-HR is if Berkshire happens to buy the ADR. Investments in things like the preferred shares (and, where applicable, related warrants) are also not included in the 13F-HR. The same is true for the Heinz common shares (i.e. not just the Heinz preferred shares).
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, May 12, 2014

Why Do So Many Investors Underperform?

This previous post focused on how investors do compared to the mutual funds they own.

Not very good.

Well, not surprisingly, they also don't do particularly well against the S&P 500.

20-year annualized returns ending in 2012
- Average Investor: 2.3%

- S&P 500: 8.2%

A separate study by Dalbar indicated a similar outcome for the 20-year period ending on December 31, 2013.

20-year annualized returns ending in 2013
- Average Investor: 5.02%

- S&P 500: 9.22%

The 30-year relative returns look, in a similar fashion, well, terrible.

The discrepancy between the studies probably isn't just down to the slightly different time frames. Each study inevitably has different methodologies, limitations, and imperfections. From this Wall Street Journal article:

Louis Harvey, Dalbar's president, says, "We have comfort that our method is reasonable," although he adds that "every method has its flaws."

Some experts think the Dalbar numbers overstate the gap. Both of the above suggest a meaningful gap. Others suggest a somewhat smaller gap in performance.

Yet they all reveal, even if to varying degrees, some meaningful level of underperformance.

What should matter less than the specific gap in performance is what it says about investor behavior. Well, a big driver of investor underperformance, to put it only somewhat too simplistically, is the tendency to chase what's recently been hot and selling what's not.

Basically buying what has already been bid up and selling what's cheap. A great way to guarantee less than stellar results and, unfortunately, a too reliable pattern of behavior.

Investors with long enough time horizons would benefit from less action. Attempts to jump in and out at just the right time are surely well-intentioned but often misguided. Many think they can successfully navigate in such ways; far less actually do. Selling when the headlines indicate trouble lies ahead -- sometimes even serious trouble -- and stock prices have moved in accordance with such news is another way to absolutely minimize returns.* John Bogle, not surprisingly, says it very well:

"The way to wealth, it turns out, is to avoid the high-cost, high-turnover, opportunistic marketing modalities that characterize today's financial service system and rely on the magic of compounding returns. While the interests of the business are served by the aphorism 'Don't just stand there. Do something!' the interests of investors are served by an approach that is its diametrical opposite: 'Don't do something. Just stand there!'"

Some of this comes down to the tendency to chase performance. In effect, this behavior leads to buying high. Chasing performance usually reduces returns. In addition, market participants tend to be sellers when things seem to be (or are) going very wrong. Well, that's usually when stocks are cheap. The pattern of buying high and selling low -- though, of course, intending to do otherwise -- leads to a predictable outcome.

Unfortunately, it's not just individual investors who are susceptible to actions that end up hurting results:

"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."

Also, at least if the following is any indication, the long run performance of most actively-managed mutual funds is hardly impressive:

% Actively-Managed U.S. Equity Funds that Outperform
- Over 20 Years: 20%

- Over 30 Years: 14%

- Over 40 Years: 12%

Pros aren't necessarily immune to buying what's hot or what currently has the most compelling story to tell. Some money managers feel pressure to perform on a shorter term basis and the necessity to buy what's currently in vogue, for example. They may also be prone to sell shares of a struggling business (or be forced to sell due to fund investor redemptions) at a price that reflects the troubles. This is often done with the idea (or hope) that it will somehow be possible to buy back in at an attractive price if/when prospects improve.
(Though, of course, there are also many capable money managers who have the discipline to avoid this sort of thing. Now, at least in theory, it shouldn't be impossible to figure out who has a sound long-term investing approach, does a good job of balancing risk and reward, and has a track record to back it up. In practice, unfortunately, it's a bit tougher to figure out which specific funds will do well many years into the future.)

This paper looks specifically at hedge fund investor performance from 1980-2008:

"Our main finding is that annualized dollar-weighted returns are on the magnitude of 3% to 7% lower than corresponding buy-and-hold fund returns. Using factor models of risk and the estimated dollar-weighted performance gap, we find that the real alpha of hedge fund investors is close to zero. In absolute terms, dollar-weighted returns are reliably lower than the return on the Standard & Poor's (S&P) 500 index, and are only marginally higher than the risk-free rate as of the end of 2008.The combined impression from these results is that the return experience of hedge fund investors is much worse than previously thought."

Keep in mind that this has had -- and is likely to continue having -- a big impact on institutional investors (pensions, foundations, educational institutions). Why is that? Apparently, at least 60% of the money invested in hedge funds these days comes from institutional investors.**

The paper then later adds that, once again, the subpar performance "seems predominantly driven by investors' return-chasing behavior."

Logically, it seems reasonable to wonder if one repercussion of all this might be that a number of pensions and other institutional investors will, as a result, find it difficult to fund their liabilities down the road.

Some of the shortfall no doubt comes down to promising too much. Yet the study above more than suggests that part of the problem will be investment policies, practices, and behavior. Meanwhile, a large proportion of investable funds are going where some of the highest frictional costs exist. With roughly 60% or more of hedge fund assets coming from institutional investors, these frictional costs are now deeply embedded in the system. So some pensions and the like may not be able to meet their long-term obligations but those who directly manage a bunch of that money -- the hedge funds -- certainly seem likely to come out just fine. In fact, the current system seems almost designed to produce just such an outcome.

Now, it's hard to fault the hedge funds, they're just going where the money is. Perfectly reasonable. It seems more about those institutional investors who choose to allocate capital this way yet are in a position to do otherwise.

In addition, at least if the above study is a mostly reliable indicator, too many what should be rather sophisticated investors behave in a way that's usually attributed to less experienced investors:

- Paying excessive fees.

- Frequent or, at least, inopportune buy and sell behavior -- in part, the result of short-termism, an illusion of control, and overconfidence -- that leads to unnecessary mistakes (and yet even more frictional costs).

- Chasing performance during the good times; selling during the tougher times; too little emphasis on margin of safety at all times.

- A focus on near-term and intermediate-term price action instead of intrinsic values -- considering the specific risks much of which is not quantifiable -- and how that value may change over time.

Among other things that generally hurt results.

So, if the study of hedge fund investor performance is even close to being correct, it means that the system in its current form surely isn't working all that well.

There are certainly some fine money managers, but that hardly guarantees the system as a whole is effective.

Even if performance was generally equal to the S&P 500 (instead of underperforming as these as these various studies suggest) there's no getting around the reality that lots of very smart people -- both those who manage funds along with the institutions that choose to invest their capital in these funds and other assets -- are engaged in these activities. If the outcome, give or take, merely matches a more passive approach, it begs the question whether that talent would be better applied elsewhere.

It's just hard to imagine how the current system is anywhere near optimal.

Now, as noted above, it's tough to fault those who choose to work in such a lucrative field. That doesn't mean the compounded negative impact of the current system over time isn't very real.

The many capable individuals who work hard to deliver superior investment results -- though often appear to be not doing so -- might just be better allocated to more productive activities.

Again, it's not as if any of these studies should be considered somehow absolutely correct. Given the inevitable biases -- and at least somewhat flawed methodologies -- that likely exist, some skepticism is warranted.

Yet, even though surely less than perfect, these results shouldn't just be discounted or ignored. It would take some contorted logic or clever marketing to do so. These studies at least suggest there's an opportunity for market participants (professional and non-professional) to improve results with some wise changes to behavior.

"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

"...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

The importance of eliminating error (or "tuning out the standard stupidities..." ) is naturally relevant to both the individual investor and the institutional investor.

Maybe, with a concerted effort over many years some of the more obvious systemic defects as well as well as the behavioral biases and tendencies that lead to unnecessary errors and frictional costs, will become at least reduced.

It's probably never going to be easy for the bulk of participants to outperform the market as a whole, but that doesn't mean the rather lousy long-term results -- experienced by both individual and institutional investors -- noted above are an inevitability.***

Still, history suggests changes will come slowly if at all.

Overcoming at least some of the behaviors that lead to poor investment decision-making alone is an awfully tough thing to do.

Even in the best of circumstances, things like cognitive bias play a big role in investor performance. Too many kid themselves that they're not susceptible to the kind of psychological forces that can hurt long-term results.

They pretend it's the other guys problem.

They imagine they'll be the coldly rational ones when it counts.

Well, fewer actually act in such a way when it matters. The above results do indicate a pattern of buying high and selling low. In other words, too many act greedy when others are greedy and fearful when others are fearful. This is, of course, pretty much the opposite of what's desirable over the longer haul. Many participants, beforehand, probably believed they'd behave otherwise; that they'd be the ones who acted sensibly during market extremes. Well, at least they did before things really started to go south; at least they thought they'd see the prevailing exuberance (and premium prices) for what it really was before they became caught up in it themselves.

Generally, the only way to buy a good asset at a nice discount to intrinsic value is when fear is pervasive. Similarly, the chance to sell at an attractive price will usually be when exuberance and greed dominate the psychological landscape. Making decisive and mostly correct decisions when the economic storm is most intense and the headlines are scariest -- whether company specific or more macro in nature -- is never easy. Watching something bought at a price that seems cheap become cheaper on a quoted basis -- even if, with the benefit of hindsight, it turns out to only be a temporary drop -- is never easy. On the other end of the spectrum, seeing others profit -- making what seems like the quick and easy money -- during exuberant market environments is tough for even very smart participants to ignore.
(Now, especially when it comes to individual stocks, this also requires knowing the difference between temporary -- even if serious -- but fixable problems and, well, maybe terminal problems.)

So it's not likely that a large proportion of those who put money at risk in the equity markets will change behavior and, as a result, improve results. That doesn't mean the individual investor -- whether a professional or not -- can't at least learn to overcome some of the most obvious mistakes that get made. The gap in performance could at least be closed somewhat with some systemic changes and with altered behavior from professional and non-professional market participants.
(If nothing else via changes that lead to reduced frictional costs.)

It's a real opportunity even if potent forces -- some psychological, some policy, some purely economic -- work against the needed changes.

So yeah, realistically, meaningful improvements will be difficult to come by.

Difficult is not the same as impossible.

This could, all things being equal, make it more difficult for any one participant to outperform the market. Well, to me, equity markets would be much improved if participant returns were mostly the result of per share intrinsic value increases over long time frames, and less from clever trading around near-term price action.

That just might dial back the prevalence of casino-like activities, and bring to the forefront effective capital formation and allocation.

Equity markets should, first and foremost, effectively, and with the lowest possible frictional costs, facilitate moving capital to where the real economy needs it.

They should be designed to serve longer term oriented investors instead of those who mostly benefit from -- via either fees, commissions, or both -- increased market activity and asset gathering regardless of investment outcome.

They certainly shouldn't be designed to encourage making various kinds of short-term bets.


Related posts:
When Mutual Funds Outperform Their Investors
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

Related articles:
Finding the Right Mutual Funds
The Performance of Mutual Funds
Don't Bet on Luck, Active Management Underperforms
Jack Bogle's market advice: "Don't do something; just stand there"

* Not to be confused with stubbornly holding onto an a bad investment that's dropped substantially. That's a great way to achieve lousy investment outcomes. Sticking with a losing proposition often leads to even bigger losses. It's just that even the soundest long-term investments will see price action that has little to do with long-term prospects and core economics. A sound investment process requires, in part, that assets only be bought when sufficiently mispriced on the low side. The investment process also requires learning to make temporarily reduced prices of a good asset your friend (or at least not making it your enemy by selling into the negative price action).
** The same paper does a good job of explaining why measuring hedge fund results from inception "is a poor representation of the return of actual investors". The reason? Investors add capital in "widely uneven bursts". So, by dollar-weighting over time to account for these bursts, they get a more meaningful measure of actual investor results. As it turns out, returns are much reduced when adjusted for this. The adjustment is meant to better reflect the actual returns on the amount of capital that's invested and when it is invested. So the longer term results, when measured from inception, appear a whole lot better than the results of investors when dollar-weighted over time. One can choose to blame the fund investors for their poor timing, the fund managers, or both, but the actual results, either way, appear to be just not good if this paper is any indication. Keep in mind that hedge funds now manage something like $2.5 trillion -- up from $38 billion in 1990 -- and have underperformed the S&P 500 over the last five years. Now, five years isn't really a long enough time frame to judge relative performance. Still, I think it's fair to say that it'll likely be a whole lot more difficult to outperform with $ 2.5 trillion in assets to manage than it was when the industry had far fewer assets to manage. The hedge fund industry, if nothing else, has successfully gathered lots of assets. Will future results become a further victim of that success? We'll see. Who knows, maybe the longer term investor results will end up being just fine but it at least seems that, all things considered, some skepticism is warranted. Some make the argument that the goal of hedge funds was never to outperform an index like the S&P 500. That they're, instead, about managing risk. Well, managing risk is certainly a big part of effective capital allocation. Whether a satisfactory risk and reward trade off will be achieved by the vast majority of hedge fund investors, considering the frictional costs and other factors, also seems to deserve some skepticism. This article, which covers findings from a book by Simon Lack, suggests returns are actually far worse than they would appear especially if "survivor bias" is considered. In other words, since only surviving hedge funds report results, the overall performance seems better than it is. Adjusting for this bias, hedge fund investor returns, from 1998 through 2010, were negative $ 308 billion while the fees collected by hedge funds were $ 324 billion. Separately, this offers an interesting argument that it is pension accounting itself creating an incentive to continue investing in hedge funds when it might otherwise not make sense.
*** Naturally, returns for participants, in aggregate, can only be equal to the market returns minus frictional costs of all kind. I'd add that it seems about time to put to rest the idea that it's only the individual investor who is susceptible to the kind of behavior -- as noted above in the main section of this post -- that is detrimental to results. Whether we are talking about individuals, institutions, or the fund managers, it appears that long-term underperformance by a large proportion of participants -- even if it's to varying degrees -- is the norm.
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, May 5, 2014

Berkshire Hathaway 2014 Meeting Highlights


Below I've summarized some of the highlights from the 2014 Berkshire Hathaway (BRKa) shareholder meeting.

Berkshire's Cost of Capital
At the meeting, Warren Buffett responded -- according to the Wall Street Journal recap -- to a question about Berkshire's cost of capital and whether the company is likely to exceed that cost in the future:

"We view our cost of capital as the returns we can get from our second-best idea…and we have to exceed that" with our best idea. But he also says he doesn't really trust or believe calculations of cost of capital…and says people who talk about cost of capital often don't know what they're talking about.

"We think we can evaluate businesses" that are available to buy, and measure whether it'd be better to own them or the stocks already in their portfolio.

Seems straightforward enough even if many still think it makes sense to bother calculating the cost of capital in some kind of precise fashion. I think that the following exchange from more than a decade ago does a good job of capturing how Warren Buffett and Charlie Munger think about cost of capital:

Buffett: Charlie and I don't know our cost of capital. It's taught a[t] business schools, but we're skeptical. We just look to do the most intelligent thing we can with the capital that we have. We measure everything against our alternatives. I've never seen a cost of capital calculation that made sense to me. Have you Charlie?

Munger: Never. If you take the best text in economics by Mankiw, he says intelligent people make decisions based on opportunity costs -- in other words, it's your alternatives that matter. That's how we make all of our decisions. The rest of the world has gone off on some kick -- there's even a cost of equity capital. A perfectly amazing mental malfunction.

Hedge Fund Bet Update
Buffett also provided an update on a $ 1 million friendly wager he made roughly six years ago with Protege Partners LLC, a New York fund of hedge funds.

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

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

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

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

So how are the hedge funds chosen by Protege doing so far against the S&P 500?

S&P 500: 43.8%

Hedge funds: 12.5%

Who knows how this ends up and, even if it does go Buffett's way, one bet certainly isn't definitive. On the other hand, considering the differences in fees* and other frictional costs, the outcome so far is not really surprising.

In other words, if it were practical to run the experiment 20-30 times, I think it's not unfair to say the S&P 500 has a pretty good chance to do relatively well most of the time. The willingness by some to pay rather substantial incremental fees seems more than a little bit remarkable.

The behavior would make a whole lot more sense if the long-term performance advantage was plain to see.

Per-share Book Value As A Performance Measure
At the meeting, there was a question about why Berkshire uses book value per share to measure performance. It's, as Buffett has explained in the past, a useful though imperfect measure:

"We have no way to pinpoint intrinsic value. But we do have a useful, though considerably understated, proxy for it: per-share book value."

Buffett adds that book value per share is not very meaningful at most companies. For Berkshire, it just happens to be a convenient proxy, as long as an appropriate adjustment is made that takes the inherent understatement into account. Here's how The Motley Fool summarized what Charlie Munger had to say in response to the question:**

For almost all of its recorded history, Berkshire has measured its performance by comparing growth in book value per share to the gains in the S&P 500 index.

But when asked about this comparison, Charlie Munger was uncharacteristically outspoken. Munger noted that, "Warren likes to make it difficult for himself." In effect, he said the measure was an unnecessary handicap...

It's true that per-share book value is an imperfect measure -- and probably to an increasing extent over time -- but it can still be used to roughly understand changes to per-share intrinsic value.

Still, its limits must be recognized. Check out the 2010 letter (page 6) for more on estimating Berkshire's intrinsic value.

Over time, as Berkshire becomes more about operating businesses and less about marketable stocks, this measure seems likely to become even more imperfect for tracking per-share intrinsic value and how much it changes.***

Activist Investors
According to the New York Times, later on in the meeting Buffett and Munger added the following about activist investors.

Buffett: " certainly scares the hell out of a lot of managers."

Munger: "I don't think it's good for America."

Apparently, Munger also likened investor activism to the way Oscar Wilde described fox hunting:

"...the unspeakable in full pursuit of the uneatable."

Earlier today, in this CNBC interview, Charlie Munger was asked whether investor activism is generally good for America. His response was only somewhat more charitable:

"Well, sometimes it's good, and sometimes it's awful. And I'm afraid that's just the way it is."

Warren Buffett, sitting next to him in the same interview, said this:

"Some of them [corporations] are going to be poorly run and some of them are going to be run in a very self-interested manner by the managers. What is the correction for that? And activism can be a correction for some of that."

Buffett then later added:

" immediate bump in the stock price should not be the measure of whether somebody has accomplished something successfully in a corporation. But there are times when change is needed in corporations and they're not going to do it themselves."

So Buffett seems, on balance, to have a somewhat more favorable view of activists compared to Munger even if that's not saying much. The measure of activist impact -- favorable or otherwise -- isn't, as Buffett says, whether actions move a stock price short-term or, for that matter, even intermediate-term; it's whether their actions produce a lasting impact on long-term business prospects.

It's just worth remembering there are things that will move up a stock price near-term yet do nothing for -- or even hurt -- business performance many years down the road. One can only guess but this may be what Munger means when he says "sometimes it's awful."

Just because someone is in a position to purchase lots of shares in a particular business, it hardly guarantees they're an expert in that business. Large percentage ownership doesn't necessarily mean the challenges that plague a particular business are understood with sufficient depth. The activist who's terrific in one arena might decide, not judging their own limits well, to move into an arena they know a whole lot less well.

Smart people with lots of funds to deploy aren't immune to overconfidence.

Activist investors who tend to buy for the long-term at least have to live with the consequences of their actions. If they influence things in a way that leads to a good long-term outcome, they'll be appropriately rewarded. If not, they'll suffer the same consequences as other owners. With a longer term focus, they're also more likely to develop a deeper understanding of business challenges and opportunities (though this is hardly assured). Well, some just aren't all that oriented to the long-term.

Buffett said the following last year which seems relevant here:

"I do not think that companies should be run primarily to please Wall Street and largely shareholders who are going to sell. I believe in running Berkshire for the shareholders who are going to stay and not the one's who are going to leave."

There are certainly more than a few capable and effective activist investors.

That doesn't mean there are yet enough focused on the longer term effects of their actions.

This seems a real opportunity to greatly enhance the current system.

Too Much Cash?
Later in the meeting, Buffett did indicate that "we will have more cash than we can intelligently invest in the future" and added "It's not on a distant horizon. The number is getting up to where we can't intelligently deploy the amounts coming in."

For some Berkshire investors these comments might be viewed as a hint that buybacks (if/when the price is right), and maybe even dividends, will increasingly need to be where excess capital ends up being allocated.

The question, of course, is just how soon. That's much harder to figure out even if "not on a distant horizon."

Buffett made it clear that any decision along these lines will be driven by the principle that it be in the interest of shareholders.


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

* Many hedge funds are compensated via the '2 and 20' fees or something along those lines. In contrast, some low cost S&P 500 index funds cost less than 1/10th of a percent.
** According to Bloomberg, Charlie Munger said the following about using per-share book value as a measure of performance: "Warren has set a ridiculously tough standard," Munger said today in Omaha, Nebraska. "If this is failure, I want more of it."
*** In the 2013 letter, Buffett makes the point that the difference between intrinsic value and book value is becoming larger: "As I've long told you, Berkshire's intrinsic value far exceeds its book value. Moreover, the difference has widened considerably in recent years. That's why our 2012 decision to authorize the repurchase of shares at 120% of book value made sense. Purchases at that level benefit continuing shareholders because per-share intrinsic value exceeds that percentage of book value by a meaningful amount."
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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