Wednesday, June 17, 2009

Seth Klarman: Why Most Investment Managers Have It Backwards

For value investors, last fall’s crisis provided an unprecedented opportunity. Down markets are a great time to buy securities, as Graham and Dodd said in Securities Analysis, since the average investor can usually only get them “at prices that the future may cause him to regret.”

For Seth Klarman, founder and president of the Boston-based Baupost Group, last fall was a period that offered many of those opportunities. He delivered the keynote lecture at the annual meeting of the Boston Security Analysts Society last week. Klarman also was the lead editor of and authored the preface to the sixth edition of Graham and Dodd’s Securities Analysis, published in 2008.

In that speech, Klarman praised his team for remaining clear-headed amid exceptional market volatility and positioning the firm’s portfolio to deliver superior long-term performance for its investors.

Unfortunately, Klarman said, clear, long-term goals are not the norm throughout the industry. Before detailing the most attractive opportunities created by the crisis, Klarman first addressed a fundamental conflict within the investment management industry that he said is at odds with investor objectives.

Investment managers, such as pensions and endowments, exist in perpetuity and should be focused on long-term wealth creation. Yet performance is almost universally evaluated using short-term results – managers are compared using quarterly, monthly, or even daily returns, creating extreme short-term pressures. “Managers who do well in the short term are rewarded with more assets,” he said. “Those who do not do well in the short term often don’t survive to see the long term.”

Full Article

Saturday, June 13, 2009

Warren Buffett: How Inflation Swindles the Equity Investor

The central problem in the stock market is that the return on capital hasn´t risen with inflation. It seems to be stuck at 12 percent.

by Warren E. Buffett, FORTUNE May 1977

It is no longer a secret that stocks, like bonds, do poorly in an inflationary environment. We have been in such an environment for most of the past decade, and it has indeed been a time of troubles for stocks. But the reasons for the stock market's problems in this period are still imperfectly understood.

There is no mystery at all about the problems of bondholders in an era of inflation. When the value of the dollar deteriorates month after month, a security with income and principal payments denominated in those dollars isn't going to be a big winner. You hardly need a Ph.D. in economics to figure that one out.

It was long assumed that stocks were something else. For many years, the conventional wisdom insisted that stocks were a hedge against inflation. The proposition was rooted in the fact that stocks are not claims against dollars, as bonds are, but represent ownership of companies with productive facilities. These, investors believed, would retain their Value in real terms, let the politicians print money as they might.

And why didn't it turn but that way? The main reason, I believe, is that stocks, in economic substance, are really very similar to bonds.

I know that this belief will seem eccentric to many investors. Thay will immediately observe that the return on a bond (the coupon) is fixed, while the return on an equity investment (the company's earnings) can vary substantially from one year to another. True enough. But anyone who examines the aggregate returns that have been earned by compa-nies during the postwar years will dis-cover something extraordinary: the returns on equity have in fact not varied much at all.
The coupon is sticky

In the first ten years after the war - the decade ending in 1955 -the Dow Jones industrials had an average annual return on year-end equity of 12.8 percent. In the second decade, the figure was 10.1 percent. In the third decade it was 10.9 percent. Data for a larger universe, the FORTUNE 500 (whose history goes back only to the mid-1950's), indicate somewhat similar results: 11.2 percent in the decade ending in 1965, 11.8 percent in the decade through 1975. The figures for a few exceptional years have been substantially higher (the high for the 500 was 14.1 percent in 1974) or lower (9.5 percent in 1958 and 1970), but over the years, and in the aggregate, the return on book value tends to keep coming back to a level around 12 percent. It shows no signs of exceeding that level significantly in inflationary years (or in years of stable prices, for that matter).

For the moment, let's think of those companies, not as listed stocks, but as productive enterprises. Let's also assume that the owners of those enterprises had acquired them at book value. In that case, their own return would have been around 12 percent too. And because the return has been so consistent, it seems reasonable to think of it as an "equity coupon".

In the real world, of course, investors in stocks don't just buy and hold. Instead, many try to outwit their fellow investors in order to maximize their own proportions of corporate earnings. This thrashing about, obviously fruitless in aggregate, has no impact on the equity, coupon but reduces the investor's portion of it, because he incurs substantial frictional costs, such as advisory fees and brokerage charges. Throw in an active options market, which adds nothing to, the productivity of American enterprise but requires a cast of thousands to man the casino, and frictional costs rise further.
Stocks are perpetual

It is also true that in the real world investors in stocks don't usually get to buy at book value. Sometimes they have been able to buy in below book; usually, however, they've had to pay more than book, and when that happens there is further pressure on that 12 percent. I'll talk more about these relationships later. Meanwhile, let's focus on the main point: as inflation has increased, the return on equity capital has not. Essentially, those who buy equities receive securities with an underlying fixed return - just like those who buy bonds.

Of course, there are some important differences between the bond and stock forms. For openers, bonds eventually come due. It may require a long wait, but eventually the bond investor gets to renegotiate the terms of his contract. If current and prospective rates of inflation make his old coupon look inadequate, he can refuse to play further unless coupons currently being offered rekindle his interest. Something of this sort has been going on in recent years.

Stocks, on the other hand, are perpetual. They have a maturity date of infinity. Investors in stocks are stuck with whatever return corporate America happens to earn. If corporate America is destined to earn 12 percent, then that is the level investors must learn to live with. As a group, stock investors can neither opt out nor renegotiate. In the aggregate, their commitment is actually increasing. Individual companies can be sold or liquidated and corporations can repurchase their own shares; on balance, however, new equity flotations and retained earnings guarantee that the equity capital locked up in the corporate system will increase.

So, score one for the bond form. Bond coupons eventually will be renegotiated; equity "coupons" won't. It is true, of course, that for a long time a 12 percent coupon did not appear in need of a whole lot of correction.