Stock Buybacks

For those that may view buybacks as a signal that a stock is undervalued, here is some food for thought.

From the article:
Bank of America, for example, bought back $19.4 billion worth of stock when its shares traded between about $40 and $55, then sold more than $13 billion at around $11 a share. Heckuva job! Citigroup happily repurchased $16.1 billion of its own shares during the bubble, then sold about one-third of itself to taxpayers when it was nearing penny-stock territory. Well done, guys!

Some investors claim the current market mustn't be cheap, because companies haven't been quick to gobble up their own shares. That may be true. But if the last several years are any indication, it may be the ultimate contrarian indicator, too.

Obviously, those buyback decisions materially hurt shareholder returns. The article focused on banks but this error in capital allocation doesn't just impact the banking industry. Companies across a variety of industries made this mistake.

Unfortunately, wise capital allocation is not something that can be taken as a given when you own a stock.

Adam

James Grant's Wall Street Journal Article

Here's a good article by Grant with his latest thoughts on the economy. It's notable in that he has turned bullish. Jim's not known for being optimistic. He's been bearish for as long as I can remember. Not now.

Here's a good quote that's used in the article from English economist Arthur C. Pigou:

"The error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born not an infant, but a giant." 

Grant continues later in the article by saying the world is positioned for disappointment but the world rarely gets what it expects.

Check out the full article.

Adam

Rocky Mountain Chocolate Factory

Here's a recent article that compares Rocky Mountain Chocolate Factory (RMCF) to See's Candy. The article describes RMCF's franchising model as being an advantage over See's. I do not necessarily agree with this. It has the advantage of lowering RMCF's capital requirements but adds risk in terms of quality control. Considering the relative lack of capital (relative to Berkshire Hathaway) that RMCF has to work with the franchising model makes sense strategically for them.

Still, in a perfect world I would prefer the company-owned approach even though more capital is needed. Owning the stores allows more careful control of service and product quality and ultimately how the brand is perceived.

"It takes almost no capital to open a new See's Candy store. We're drowning in capital of our own that has almost no cost. It would be crazy to franchise stores like some capital-starved pancake house." - Charlie Munger

Given RMCF's capital constraints during most of its existence, growing this way appears pretty smart to me as long as they control quality and franchisees share in the success. As their financial flexibility increases over time they could always tilt the model toward the See's approach.

So the franchise approach is not a fatal flaw but, at the margin, company-owned is my preference.

I continue to find RMCF to be an interesting company with what looks like potentially great long-term economics.

Over time, I would like to learn whether the franchisees are also reasonably successful economically. Distribution has been a concern of mine but may not be problematic. It's just that franchisees need to be successful if the model is going to be sustainable and, service/product quality must be consistently good to reinforce the brand.

I'd also like to know why they need a 300+ (only 5 of them company-owned) store footprint to produce approximately $ 30 million in sales. See's Candy produces $ 380 million in sales with 200 stores. The economics seem to work for RMCF but it's still an open question.

According to the most recent 10-K:

The Company believes that, on average, approximately 40% of the revenues of Rocky Mountain Chocolate Factory stores are generated by products manufactured at the Company’s factory, 55% by products made in the store using Company recipes and ingredients purchased from the Company or approved suppliers and the remaining 5% by products, such as ice cream, coffee and other sundries, purchased from approved suppliers.

So the comparison is not apples-to-apples but that order of magnitude difference in sales is not explained by the franchise model of RMCF versus the company-owned model of See's Candy.

RMCF has no debt...had $ 3 million plus FCF during the recession (more like $ 5 million normalized), and requires less than $ 12 million of capital to run the business (that comes to ROC* in the 30-40% range...impressive if sustainable). So the economics appear to compare favorably to See's Candy...what Buffett calls his "prototype of a dream business".

BTW - the franchising model may be working beautifully...it's just an open question for me as an investor.

Just wish the stock would come down 20-30%.

Adam

* Return on Capital: If the business earns 6% o­n capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return even if you originally buy it at a huge discount. Conversely, if a business earns 18% o­n capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result." - Charlie Munger at USC Business School in 1994

Buffett on See's Candy: Berkshire Shareholder Letter Highlights

From the 2007 Berkshire Hathaway Shareholder Letter:

Let's look at the prototype of a dream business, our own See's Candy. The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn’t grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See's, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry's earnings.

At See's, annual sales were 16 million pounds of candy when Blue Chip Stamps purchased the company in 1972. (Charlie and I controlled Blue Chip at the time and later merged it into Berkshire.) Last year See's sold 31 million pounds, a growth rate of only 2% annually. Yet its durable competitive advantage, built by the See's family over a 50-year period, and strengthened subsequently by Chuck Huggins and Brad Kinstler, has produced extraordinary results for Berkshire.

We bought See's for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories.

Last year See's sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See's has given birth to multiple new streams of cash for us. (The biblical command to "be fruitful and multiply" is one we take seriously at Berkshire.)

 Few businesses are better than that.

 Adam

Charlie Munger & Professor William Bratton

Here's an interesting exchange from back in 1996 between Professor William Bratton of the Rutgers-Newark School of Law and Charlie Munger.

Bratton: I think we all know what an optimal investment is.
Munger: No, I do not. At least not as these people use the term.
Bratton: I don't know it when I see it but in theory, if I knew it when I saw it this conference would be about me and not about Warren Buffett. (Laughter from the audience)
Munger: What is the break point where a business becomes sub-optimal or when an investment becomes sub-optimal?
Bratton: When the return on the investment is lower than the cost of capital.
Munger: And what is the cost of capital?
Bratton: Well, that's a nice one and I would…
Munger: Well, it's only fair, if you're going to use the cost of capital, to say what it is.
Bratton: I would be interested in knowing, we’re talking theoretically.
Munger: No, I want to know what the cost of capital is in the model.
Bratton: In the model? It will just be stated.
Munger: Where? Out of the forehead of Job or something?
Bratton: That is correct. (Laughter)
Munger: Well, some of us don't find this too satisfactory. (Laughter)
Bratton: I said, you'd be a fool to use it as a template for real world investment decision making. We're only trying to use a particular perspective on human behavior to try to explain things.
Munger: But if you explain things in terms of unexplainable sub-concepts, what kind of an explanation is that? (Laughter)
Bratton: It's a social science explanation. You take for what it's worth.
Munger: Do you consider it understandable for some people to regard this as gibberish. (Laughter)
Bratton: Perfectly understandable, although I do my best to teach it. (Laughter)
Munger: Why? Why do you do this? (Laughter)
Bratton: It's in my job description. (Laughter)
Munger: Because other people are teaching it, is what you're telling me. (Laughter)

Buffett and Munger both expressed, rather bluntly, their skepticism toward the idea of cost of capital during the 2003 Berkshire Hathaway (BRKa) shareholder meeting:*

Notes from the 2003 Berkshire Hathaway Annual Meeting

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

Munger: The rest of the world has gone off on some kick -- there's even a cost of equity capital. A perfectly amazing mental malfunction.

Munger is complimentary about other aspects of Professor Bratton's work and he made that clear after the exchange above occurred. He just has a problem with the way that cost of capital is often taught and, in his own unique way, certainly made that point very clear during the exchange.

Adam

* The comments of Buffett and Munger are based upon the notes taken by Whitney Tilson

Buffett & Bogle: Short-termism

On September 9th, 2009 Warren Buffett and John Bogle, along with 26 others, signed the following statement with the title "Overcoming Short-termism". The statement was released by the Aspen Institute and makes the case that lower trading costs and technology has enabled investors to become increasingly focused on the short term, and argues for making changes to incentives to discourage this. The statement argues that the problem is systemic and incentives need to be changed to create more long-term investing.

From the Aspen Institute statement:

...in recent years, boards, managers, shareholders with varying agendas, and regulators, all, to one degree or another, have allowed short-term considerations to overwhelm the desirable long-term growth and sustainable profit objectives of the corporation.  We believe that short-term objectives have eroded faith in corporations continuing to be the foundation of the American free enterprise system, which has been, in turn, the foundation of our economy.  Restoring that faith critically requires restoring a long-term focus for boards, managers, and most particularly, shareholders—if not voluntarily, then by appropriate regulation.

This Wall Street Journal article, "An End To The Focus On Short Term Urged", says lower trading costs and technology has led to frequent trading.

The article highlights the idea that tax policy changes could be implemented to reward long-term holders over short-term holders. That's already true today, of course, but maybe it should be even more so.

Full Statement: Overcoming Short-termism

I think there's little question we'd be better off reversing the short-term oriented direction our capital markets have been heading for years.

Adam

Charlie Munger on...

Intrinsic Value
"If you buy something because it's undervalued, then you have to think about selling it when it approaches your calculation of its intrinsic value. That's hard. But if you buy a few great companies, then you can sit on your $%@. That's a good thing." - Charlie Munger at the 2000 Berkshire Annual Shareholder Meeting

Investment Banks
"The general culture of investment banking has deteriorated over the years. We did a $6 million deal years ago for Diversified Retailing and we were rigorously and intelligently screened. The bankers cared and wanted to protect their clients. The culture now is that anything that can be sold for a profit will be. 'Can you sell it?' is the moral test, and that's not an adequate test." - Charlie Munger at the 2002 Berkshire Annual Shareholder Meeting

IQ
"A money manager with an IQ of 160 and thinks it's 180 will kill you," he said. "Going with a money manager with an IQ of 130 who thinks it's 125 could serve you well." - Charlie Munger in San Francisco Business Times

"The hedge fund known as 'Long Term Capital Management' collapsed...through overconfidence in its highly leveraged methods, despite I.Q.'s of its principals that must have averaged 160. Smart people aren't exempt from professional disasters from overconfidence. Often, they just run aground in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods." - Charlie Munger in Philanthropy Magazine

"You need to have a passionate interest in why things are happening. That cast of mind, kept over long periods, gradually improves your ability to focus on reality. If you don't have the cast of mind, you’re destined for failure even if you have a high IQ." - Charlie Munger at the 2002 Berkshire Annual Shareholder Meeting 

South Korea
"I would regard Korean culture and what they've created as one of the most remarkable in the history of capitalism. We don't think it's an accident that Iscar discovered Korea. If you try to find 10 countries better than Korea … you won't get through one hand. We are huge admirers of Korea." - Charlie Munger at the 2006 Berkshire Hathaway Shareholder Meeting

Packaged Luck

On CNBC yesterday, Dan Solin said the following about Wall Street:

"Active management has investors chasing returns that all the studies show, just don't work," said Solin. 

"What Wall Street does is package luck and sell it as skill. The real data shows that passive management, actually in the last 20 years has achieved a greater return than active management."

In the segment, Dan Solin references a study by three professors (Barras, Scaillett, Wermers) to back up his claim that Wall Street is in business to "package luck and sell it as skill". The conclusions of the study are consistent with what John Bogle has been saying for decades.

...we find a significant proportion of skilled (positive alpha) funds prior to 1996, but almost none by 2006. 

Their findings strongly suggest very few actively managed funds truly outperform in the long run.

Adam

Sequoia Fund

This fund came about after Warren Buffett decided to end his partnerships. After ending them, he asked Bill Ruane (the founder of the Sequoia Fund) to take care of his former investment partners.

Thoughts on several companies the current managers of the Sequoia Fund like can be found here. One of the companies commented upon by them is Mohawk Industries (MHK).

Some excerpts from the latest shareholder meeting:

"Mohawk sells floor covering. Its sales are driven primarily by existing home sales, commercial construction and remodeling and, to a lesser extent, new home sales. It's no news that we haven't been buying or selling a lot of houses, and we haven't been building many houses. In fact, we built way too many houses. And it's going to take a long time for that excess inventory to get sopped up.

One way to think about Mohawk today, and to put it into the context of Bob's comments, is to look at the pluses and minuses for the company as it exists now, given the way we feel about the economy. On the downside, of course, is this continuing contraction of consumers' spending and their being more thrifty — obviously, it's better if people are going to throw around a lot of money, buy vacation houses, and put flooring in — Mohawk will suffer from that.

But the structure of the company is such that it's in a pretty good position, even if people are going to be thrifty because its product line goes from goods that are very expensive to those that are very inexpensive. If the consumer moves down market, Mohawk still stands in a good position to capture a lot of that business."

"On the other side, somewhat offsetting a longer-term contraction of consumer spending, is the fundamental driver of housing, which is household formation. And that is simply going to continue no matter how thrifty we are."

"If you just look at the numbers, there's a very big demographic wave coming to create demand for housing in the future. So it's very, very difficult to tell how long the recovery in demand is going to take, but the fundamental driver of housing is still there. It's alive and walking around. So I think over the long run Mohawk will be fine.

It will be difficult for it to produce the same volume of sales as in the past because there's not going to be a housing boom. But again, partially offsetting that, the business itself — the whole industry has contracted. Marginal players are strapped."

"When demand returns, Mohawk will be manufacturing with its most productive assets. So over the long run, it will be okay. When exactly that is going to happen I'm not prepared to say because I don't know.

What I would add to that is Mohawk has a terrific family ownership. It's the kind of owner-manager whom we really like. It has a very good duopoly position in the industry. Shaw is the other major flooring company. With only two large companies in that industry, you should have very rational pricing over time. They are much stronger than any of the smaller companies."

Buffett & Munger on Diversification

From a speech given back in 1998 by Charlie Munger:

I have more than skepticism regarding the orthodox view that huge diversification is a must for those wise enough so that indexation is not the logical mode for equity investment. I think the orthodox view is grossly mistaken.

In the United States, a person or institution with almost all wealth invested, long term, in just three fine domestic corporations is securely rich. And why should such an owner care if at any time most other investors are faring somewhat better or worse. And particularly so when he rationally believes, like Berkshire, that his long-term results will be superior by reason of his lower costs, required emphasis on long-term effects, and concentration in his most preferred choices.

I go even further. I think it can be a rational choice, in some situations, for a family or a foundation to remain 90% concentrated in one equity. Indeed, I hope the Mungers follow roughly this course. And I note that the Woodruff foundations have, so far, proven extremely wise to retain an approximately 90% concentration in the founder's Coca-Cola stock. It would be interesting to calculate just how all American foundations would have fared if they had never sold a share of founder's stock. Very many, I think, would now be much better off. - Charlie Munger
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The Warren Buffett/Charlie Munger approach rejects the idea that vast diversification is needed. Risk can be reduced, in their view of the world, by concentration on a few holdings.

Our policy is to concentrate holdings. We try to avoid buying a little of this or that when we are only lukewarm about the business or its price. When we are convinced as to attractiveness, we believe in buying worthwhile amounts. - Warren Buffett in the 1978 Berkshire Hathaway Shareholder Letter

The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. - Warren Buffett in the 1993 Berkshire Hathaway Shareholder Letter

Over the years, much of the time, 70% of Buffett's equity portfolio was concentrated in 5 holdings.
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Having said that, those with less experience investing clearly require more diversification.

For some investors, index funds may make more sense than buying individual stocks. It's important to know which is your comfort zone before investing a penny.

Either way, whether investing in stocks or funds, it's always key to keep the trading and other forms of frictional cost to a minimum.

As always, know your limits and stay well within them.

Adam

Related:
Charlie Munger in Philanthropy Magazine

Six Stock Portfolio Update

Portfolio performance since mentioning on April 9, 2009 that I like these six stocks as long-term investments if bought near prevailing prices at that time (or lower, of course).

While I never make stock recommendations each of these, at the right price, are what I consider attractive long-term investments for my own capital.

Stock|% Change*
WFC|+47.3%
DEO|+36.3%
PM  |+19.2%
PEP |+8.0%
LOW|+6.7%
AXP|+91.9%

Total return for the six stocks combined is 34.9% (excluding dividends) since April 9th. The S&P 500 SPDR ETF is up 21.1% since that date. This is a conservative calculation of returns based upon the average price of each security on the date mentioned. Better market prices were available in subsequent days so total returns could have been improved with some careful accumulation.

The purpose is not to measure returns over such a short time frame. It's meant to be, in part, just an easy to verify working example of Newton's 4th Law.

Most equity investors would get improved returns if they: 1) bought and held shares in 5-10 great businesses (if time permits stock research), 2) avoided the hyperactive trading that is so popular these days to minimize mistakes & frictional costs, and 3) sold shares in a business only if the core long-term economics become impaired or opportunity costs are extremely high.

A six stock portfolio is very concentrated but this approach rejects the idea that vast diversification is needed. I've noted this in a previous post.

"We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it." - Warren Buffett in the 1993 Berkshire Hathaway Shareholder Letter

Having said that...the less experienced you are as an investor the more diversification may be a necessity. Those that fall into this group probably need to diversify holdings more but still keep trading and frictional costs to a minimum. Index funds may make more sense than buying individual stocks. It's important to know which camp you fall into before investing a penny.

The above concentrated portfolio of six stocks won't outperform in every period. In the long run it has a reasonable probability of doing well compared to the S&P 500 due to lower frictional costs and the quality of the businesses. The growth in value comes from the intrinsic value created by the businesses themselves...not some special aptitude for trading or timing the market. It probably won't outperform the very best portfolio managers but should do very well against many mutual funds** over a period of 10 years or longer.

In any case, this simple experiment is designed so it's easy for anyone to check the results. If this six stock portfolio*** isn't performing well against the S&P 500 (it'll take a few years, at least, to meaningfully start judging performance) it will be obvious.

Finally, an opportunity may come along where the capital from one of these stocks is needed.

My view is under such a scenario the threshold for making changes needs to be high. That hypothetical new investment must have clearly superior economics.

In addition, if something appears to fundamentally threaten the moat (ie. the effect of the internet on the newspaper biz) of one of these businesses a change may also be warranted.

So I may rarely add or switch some of the stocks in this portfolio but I will only make a change if the situation described above exists (ie. if the core long-term economics of one of these stocks become impaired or opportunity costs are extremely high).

Adam

Long position in DEO, AXP, PEP, PM, WFC, and LOW

* As of 8/31/09.
** There's no shortage of evidence that many actively managed equity mutual funds underperform the S&P 500. Also, DALBAR's Quantitative Analysis of Investor Behavior (QAIB) study released in March 2009 revealed that over the past 20 years investors in stock mutual funds have underperformed the S&P 500 by 6.5% a year (8.35% vs. 1.87%). Beyond the performance of the funds themselves, it shows that much of these poor returns come down to investor behavior. The tendency of investors to buy the hot mutual fund that has been going up while selling when the market is going down out of panic or fear (the same is true for stocks).
*** I don't think these are necessarily the six best businesses in the world, but I believe they are all very good businesses that were selling at reasonable prices on April 9th. At any moment, there is always something better to own in theory but I don't think you can invest that way (as if stocks are baseball cards) and have consistent success. So there are certainly quite a few other shares in businesses that would be good alternatives to these six. The point is for me to get a handful of them at a fair price and then let time work.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to be long the positions noted unless they sell significantly above intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.

James Grant's Latest Newsletter

Here is the most recent issue of Grant's Interest Rate Observer.

The newsletter is usually available by subscription only but this one's free.

An excerpt:
If it's taking this much to revive today's economy (which, as of now, remains unrevived), what kind of a jolt might be necessary to succor tomorrow's? An even bigger shock, we surmise, if tomorrow's economy is no less encumbered than today's. But it is almost certain to be more encumbered, since the active ingredient of the Bush-Obama palliative is credit formation, the very hair of the dog that bit us.

To try to exorcise the Great Depression, President Herbert Hoover deployed fiscal and monetary stimulus equivalent to 8.3% of gross domestic product (i.e., GDP for 1933, the year the Depression officially ended). To banish the demons of 2008-9, successive administrations have spent, or encouraged to be printed, the equivalent to 28.9% of GDP. A macroeconomist from Mars, judging by these data alone, would never guess how much more severe was that depression than this recession. The decline in real GDP from August 1929 to March 1933 amounted to 27%; that from December 2007 to date, just 1.8% ("just 1.8%" is the phrase to use if one is still employed). So for a slump 1/15th as severe as the Depression, our 21st century economy doctors have administered a course of treatment more than three times as costly.