The Investments Blog

Munger's Daily Journal: Portfolio Expands Eight-Fold Over Five Years

2012-02-13T13:46:00.003-05:00

What are the long-term prospects for the The Daily Journal?

I think that's far from clear but the results from the deployment of company funds into investments have been impressive in recent years. When it comes to deploying the company's funds, The Daily Journal benefits from having Charlie Munger as its Chairman.

Through smart deployment of free cash flow and cash on the balance sheet, the Daily Journal (DJCO) has increased the value of investment portfolio by roughly eight-fold in five years.

Yeah, that's right.

The Daily Journal is a good example of a solid, if unexciting, core business with difficult to judge (at least for me) long-term prospects.

Yet, because, at least in the near term or medium term, the core business continues to require little capital, the excess funds it produces can be allocated to other high return use. It's a study in why it often makes sense, when in doubt, to choose shares of businesses that require little capital to remain competitive.

Growth prospects for a business can be uninspiring if the excess capital it produces can be allocated productively elsewhere (the worst businesses need every dollar they make and then some to maintain competitiveness). The problem starts when those in charge of capital allocation don't make wise choices.

Some businesses can put lots of capital to good internal use while some otherwise fine businesses cannot.

See's Candy is an example of a fine business that doesn't need much incremental capital (prior post: Buffett on See's). The profits from See's over the years have been used by Berkshire to make other attractive investments.

The Daily Journal operates as two different businesses. The company describes its "traditional business" (where effectively all the operating profits are produced) as follows in the latest 10-Q filing:

The Daily Journal Corporation (the "Company") publishes newspapers and web sites covering California and Arizona, as well as the California Lawyer magazine, and produces several specialized information services. It also serves as a newspaper representative specializing in public notice advertising.

The other business is a wholly-owned subsidiary (Sustain Technologies, Inc.). It's been mostly an unprofitable software business which supplies case management software systems and related products to courts and other justice agencies.

I'll look at how capital has been allocated in recent years in a follow up.

Adam

Tweedy, Browne: Positions In Globally Diversified, Underleveraged Businesses

2012-02-10T11:47:00.000-05:00

Morningstar's 2011 International-Stock Fund Manager of the Year was awarded to the team that manages the Tweedy, Browne Global Value Fund (TBGVX). It's their flagship international fund.

The team of managers at Tweedy, Browne tend to be positioned in "larger, more globally diversified, underleveraged businesses" selling "products that are of growing interest to emerging middle classes around the globe."*

The fund has relatively low turnover which is always good to see.

According to Morningstar, the annual turnover of the fund is just 12% so there's a pretty good chance the shares owned at the end of a quarter will be held longer term. Funds with very low turnover like Tweedy, Brown Global Value are more about investing, less about trading.

In contrast, what's owned by a fund with very high turnover at the end of a quarter doesn't mean much. What was owned at the end of the quarter has a decent chance of having been sold or being sold sooner than later. Unfortunately, there are too many funds with very short time horizons when it comes to stocks. These funds are more about trading, less about investing.

Here's the top five holding of the Tweedy, Browne Global Value Fund as of the end of the 4th Quarter 2011:

Top 5 Holdings
1 Phillip Morris International (PM)
2 Nestle (NSRGY)
3 Diageo (DEO)
4 Roche (RHHBY)
5 Total (TOT)

The team did trim their position in Diageo somewhat during the quarter. Otherwise, there were no changes among the top five holdings.

Some excerpts of note from the most recent Tweedy, Browne Quarterly Commentary:

Our fourth quarter results were led by continued strength in consumer staples stocks such as Philip Morris, Diageo, Walmart and Unilever, and a significant uptick in some of our more cyclical holdings including Axel Springer, Total, Royal Dutch, and Union Pacific.

Later in the letter they added...

We continue to maintain significant positions in consumer staples and healthcare stocks, but also have substantial positions in more cyclical areas such as insurance, industrials, energy and media. While the spread in valuation between the more defensive and the more cyclical parts of the equity market has widened of late, the overall valuation for our portfolios remain quite reasonable to attractive with a forward 2012 weighted average price earnings ratio for our Funds' equities, which range between 11.4X and 12.3X estimated earnings.

It's notable that positions in consumer staples make up over 30% of the portfolio. That high percentage allocation is not unlike the low turnover equity portfolios of Berkshire Hathaway (BRKa) and The Yacktman Funds. Many funds have a smaller allocation because they're considered "defensive" investments even though there's plenty of evidence that suggests otherwise.

Both Berkshire and Yacktman have more than 30% of their equity portfolio in consumer staples stocks.

Readers of my many prior posts on consumer staples stocks will know that I generally favor shares of the better ones as core long-term holdings.

Of course, like anything else, the shares need to be purchased at reasonable valuations. Many of them were very reasonable valued not too long ago.

The discounts on most are much smaller now.

Still, when bought well and held longer term the best consumer staples businesses are capable of producing very attractive risk-adjusted returns.

Adam

* From the Tweedy, Browne 4th Quarter 2011 Commentary

Established long positions in PM, DEO, TOT, WMT, and UNP at much lower than recent prices

Buffett: Why Stocks Beat Gold and Bonds

2012-02-09T11:41:00.001-05:00

There's a new column in Fortune Magazine by Warren Buffett well worth reading in its entirety. In the column, which is an adaptation from his upcoming shareholder letter, Buffett writes about what he describes as the three major categories of investments.

Warren Buffett: Why stocks beat gold and bonds

Below are some excerpts of Buffett's thoughts on the first of the three categories.

Category I: Currency-Based Investments

Risk and Beta
The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability -- the reasoned probability -- of that investment causing its owner a loss of purchasing power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period...a nonfluctuating asset can be laden with risk.

The Most Dangerous Assets
Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as "safe." In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.

Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as these holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur.

...and the U.S. dollar?

Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire.

Buffett goes on to make the point that 4.3% interest annually tax-free would be needed from bond investments since 1965 to just maintain purchasing power. In other words...

...managers would have been kidding themselves if they thought of any portion of that interest as "income."

Of course, for most of us, interest is certainly not tax-free.

These days, many are willing to accept a 2% yield on 10-Year U.S. Treasury notes and, somehow for them, that's enough interest income to compensate for the risks.

Now, think of that interest income the same way you'd think about the earnings produced by a good business.

In effect, these investors are paying a price to "earnings" ratio of 50x (inverse of the 2% yield) for an investment that, unlike shares of a good business, has no possibility of any growth in the stream of income.

At 2%, the interest income is likely to prove inadequate when it comes to maintaining purchasing power in the long run. Inadequate compensation considering the risks.

In contrast, it's not hard to find businesses with shares selling at a price to earnings ratio of 12-14x and, in some cases, even less. With the better businesses, there's a more than a reasonable probability they'll produce a stream of earnings that grows in a way that more than maintains purchasing power.

As always, the key is buying the shares at a price (margin of safety) that provides more than adequate compensation considering the risks.

Of course, unlike a 10-Year U.S. Treasury note, a business usually pays out only a portion of earnings as an explicit dividend but the part not paid out is obviously no less real.

The question always is how intelligently the part that is not paid out is put to work. As long those retained dollars are consistently put to high return use by management*, the economic value created will increase shareholder value. It should also enhance the capacity for meaningful dividend growth for most businesses.

Good businesses, those with durable competitive advantages, can produce a rising stream of earnings over time yet require only modest incremental capital investment.

The best have pricing power and, as a result, a built in capacity to offset the inevitable degradation of a paper currency.

Despite the relative undesirability of currency-based investments, Buffett still makes the point that it's wise to always have ample liquidity. For Berkshire, that is at least $ 10 billion in something like U.S. Treasury bills though the company generally has much more on hand.

The thinking that fluctuation equates to risk or that shares of a good business bought at a reasonable price relative to value is somehow more risky than currency-based investments is just plain flawed.

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

Adam

* Far from a certainty so find businesses run by capable management with sound capital allocation skills. You need a management that knows when it'd better to return money to shareholders versus pursuit of low return projects or acquisitions that may be more about expanding the empire at the expense of shareholders.

Barron's on Bezos: Time To Rein In Amazon's CEO?

2012-02-08T12:39:00.000-05:00

According to Barron's it is.

Some excerpts from this recent Barron's article on Amazon's (AMZN) Jeff Bezos:

Spending Like A Drunken Sailor
Since its inception, Amazon has spent like a drunken sailor in the name of innovation, expansion and increased market share. And for the most part, investors who believe in the company have been willing to overlook weak profit-margin growth as long as the top line continued to rise.

The article continue with the following...

Amazon's Hall Pass
Amazon shareholders have been conditioned to expect slender profit margins in exchange for sales growth, but perhaps they should start holding Amazon to profit expectations as they do other retailers. "The market has always given Jeff Bezos a hall pass on margin erosion," says Larry Haverty, associate portfolio manager of the closed-end Gabelli Multimedia Trust, which owns a small stake in Amazon. "In this case, it seems that anything that Jeff wants to do, he has a license to do. Will investors ever take the hall pass away?"

Barron's: It's Time to Rein In Bezos
---
Some fans of the company's stock seem to argue that it is Amazon's superb free cash flow justifies the extreme valuation.

The problem with that is growth in accounts payable makes up a large portion of the company's operating cash flow. It's growth financed (at least in part) by vendors. That may be a good source of "float" (zero-cost financing) and a sound working capital model, but it shouldn't be considered high-quality cash flow. Adjust for the impact of accounts payable growth, subtract CapEx, and it becomes clear that the company's free cash flow has been unimpressive (and I'm being kind here) over the past three years and is certainly not improving.

More from the Barron's article:

"Low Quality" Cash Flow
IN ESSENCE, AMAZON IS THROWING OFF "low-quality" cash flow, which makes it difficult to justify the high price of the shares—even after last week's drop, Haverty argues. Amazon is trading at 70 times forward earnings, compared with Apple (AAPL), which is trading at 10 times earnings.
---
Apple earned more money last quarter than Amazon has earned in total over the 17 years that it has been in business. Of course, Amazon became profitable until 2003. So, to be fair, let's not include the early unprofitable years. Instead, let's add Amazon's last nine years* of positive earnings together then compare that total to Apple's most recent quarter. Do that math and it turns out Apple earned in roughly 35 days last quarter what Amazon earned in all of its nine profitable years added together (yeah, that's right).

The article goes on to make the following points:

-Amazon has never been a shareholder-friendly company.

-Bezos has always believed in expansion regardless of cost.

-Investors shouldn't expect Bezos to change after 17 years on the job.

I'd add that shares outstanding have grown by well over 20% in the past decade.

It goes without saying that Amazon is a very significant and successful company. The success is born, in part, from shareholders willing to accept modest profits now with an eye toward a promising future.

A long-term view by management is a very good thing. As is a long-term view by investors but it all comes down to whether the price paid provides an acceptable risk-adjusted return.

Relative to available investing alternatives, I suspect those who have paid recent prices (and even quite a bit lower) won't get compensated all that well on a long-term risk-adjusted return basis.

Time to start thinking about revoking the hall pass?

Adam

* From 2003-2011. Amazon lost money in all previous years so adding in any other year would only make the comparison worse.

Coca-Cola Reports Full-Year and 4Q 2011 Earnings

2012-02-07T10:47:00.002-05:00

From the Coca-Cola (KO) Full-Year and 4th Quarter 2011 Results released earlier this morning:

The Coca-Cola Company reported worldwide volume growth of 5% for the full year and 3% during the quarter. Excluding new cross-licensed brands in North America, primarily Dr Pepper brands (which the Company began distributing Oct. 2, 2010), worldwide volume grew 4% for the full year, at the high end of our long-term growth target. Volume growth for the full year was well-balanced across the globe, with solid growth in key developed markets like North America, Japan and Germany and double-digit growth in key emerging markets like India and China. In addition, solid growth continued in countries with per capita consumption of Company brands less than 150 eight-ounce servings per year, with volume up 6% for the full year and 4% in the quarter.

The press release also added the following:

We continued to see growth in sparkling beverages, with gains in global volume and value share for the full year and in the quarter. This growth was driven by our continued focus on and investment in our brands, starting with brand Coca-Cola. Brand Coca-Cola volume grew 3% in both the full year and the quarter, with strong growth in the fourth quarter in a number of markets around the world, including 33% in Thailand, 15% in India, 13% in China, 12% in Argentina, 9% in Germany, 8% in Russia, 4% in both Mexico and France, and 3% in Japan.

Perspective can sometimes be lost comparing earnings year over year or quarter over quarter. Occasionally, it is worth stepping back a bit instead of making such short-term comparisons. For an investor, understanding the sustainable long-term trajectory of a business is what matters. Sometimes the near-term noise gets in the way of understanding that sort of thing.

Let's see how Coca-Cola's business has progressed since prior to the beginning of the financial crisis. One test of a good business is how it performs during times of stress.

I think it's fair to say that 2006 to 2011 saw more than its share of economic challenges.

Coca-Cola's earnings in 2006, the year before the market peaked and the financial crisis started unfolding, was just over $ 5 billion.

During 2008, when the financial crisis was really gaining some momentum earnings came in at $ 5.8 billion (slightly lower than 2007). So while many other businesses experienced dramatic reductions in profitability, Coca-Cola continued to do just fine. The economic stresses merely ended up delaying some earnings growth.

From the most recent earnings report, we just learned that Coca-Cola earned $ 8.6 billion for the full year of 2011.

So, with $ 8.6 billion in 2011 earnings, the company appears to have been able to improve earnings nearly 70% compared to the just over $ 5 billion it earned in 2006 (on a per share basis it's slightly better as share count has been reduced slightly via buybacks). I think that counts as a pretty solid performance considering much of that time contained an extended tough economic environment.

It's not just that Coca-Cola's earnings have fully recovered to pre-crisis levels and then some (some lesser businesses have still not even returned to pre-crisis profitability), it's that earnings didn't drop off much during the worst of the crisis.

A sign of resilience.

A good way to understand the earnings power of most businesses is to see what happens over a full business cycle and be sure the earnings doesn't come from events that result in one time gains.*

For some, a full business cycle isn't even long enough.

One easy mistake to make is to value certain cyclical businesses (something Coca-Cola certainly is not) with higher operating leverage (and, in some cases, financial leverage) using peak or near peak earnings. Cyclical businesses typically look cheapest when they are actually quite expensive. So an investor needs to normalize earnings over many years to get a meaningful economic picture and avoid misjudgment.**

Coca-Cola's stock now sells for around $ 68/share. At that price, the stock is no longer a bargain as it sells for ~18 times 2011 earnings.

On a forward basis it looks a bit cheaper, of course, but as is usually the case the opportunity to buy the stock with a large margin of safety was a couple years back when the economic storm clouds were front and center.

Adam

* In 2010, Coca-Cola bought the North American bottling business from Coca-Cola Enterprises (CCE), its largest bottler: MarketWatch - Coca-Cola buying CCE North American bottling business. Excluding that type of gain is the best way to understand Coca-Cola (or any business) on an operating basis.
So Coca-Cola's earnings in 2010 including a large one time gain from the purchase of those bottling operations. Reporting the one time gain this way is required by Generally Accepted Accounting Principles (GAAP) as it should be. Yet, it ends up making net income appear larger than it really is on an operating basis. Though correct from an accounting point of view, it may make Coca-Cola seem cheaper than it is if just a simple ratio is used without backing out the one time gain. The non-recurring gain should be backed out to get a more meaningful picture of Coca-Cola's true current operating economics. (As it turns out, this one time gain did actually make Coca-Cola's price to earnings (P/E) ratio appear lower on some of the popular finance sites. The "E" in "P/E" can't be relied upon unless it has been checked for non-recurring gains and losses.)
**This is especially true for highly cyclical businesses that are capital intensive (think airlines and auto manufacturers). Those with less predictable revenue and high operating leverage (high fixed costs) are usually more vulnerable to financial strain during a serious economic crisis especially if financial leverage is also involved. Adding financial leverage is usually a bad idea in any business with inherently less predictable revenue, a lack of pricing power, and high operating leverage. So sometimes avoiding certain so-called "cheap" cyclical businesses altogether makes sense. In other words, no price is low enough to account for the potential risks during an economic downturn. In other cases, a perfectly good business with durable competitive advantages just happens to have inherently more variable earnings. So highly variable earnings is not, in itself, a problem if the business is built to handle economic busts. Being built to last likely means having a sustainable position as low cost producer (or possibly some other advantage unique among competitors), a fortress balance sheet, and capable management. Businesses with predictable revenue and a little pricing power can usually safely handle a bit more financial leverage. Both operating leverage and financial leverage magnifies gains and losses (reward and risk). The businesses that had profitability drop the most during the recent financial crisis likely had one or both types of leverage working against them (and if they survive...working for them).

Buffett: The Test of a Good Business

2012-02-06T12:29:00.000-05:00

Some excerpts from a lecture* given by Warren Buffett to Notre Dame faculty, MBA students, and undergraduates in 1991.

In the lecture, Buffett says that one way to test the quality of a business is by asking the following question:

"How long does the management have to think before they decide to raise prices?"

If the answer is "not long" then you've probably got a pretty good business. More from the lecture:

You're looking at marvelous business when you look in the mirror and say "mirror, mirror on the wall, how much should I charge for Coke this fall?" [And the mirror replies, "More."] That's a great business. When you say, like we used to in the textile business, when you get down on your knees... [and say] "just another half cent a yard." Then you get up and they say "We won't pay it." It's just night and day. I mean, if you walk into a drugstore, and you say "I'd like a Hershey bar" and the man says "I don't have any Hershey bars, but I've got this unmarked chocolate bar, and it's a nickel cheaper than a Hershey bar" you just go across the street and buy a Hershey bar. That is a good business.

The ability to raise prices – the ability to differentiate yourself in a real way, and a real way means you can charge a different price – that makes a great business.

Buffett also mentioned this very different example of a good business:

The highest priced daily newspaper in the United States, with any circulation at all, is the Daily Racing Form...You can charge $2.00 for The Form, you can charge $1.50, you can charge $2.50 and people are going to buy it. It's like selling needles to addicts, basically. It's an essential business. It will be an essential business 5 or 10 years from now. You have to decide whether horse racing will be around 5 or 10 years from now, and you have to decide whether there’s any way people will get their information about past performances of different horses from different sources. But you've only got about two questions to answer, and if you answer them, you know the business will make a lot of money. The Form has huge profit margins, incidentally. Wider than any other newspaper. They charge what they want to basically. It's an easy to understand business...

Finally, later in the same lecture Buffett added the following:

You really want something where, if they don't have it in stock, you want to go across the street to get it. Nobody cares what kind of steel goes into a car. Have you ever gone into a car dealership to buy a Cadillac and said "I'd like a Cadillac with steel that came from the South Works of US Steel." It just doesn't work that way, so that when General Motors buys they call in all the steel companies and say "here's the best price we've got so far, and you've got to decide if you want to beat their price, or have your plant sit idle."

Buffett made the above comments about the Daily Racing Form over 20 years ago. Knowing how much the newspaper business has changed over the past decades, it certainly seems worth challenging the idea that it remains such a good business. Buffett himself, in the 1987 Shareholder Letter, made the point that "severe change and exceptional returns usually don't mix."

Good businesses often reside in industries experiencing little change.

Well, I think "experiencing little change" hardly describes what's been happening to most newspaper business models over the past decade plus. Yet, as it turns out, the Daily Racing Form may still be doing just fine despite all the change that has occurred in the industry.

Arlington Capital Partners bought the Daily Racing Form for $ 200 million back in 2007. Since it is a private company, verifying how the business might be doing these days isn't easy but I did find some things of note. According to this article from back in 2010, the Daily Racing Form can now charge more like $ 5 to $ 6 a copy (compared to the $ 2 they were charging 20 years ago).

So, at the very least, there is still plenty of pricing power.

From the article:

DESPITE NEWSPAPERS' hard times, at least one daily is thriving, even though its price—$5 to $6 a copy—makes it one of the most expensive papers in the world. In a way, that high price is the Daily Racing Form's strength: 95 percent of its revenue comes from circulation, only 5 percent from advertising. Furthermore, the DRF, which is to horseplayers what the Wall Street Journal is to investors, also prospers online: about 20 percent of its revenue comes from downloading fees for its racetrack data.

That sounds fine but the number of copies sold daily has fallen off dramatically since the early 1990s. According to this New York Times article, 33,000 copies were sold daily or roughly 12 million/year.

Buffett mentions it being more like 150,000 daily in the 1991 Notre Dame lecture.

So that's certainly a steep decline.

Clearly, understanding how circulation is likely to progress over time from here is key. Will the decline continue or stabilize? There's no way to know if it is up to date, but the Arlington Capital Partners website currently says 12.4 million print copies are still being sold each year. That is similar to the numbers from the New York Times article above written back in 2009 and a press release from 2008.

If it is still roughly at the same level 2 or 3 years later, maybe the decline in circulation is stabilizing.

Hard to know.

Still, considering its pricing power, and what I'd expect to be just modest capital needs, the Daily Racing Form seems likely to remain a sound business even as print circulation shrinks.**

Of course, any rapid decline in print copies sold would be more troublesome but it sure seems that their audience is willing to pay for the kind of specialized information they offer.
(Note: It's tough to judge, with available information, what the economics of their internet site is or how it is likely to evolve but, at 20% of revenue already, it obviously seems a big factor long-term.)

Apparently, its status as "the bible" for those who bet at the track remains in tact. From the New York Times article:

"Oh, The Racing Form is the bible," said William Nack, the former Sports Illustrated horse-racing writer and a biographer of Ruffian and Secretariat who grew up admiring The Form's top columnist, Charlie Hatton. "You can't be without it at the track."

Steven Crist, Chairman and publisher of the Daily Racing Form added:

"Absolutely, we're profitable," Crist said. "It's not even close. We turn over a lot of cash." The Form is privately owned by a venture-capital firm, Arlington Capital Partners of Chevy Chase, Md., so there is no independent verification of Crist's profitability claims.

While that's certainly not definitive proof of how well the business is doing, it seems newspapers with content that is specialized, like the Daily Racing Form or even legal newspapers like the Daily Journal (DJCO), have held up much better economically than others.

Most in the newspaper business, of course, have watched their core economics become badly wounded as the internet disrupted their traditional business models.

There will be exceptions, of course, but I doubt many newspapers are entirely immune from the long-term trends and forces at work here.

The ones that thrive in a niche of some kind should continue to do quite well. Yet, I still don't think it's easy to judge how robust the economic moat of most newspaper businesses will be over the very long haul. The more specialized ones could do just fine but picking long-term winners still ought to be a bit tricky.

In general, most businesses with sustainable pricing power that aren't particularly capital intensive will be more attractive investments. To me, those that sell trusted small-ticket consumer brands with broad distribution are tough to beat on a risk-adjusted basis. Snacks, candies and beverages aren't a bad place to start if you can find shares of those kind of businesses selling at fair or better than fair prices.

Adam

* Lightly edited by Whitney Tilson
** A shrinking market dominated competitor doesn't necessarily invite capable competitors so the pricing power on less circulation may work longer and more profitably than otherwise. If return on capital remains above average and the capital will be wisely allocated it may still be a fine business to own. The intrinsic value of a business is driven by expected future cash flows discounted back to present value whether it happens to be growing or shrinking. It's not any more difficult to calculate intrinsic value for a business if it happens to have a shrinking but profitable base of customers. Like anything else, pay a discount to that value and it can be a sound investment. Fast growing businesses in dynamic industries grab the attention but ultimately investing is about paying a nice discount to value that can be (and has been) judged reasonably well.
In contrast, a capital intensive business (especially one with some financial leverage), with high fixed costs (operating leverage), and little pricing power will often have trouble remaining profitable with a shrinking base of customers. As a result, the intrinsic value suffers (if there ends up being any at all). Businesses with predictable revenue and pricing power can usually handle a bit more financial leverage even if its model inherently still requires having lots of operating leverage. Economically sensitive businesses with less predictable revenue streams and high operating leverage should keep financial leverage to a minimum.

Yacktman Funds 4Q 2011 Portfolio Update (PEP, NWSA, PG, MSFT, BCR, CSCO, GS, STT, NTRS, BAC, USB, AVP)

2012-02-03T11:29:00.002-05:00

Donald Yacktman and his team have a very solid long-term track record managing the Yacktman Fund (YACKX) and Yacktman Focused Fund (YAFFX). Both funds have returned more than 11% per year over the past ten years.

For a comparison, the S&P 500 is up 3.7% per year over the same time frame.

At the end of the most recent quarter, both funds continued to hold substantial positions in large capitalization stocks with many being household names.

These funds are very similar but the more concentrated of the two funds, as the name suggests, is the Yacktman Focused Fund.

Top 5 Holdings of The Yacktman Focused Fund

1 Pepsi (PEP)

2 News Corp (NWSA)
3 Procter & Gamble (PG)

4 Microsoft (MSFT)

5 C.R. Bard (BCR)

Approximately 40% of the Yacktman Focused Fund portfolio is in the top 5 stocks.

Top 5 Holdings of The Yacktman Fund

1 Pepsi (PEP)

2 News Corp (NWSA)
3 Procter & Gamble (PG)

4 Microsoft (MSFT)

5 Cisco (CSCO)

Approximately 35% of the Yacktman Fund portfolio is in the top 5 stocks.

The annual turnover of these portfolios is typically less than 10%. That low turnover rate is impressive and, as far as I'm concerned, something not seen often enough.

Yacktman continues to have minimal exposure to financials (~5%) though some small new positions in banks were added last quarter (Goldman Sachs GS, State Street: STT, Northern Trust: NTRS and Bank Of America: BAC).

None of the recent bank purchases are large enough positions to be in the top 25.

Donald Yacktman was asked, in this recent interview with Consuelo Mack, about having added positions in financials after mostly avoiding them in recent years:

...in all cases, you'll notice they're very small positions, and we spread the risk. Sometimes, when things are less predictable, the way to deal with that is to have a smaller position and allow for a greater spread over what your normal hurdle rate would be, to allow for that uncertainty. - Donald Yacktman

The only bank that is a top 10 position is U.S. Bancorp (USB).

The following stocks purchased in the 4th quarter had a greater than 1% portfolio impact.

Stocks purchased
C.R. Bard
Avon Products (AVP)
Pepsi
Microsoft

There were no top 25 positions sold last quarter.

The two funds that Yacktman and his team manage have performed very well but what's even more notable, at least to me, is how they go about producing those returns.

One of the common phrases we use at our firm is, "It's almost all about the price". Often, the most important variable in having a successful investment and managing risk is the price paid for a security. - Donald Yacktman

They've been able to outperform by generally buying shares of quality businesses with the best risk-adjusted returns and having the discipline to buy when selling at a nice discount.

Adam

Established long positions in PEP, PG, MSFT, CSCO, USB at lower than recent prices

Facebook Files For IPO: What the S-1 Reveals

2012-02-02T11:25:00.002-05:00

Some things of interest from yesterday's Facebook S-1 filing:

- Facebook's 2011 revenue was $ 3.7 billion. Revenue grew 88% year over year and is up nearly five fold since 2009.
- Facebook has $ 3.9 billion in cash.
- Net profit was $ 1 billion, a 27% net margin. However, free cash flow was less than half that amount at $ 470 million.
- 845 million active users, up nearly 40% from the previous year.
- In 2009, 98% of its revenue came from advertising.
- In 2011, revenue from advertising was down to 85%. The other 15% is, for the most part, driven by in-app purchases from games like Farmville (12% of revenue comes from Zynga).
- Facebook's revenue last year is slightly higher than Google's was the year it went public ($ 3.7 billion compared to $ 3.2 billion). Facebook's $ 1 billion of net income is more than the $ 400 million Google earned in 2004.
- Mark Zuckerberg owns a little more than 28% of the company. That means his stake is likely to be worth $ 25 billion or so. He'll be fine.

According to this article, revenue growth is expected to slow substantially over the next couple of years:

The bad news is that Facebook ad sales worldwide are slackening. They grew 104% in 2011 but are expected to climb just 52% to $5.8 billion this year and only 21% to $7 billion next year, according to eMarketer.

The same article goes on to point out that the value of Facebook's ad inventory fares poorly when compared to the industry average and especially to Google:

"Facebook is not as effective as paid search (on Google, Yahoo and Microsoft)," says Dave Beltramini, director of online strategy for G5, a marketing services firm. "The intent of consumers on Google is more about shopping. On Facebook, people are more social, looking at photos of their friends' kids."

Facebook fares poorly in a key pricing metric used in the industry to measure the value of ad inventory in reaching an audience. Its CPM, or cost per thousand impressions, is 22 cents, less than half the industry average for the Web (50 cents) and minuscule compared with Google's, which is north of several dollars, says Chris Moore, a partner at venture-capital firm Redpoint Ventures.

Facebook is looking to raise around $ 5 billion in this offering but, of course, that number could change between now and when the IPO happens. From the S-1:

We intend to use the net proceeds to us from our initial public offering for working capital and other general corporate purposes; however we do not have any specific uses of the net proceeds planned.

So whatever they do end up raising should be a nice addition to the $ 3.9 billion of cash they already have on their balance sheet.

Most companies aren't a large cap stock the day it goes public but, at a $ 75-100 billion expected valuation (and, of course, a 75 to 100x P/E), it looks like Facebook's going to be an exception. Facebook will have nearly 3-4x the market valuation that Google had when it went public in 2004.

Now, I don't doubt the company could become worth that kind of money or even much more some day.

Whether Facebook is actually worth that much YET is another question.

Profitability will need to grow substantially and prove durable to even justify the expected initial valuation (never mind actually make some money for an investor).

My point is this. Paying a substantial premium to the current valuation with the hope that an investment may actually be intrinsically worth it someday isn't exactly the road to riches. I mean, who puts capital at risk for the privilege of eventually getting it back? So, even though Facebook may someday justify its lofty valuation (and even then some) over time, it won't necessarily provide great risk-adjusted returns compared to alternatives.

It's not that returns will necessarily end up being negative.

It's that returns relative to the risk taken will be inadequate. The direct result of paying an excessively high initial price.

In other words, getting something "right" yet being compensated little for it. Now, Facebook could sure end up being, once again, an exception. It is quite a franchise. Yet, most of the time, pay a price that represents a possible future value instead of a discount to current value and odds are long-term results will be subpar or worse.

Facebook is clearly worth a lot of money. It's already a sound business that has a good probability of increasing in value over time. Considering the high profile of the company, it's not hard to imagine it starting out as an expensive stock and proceeding to become even more so in a speculative frenzy.

That may make it an interesting trade for those who do that sort of thing but, unless the valuation drops far below what is expected, it's going to be a tough thing to truly invest in. There's nothing wrong with not owning shares of even a very good business if a chance to buy with an appropriate margin of safety isn't available.

Adam

The Fracking Revolution: End of the Peak-Oil Hypothesis?

2012-02-01T10:48:00.000-05:00

Fracking* is a method of extracting natural gas (and increasingly oil) that seems to be transforming the energy industry.

From this Bloomberg article:

Fracking Boom Could Finally Cap Myth of Peak Oil

The U.S. oil market could be on the verge of its own fracking revolution, similar to what the natural-gas market is already experiencing. As a result, domestic production is now projected to rise significantly over the coming decades, reducing the relative share of imports in U.S. oil consumption.

Advances in horizontal drilling and hydrofracking, in which highly pressurized liquids are injected into underground rock, have been used increasingly over the past few years to extract natural gas. The result has been a substantial increase in recoverable reserves...

Past few years? That's not much time at least in the context of the oil and gas industry. It sure seems like an important transformation possibly in its early stages.

In the U.S., the primary controversy when it comes to fracking has been and continues to be concerns over the adverse environmental effects. Still, what seems amazing, no matter how the environmental issues play out, is how quickly these advances have changed the oil and gas landscape.

Oil is already being produced from shale at several locations throughout the U.S., most notably the Bakken shale in North Dakota.

As Jim Mulva, the chief executive officer of ConocoPhillips, recently said, "The revolution has spread to domestic oil production. And it may track the path it followed with natural gas. We just don't know yet. But it looks promising."

Experts refer to oil that comes from shale formations as "tight oil".

The federal Energy Information Administration estimates that production of crude oil in the U.S. will rise to 6.7 million barrels per day by 2020 (much coming from tight oil and development of offshore resources), a level not achieved since 1994.

As a comparison, domestic crude oil in the U.S. was produced at a rate of 5.5 million barrels per day in 2010.

Some think the future estimates are still conservative since projections of "tight oil" continue to be revised higher. More from the Bloomberg article:

For years, analysts have worried that known oil reserves have peaked, so that prices will keep rising. Tight oil could change that dynamic. As the energy analyst Seth Kleinman...argues, the price effects of the shift to tight oil "may be more immediate and subtle than the supply-and-demand balances hint at."

The year ahead, he says, "could really see the death of the peak-oil hypothesis, something that has been underpinning a lot of the structural bullishness on oil." (The terminology is thus borderline ironic, since tight oil could make oil markets much less tight.)

This Reuters article from late last year also explains some of the implications of horizontal drilling and fracking. Some excerpts from the article:

Transformed in Less Than Half a Decade
The combination of horizontal drilling and hydraulic fracturing has already transformed North America's natural gas market in less than half a decade. It is now starting to do the same for U.S. oil production, with the dramatic rise in output from North Dakota's Bakken and Texas' Eagle Ford formations resulting in the first increase in domestic output since the mid-1980s.

Worldwide Transformation & Major Constraints
Tight oil and gas will not be restricted to North America. Fracking and horizontal drilling have the potential to transform the industry worldwide.

Inside North America and Western Europe, the major constraint on the roll-out of the technology is political and environmental opposition. Outside the United States, the main constraints are lack of specialised equipment, know-how and skilled personnel.

The lack of specialised equipment and skills outside the U.S. would seem to sort itself out over time. Knowing how some of the environmental controversies end up impacting the potential of all this seems harder to gauge.

Adam

* The term fracking (or hydrofracking) is short for hydraulic fracturing.

Edward Owens: Vanguard Healthcare Fund Update (MRK, UNH, FRX, ABT, MCK, RHHBY, PFE,

2012-01-31T09:44:00.001-05:00

Edward Owens has been manager of the Vanguard Healthcare Fund (VGHCX) since 1984. The fund has returned more than 12%/year for the past 15 years and more than 16%/year since inception.

Historically, Vanguard Healthcare has had very low turnover (9% annual turnover) so the investments by the fund tend to have a longer term horizon. Nearly 40% of the fund's holdings are represented by the top ten.

Top Ten Holdings
Merck (MRK)
United Health (UNH)
Forest Labs (FRX)
Abbott Labs (ABT)
McKesson (MCK)
Roche Holdings (RHHBY)
Pfizer (PFE)
Amgen (AMGN)
AstraZeneca (AZN)
Eli Lilly (LLY)

Owens added no new stocks to the portfolio this past quarter and there were no additional shares bought among the top ten positions.

Slight reductions in two top ten positions were made:

Abbott (ABT) was reduced by ~10% while Eli Lilly (LLY) was reduced by ~5%.

Several meaningful increases to much smaller positions were made. Yet, even after the increases, none of these positions individually make up even 1% of the portfolio.

Position
Boston Scientific (BSX)
Hospira (HSP)
Zimmer Holdings (ZMH)
CVS Caremark (CVS)

The turnover by investment managers at a number of other mutual funds is so high that what is owned at any given moment doesn't often tell you much.

Edward Owens certainly isn't one of those investment managers.

Lack of activity in a fund like this may make it seem less exciting, but the approach leads to lower frictional costs (taxes, commissions). The main driver of long-term returns is generally achieved by owning businesses that themselves compound at a high rate and not paying too much for the privilege of ownership.

To me, the approach is an admirable one. Success will always comes down to the quality of the businesses owned and the price that was paid. Things like superior trading skills, well-timed sector rotation, or technical analysis not required.

Adam

Buffett: High Current Yield, Long-term Capital Growth, and Stock Market Pyrotechnics

2012-01-30T12:00:00.000-05:00

From the 1979 Berkshire Hathaway (BRKa) Shareholder Letter:

Phil Fisher, a respected investor and author, once likened the policies of the corporation in attracting shareholders to those of a restaurant attracting potential customers. A restaurant could seek a given clientele - patrons of fast foods, elegant dining, Oriental food, etc. - and eventually obtain an appropriate group of devotees. If the job were expertly done, that clientele, pleased with the service, menu, and price level offered, would return consistently. But the restaurant could not change its character constantly and end up with a happy and stable clientele. If the business vacillated between French cuisine and take-out chicken, the result would be a revolving door of confused and dissatisfied customers.

So it is with corporations and the shareholder constituency they seek. You can't be all things to all men, simultaneously seeking different owners whose primary interests run from high current yield to long-term capital growth to stock market pyrotechnics, etc.

The reasoning of managements that seek large trading activity in their shares puzzles us. In effect, such managements are saying that they want a good many of the existing clientele continually to desert them in favor of new ones - because you can't add lots of new owners (with new expectations) without losing lots of former owners.

We much prefer owners who like our service and menu and who return year after year. It would be hard to find a better group to sit in the Berkshire Hathaway shareholder "seats" than those already occupying them. So we hope to continue to have a very low turnover among our owners, reflecting a constituency that understands our operation, approves of our policies, and shares our expectations.

What Buffett describes above would seem nearly impossible to find in today's short-term oriented capital markets culture (with many participants now buying/selling via ETFs & employing other short-term trading strategies).

Yet, wherever possible, I'll take investing alongside an investor constituency of informed long-term owners that don't head for the exits at the first sign of trouble in a business (or the macro environment).

These days, quite a few market participants seem to have no shortage of an attention deficit, employing strategies that often make business fundamentals an afterthought (if at all).

Among those that do actually happen to look at fundamental business values from time to time, more than a few seem to embrace the if you don't like near term prospects just sell the stock school of investing. This includes small investor and large institutions alike.* At some level, there's nothing wrong with that, I suppose. Investors and other market participants are free to invest any way they want, of course.

Yet, I'd prefer investing next to a high percentage of co-owners and executives that can be trusted to stick around during the inevitable rough patches (macro or otherwise). Even the best businesses will, at times, experience real but fixable difficulties (I'm not talking about truly broken businesses here). When change intended to improve long-term returns are needed, long-term committed owners, especially those that control a large % of stock, are more apt to use their influence to work with and put pressure on the board and management to fix real problems.**

In the real world, things rarely work anywhere near this ideal but investing with other long-term oriented owners and managers when possible at least improves the odds of shareholder-friendly actions. It also has the advantage of allowing an investor to gain in-depth knowledge and insight into the unique risks/potential of a specific business. It's not possible to know a lot about every business so it helps to concentrate on what one truly can understand. In this approach, returns are generated by the compounded wealth creation of a good business over time, bought at reasonable or better prices, not well-timed trades (something that has been emphasized more than a few times on this blog).

A good business, even one with occasional short-term problems, is a franchise capable of high and sustainable return on capital (superior economics). Long-term portfolio returns can only be above average if the businesses in the portfolio generally produce above average return on capital. A business with below average economics will produce subpar long-term returns even if it is bought at what seems like a substantial discount (though it is possible to make money over a shorter horizon this way).

Now, clearly sometimes having a few co-owners that lack long-term conviction is a benefit. It allows the long-term owners to accumulate more shares from the weak holders. It also may allow the company to buyback shares on the cheap. That's fine up to a point. Yet, there's another less optimal (if more subtle) side to this. Let's say a large block of shareholders (lacking in long-term conviction) are susceptible to selling temporarily depressed shares during times of market stress. This sets up a situation where a smart outside buyer could come along and pay a nice premium to the market price but still well below what remaining committed long-term owners consider anywhere near fair intrinsic value. If enough low-in-conviction co-owners are willing to sell the temporarily depressed shares to this buyer, then the judgment of the business intrinsically being worth more, even if correct, won't matter.
(Of course, it's possible to be a long-term committed owner that is overly optimistic about value and better off with that buyout.)

This may seem improbable but it certainly can happen. So that's just another reason why the more informed and long-term oriented the other owners are the better.

None of this, of course, is particularly easy to judge for a smaller investor, but I still think it's still worth putting any long-term investment through this kind of mostly subjective filter. At some level, the way the market is structured today (speculative activity of various kinds in favor of investing) makes this way of thinking difficult to put into practice.

Difficult yet not irrelevant.

It may be at odds with much of today's investing culture but, at least at the margin, finding businesses where an informed shareholder constituency is generally on board for the long haul is worth it.

Capital put at risk by informed, patient long-term shareholders increases the probability of (though hardly guarantees) improved results. Owners and agents concerned with price action measured in months (or even just a few years) will likely make different decisions than those concerned with the creation of enduring value over, say, 20 years. Most good businesses have the chance to compound at a rate closer to full potential with shareholders, the board, and management all focused upon long-term effects.

Investors as a whole should, on average, end up better off. More importantly, if the main participants were focused upon long-term effects, capital markets would likely function more effectively when it comes to the crucial role of facilitating capital allocation.

Wise capital and other resource allocation is more likely to happen when more owners are in it for the long run (informed about/engaged in what the board and key executives are doing with the resources of the business they own).

Instead, it seems an increasingly extreme amount of mental energy is expended by market participants speculating on near-term stock price action. I think it is safe to say that there are real costs (some hidden, some explicit and obvious) when the proportion of speculative versus investing activities goes to an extreme.***

Well, in a typical recent year, ...our financial system has directed around $200 billion a year into initial public offerings and additional new public offerings and then additional offerings of company stock--$200 billion. We trade $40 trillion worth of stocks a year. So, that's 200 times as much speculation as there is investment. - John Bogle on Speculation Dwarfing Investment

There's nothing wrong with speculation.

It will always have a place in the markets but the proportion matters.

Adam

* That small investors behave this way is somewhat understandable, since they cannot usually influence the board and management. In many cases it's necessary to move on due to that lack of influence. For agents and/or investors capable of owning enough shares to influence corporate governance practices and other strategic decisions it seems much less understandable.
** Knowing that there are a few smart larger co-owners is always nice when management/board governance/other strategic changes end up being needed in a business. Otherwise, I think about shares of a business the same way I think about owning a good smaller business 100%. A small or medium size private business owner doesn't generally bail if some near-term serious but manageable problem emerges. Why not then, at least most of the time, treat share ownership of public businesses with that mindset? For me, reasons to sell include when the economic moat of a business becomes materially impaired and is likely to deteriorate. In other words, the core long-term economics fundamentally change. Also, sometimes valuation will go to an extreme high. For me, short-term difficulties associated with the macro environment or a specific but fixable problem in the business aren't generally good reasons to sell a sound business that I like. There are, of course, times that funds are needed for a clearly superior alternative long-term investment. So outside of the business economics fundamentally breaking down, an extreme valuation, or high opportunity costs, my bias is to own the shares of a good business (bought well) for a very long time.
*** By just about any measure speculation is at unprecedented levels. The average holding period of stocks is now around 3 months while the average holding period during most of the past century was measured in multiple years.

John Bogle on Speculation & Capitalism's "Pathological Mutation"

2012-01-27T11:08:00.002-05:00

"It is said on Wall Street, correctly, 'money has no conscience,' but don't allow that truism to let you ignore your own conscience, nor to alter your own conduct and character." - John Bogle

In this speech in 2009, John Bogle, founder and former chief executive of The Vanguard Group, explained what inspired the title of his book Enough:

"I wrote my new book largely because I care deeply about the traditional values that are eroding not only in our financial system, but also in our businesses, in our communities, and even in our own lives. The story of ENOUGH begins with a sort-of-poem by Kurt Vonnegut. It was entitled "Joe Heller," and I chanced upon it in The New Yorker in April 2005. The poem was a tribute to the late author of Catch 22—one of the seminal books of the post-World-War-II era, and one of its most successful. I can summarize the short poem in just a few words:

At a party given by a billionaire on Shelter Island, Kurt Vonnegut tells Heller that their host, a hedge fund manager, had made more money in a single day than Heller had earned from his wildly popular novel Catch 22 over its whole history. Heller responds, 'Yes, but I have something he will never have . . . enough.'"

For Bogle, the rampant greed and disgraceful conduct that now overwhelms "our financial system and corporate world runs deeper than money." To him, the behavior "subverts our society's traditional values" and results in the "diminution of our national character and values."

More from the 2009 speech by John Bogle:

Capitalism's Pathological Mutation
"During the past half-century, the very nature of capitalism has undergone a pathological mutation. We have moved from an ownership society in which 92 percent of stocks were held by individual investors looking after their own interests and only 8 percent by financial institutions, to an agency society in which our institutions now hold 75 percent of stocks and individuals hold but 25 percent.

These institutional agents have not only betrayed the interests of the principals to whom they owe a duty of trusteeship, but have also abandoned their traditional investment principles. For it is these agents who have been the driving force in changing the central characteristic of market participation from long-term investment—owning businesses that earn a return on their capital, creating value by reinvesting their earnings and distributing dividends to their owners—to short-term speculation, essentially trading stocks and betting on their future prices. It is not only hedge funds that are playing this game, but most mutual funds and many giant pension plans.

Today, we are witnessing an orgy of speculation the likes of which have never been seen before."

Speculation in the Drivers Seat
"Revenues of our stock brokerage firms, money managers, and the other insiders soared from an estimated $60 billion in 1990 to some $600 billion in 2007.

So while trading back and forth with one another—foolish as it is—is by definition a zero-sum game, once the costs of our Wall Street croupiers are deducted it is a loser's game."

Later he added...

"That $600 billion in 2007 plus many hundreds of billions in earlier years, obviously represent a truly staggering hit to the gains investors earned in the bull market, and a financial slap in their face in the bear market that followed. Any confidence in Wall Street that our investors once may have had has largely vanished, just as it should have."

John Bogle has long been known as the conscience of Wall Street for a reason. In a more recent speech, he said "we need not only ethical principles to guide us, but ethical principals to assure their observance".

Well, I happen to think the principles that led to his founding of The Vanguard Group and his contributions since have made the world a bit better for investors.

Adam

Are Large Cap Stocks Cheap?

2012-01-26T11:45:00.001-05:00

For some context, I'll start this out by looking at valuations in the late 1999. At that time, the top five U.S. companies in terms of market capitalization was Microsoft (MSFT), General Electric (GE), Cisco (CSCO), Exxon Mobil (XOM), and Wal-Mart (WMT).

Combined, these five companies had a market capitalization of roughly $ 2 trillion dollars at the time.

Yeah, that's right.

Now, check out the annual earnings of these five stocks back in 1999:

Microsoft: $ 7.8 billion
General Electric: $ 10.7 billion
Cisco: $ 2.1 billion
Exxon Mobil: $ 7.9 billion
Wal-Mart: $ 4.4 billion

So, back then, these five businesses had ~$ 33 billion of combined earnings power.

With $ 2 trillion of combined market capitalization, that means investors were willing to pay an average of ~60 dollars for every dollar of earnings.

For whatever set of reasons or rationalizations, not nearly enough investors (professional or not) seemed to find this to be a bit of odd situation. I remember it well and still find the rationalizations that were being used to justify the market prices to be completely astonishing to this day.

How can companies of that size possibly be worth on average 60x earning?

An earnings yield of less than 2%, really?

Why wasn't that perfectly obvious?

Well, it wasn't and that's worth remembering.

In contrast, this year these five companies will earn more than $ 100 billion. As far as I'm concerned, if businesses this large can triple earnings in a little over ten years like they did, that's a good decade of work.

Today, these five businesses have a combined market value that is ~ $ 1.2 trillion. So investors are paying a far more reasonable 12x earnings or so. That doesn't mean these stocks will do well in the next few months (or even years), but 12x provides at least some margin of safety in a way that 60x certainly does not.

The next time someone says a particular stock has been performing poorly for a long time, it's worth remembering where some of them started in terms of valuation a little over a decade ago.

Apple (AAPL) is now, of course, one of the top five. Actually, as of yesterday, it is roughly tied for being the most valuable company with Exxon Mobil (~ $ 420 billion). In the late 1990s Apple was certainly nowhere near this top five. The company was being nursed back to health after its near collapse and had a market value that was still less than $ 20 billion.
(Yesterday's post cover Apple's earnings and what still seems hardly an extreme valuation.)

Back in 1999, there were many favorite rationalizations on display (expert and otherwise) of why paying such extreme multiples of earnings for stocks made sense. Yes, stocks seemed expensive but somehow they should be. Those rationalizations clearly made no sense but they seemed to, at least for some, at the time.

At least enough market participants believed it that prices sustained increasingly lofty levels for quite a while.

To me, there's a simple, practical reason that all this is worth remembering.

If someone tries to now rationalize why these stocks are cheap and they should be*, it's worth considering that this is probably the same error in judgment only in reverse.

They are cheap now for the same reason that were expensive then.

Mr. Market is one moody dude.

Adam

* It's not all or none, of course. Many understood stocks were overvalued in the late 1990s just as many today see valuations as compelling. Having said that, Dow 36,000 is a book written by James K. Glassman and Kevin A. Hassett that was published in 1999. With stocks already very expensive by any measure at the time, they came up with a rationale why Dow Jones Industrial Average should rise to 36,000 within a few years. From this article in the Atlantic back in 1999: In explaining their new theory of stock valuation, the authors argue that in fact stock prices are much too low and are destined to rise dramatically in the coming years. So that's just one example of someone rationalizing why it was warranted for stocks to have been expensive. These days, there are many rationales for why stocks should be cheap. Some of the current favorites are global deleveraging, various systemic risks, banks, Europe, China, inflation, and deflation among many others. The list goes on. Those are real concerns but there is always something on the radar. Yes, stock prices would likely fall, maybe even for an extended time, if the worst scenarios played out. The fact is no one should own stocks without a very long time horizon. There will never be a shortage of bullish and bearish rationales. To me, it's better to just ignore them all. Investing is mostly thinking for yourself, occasionally gaining an insight, and not getting distracted. Effectively judging value (calculated conservatively) and always paying a nice discount to account for errors and the unforeseeable guarantees nothing, but at least increases the probability of good long-term results. The rest, especially the macro stuff, is mostly noise and distraction. The past century supplied plenty of good reasons to be fearful about the future (there's no reason to not expect more of the same). Despite those oft-warranted fears, many good businesses persisted through the worst and kept creating value. During those rare occasions when economic skies appeared clear and all seemed calm, you can be sure that stocks weren't cheap. So, while there will always be future risks to consider for investors, some known and some unknowable, the good news is the world doesn't end all that often.

Apple's Strong Earnings

2012-01-25T09:21:00.000-05:00

What can you say. Apple's (AAPL) quarterly earnings were released yesterday and it looks like the company's stock will open at all time highs.

Check out these numbers:

$ 13 billion
That's Apple's quarterly net profit. One quarter. Net profits more than doubled from $ 6 billion a year earlier. Five years ago Apple earned $ 3.5 billion for the entire year. Now it has earned nearly 4x that much in one quarter.

Consider that Apple now earns nearly twice as much per quarter as Microsoft (MSFT). Not too long ago Apple's earnings were a mere shadow of Microsoft's.
---
$ 97 billion
The amount of cash and investments that Apple has on its balance sheet. No debt. It ended the previous quarter with $ 81 billion. A $ 16 billion increase. The reason cash and investment grew faster than net profits comes mostly down to free cash flow exceeding net profits.
---
$ 395 billion
Apple's market value as of yesterday's close.

Exxon Mobil's market value is still slightly higher at $ 423 billion (that may change today based upon Apple's pre-market price). The integrated oil company is expected to earn roughly $ 40 billion this year. After earning $ 13 billion in just one quarter, it seems reasonable to think that Apple will earn even more than Exxon Mobil.

If so, that means Apple is selling at a lower multiple of earnings than Exxon Mobil (XOM). That is true even before you back out the nearly $ 100 billion cash on Apple's balance sheet.

So, even if this past quarter is some kind of slight anomaly on the high side for earnings, it seems likely that Apple still sells at a single digit multiple of this year's earnings.

Now, not surprisingly considering the capital intensiveness, Exxon Mobil needs roughly 10x more capital than Apple to run its business and generate those profits. Exxon Mobil's return on capital is more than respectable for an integrated oil company. Having said that, return on capital for Apple is pretty much off the charts (easily over 100% by my math). So the two companies operate in a totally different economic universe.
---
What will be Apple's very long run profitability? I think, unlike some businesses in less dynamic industries, it's a tough call. At a minimum, any estimate of the intrinsic value of Apple has to have an extremely wide range.

Earnings power could end up being much higher, at least for a while, but who knows. At this point it's tough to bet against them.

Gauging the intrinsic valuation of something has to be based upon some conservative estimate of a very long run stream of cash flows. Valuation can't be based upon a few years of stellar earnings that then drop off. That's a recipe for paying too much and permanent loss of capital. Trying to estimate the future stream of cash flow for Apple seems to me nearly impossible. So it's somewhat speculative in that sense.

Will Apple become the first company actually worth a trillion dollars? Will, instead, the economics begin to hit a wall?

Both of those very different outcomes still seem at least plausible. I'm sure some others see the upside or downside with more certainty (and may very well end up being right).

Today, Apple's economics are driven by what is essentially a product cycle business (this may change over time, of course). The future always comes down to successfully inventing and executing on great new products and anticipating a very dynamic competitive landscape. Seeing things others haven't imagined. That's not often a recipe for a great long-term investment. In contrast, I'm pretty sure people will be buying Coca-Cola (KO) and Pepsi (PEP) products even if they don't innovate. Sales may suffer a bit but they'd probably do okay economically.

I'm not saying that Coca-Cola or Pepsi's business is easy. No business really is.

It's just that in the world Coca-Cola and Pepsi operate, the competitive landscape changes relatively slowly and they have tremendous durable competitive advantages. They may get beat up a bit from time to time (or beat each other up...at least in beverages) but the essential economics remain more knowable while the range of likely outcomes seem at least relatively narrow compared to Apple.

Now, plenty of speculation* occurs in shares of subpar businesses with questionable long-term prospects. Apple is far from being something like that.

It's well established that the company is capable of setting the standard with brilliant innovation and design yet there's much more to the story. It's also a business with formidable supply chain strengths that lead to cost advantages. Those supply chain strengths also feed into the superior product design. The brand equity they've built through their innovative products have also led to substantial pricing power.

The list of advantages doesn't end there but all of these qualities interact in ways that don't seem exactly easy to replicate. The result is superior economics by any measure.

The above characteristics are not usually associated with a business selling at a single digit price to earnings ratio (P/E). Generally, single digits P/E's are associated with businesses that have questionable economics or troubled businesses experiencing no growth or even decline.

Somehow, even at its substantial size, Apple continues to grow as if a smaller company (and growth that has been achieved with just ridiculous return on capital).

Apple has obviously been a tremendous stock over the past decade yet, somehow, the explosive earnings growth of Apple actually seems to have outrun the stock price.

Considering how well the stock has done it probably doesn't seem possible but the E may have actually, at least based upon what can be known up to this point, outrun the P.

The company's many strengths in combination provide at least for some kind of economic moat...at least for now. The problem I will always have is what that moat will be like five and especially ten years from now.

So Apple's never going to be the kind of business that's really in my comfort zone but it's hard not to be impressed.

For my own money, it's worth owning some shares of Apple when the valuation is low enough.

The economics are, for now, exceptional.

The valuation still not at all high given what's knowable.

Yet, I still consider it somewhat speculative. So, unlike businesses with more clear long-term durable competitive advantages, it will always be kept on a shorter leash.

Adam

* Along with speculative prices. In fact, shares of quite a few seemingly inferior businesses in recent times were/are selling at 50x to 100x earnings or more. Oh, and some pretty good businesses also sell at very high P/E's.

Long positions in AAPL, MSFT, KO, and PEP all bought at much lower than recent market prices.

Buffett on Life & Debt

2012-01-24T11:40:00.001-05:00

From the "Life and Debt" section of the 2010 Berkshire Hathaway (BRKa) Shareholder Letter:

The fundamental principle of auto racing is that to finish first, you must first finish. That dictum is equally applicable to business and guides our every action at Berkshire.

Unquestionably, some people have become very rich through the use of borrowed money. However, that's also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade – and some relearned in 2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.

Leverage, of course, can be lethal to businesses as well. Companies with large debts often assume that these obligations can be refinanced as they mature. That assumption is usually valid. Occasionally, though, either because of company-specific problems or a worldwide shortage of credit, maturities must actually be met by payment. For that, only cash will do the job.

Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed. When either is missing, that's all that is noticed. Even a short absence of credit can bring a company to its knees. In September 2008, in fact, its overnight disappearance in many sectors of the economy came dangerously close to bringing our entire country to its knees.

Charlie and I have no interest in any activity that could pose the slightest threat to Berkshire's wellbeing. (With our having a combined age of 167, starting over is not on our bucket list.) We are forever conscious of the fact that you, our partners, have entrusted us with what in many cases is a major portion of your savings. In addition, important philanthropy is dependent on our prudence. Finally, many disabled victims of accidents caused by our insureds are counting on us to deliver sums payable decades from now. It would be irresponsible for us to risk what all these constituencies need just to pursue a few points of extra return.

Later in the letter Buffett added:

By being so cautious in respect to leverage, we penalize our returns by a minor amount. Having loads of liquidity, though, lets us sleep well. Moreover, during the episodes of financial chaos that occasionally erupt in our economy, we will be equipped both financially and emotionally to play offense while others scramble for survival. That's what allowed us to invest $15.6 billion in 25 days of panic following the Lehman bankruptcy in 2008.

In a recent post, I highlighted the advantage that Wells Fargo (WFC) and U.S. Bancorp (USB) have over some other banks in terms of net interest margin. Simplifying things greatly, both banks obtain a superior spread between the cost of its funds (cheap deposits) and what they're paid for the money that it loans to customers. Still, like any bank, they must employ substantial leverage to generate above average returns.

Berkshire is ultimately also profiting from the spread between cost of funds (mostly its substantial insurance float) and what it does with that money. So it's similar to a bank in that respect. Yet, the way Berkshire goes about making above average long-term returns is very different. What's the main difference? Again, simplifying things a bit, Berkshire employs modest leverage but makes up for it via the extreme "spread" between its low cost (actually, in some years better than no cost) float and the assets it invests in.*

So Berkshire doesn't need the multiplier of leverage (and, since leverage cuts both ways, nor is it exposed to the downside risk).

"Leverage is the only way a smart guy can go broke." - Warren Buffett on The Charlie Rose Show

Paying nearly nothing for money and buying businesses that often generate a return in the teens is a good way to make a living.

Sounds easy but, of course, it is not.

"The businesses that Berkshire has acquired will return 13% pre-tax on what we paid for them, maybe more. With a cost of capital of 3% -- generated via other peoples' money in the form of float -- that's a hell of a business. - Charlie Munger at the 2001 Wesco Annual Meeting

So these days a good bank might get a 4% spread between what it pays for deposits and the various loans it makes.

Through smart capital allocation, Berkshire can produce 2 to 3 times or more than that spread while using little leverage.

Berkshire is set up to produce an extreme spread between cost of funds and the returns it gets on investments. The result: the company is capable of generating high returns without the need for the kind of leverage that is involved in banking.

Adam

* Primarily good businesses (or shares of good businesses), preferred shares, and a sizable bond portfolio.

Buffett Boosts Stake in Tesco

2012-01-23T12:15:00.000-05:00

Britain's dominant supermarket chain Tesco PLC (TSCDY) has had, to say the least, some disappointing results as of late. Earlier this month the retailer posted weak seasonal figures that the CEO Philip Clarke described as "disappointing".

The company followed that up with its first profit warning in twenty years.

From this Bloomberg Businessweek article:

Though it told investors that underlying pretax profit and earnings per share for 2011/12 will be broadly in line with market consensus forecasts, it warned that group trading profit growth will "be around the low end of the current consensus range."

It also said trading profit growth for the 2012/13 financial year will be "minimal" as it continues its drive to deliver what it calls "an even better shopping trip for customers, particularly in Britain."

The fallout from all this was, unsurprisingly, a substantial decline in the shares of Tesco. Somewhat less expected was Warren Buffett's decision to add substantially to an already sizable position in the shares.

From this Reuters article:

According to papers filed in the US overnight, Berkshire Hathaway's Tesco position moved from 3.21% to 5.06% between 12 January - the day that Tesco issued its snap profit warning and an increase in position bought for around £500 million according to the day's closing share price - and 13 January.

The additional shares of Tesco should make the position among the top ten within the Berkshire Hathaway common stock portfolio.

It's hard to know whether an announcement like this is just the first of several shoes to drop. Was the recent profit warning just the first of many as they go about fixing some of the problems within their business?

At current levels of profitability Tesco is selling for roughly 10x earnings. So, on the surface, it seems reasonably valued. The 4% plus dividend seems well covered by current profit levels. The question is whether the current level of profitability remains relatively firm or not while the necessary adjustments to the business are made.

Tesco has industry leading operating profit margins (over 6% is certainly high for retail). Will those margins will be squeezed going forward as it spends money to fix supermarkets and otherwise improve its competitiveness?

The company admits it has issues with customer service and the quality/availability of goods in stores. They seem to have allowed store experience in its home market to become stale and dated while they were investing in overseas expansion. Tesco's overseas businesses have had relatively strong sales growth compared to the home market. With more than 5,300 stores in 14 countries its geographic footprint is considerable.

Last year, Buffett criticized the company for entering into the U.S. grocery market though, based upon his actions, he clearly remains a fan of Tesco's business overall.

Charlie Munger had this to say about Tesco's move into the U.S. market:

Tesco's move across the Atlantic, particularly into California, was ill-advised, Munger said. "I could have told them if they had asked me, but they didn't." Munger is well-placed to have a view on Tesco's US expansion – as well as being Buffett's highly-regarded partner, he has served on the board of Costco, the huge US warehouse-club retailer, for 14 years. Munger, who lives in California, has been able to observe Tesco's efforts first hand – the British retailer chose the west coast to launch Fresh & Easy and has a branch in his hometown of Pasadena.

"Tesco is God Almighty in England. But you come into southern California and you have Trader Joe's and Costco, that's tough competition," Munger said. "It's a different world."

Munger also jokingly said Tesco should rename the U.S. grocery chain "Fresh & Hard".

Tesco's record of consistent profitability is impressive. The company seems focused on making necessary changes that strengthen the franchise. That may turn out to be good news for shareholders in the long run if they can execute.

Still, it's not all that easy to gauge how long it will take for the needed changes to have an impact. Nor is it clear whether the cost of these changes will end up altering operating margins and ultimately the company's valuation.

Adam

Michael Spence: Mind Over Market

2012-01-20T10:51:00.002-05:00

Below are some excerpts from an article, Mind over Market, that is part of The New Wealth of Nations series written by Michael Spence. Professor Spence is a recipient of the 2001 Nobel Prize in Economics.

From the Mind Over Market article:

Imperfect Markets
Markets are tools that, relative to the alternatives, happen to have great strengths with respect to incentives, efficiency, and innovation. But they are not perfect...

Decentralized Networks of Increasing Complexity
We live in a world of largely decentralized networks of increasing complexity: electronic networks, networks of supply chains and trade, financial networks that link the balance sheets of disparate entities. Market incentives cause actors to operate or modify parts of the network in ways that maximize efficiency locally. But the presumption – often an article of faith – that the whole remains stable and resilient has no theoretical or empirical support. Indeed, it seems inaccurate.

Redundancy Undersupplied
Resilience is a public good, created by the right kind of redundancy.

In a decentralized structure, redundancy tends to be undersupplied in the process of local optimization. That is why the tsunami that hit Japan last year disrupted many global supply chains: they were (and still are) too efficient from the standpoint of withstanding shocks.

In financial markets, local optimization seems to lead to excessive leverage and other forms of risk-taking that undermine the stability of the system. Much research is needed to understand which interventions or restrictions on individual choice are needed to make certain kinds of market equilibria stable. But, clearly, markets do not do this well by themselves.

The risks associated with the scale, complexity, and interconnectedness of the financial system are clearly not well enough understood. A paper by James Rickards expands a bit on what Professor Spence says above. An excerpt from the paper:

...there can be little doubt that the current period of globalization from 1989–2009, beginning with the fall of the SovietUnion and the end of the Cold War, represents the highest degree of interconnectedness of the global system of finance, capital, and banking the world has ever seen. Despite obvious advantages in terms of global capital mobility facilitating productivity and the utilization of labor on an unprecedented scale, there are hidden dangers and second-order costs embedded in the sheer scale and complexity of the system. These costs have begun to be realized in the financial crisis that began in late 2007 and have continued until this writing and will continue beyond. - James Rickards

I'd say it's more than fair to say the financial system needs to be reigned in somewhat. Changes are sorely needed to reduce systemic risk. Though in itself an insufficient solution, less leverage and more limits on the use of derivatives seems a good place to start. Derivatives in their current form are, of course, a huge source of hidden leverage and hard to measure risk.

One potentially beneficial circuit breaker that has been talked about for years, yet is nowhere near being implemented, is a clearinghouse of some kind for for over-the-counter derivatives.

A clearinghouse would add needed transparency. Also, the kind of intermediation that a clearinghouse provides by its nature can reduce systemic risk substantially. Those that object to a clearinghouse claim nonuniformity of contracts make this impossible. That excuse seems like, well, an excuse. Contracts can be modified to create uniformity.

Many other safeguards and limits are almost certainly needed to assure system stability and it's better to do so before we're in the next crisis. I'm guessing, in time, we'll learn, one way or another, much more has to be done to protect the system against the risk of instability and collapse.

I've yet to read it but, in his book Currency Wars, my understanding is that Jim Rickards provides a useful foundation for understanding complex systems and he suggests what we should do proactively to prevent the next financial crisis. The paper by Rickards is a good way to get some background on his thinking.

Ultimately, a system this large and complex when under stress (what Rickards describes in the paper as the supercritical state) cannot be expected to behave predictably in any meaningful way.

Rickards makes that point very clear.

More limits and safeguards that protect the system (not the participants) seem inevitable. The question is whether we'll make sure this gets done proactively or not.

Rickards explains why complex systems by their nature behave unpredictably and are prone to collapse. He also seems to think that regulators and bankers are still not using the right tools or metrics to assure system stability.

In any case, the time to put up the firewalls is before there's another fire.

Adam

Bank Earnings: Traditional Banking Doing Just Fine, Investment Banking Is Not

2012-01-19T12:10:00.000-05:00

Bank of America reported earnings this morning reinforcing a clear pattern that has emerged this earnings season among the bigger banks. Investment banking and capital markets results have been weak while more traditional banking* is much stronger.

That has meant the those with a more traditional banking mix, like U.S. Bancorp (USB) and Wells Fargo (WFC), are doing just fine while the likes of Citigroup (C), J.P. Morgan (JPM), and Bank of America (BAC) have been hurt by their sizable investment banking and capital markets operations.

Below are some excerpts from recent articles commenting on bank earnings results (each bank below has at least some traditional banking in its mix). It's clear that, while the traditional banking world still has its problems, the environment continues to improve in a meaningful way.

In contrast, Wall Street businesses continue to struggle.

BofA - WSJ: The Big Surprise in Bank of America's Earnings
BofA's Tier 1 common capital rose 1.26 percentage points last year to 9.86%. Earnings? Perhaps not so impressive. "Higher capital ratios may be somewhat offset by the fact the company is demonstrating very little earnings power," says Stifel Nicolaus.

Bank of America shares are up 5.7% in pre-market trading to $7.19, after sitting just above $5 before Christmas.

Good luck making sense of Bank of America's earnings release, which is packed with a dizzying number of one-time gains and losses. There was a $2.9 billion gain from BofA's sale of its investment in China Construction Bank, a $1.2 billion gain from its swap of some preferred stock, a $600 million goodwill impairment, a $1.5 billion expense tied to BofA's endless mortgage lawsuits. In short, it was a messy quarter.

What is clear is Bank of America followed a trend seen at its peers Citigroup and J.P. Morgan. Fourth-quarter results were ugly in its stock-and-bond trading and other Wall Street businesses, but BofA's traditional banking businesses – making loans to businesses and consumers — were stronger.

U.S. Bancorp - Fitch: U.S. Bancorp Continues Solid Earnings Generation in 4Q'11
Fitch Ratings notes that U.S. Bancorp's (USB) results continue to outpace those of many of its rivals. USB reported net income of $1.35 billion in fourth quarter 2011 (4Q'11), a solid 6.0% increase from net income of $1.27 billion in the sequential quarter. These earnings equated to a strong 1.62% return on assets and 16.8% return on common equity.

Wells Fargo - Wells Fargo Net Up 20%
Wells Fargo & Co.'s fourth-quarter earnings jumped 20% as the banking giant sold more commercial loans and saw a surge in mortgage creation.
---
Wells Fargo, the nation's fourth-biggest bank by assets, further differentiated itself, along with other more traditional lending banks, from investment banks. Citigroup Inc. got walloped in its fourth quarter, following J.P. Morgan Chase & Co., which on Friday reported a slump in profit.

Citigroup - Citigroup Earnings Fall Short of Expectations
Despite signs of life on Main Street, Wall Street is still struggling.

That dichotomy was evident on Tuesday, when Citigroup reported fourth-quarter results that fell far short of what analysts were forecasting, despite a pickup in lending and a drop in losses on bad loans. The culprit was the banking giant's capital markets division, where revenue fell 10 percent last quarter as traders headed for the sidelines, hurting businesses like stock and bond trading as well as investment banking.

J.P. Morgan - J.P. Morgan Earnings Miss Wall Street Expectations
The big disappointment at J.P. Morgan was the investment bank, and its slide allowed J.P. Morgan's Main Street businesses to take command. J.P. Morgan's division made up of credit cards and auto lending overtook the investment bank in revenue and profit in the fourth quarter.

The net interest margin of Wells Fargo is 3.89% while the net interest margin of U.S. Bancorp is a bit lower but a still impressive 3.6%. On this important measure, both banks have a big advantage over most peers.

Consider that Wells Fargo has typically had a 1% or larger net interest margin advantage compared to other big banks. That may not sound like much but consider this: If Wells Fargo's net interest margin was more like its competitors (something like 1% lower...2.89% instead of 3.89%), the bank would earn $ 11.3 billion less pretax!**

Now, even the best large banks a susceptible to systemic risk. There's no getting around that. The complexity and interconnectedness of large banks making gauging the risks difficult at best (though U.S Bancorp is not exposed to global systemic risk in the same way as someone like Citigroup. It is a much more straightforward banking business). Considering the many other attractive investing alternatives, I can see why an investor would not want to bother with any of these larger banks.

Having said that, banks with higher net interest margins (low cost deposits combined with loans intelligently priced) and other reliable sources of noninterest income can produce above average return on equity (ROE). Banks with relatively high ROE (mid-teens or higher) that maintain a disciplined credit culture throughout the business cycle have a better likelihood of producing above average long-term returns for shareholders.

J.P. Morgan is considered by many to be one of the stronger large banks yet, while the two banks are of course nothing alike, U.S. Bancorp's 16.8% return on equity is more than 2x that of J.P. Morgan. If sustained, that advantage should benefit long-term U.S. Bancorp shareholders in a measurable way.

Even though J.P. Morgan is far larger and certainly more complex (it has a balance sheet that is roughly 7x larger in terms of assets), U.S. Bancorp can hardly be considering small with its $ 340 billion in assets.
(So I'm not really a fan of J.P Morgan due mainly to its complexity, but its shares did seem to get very cheap very recently. It has rallied since but continues to sell at a lower multiple than Wells Fargo or U.S. Bancorp. Still, I'd not be interested in it as a long-term investment. My preference is for less complexity and a bigger emphasis on a more traditional banking model.)

The bad news is, for those that still want to bother investing in one of better large banks, they're much more expensive now. On many occasions these past few years there were opportunities to buy the better banks at very attractive prices (They've gone from being 4 or 5x my estimate of normalized earnings in 2009 to more like 10 or 11x more recently). For my money, an acceptable margin of safety has all but disappeared near current prices.

Of course, as we've seen quite a few times in recent years, that can change pretty fast.

Cheap stocks and good news rarely coincide.

Adam

* Accumulating deposits then making loans (net interest income) and providing related services (noninterest income) to businesses/consumers.
** Here's another way to look at it. The 1% net interest margin advantage enables Wells Fargo to absorb an additional $ 11.3 billion per year of losses before it has to put a dent in equity capital during times of economic and/or financial stress. So there's a defensive angle to this advantage as well. Some look at banks more statically and seem to not give much weight to this important dynamic.

Long WFC, USB, and JPM bought at much lower prices

An Interview with Markel's Tom Gayner: On Hedging, Intrinsic Value, Banks, and Investing in Europe

2012-01-18T11:19:00.003-05:00

Tom Gayner is president and chief investment officer of Markel Corporation (MKL) and president of Markel Gayner Asset Management (the investment subsidiary of Markel Corporation). He's been investing their since 1990 and manages roughly $ 2 billion.

Over the past twenty years the book value* of Markel has compounded in the high teens.

As of September 30, 2011, the top holdings in the Markel portfolio included: Carmax (KMX), Berkshire Hathaway A & B shares (BRK.a, BRK.b), Fairfax Financial Ltd (FRFHF) and Diageo (DEO). Gayner doesn't sell stocks in the Markel portfolio all that often.

Some excerpts from this recent GuruFocus interview with the value investor:

On Hedging
It's not something we try to do...we just try to have a natural hedge in the portfolio so that we own about as much as in fixed income assets in a particular currency as we would have liability in any one currency. Beyond that, the costs of hedging are substantial, so we try not to incur those. We don't assume that we have a more accurate view of the future than others. So in general we try to avoid incurring those costs, which helps the returns.

On Markel's Intrinsic Value
I would not put a specific number on it, but the mentality that I would have in thinking about it is, I would think about a our insurance businesses with a normalized amount of premium volume, and a normalized amount of underlying profitability. That gives a normalized amount of operating earnings from the insurance company. Then I would look at our net investments per share, which was total investments minus all the debt. I would then think to myself, well, if this insurance company continues to operate at an underwriting profit, and at least stays the same size, then all of the net investments per share are actually working for the shareholder, so that value should be added. Then the third thing I would think about is the Markel ventures set of companies and what the operating cash flows and operating earnings are on a normalized basis and assign a multiple of that. I would divide that by the number of shares outstanding, and get a sense of what Markel each share is worth.

Gayner's answer on intrinsic value is very similar to the way Berkshire Hathaway's intrinsic value can be estimated.

On Large Bank Stocks
...I have decided that they're beyond my circle of competence to invest in them.

In the interview, Gayner was asked about Fairfax Financial (and, as noted above, one of Markel's top holdings) saying:

"...we have a lot of respect for what they're doing and how they've compounded value over the years."

He was also asked about Prem Watsa, the founder, chairman, and chief executive of Fairfax Financial calling him...

"a very talented and honest businessman."

On Investing in Europe and Watsa's Investment in Bank of Ireland (IRE)
He has different skills than me, so I would not be making those investments. I don't know how to do it the way he does. By contrast one of our largest holdings is Nestle (NSGRY). It is a European company but sells around the world. Another company we own is Diageo (DEO), it is a UK based company but it also sells products around the world. That is the kind of company that we see as a solution to invest in Europe. If you look at Nestle and Diageo whether Europe goes up, down, sideways, whether they solve the problem in one month, or one year, or ten years, the economics of those companies are likely to do pretty darn well.

A good example of what is one of the more important qualities of successful investors: knowing one's own limits.

Read the full GuruFocus interview here.

Adam

* An imperfect measure but still a useful gauge.

Wells Fargo Reports 4Q and Full Year 2011 Net Income

2012-01-17T12:15:00.000-05:00

Almost all bank stocks did poorly during the crisis.

Most of the stocks, yes. Yet, at least in some cases, the best in the banking business came out the crisis just fine.

Telling the strong from the weak at the height of the crisis wasn't easy but, now that some time has passed, it's become more clear where the quality was and is.

Some of the best banks are intrinsically more valuable now per share than before the crisis occurred. Short of another financial crisis, the better ones are in a solid position to continue building on that value.

Wells Fargo (WFC) seems a good example. The bank just reported 4th quarter and full year net income:

Wells Fargo & Company (NYSE: WFC) reported record net income of $4.1 billion, or $0.73 per diluted common share, for fourth quarter 2011, compared with $3.4 billion, or $0.61 per share, for fourth quarter 2010, and $4.1 billion, or $0.72 per share, for third quarter 2011. Full year 2011 Wells Fargo net income was $15.9 billion, or $2.82 per share, up 28 percent from 2010.

"I'm extremely pleased with Wells Fargo's performance in 2011 – including strong deposit and loan growth, record cross-sell and record earnings," said Chairman and CEO John Stumpf. "We achieved these results while completing the conversion of Wachovia's retail banking stores – the largest such conversion in banking history – and now all of our 6,239 retail banking stores are on a single platform serving customers coast to coast. At the time of the merger, we said the integration of Wachovia would take three years and we are right on track."

Wells Fargo certainly made their fair share of mistakes during the crisis but, compared to most peers, they've come through it just fine to say the very least.

In what is still a very challenging bank environment, Wells Fargo is now already earning more per share than it ever did pre-crisis.

That may or may not seem like a huge deal but, in contrast, other less well run banks are still having a tough time earning even a fraction (if they're even still around) of what they earned pre-crisis.

Citigroup (C) is as good an example of this as any. The bank may be getting its house in order now, but that doesn't change what it looks like from a long-term equity investors point of view.

At its pre-crisis peak, Citigroup earned more than $ 48/share (apples to apples accounting for the 10-1 reverse stock split) but earned less than $ 4/share during all of 2011 (as just reported).

Even when things begin to fully normalize for Citigroup, the amount of wealth destruction for shareholders has been extensive. Much of that value destruction, of course, is due to extreme share dilution and the need to sell off valuable assets to clean up the balance sheet. As a result, as far as the common stock goes, it is a shadow of its former self.

Not so at Well Fargo, the bank is intrinsically more valuable absolutely and, most importantly for an investor, on a per share basis. There is also plenty of reasons to think they'll compound that value at a higher than average rate for a bank going forward.

In its peak earnings year prior to the crisis, Wells Fargo earned $ 2.49/share.

For the just reported 2011 full year, the bank earned $ 2.82/share (Wells share dilution during the crisis was more than offset by increases to earning power).

So, at a time when Citigroup still can't even earn 1/10th of what it did pre-crisis, Wells Fargo is already earning more than its best pre-crisis year (earnings are expected to be higher in 2012...we'll see).

In what is still a rough environment for any bank, Wells Fargo has figured out a way to earn more than it ever did previously while building a healthy balance sheet (and also absorbing the not-so-healthy and very large Wachovia).

When a more healthy economic expansion begins to kick in, the deposit and loan growth should lead to much more earning power and eventually more capital being returned to shareholders.

In addition, compared to peers, Wells is less complex and requires a much smaller balance sheet to produce a similar amount of net income.* Unlike the other large banks, Wells Fargo never really focused on investment banking and its many pitfalls. Not a small advantage. The result is a cleaner model focused primarily on commercial banking. The bank has a substantial advantage over most peers in terms of net interest margin. If sustainable, in combination with their credit culture and other qualities, should lead to higher than average return on equity (ROE) over time (for a bank, a sometimes useful if imperfect proxy for investor returns given the limits of accounting) and, ultimately, superior long-term investor returns (faster increases to intrinsic value).

When it comes to banks, investors should tread carefully with what looks like a "bargain". The better bank stocks sometimes look relatively expensive compared to book value** and/or earnings per share, but that's often because the best are capable of increasing intrinsic value at a higher rate.
(Wells Fargo has been very cheap, at times, for several years but that's no longer the case as of today. It's selling at slightly more than 10x earnings. Expensive? No, but not cheap either. Many banks sell at a far lower earnings multiple or discount to book value but watch out for those that are cheap and, well, worth it.)

As always, you've got to pay an appropriate discount to value. For most banks, the analysis of what it's worth should start with balance sheet health and net interest margin performance but credit and selling culture, complexity, compensation systems, and attitudes toward accounting practices are crucial. Having a simpler business model and a management team that prioritizes balance sheet health over short-term income statement performance likely wins in the long run. All these characteristics contribute to the robustness of the franchise and help an investor gauge, though never precisely, how rapidly intrinsic value is likely to increase over multiple business cycles.***
(It's how these many different moving parts play out in combination over time that determines returns...not just one or two of these things.)

Evidence of sustainable and high return on equity (or book value) relative to peers is a useful if insufficient measure.

Paying a reasonable multiple of normalized earnings always makes sense to protect, at least somewhat, against the unforeseen and unforeseeable.

Still, in the long run, if you don't gauge things like culture and the effectiveness of compensation systems reasonably well the rest likely won't matter much.

Also worth asking: Is the the culture, practices, and competitive advantages that produced prior results still mostly in place?

It is one thing for a bank like Wells Fargo to temporarily have reduced earning capacity per share as it absorbs credit losses. With even the best bank that kind of goes with the territory. For shareholders, the key thing is that those earnings are substantially restored (and then eventually begin climbing again) after the worst of a credit cycle passes.

It's a whole different ballgame, as is the case with Citigroup, to have so much earning power per share (and, of course, intrinsic value) permanently destroyed. Some of the wealth destruction comes down to dilution and asset sales but there is another disadvantage: It's a lower return business than Wells. Even when things begin to more fully normalize Citigroup will continue to be a shadow of itself on a per share basis.

In general, I can think of easier ways to produce solid long-term risk adjusted returns other than investing in financials. Wells Fargo may be "less complex" than other large banks but that's not really saying much. Any large bank, including Wells Fargo, is not at all simple and ends up being a bigger leap than most other investments.

There's more room for error with businesses in other sectors.

It's worth remembering that during the worst of the financial crisis, very few distinctions were being made between quality financial institutions and those that behaved the worst. The downward price action was awful for just about all of them and that action always has the potential to become self-fulfilling, at least to some extent, under times of stress.

The situation is very different for a business like Coca-Cola (KO). The beverage company doesn't much depend on the kindness of the capital markets to fund itself.

The difference in possible outcomes is night and day.

A long track record of producing returns and protecting wealth, especially through difficult periods, is one way to begin judging the quality of any financial institution. The benefit of the recent financial crisis is it provided a good real world stress test. No bank came through 2008-9 without real financial pain though it is much more clear now who avoided the excesses.

That should count for a lot and inform any analysis but will always be insufficient.

Adam

Long WFC

* Example: J.P. Morgan (JPM) has ~$ 2.3 trillion in assets compared to $ 1.3 trillion for Wells Fargo yet earned only $ 17.6 billion compared $ 15 billion. So almost $ 1 trillion more in assets (73% more than Wells) produced just $ 2.6 billion more in earnings (17% more than Wells) for common shareholders. On way to look at it is this: JPMorgan is on the hook for a relatively large chunk of additional assets (~$ 1 trillion and the associated risks of potential loss/other liabilities) but produces a relatively small ($ 2.6 billion) amount of incremental earnings with those assets.
** Book value is a decent starting point only for determining value but, given the limits of accounting, is ultimately very flawed. Book value can be much higher or lower than intrinsic value (itself a necessarily imperfect measure that, using the John Burr Williams definition, is primarily the present value of future cash flows). A bank that has higher sustainable net interest margin and fewer credit losses (and otherwise similar expenses) over a complete business cycle is naturally worth more intrinsically. The return it will generate on that book equity and, more importantly, the economic returns driven by cash flows will be vastly superior resulting in more intrinsic value creation over time. The opposite, of course, is also true. A low net interest margin and higher credit losses will destroy bank returns.
*** Balance sheet health, net interest margin, and return on equity are easy to quantify measures that matter an awful lot. Yet, a culture that chooses balance sheet health over short-run income statement performance, with conservative accounting practices, and smart credit standards is much harder to measure but often determines durability. Also, those who have designed compensation systems around short-run outcomes will inevitably lead to a gaming of the system by management. A multi-year approach to measuring results has to be adopted. None of this is exactly easy to judge.

Microsoft: A Gem In Plain Sight? (MSFT, AON, BRKb, GOOG, DELL, WFC, TXN, COP, UPS, TYC)

2012-01-13T10:15:00.000-05:00

So is Microsoft (MSFT) a gem in plain sight? According to Brad Hinton, a portfolio manager with Weitz Funds, it certainly is.

During a recent Barron's interview, the value investor explained why he likes Microsoft.

Loading Up on Cash-Rich Value Stocks

Q: Let's talk about Microsoft (MSFT), which was recently the No. 1 holding in Weitz Value. Why do you like it?

A: It's sort of the hidden gem in plain sight. I mean everyone knows the story of its collection of businesses. Our view is the valuation is just dirt cheap. A lot of the larger old-line businesses are likely to do better than people think, and we don't think that means robust growth. But we also don't think the Windows franchise is dead. We don't think the Office franchise is anywhere close to dead. The server and tools business is underappreciated. It's a cash-flow machine that can continue to lumber along, and like a lot of other people, we would love to see them buy back more stock than they are. But they pay a very healthy dividend. They are buying back some stock, and our view is it is just far too cheap. Microsoft is trading around $27 and is very likely to do close to $3 of yearly earnings; we think it can still grow that earnings stream at a mid-single-digit rate at worst.

Q: So we are talking about a nine times forward earnings stock?

A: And that's pre-cash. They have a ton of cash on the balance sheet that we don't give them a ton of credit for. This stock is also paying a 3% dividend yield while we wait for things to play out, which is not too bad in this environment.

Here's the top ten holdings of the fund family's flagship Weitz Value Fund (WVALX) as of September 30, 2011:

1) Microsoft (MSFT)
2) AON (AON)
3) Berkshire Hathaway (BRK.b)
4) Google (GOOG)
5) Dell (DELL)
6) Wells Fargo (WFC)
7) Texas Instruments (TXN)
8) Conoco Phillips (COP)
9) United Parcel Service (UPS)
10) Tyco International (TYC)

Morningstar: Weitz Value Fund Portfolio

Microsoft has more than $ 5/share of net cash and investments (cash and investments minus debt) on the balance sheet. Taking that into account, the company is selling at less than an 8x multiple of earnings.

Adam

Barron's interview

Five Dow Stocks with the Highest Earnings Yield

2012-01-12T12:00:00.000-05:00

Here is the five Dow stocks with the highest earnings yield (inverse price to earnings) based upon consensus earnings:

Dow Industrials Consensus Earnings

Stock | Earnings Yield
Hewlett-Packard (HPQ) | 16%
Bank of America (BAC) | 15%
JPMorgan (JPM) | 14%
Chevron (CVX) | 12%
Pfizer (PFE) | 11%

Some things to consider:

- Chevron may seem cheap but, there are other large, integrated oil companies that appear even cheaper. These happen to be located in economically dismal Europe yet derive their economics globally. Examples include BP (BP), Total (TOT), and Royal Dutch Shell (RDS-A). Considering the capital intensiveness of these businesses they should have low multiples in my view.

- If you adjust for net cash and investments* on the balance sheet, Microsoft (MSFT) and Cisco (CSCO) would displace Chevron and Pfizer in the top five.
(Most estimates of Cisco's earnings are non-GAAP. In my view, it creates an optimistic view of the company's true earnings power. This inflated earnings picture is primarily the result of stock-based compensation. Using my more conservative numbers Cisco wouldn't make the top five.)

- Earnings season is just ahead so what is revealed in each earnings report may change the consensus (up or down) meaningfully in the coming weeks. To be clear, I NEVER use another analyst's estimate to figure out intrinsic value. Personally, I don't think any investor should use someone else's numbers or assumptions. It's also why I do not believe in making stock recommendations (which is something I'd never do). I think the work has to be done by the owner so that person really knows, in a substantive way, why they want to own a specific stock.

- Instead of using someone else's estimate, I come up with an estimate of intrinsic value** (and how it may change over time) using my own conservative estimate of future earnings power and return on capital of the business. I weigh heavily how the business performed over the previous business cycle. If I think the price paid produces a nice long-term risk-adjusted return based upon these conservative estimates, I'm certainly not going to mind if the business ends up having even more earnings power than I realized. I also make subjective judgments on whether management can be trusted to allocate capital intelligently and, ultimately, how confident I am the business has a sustainable economic moat. There are many other subjective judgments to be made so spreadsheets matter less than some seem to think. An investor that doesn't take the time to get their arms around these things shouldn't really be buying an individual stock in my view.

-Weighing all the above, on a risk-adjusted basis most of these five actually do not look extremely cheap compared to alternatives. Though I do find HPQ and JPM to be the most interesting if they get near prior recent lows again.
(Though I own shares of some banks, my view continues to be that most banks are not really worth the trouble. The larger ones, for the most part, are just too complex to really understand.)

- While some of the banks appear very cheap, most have rallied substantially in recent weeks. Bank of America has a wide range of estimates among analysts so the so-called consensus earnings are really anything but a consensus. On the other hand, Bank of America is not yet producing the kind of profits it likely can once its house in order. The question is will material dilution end up happening, especially at a low stock price (making the dilution even more painful), hurting the shareholders who already own it. A tough call that doesn't seem worth the risk to me considering alternatives (something I've said on a prior occasion). This seems easily the most speculative of the bunch.

Finally, A double digit earnings yield implies an expectation for earnings to shrink, in some cases substantially, proving these estimates to be too optimistic. It would seem that, near recent market prices, most of these just have to prove that their business is not in some kind of secular decline or near a cyclical peak (revealing true earnings power to be much lower than it now seems). In other words, eventually the earnings yield gets high enough to compensate an owner for the risks even if no meaningful growth is in the cards.*** Now, if it turns out these businesses do begin to profitably grow in a sustained way again, even if modestly, long-term owners of the shares can do quite well at a double digit earnings yield entry point.

Adam

* Cash and investments minus debt.
** Estimates of intrinsic value is actually more a range of likely values and certainly is not a precise number. Attempts to be falsely precise in this business can be expensive.
*** As long as management makes intelligent, shareholder-friendly, use of the capital. That's not something that is guaranteed by any stretch.
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I do not make stock recommendations as that comes down to individual circumstances. The site is for information and educational use and the opinions found here should not be treated as investment advice.Visitors should consult their own financial advisor before making any investment decisions. In general, I am long the positions above or considering taking a long position.

Jamie Dimon on Buying Back Stock

2012-01-11T12:10:00.003-05:00

When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases. - Warren Buffett in the 1984 Berkshire Hathaway Shareholder Letter

From this TheStreet.com article:

JPMorgan Chief Jamie Dimon told CNBC on Monday that he expects the bank to comfortably pass the Fed's annual stress test and would likely report a Base 1 Tier 1 Capital of 7% to 8% even after modeling for losses in an extremely harsh economic scenario.

He also said that buybacks and dividend increases remain a board decision and that the bank will not buy back stock at any price. "Buying back stock makes sense when you are buying below intrinsic value. If you are buying above intrinsic value you are only benefiting exiting shareholder," he said, adding that he believes the bank's stock is cheap.

Good to hear "buying back stock makes sense when you are buying below intrinsic value" from a CEO. On too many occasions buying back stock is done for some other less economically sound reasons. Whether a buyback makes sense comes down to:

Are the shares are selling comfortably below a conservative estimate of intrinsic value?

Is the business in a financially and competitively strong position?

Are expenditures that maintain competitiveness (protect or enlarge the moat) still getting done?

Does buying back shares compare favorably, on a risk-adjusted basis, to alternative investments including high return expansion opportunities?

If the answer is clearly yes to questions like that, and intrinsic value has been estimated reasonably well (a rough estimate, of course, due to the necessarily imprecise nature of intrinsic value), then a buyback has a good chance of working very well.

What never makes sense is buying back shares when they are selling above intrinsic value though it certainly does happen.

Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason: to pump or support the stock price. The shareholder who chooses to sell today, of course, is benefitted by any buyer, whatever his origin or motives. But the continuing shareholder is penalized by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around.

Charlie and I admit that we feel confident in estimating intrinsic value for only a portion of traded equities and then only when we employ a range of values, rather than some pseudo-precise figure. - Warren Buffett in the 1999 Berkshire Hathaway Shareholder Letter

Seems incredible that buybacks were "all the rage" in 1999 when most stocks were unbelievably expensive. Of course, buyback activity was also intense leading up to the market peak in 2007.

From this Barron's article:

...research firm Biryini reports that the biggest year ever for buybacks was 2007, with companies authorizing $863 billion of them on the very brink of the historic market crash.

So, all too often, shares are bought when they're selling plainly above intrinsic value. Also, buybacks sometimes used in an attempt to stem the decline or prop up the value of a stock. Not a good idea unless the stock happens to be selling nicely below intrinsic value at that time (just because the stock is dropping doesn't mean it's selling below intrinsic value) and the business is otherwise healthy enough with free cash available:

We will never make purchases [ of Berkshire's stock] with the intention of stemming a decline in Berkshire's price. Rather we will make them if and when we believe that they represent an attractive use of the Company's money. - Warren Buffett in the in the 1999 Berkshire Hathaway Shareholder Letter

So a buyback should never be about influencing price action. It's about paying less than a dollar to get a dollar of value (a dollar of value that, if a good business, should grow) in return*.

On the other end of the spectrum is when a CEO has an extremely cheap stock but opts for an expensive acquisition instead.

That pretty much sums up Sanofi's (SNY) purchase of Genzyme:

Asked on a conference call Monday about repurchases, Sanofi CEO Chris Viehbacher blasted them, saying, "I personally don't believe that buybacks add any shareholder value."

One big investor criticizes drug-company CEOs, telling Barron's: "For these types, buybacks are a pejorative, a 'going out of business strategy' equated with no growth or ambition. Of course, the ambition to grow value per share instead of all the other stuff seems to escape many of them. I wonder how it's possible that so many well-educated people can be so ignorant of some pretty basic math."

From this Barron's article:

Some Sanofi investors would rather see the company buy back some stock at seven times earnings than pay 20 times profits for Genzyme, a view that we've endorsed.

When executed intelligently, buybacks work very well and, just as importantly, can reveal whether management actions are driven by shareholder wealth creation.

By making repurchases when a company's market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management's domain but that do nothing for (or even harm) shareholders. - Warren Buffett in the 1984 Berkshire Hathaway Shareholder Letter

The track record of effectively executed buybacks is certainly mixed at best but buybacks are neither inherently good nor bad. Careful consideration of the specific circumstances is always required.

I think that's worth remembering when a generalization is being made about the merits of repurchases (or the lack thereof).

Adam

Related posts:
How Not to Spend $ 18.5 Billion
Sanofi to Buy Genzyme
Should Berkshire Repurchase Its Own Stock?
Buffett: When it's Advisable for a Company to Repurchase Shares
Berkshire Hathaway Authorizes Share Repurchases

* Let's say something like 70 cents is paid for a dollar of business value (as if it can be could be calculated with that kind of precision) but, of course, that dollar of value is not static. If a sound investment, that dollar in business value grows intrinsically over time. Of course, the opposite is true. Consistently judging reasonably well how value is likely to change over time matters. A discount provides only so much protection against mistakes.

John Bogle: America's Financial System - Powerful but Flawed

2012-01-10T11:40:00.000-05:00

From this lecture by John Bogle late last year:

America's Financial System - Powerful but Flawed

Classical economics has tended to make a distinction between the real economy—the production and consumption of goods and services—and the paper economy—the vast network of financial assets and liabilities that is, finally, supported by the productive economy. The fact is that our productive economy and our financial economy are closely, indeed inextricably, interlinked.

The principal role of our nation's financial institutions is to allocate scarce investment capital among our corporations and economic sectors in a way that maximizes the growth potential of our economy. But changes in our financial sector have undermined this goal. Most notable among those changes are: first, the growing dominance of agents (giant banks and investment banks, and institutional money managers) as stock owners over principals (individual investors); and second, the ascendance of short-term speculation over long-term investment, focused on the illusion represented by the momentary precision of stock prices rather than the reality represented by intrinsic value—simply put, the discounted value of future cash flows. Both of these major changes in how we invest have played a critical role in creating a dysfunctional and expensive financial system, and in turn have ill-served our real economy.

The downside of a dominance of agents over principals? Some excerpts from this interview last year with John Bogle:

...agency dominance is never going away. The problem is if you're an agent and you're not investing your own money, you've got a lot of other things to keep you going. Adam Smith has a saying "Managers of other people's money [rarely] watch over it with the same anxious vigilance with which… they watch over their own."

The focus in the mutual fund business and in the pension business is on short-term performance. It's absolutely idiotic but it is not going to change.

In Bogle's view, we've traded an ownership society for a failed agency society. Later in the interview, Bogle added...

I'm afraid we've got to be satisfied with incremental changes that come down to investors and pension fund managers acting more intelligently. If we did have a fiduciary duty for institutional money managers, it would force the corporations that they control in today's agency system to honor the fiduciary duty to their clients.

Bogle thinks that out of this failed agency society needs to emerge a robust fiduciary society.

So, out of the ashes of our old ownership society and our failed agency society we must develop a new fiduciary society... - From "Building a Fiduciary Society" on Page 11 of America's Financial System - Powerful but Flawed

Now, what about the downside of what Bogle, in the above lecture, calls "the ascendance of short-term speculation over long-term investment"?

Wall Street is raising capital for industry, as it always has, in reasonable amounts considering the needs of the corporations. The problem is that primary capital formation or capital allocation — call it whatever you want — it has been totally overshadowed by all this speculation in the secondary markets.

So, in Bogle's view, what's the result?

...speculators don't give a damn about corporate governance. They don't give a damn about executive compensation. They don't give a damn about anything except the price of the company's stock, which is basically a momentary illusion.

Bogle has often referred to the fabled "Wall Street Rule" which essentially is if you don’t like the management, sell the stock. Sounds like a perfectly reasonable practice until you realize how that view of the world might contribute to the so-called agency problem*.

Who has a better likelihood of influencing important changes at the board level to improve corporate performance?

A system where institutional money managers are held accountable to a strong fiduciary duty requirement (the duty to make sure management and the board of companies they own shares in are putting shareholders' interests first) or those that operate under something akin to the "Wall Street Rule"?

Long-term investors or speculators?

A system dominated by relatively short-term oriented agents that live by things like the "Wall Street Rule" and speculators with very short time horizons isn't likely to expend much energy influencing and trying to fix what might be broken with a company's board and management.

In the same interview, Bogle suggests a different rule:

So if you don't like the management, improve the management! It's not complicated.

Even if slowly considering the forces involved, some of the more expensive and economically useless activities in the current system could be replaced by playing a key role in forcing useful change and improvement where crucial resource utilization and investment decisions are made every day. More from Bogle:

I think each of us have a responsibility to leave everything we touch in our lifetime a little bit better. Whether it's a family. Whether it's a community. Whether it's a corporation.

It's unlikely that the current system dominated by 1) short-term oriented agents and weak fiduciary standards along with 2) speculators will play the vital role of improving corporate governance.

America has some fine companies despite the weaknesses in the system. That doesn't mean the status quo is acceptable.

Change is needed and the impact on the real world is far from academic. There's very real economic and social benefits at stake in all this.

Adam

* What's the agency problem in this context? Agents (banks and institutional money managers like mutual funds, pensions etc.) often have enough scale to influence accountability at the board level of a company they own shares in (and ultimately the management) but do not feel, too often in the current system, obligated to fulfill that responsibility. It contributes to an all too frequent outcome. Inadvertently or not, agent and/or management interests end up favored over shareholders' and beneficiaries' interests (even if cleverly cloaked otherwise). The lack of long-term investing by many institutional money managers certainly also contributes. In other words, if you aren't going to own something long-term why bother with fixing an inept board and/or management team. This has a direct and cumulative effect on corporate misbehavior and resource misallocation. The fiduciary duty of institutional money managers in representing shareholders and pension beneficiaries is overwhelmed by their financial interest in gathering and managing the assets.

Buffett on Efficient Market Theory

2012-01-09T10:15:00.000-05:00

From the 1988 Berkshire Hathaway (BRKa) Shareholder Letter. In that letter, Warren Buffett provides some thoughts on "efficient market theory" (EMT).

An excerpt:

Amazingly, EMT was embraced not only by academics, but by many investment professionals and corporate managers as well. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.

In my opinion, the continuous 63-year arbitrage experience of Graham-Newman Corp. Buffett Partnership, and Berkshire illustrates just how foolish EMT is. (There's plenty of other evidence, also.) While at Graham-Newman, I made a study of its earnings from arbitrage during the entire 1926-1956 lifespan of the company. Unleveraged returns averaged 20% per year. Starting in 1956, I applied Ben Graham's arbitrage principles, first at Buffett Partnership and then Berkshire. Though I've not made an exact calculation, I have done enough work to know that the 1956-1988 returns averaged well over 20%. (Of course, I operated in an environment far more favorable than Ben's; he had 1929-1932 to contend with.)

All of the conditions are present that are required for a fair test of portfolio performance: (1) the three organizations traded hundreds of different securities while building this 63- year record; (2) the results are not skewed by a few fortunate experiences; (3) we did not have to dig for obscure facts or develop keen insights about products or managements - we simply acted on highly-publicized events; and (4) our arbitrage positions were a clearly identified universe - they have not been selected by hindsight.

Over the 63 years, the general market delivered just under a 10% annual return, including dividends. That means $1,000 would have grown to $405,000 if all income had been reinvested. A 20% rate of return, however, would have produced $97 million. That strikes us as a statistically-significant differential that might, conceivably, arouse one's curiosity.

Yet proponents of the theory have never seemed interested in discordant evidence of this type. True, they don’t talk quite as much about their theory today as they used to. But no one, to my knowledge, has ever said he was wrong, no matter how many thousands of students he has sent forth misinstructed. EMT, moreover, continues to be an integral part of the investment curriculum at major business schools. Apparently, a reluctance to recant, and thereby to demystify the priesthood, is not limited to theologians.

Naturally the disservice done students and gullible investment professionals who have swallowed EMT has been an extraordinary service to us and other followers of Graham. In any sort of a contest - financial, mental, or physical - it's an enormous advantage to have opponents who have been taught that it's useless to even try. From a selfish point of view, Grahamites should probably endow chairs to ensure the perpetual teaching of EMT.

Amazingly, you'll find EMT taught to this day at respected major universities and colleges.

I've said before that it's best to never underestimate how long it takes for lousy yet influential ideas, even if they happened to be cloaked in respectability, to disappear.

Adam