Wednesday, June 24, 2009
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.”
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.
Tuesday, June 02, 2009
Wednesday, May 13, 2009
Leucadia 2009 AGM Notes
Sears 2009 AGM Notes
I went to the Sears Holdings annual shareholders meeting on May 4th, and thought i'd share some of what i heard.
First, i will say that i was extremely impressed with Eddie Lampert and left the meeting 100% reinforced that he is one of the smartest people out there.
The meeting was about 3 hours, the first 20 minutes or so, Bruce Johnson gave a presentation on the operating businesses, talked about things like expense control and inventory reductions, and he also highlighted things i had not noticed before, such as the improving performance of comp sales relative to competitors, quarter by quarter. The number of competitors who had comp sales worse than Sears Holdings accelerated dramatically towards the end of last year and Eddie Lampert brought up the point of saying, Which is worse, negative 4% comps four quarters in a row, or flat comps for three quarters and then a single quarter of negative 25% comps, as in the case of Abercrombie.
K-Mart had 1.4 million new layaway customers last year. Bruce Johnson talked about the subsequent purchases that layaway brings as customers visit the stores every two weeks to make payments.
Bruce Johnson talked about market share, saying that Sears Holdings has 34.6% market share in appliances, which leads all competitors, up from 30% in Q3 2007. Said they are reversing years of declines in market share in the appliance category. Eddie Lampert said that while you could sell a heck of alot of $3,000 washer/dryers at $1,500... all you'd essentially be doing is "renting market share" and that they wanted to "own market share".
Market share in other categories mentioned:
22.3% tools
14.2% home repair
21.0% power lawn and garden
The majority of the meeting though Eddie Lampert took questions from the audience. Some interesting points and comments he made were:
Lampert wants to encourage more experimentation, even though it could mean more failures.
He noted that Sears is determined not to make any "serious mistakes" that can put you out of business, he noted ethical mistakes and serious amounts of leverage as two "serious mistakes"
Monday, May 04, 2009
Live from the Berkshire Shareholders meeting 2009
8:41 | The Berkshire Hathaway annual movie has begun. It started with a cartoon of Warren Buffett, Charlie Munger and other executives acknowledging a difficult year in 2008 and pledging to work hard in 2009. Not even Berkshire escaped the global recession unscathed. |
8:45 | The Qwest Center Omaha is packed to the rafters. The arena seats more than 18,000 people. About 35,000 shareholders are in Omaha this year, many of them spilling out into the exhibition hall at the adjoining convention center. The annual meeting is piped into the hall and other rooms so people can watch and hear it. |
8:52 | Late night television and other comedians were highlighted in one snippet of the annual movie, joking about the recession and government efforts to revive the economy. One was David Letterman proclaiming it was a good time to buy stocks, playing off Buffett's advice at one point in the crisis. Letterman suggested that instead of that latte you are accustomed to buying, folks should pick up a few shares of GM. |
9:03 | Another segment has Buffett in Berkshire-owned Nebraska Furniture Mart taking a nap on a mattress, checking "product quality." A manager steps up and tells him the days of sleeping until the phone rings are over, given the stock plunge for Berkshire in 2008. Buffett agrees and tries to sell a mattress to a customer, saying the board of directors suggested he find something else to do. Buffett told the customer it had something to do with a downgrade in Berkshire's credit rating. He gets her to buy a mattress called the "Nervous Nellie," a big seller since the Dow Jones industrials dropped. The mattress features pockets into which can be placed cash and other valuables. The woman goes off to buy the mattress and Buffett takes out all the cash displayed in the mattress, along with a Nebraska Cornhuskers football, magazines and other items. He calls Charlie Munger to set up delivery. |
9:17 | Viewers of the annual movie learned the history of Geico auto insurance company's advertising icon Gecko. The lizard was not like other gecko's, the story goes, and hung out with a family cutting out coupons to help save people money. Then the Gecko left a note with the family, saying he wanted to strike out on his own, to bigger and better things. His lonely life changed when he received calls from people confusing him with Geico. He visited Geico's offices and the chief of marketing realized the Gecko wanted to help save people money, just like Geico tries to do with auto insurance. Geico sounds like Gecko, and the advertising legend was born. |
9:21 | Like last year, a comedy sketch is featured this year, with an investment banker interviewed about the complex financial instruments that backed bad home mortgages. Asked what caused the setup to unravel, the investment banker said people started to ask what the mortgages were actually worth. "Oh for the good old days," the banker sighs. |
9:24 | The annual movie is over. |
9:27 | Warren Buffett and Charlie Munger have taken their seats. Buffett says questions and answers will be different this year, with journalists alternating questions e-mailed by shareholders with those posed by shareholders in the audience. |
9:33 | Buffett notes that U.S. Treasury bonds recently have had negative yields. He said people might not see that phenomenon again in their lifetimes. |
9:33 | Journalist Carol Loomis says more than 5,000 questions were relayed to three journalists involved. |
9:40 | Journalist Carol Loomis said more than 5,000 questions were submitted via e-mail. The first question relates to derivatives and whether those financial deals are good for Berkshire. Buffett says over time, Berkshire expects to make money on the current deals. Buffett says the only money that crossed hands in the stock market deals so far has been $4.9 billion given to Berkshire in premiums. Buffett says the company can use that money for the next 15 to 20 years. And the stock markets on which the deals are made are expected to be higher than when the deals were struck. |
9:47 | tt |
9:52 | Buffett and Munger said the government's response to the financial crisis has not been perfect but it has been reacting the best it can. Munger said given the emegency the government should be judged with some leniency. |
10:08 | Journalist Andrew Ross Sorkin of the New York Times says about 300 shareholders had a similar question: Why does Berkshire keep a high investment in Moody's at a time that credit agencies are being criticized for conflict of interest and using flawed history based models? And why not use Berkshire's clout to change the behavior of the credit agencies. Buffett says the big mistake ratings agencies, Congress, bankers and buyers of homes made was thinking housing prices would continue to rise _ and then they collapsed. Buffett says ratings agencies continue to be a good business because there are not many of them and they deal with a large part of the capital markets. Buffett said Berkshire also does not buy stocks in companies to change their behavior. Buffett says in fact he has tried to influence behavior in the past, and never has been very successful. |
10:17 | Buffett is asked how the four investment managers chosen as possible successors to him did in 2008, a very difficult year. Buffett says there are three candidates as CEO, all are internal candidates. There are four possible investment successors, and one or more could be chosen. They are from inside and outside Berkshire. The four investment managers did no better than match the S&P 500. In 2008 they did not cover themselves with glory, Buffett says, but neither did he, so he is tolerant. Munger says any investment manager he knows who is regarded as intelligent and the rest, they all got creamed last year. Buffett says the investment managers over 10 years have done better. Buffett says he has not changed the list of four possible investment managers, either. Buffett says the CEO job is different, that person needs to step right in if something happens to Buffett. But Buffett says one or more investment managers do not have to actions right away. Buffett says an announcement should not be expected right away on investment managers if something happens to him. But within a month or so, an announcement might be made. |
10:24 | Becky Quick of CNBC says a question about three candidates for CEO successor: What are benefits of bringing in CEO early to give that person a chance to get used to the job? Buffett says he has heard that question before. Buffett says if there was a good way to inject someone into a role that would that person a better CEO for Berkshire, they would do that. But he says the three CEOs are running major businesses right now, and to sit in the office while Buffett is reading or on the telephone -- there is really nothing to do. He says "it would be a waste of talent." Buffett says the three candidates are 100 percent ready for the job right now. He says the biggest job they will have is developing relationships with potential buyers of businesss, with the world at large, with the shareholders. He says that will take time, though not a great deal of time. He says they know how to run businesses, and they probably would do some things better than he would. Munger says a lot of models that have worked well in the world, like Johnson and Johnson, work something like Berkshire and these talents pop up in the subsidiaries. |
10:32 | A shareholder asks Buffett to explain his investment strategies, like value investing, and how teach young people. Buffett says he brings in college students to talk with them each year. Buffett says he tells them it is important to know how to value a business and to know how to judge the markets. He says there would be nothing about modern portfolio theory or anything like that. He says it is important to know your circle of competence, start small and learn as you go along. Buffett says some accounting principles also are important. And then learn about market fluctuations and learn that the market is there to serve you. And that is not an issue of a high IQ, but rather an emotional stability and inner peace about the decisions you have made. Munger says there is the basic problem of always having half the future investors in the world in the bottom 50 percent. Munger says largely people should reduce the nonsense. Buffett and Munger agree that emotional makeup is more important than a high IQ. Buffett says he is asked by college students, "what are we being taught that is wrong?" Munger asks how Buffett can handle that question in just one session. |
10:36 | Buffett is asked how he would replace someone like Ajit Jain in the insurance division. Buffett says you don't, that Jain is unique. But authority does not go to the position -- it goes to the person. |
10:46 | A shareholder asks how Buffett views the markets' valuation of Berkshire shares. The market has it down 30 percent, while earnings were not down that far. Buffett says the shareholder put his finger on something there. Buffett says the investments are what they are in the stock market, so he does not have a problem with that side of the equation. Buffett says the earning power of businesses were down last year and will not do as well this year. But they are by and large good businesses. He says a few of them have problems, others will do very well. Buffett says Berkshire was cheaper in the stock market last year than its intrinsic value would indicate, but most companies were in the same boat. Buffett says over time, both stock price and intrinsic value will increase. And he hopes the operating companies over time will do better. Munger says last year was a bad year for a float business, making the owner of the float (insurance premiums held by Berkshire that can be invested) appear to be worth less than the owner will be worth over time. Munger says Berkshire's casualty insurance business is probably the best in the world. He says other companies in Berkshire's holdings also rank high in the world. Munger says if you think it is easy to get in the position that Berkshire occupies, you are living in a different world than the one that I occupy. Buffett says Berkshire's insurance business is remarkable, with remarkable managers. Buffett says with the economic meltdown, like the China Syndrome or something, it hurt jewerly and NetJets and other businesses, American Express, etc. But the meltdown also caused the phones to ring more at Geico. Buffett says all of a sudden saving money became very important. Buffett says that builds a lot of value over time. Buffett says Geico is now the third largest auto insurer in the country this year and the fundamentals are in place to take Geico much higher. |
Thursday, April 23, 2009
Bill Ackman: The Optimist
Bill Ackman’s friends describe him in two ways. They offer the euphemism that the prominent hedge fund manager “does not suffer from low self-esteem.” Then they observe that he is optimistic—almost clinically so. A pop psychologist might diagnose Ackman with hypomania, a condition notable for persistently elevated moods but without the self-destructiveness of true mania. “He doesn’t register reversals and defeats and hard feelings the way other people do,” says David Klafter, a former colleague.
I ask Ackman about the condition while he is driving in a car with his family. He hasn’t heard of it, but says he is an “extremely resilient person.”
His 11-year-old daughter playfully chides from the backseat, “And you’re modest.”
Ackman is an activist investor, a respectable term for people who in the 1980s were known as corporate raiders. He buys big stakes in companies and then offers his opinions—loudly—on how to improve their operations. Often, Ackman has been a contrarian. He bought shares of Rockefeller Center when Manhattan real estate was on its back in the mid-1990s, and he launched an attack in 2002 on MBIA Inc., the powerful and politically connected bond insurer, when everyone else on Wall Street was convinced the company was gold-plated. In early 2007, he sounded one of the most prescient warnings about the credit bubble and the leveraged complex of American finance.
William A. Ackman, who turns 43 this month, has had the seminal financial career of the past two decades, which is to say that he’s had the seminal American career of the era. Almost immediately after business school, he started a hedge fund to manage millions for wealthy people—with no investing track record. About a decade later, he was forced to shut down. He endured regulatory investigations played out in the klieg lights of the press. He relaunched and clawed his way back to respectability, becoming a member of a new generation of Wall Street wise men. No hedge fund manager or investment banker will be able to replicate his trajectory for at least a generation.
Now he’s gearing up for one of the biggest battles of his professional life. After losing nearly $2 billion in a calamitous bet on the retailer Target Corp.—almost all that investors had given him for the investment—he is waging a proxy fight against the company. He will have a tough sell in the leadup to the annual shareholder meeting in May. Taking on a company as big as Target is almost unheard of. Target decries the contest as “costly and disruptive.”
Irrational Everything
Prof. Daniel Kahneman has dozens, perhaps hundreds, of stories about people's irrational behavior when it comes to making economic decisions. It's no wonder, because for dozens of years he and his late colleague Amos Tversky researched human behavior. Many of their studies concerned the making of financial decisions.
But the story Kahneman recalls when asked about the economic models at the root of the current financial crisis is actually taken from history, not an experiment. It concerns a group of Swiss soldiers who set out on a long navigation exercise in the Alps. The weather was severe and they got lost. After several days, with their desperation mounting, one of the men suddenly realized he had a map of the region.
They followed the map and managed to reach a town. When they returned to base and their commanding officer asked how they had made their way back, they replied, "We suddenly found a map." The officer looked at the map and said, "You found a map, all right, but it's not of the Alps, it's of the Pyrenees."
According to Kahneman, the moral of the story is that some of our economic models, perhaps those of the investment world, are worthless. But individual investors need security - maps of the Pyrenees - even if they are, in effect, worthless.
Wednesday, April 22, 2009
Understanding Socialism
All grades would be averaged and everyone would receive the same grade so no one would fail and no one would receive an A. After the first test the grades were averaged and everyone got a B. The students who studied hard were upset and the students who studied little were happy.
But, as the second test rolled around, the students who studied little had studied even less and the ones who studied hard decided they wanted a free ride too; so they studied little. The second test average was a D! No one was happy. When the 3rd test rolled around the average was an F.
The scores never increased as bickering, blame, name calling all resulted in hard feelings and no one would study for the benefit of anyone else. All failed, to their great surprise, and the professor told them that socialism would also ultimately fail because when the reward is great, the effort to succeed is great; but when government takes all the reward away; no one will try or want to succeed.