Tuesday, March 20, 2012

Buffett's Biographer Accuses him of Hypocracy

Alice Schroeder, who wrote the "authorised" biography of Buffett, The Snowball, is now arguing that Buffett has been making major mistakes in the past few years, including an increasing focus on partisan politics and policy, engaging in investment practices he condemns in others and - gasp - mediocre investment returns.

Just before we explore her argument - a word about Schroeder, as I have read her biography of Buffett.
Schroeder's biography is a must read for any Buffett follower.  If you have not read it, buy it NOW.  You will quickly realize why what only Buffett does what he does.  Quite simply - if you are an Outside Passive Minority Investor (OPMI) you are not following Buffett's investment style.  This doesn't mean you shouldn't use Graham/Dodd principles or look for great growth companies like Philip Fisher.  It just means, don't be fooled by mutual funds and newsletters selling their "Buffett-like" investing advice.

The most amazing story in the book to me was hearing about how Buffett would pour over the Value Line Investment Survey and the Moody's stock profiles.  In the days long before the internet, these were essential tools for doing stock screens.  You had to request the SEC filings of companies, unless you owned their stock, so there was more than a bit of effort required.  Buffett, not wanting to miss any good opportunities, noted that he reviewed and valued EVERY SINGLE company in the books.  He notes that there were many on which he didn't spend much time, but here was a guy putting a value on each of 2000 companies about every 3 months.  So dedicated was he to this practice that he piled the books into the back of his car when he went on his honeymoon.  Most of us just look at a few companies we know of or have heard of.  Some more of us look at various screens and the like, Buffett set out to value every listed US company.

Back to Schroeder's argument - I rather agree with some of her points.  Buffett has become a celebrity businessman, and most celebrities like having the floor.  Since politics is simply the biggest stage their is, it may be that he is drawn to it like a moth to a flame. Schroeder is right, he is entitled to his opinions and to enter the public space to share them.  But she is also right to argue that Buffett's true legacy is Berkshire and that the company operates in lots of heavily regulated industries, including insurance, banking, transport and energy and that it all seems rather well, not right, that Buffett should be so tightly wound up with the people who should be setting policy for his firms.  It is worse when Buffett argues that policies from which he has benefitted should be denied others.  This is a ladder pull by someone high up the economic slope.  Should future investors really be denied the same opportunities to build wealth that he has enjoyed?

Likewise, she notes that the same person who decried derivatives as "financial weapons of mass destruction" himself runs a book of derivatives with billions in nominal value.  True, Buffett sold the options, so he hopes (and expects) the options to expire worthless - enabling Berkshire to keep the money - but in acknowledging that like nuclear energy or chemical engineering, or kitchen knives, derivatives have potential to be employed usefully and productively as well as destructively - Buffett has done an about face on the topic.  Yes, his current position is more correct - the danger lies mostly with the user, since the thing itself is morally neutral - but it is his earlier position that is used to argue for overhauls of the global financial industry.  And if he thinks that the main problem is the banks can't handle derivatives (and prop trading) then why is he buying them and saying how smart they are?

Her biggest criticism is that Buffett is earning poor returns.  Since 2000 this has largely been true - even measured by Buffett's yardstick, growth in Book Value per share vs. the S&P.  There are a few reasons for this - one is that the sums of capital Buffett needs to deploy are now so large that paradoxically, his investment universe is shrinking.  He needs investments that enable him to deploy billions in capital on a single deal, and there are only a few hundred firms where this is possible.  Most of these firms do not have significant amounts of undervaluation, since they are solid businesses and so it is more difficult to make outsized returns on these investments, (though I believe that large and mega cap stocks have actually represented the best values in the market over the past 5 years).  In general, I believe his purchases of large cap stocks have been sound, they are all strong companies trading a reasonable prices (although their growth may be suspect).

Buffett's other problem is legacy.  He has acquired a stable of good businesses, but since "trees do not grow to the sky" many of these businesses are reaching maturity, and in some cases may even be in decline (the Washington Post comes to mind.  For the first time, the company did not make the list of significant equity investments).  Buffett is not at liberty to sell them, however, because he made a deal with the owners of those businesses that Buffett would be a permanent home for them.  This means the full range of strategic options for businesses in such a situation, which normally would include mergers, are not available to his companies.  Berkshire's investors got the gains up front, now they have to pay the piper.  This is not to say they got a bad deal, only that slower growth is in Berkshire's future.  If decline is managed well, as it was with the original textile businesses, it can even produce value for shareholders.  But is the board prepared to manage these firms into what may be terminal decline in some cases?  Hard to say.

It seems reasonable that the share price is undervalued.  Berkshire has incredible earning power, but future returns on equity are likely to be satisfactory, not extraordinary, and so the company will trade nearer to book value than in the past.  Whether that is Buffett's fault, in the sense of making poor current decisions, brought on, as she believes by declining acumen, or whether it is really just the burden of historical investments now earning normal returns, remains to be seen.

I think the jury is still out on this, even if Schroeder is right to question Buffett's judgment.

Thursday, March 15, 2012

Buybacks vs. Dividends - McKinsey weighs in

This week the McKinsey Global Institute published a study indicating that most stock buyback programs are value destroyers, in that they tend to buy high and not low.  Their specific example is a technology company that repurchased increasing amounts of shares during the stock market boom into 2008, but then stopped buying shares, even as they plunged during 2008 and 2009.


This seems a fitting academic underline of my point about why dividends are better than buybacks: management rarely buys shares at a significant discount to intrinsic value, whereas investors who receive dividends and reinvest them benefit from dollar cost averaging and can also choose to make opportunistic purchases (without an automatic reinvestment plan).
Management faces thre, e hurdles that almost guarantee that it will make poorly timed purchases of its own stock:
·         Management rarely has lots of spare cash when the stock is cheap.  Buybacks require significant free cash flows.  When a company is generating significant free cash flow, however, the market often places a premium on the price of the stock.  The corollary to this is that when markets are weak (and buybacks represent the best value) management usually has better priorities for its funds, including: preserving cash to ensure adequate liquidity in the face of difficult credit conditions, opportunistic acquisitions – everyone else’s stock is cheap, too, after all, and reinvesting in operations when goods, materials and labor are readily available.

·         Timing of buybacks often coincides with option exercises, which are more likely to occur when the price is high.  If the company makes corresponding open market purchases to offset dilution, the company is allowing sellers to pick the timing of the transaction, which is rarely going to work in the buyer’s favor.  Stock buybacks at nearly all firms are partially aimed at eliminating the dilutive effects on EPS that stem from new (or treasury) shares being issued as part of employee compensation.  Naturally, those employees want to exercise their options at a high price, and since multi-year fixed value options offer the holder significant discretion in when to exercise, options are more likely to be converted at cycle highs.

This is one of the most important misalignments of shareholders and management – the classic agency problem options were supposed to fix. When the same management that is selling high for its own account on the one hand is also directing the company’s cash to buy at the same time must be committing the company (and the other shareholders) to buying high.

·         Large scale buying by one investor tends to drive prices higher.  The kind of buyback activity that drives EPS and sometimes share prices higher requires significant acquisition of shares – at least a few percentage points of shares outstanding.  Such significant buying is best done by those who do not have to report their purchases, and who do not move markets.  Companies that pile up their repurchases (say in the run up to the end of the quarter) can become major market participants buying large quantities of shares in bulk and bidding up prices.  Even if management tries to buy opportunistically when share prices are weak, their own buying may eliminate the weakness.  This is good for shareholders in general – ideally share prices would always trade near intrinsic value so that all shareholders would get paid full value when they sold – but it inhibits management’s ability to create value for loyal shareholders.
Given these limitations, I generally agree with McKinsey that managements that want to repurchase stock should do so using a method calculated to minimize the disruption of the markets.   Moreover being sellers themselves they have a fiduciary responsibility not try to steer the purchases of those to whom they are selling – this is sitting on both sides of the table.
Instead, management that wants to repurchase say 25 million shares in the course of a year should simply buy 100000 shares per day on each of the 250 days or so the market is open and trading normally.  If these can be purchased in blocks near market price, fine, if they have to be purchased in lots, also fine.  If this means that the shareholders are not big enough buyers on days when management is exercising lots of options (which expire on the same day) so much the better.  This may lower the spread on the option – so what?
Finally, this raises a question about whether options should be used for compensation at all.  This is another topic, for another post.  Suffice it to say, I am not a fan of incentive programs that turns management into sellers of shares.

Tuesday, March 13, 2012

Bank shares rally on JPM

This week, we find out about how banks have fared on the stress tests to which they are being subjected by the US treasury.  In an interview a few days ago, Brian Moynihan, CEO of Bank of America indicated that the banks would be shown to be fine, even under extreme conditions (including unemployment of 20% with the related cases of default).

Today JP Morgan demonstrated that they are in the strongest position of all of the US banks by announcing a dividend hike and a massive buyback, equivalent to almost 10% of their market capitalization.  With a payout ratio of 25%, JPM appears to have lots of room to increase the amount of its dividends go forward.

I believe that BAC is in a similar position, even though operational changes have allowed Chase to take over leadership in branches, I firmly believe that BAC is a stronger franchise.  (I cannot believe that I am saying this given that J. Pierpont Morgan is a personal hero).

By 2013 BAC will also be paying a dividend and buying back some of the nearly 11bn shares outstanding.  The stock, which had a nice rally today, will trade at $16-20.  Even with the rally since December, the stock is well positioned to post nice gains over the next 12-24 months.  This is why I am very long the stock, it is by far my largest position.

Monday, March 12, 2012

Some investing wisdom

I haven't had much time to write lately, so I figured I would share some investing wisdom I have come across recently.

Matt Schifrin over at Forbes has written a great synopsis of the investing habits of some extraordianrily successful individual investors.

Jason Trennart raises and interesting argument that successful investing may require less of the technical tools taught in busineses schools and more of the social sciences contextual approach to problems, with the ability to synthesize data of various (and often qualitative) sorts.  Personally,  I believe this is true.  As an historian (undergrad) with an MBA, I can say that while financial skills are important (value is a financial concept), evaluating the risks around the estimate of value often require imprecise contextual thinking.  This is most true in evaluating the managers who hold investors assets in their hands.

Aelph suggests that buy and hold investing is neither dead nor a bad idea.  Admittedly, returns on equity do fall for most businesses over time as it gets harder to redeploy cash generated by the business in initiatives with the ROI of previous investments, but this is an argument for dividends, not an argument against buy and hold.

And a two-for-one: Aelph also has eight rules of investing.  I generally agree with them, though I think he puts too much emphasis on relative valuation, which is a strategy for long-only mutual funds and investment "professionals" who cannot afford to appear to be too passive (especially if the market is rising).  Personally, I believe a real advantage of the individual investor is the luxury of looking at absolute valuation, and mitigating risk by NOT INVESTING when there aren't attractive risk/return opportunities (e.g. US equities in 1999 and 2000).

Finally, I have to give Aelph huge credit for the diligence with which he posts.  I aspire to have that much to contribute.

Sunday, March 11, 2012

More evidence of risks investing in China

On the back of lowered Chinese Communist Party targets for economic expansion, the Economist is noticing a series of trends cropping up in China - higher wages, more difficulty adding workforce and above all the need to innovate in order to continue expansion - trends the Strategic Investor suggested as far back as 2007, would begin to manifest themselves in 2012.

How could we be so accurate - simple, we just looked at the simple math of economic expansion (which, despite claims of "miraculous" activity everywhere from West Germany to Korea, is actually quite straightforward).

GDP is simply the product of hours worked and outper per hour.  China faces challenges in both places.  For the past 30 years, China has been able to lift both by increasing workforce participation (by limiting births and time off, keeping women in work) and by employing that labor at higher output factory jobs (albeit labor-intensive ones).  But after decades of low birth rates, the Chinese workforce has finally peaked, which means that unless the Chinese can find a way to keep more older workers in the workforce (tough when many jobs are physically demanding), hours worked is likely to fall.  Of course, if the remaining workers were to work more hours, hours worked could be maintained, but hours worked is not terribly elastic, and if history is any guide, rising incomes will lead to FEWER hours worked, not more, as workers use higher incomes to consume more leisure.

What of higher productivity?  Increasing output per hour is a certainty in China, as the capital stock increases, there will be gains in worker productivity.  These gains will likely be slower, however, because China will have to have better managers to organise the labor around knowledge work, and because success in more cutting edge technologies involves innovation, not duplication.  Here, Communist regimes have a dismal record, which is more or leses echoed by the Economist.  China has few, if any, global brands that are truly home grown.  Lenovo, after all, became famous by purchasing the PC assets of IBM.

China still has many advantages, as do the US, Canada, the UK and Germany.  But as China "catches up" with them and attempts to invade space they now occupy, it will struggle with the limitations of its economic model.  I expect a hard landing in China before the decade is out - possibly as early as 2015.

Friday, March 09, 2012

CL boosts dividend

You heard it here first: CL.  After reviewing CL's 10-K, I predicted that the dividend would rise to $0.62 per quarter from $0.58.  My logic was that this number gets closest to a 50% payout ratio (based on 2011 EPS), without going over.  This is usually the level CL tries to maintain, providing an effective payout ratio in the mid- to upper-40% range (as forward earnings are usually higher than trailing earnings, restructurings notwithstanding).

As I expect earnings around $5.30-$5.40 in 2012, I will predict now that dividends in 2013 will be raised to $0.67 per quarter, for a full year payout of $2.68, with a possibility to skew a bit higher in the event that mangement is able to expand margins (and EPS) faster than I expect.  If management is able to keep repurchasing 20mn shares (gross), then EPS will likely be higher than my anticipated range, since outstanding shares will fall by 3%.

Overall, this represents a dividend growth rate of 7-9% per year plus the 2.5% yield you are collecting.  A very nice and safe 9.5% return in a low return evironment.

Friday, March 02, 2012

Does Crime Pay? Forbes thinks so

One of the best financial magazines ever, Forbes, has always approached the topic of investing and managing money with a low-tax slant and a healthy dose of humor (wealth and happiness are correlated, despite claims of many starving artists to the contrary.  It's just that the correlation is logarithmic). 

Anyway, they are starting a nice series on how crime might indeed pay - the secret is to be a financial "advisor" of any type.  They favor a Ben Graham appraoch - make sure you have fat pitches and high probabilities on the upside and relativel low risk (a margin of safety) on the downside.

I am looking forward to part 2.