Friday, August 29, 2014

The Benefits of a Declining Stock

I have covered on a number of occasions -- okay, maybe too many occasions -- why the long-term investor should hope that any stock they bought cheap performs poorly over the near and even intermediate term.

Well, at least if long run business prospects remain at least reasonably sound.

Over the very long haul, market prices will roughly track changes to per share intrinsic value.

Over the short haul, prices can do just about anything.

That's an advantage for the long-term investor.

Warren Buffett explained it this way in the 2011 Berkshire Hathaway (BRKa) shareholder letter:

"When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well."

and

"If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day's supply.

Charlie and I don't expect to win many of you over to our way of thinking – we've observed enough human behavior to know the futility of that – but we do want you to be aware of our personal calculus."

Here's another good take on the subject from Vitaliy Katsenelson:

"A stock decline is not necessarily a bad thing, even if it happens right after you buy (assuming fundamentals have not collapsed)."

and

"It may be painful to see your newly minted position show losses right away or remain below your purchase price for a long time. But if a company is taking advantage of its stock's cheap valuation through share repurchases, the intrinsic value of what you own is actually enhanced by the price decline."

Watching recently purchased shares drop in price right after the purchase occurred naturally doesn't exactly feel great. That's loss aversion at work and, of course, perfectly understandable. Yet it's not impossible to develop a more appropriate and sensible response. Even if an underperforming stock does not feel like such a wonderful thing, under the right circumstances and viewed rationally, it actually is.

In contrast, if an investor pays a speculative premium price on what seem like exciting future prospects that don't become reality, a drop in stock price feels pretty bad and, well, is very bad. That's likely to lead to permanent capital loss or, at least, insufficient returns considering risks and alternatives. This approach also depends heavily on being good at reliably picking winners -- usually in a dynamic and unpredictable new space where the core economics are not yet well defined -- and not paying too much for promise.

Now if, instead, the approach is to consistently pay a plain and comfortable discount to current estimated value based upon conservative assumptions, some good things seem likely to happen; big mistakes, including the likelihood of permanent capital loss, become more avoidable.

This, for example, might require judging whether a business with sound core economics and durable advantages that has long dominated an industry will continue to do so. Not exactly easy but, with enough patience and work, at least potentially less likely to produce large misjudgments and the associated losses compared to more speculative approaches.

An undervalued stock can naturally become even more undervalued but attempting to guess whether that will happen or not is folly. When I buy something, I never know what direction the price action is going to be, nor do I even try to figure that out. It's a waste of energy and leads to unnecessary mistakes (incl. errors of omission).

So temporarily lower stock prices only improve the long-term outcome if something was bought at a discount in the first place.

A long-term investor should celebrate if something they bought cheap temporarily gets even cheaper.

That's just the nature of investment even if it might go against intuition and instincts.

The tough part is becoming comfortable with thinking this way about investments. It's knowing when intrinsic value can be estimated within a narrow enough range, always paying a nice discount to that estimate, and having a truly long-term investment time horizon.

That's necessarily measured in at least many years, preferably decades or, ideally, the favorite holding period of Warren Buffett and Charlie Munger.

That'd be forever.

From the 1988 Berkshire Hathaway shareholder letter:

"...when we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever. We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint. Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds."

So this approach doesn't work when a high price is paid and the long-term outcome is dependent on speculative assumptions.

Assumptions that, while possibly not even unreasonable, cannot be known with enough warranted confidence to invest in this manner.

When dependent on lots of difficult to foresee good things happening, it's easy to underestimate how one negative surprise can do huge damage to overall portfolio returns. A big part of investing well long-term is the elimination of large mistakes. That may not be as exciting as trying to judge what the next big thing is going to be then riding the wave, but it can offer a useful way to balance risk and reward.

What matters is whether the business at least has durable free cash flows even if it lacks exciting growth prospects. When, let's say, less than 10x durable free cash flows is paid, future share repurchases can have a big impact if the multiple at least remains roughly at that level or, ideally, goes even lower. At that kind of valuation it is durability that matters more than growth. When a plain discount to conservative per share value is paid upfront, and that discount temporarily gets even bigger, not only should it be of no concern to the long-term owner, it should be viewed as a positive development.

Of course, none of this will be of much interest to those who are primarily focused on making bets on price action.

This approach won't work very well if per share intrinsic value can't be estimated well.

This won't work if the price paid doesn't offer an appropriate margin of safety.

This won't work if time horizon is measured in only a few years or less.

Ignoring these things leads to unnecessary permanent losses and subpar results.

More in a follow-up.

Adam

Long position in BRKb established at much lower than recent market prices

Related posts:
The P/E Illusion (follow-up)
Buffett's Purchase of IBM Revisited
Buffett on Buybacks, Book Value, and Intrinsic Value
Buffett on Teledyne's Henry Singleton
Why Buffett Wants IBM's Shares "To Languish"
Buffett: When it's Advisable for a Company to Repurchase Shares
The Best Use of Corporate Cash
Buffett on Stock Buybacks - Part II
Buffett on Stock Buybacks
Buy a Stock...Hope the Price Drops?
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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 should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, August 22, 2014

John Kay: Decline in Equity Issuance

In 2012, John Kay produced a report on UK equity markets that was focused on, among other things, the reduction in long-term oriented behavior among UK equity market participants and corporate decision-makers.

This post from last year focused on the first section of that report.

John Kay on Equity Markets: Exit, Voice, and Short-termism

In the second section of the report, the emphasis is on new equity issuance or, more specifically, the lack of it:

"Equity markets have not been an important source of capital for new investment in British business for many years. Large UK companies are self-financing – the cash flow they obtain from operations through profits and depreciation is more than sufficient for their investment needs. This is true of the quoted company sector as a whole and of a large majority of companies within it."

and

"Finance raised through placings and rights issues by established companies, and initial public offerings (IPOs) by new companies, have generally been more than offset by the acquisition of shares for cash in takeovers and through share buyback..."

As a result, the issuance of equities has been negative over the last decade even if the situation has recently improved somewhat.

Why has there been a decline?

"There are many reasons for the decline in the role of equity issues in investment. In a modern economy, investment in physical capital is much less important than it was."

Yet...

"Even companies in sectors that have large capital requirements – such as oil and utilities – make little or no use of primary equity markets, relying instead on debt and internal funding."

There are many explanations for why equity issuance has declined -- and some of them are valid to an extent -- but the report states "we do not find them adequate" while adding "we believe the fundamental reasons go deeper, and reflect the nature of financial intermediation itself."

The combined impact of regulatory and cultural changes over the years led to "the rise of an ethos which emphasised transactions and trading over relationships. This ethos permeated all areas" of financial services and "the shift from relationship to trading, from voice to exit, came to affect not only the interaction between shareholders and companies but between corporate executives and their companies: some managers came to see themselves as traders, engaged in the management of a portfolio of businesses to which they owed no particular attachment."

The United States has had more than its fair share of influence on the changes that have occurred in recent decades. Equity markets, of course, need to facilitate the funding of new and existing businesses. If working well, equity capital efficiently gets where it's needed while misallocation and mispricing is minimized.

Increasingly, that's not their primary function.

Equity markets are also "one of the means by which investors who support fledgling companies can hope to realise value. Equity markets provide a means of oversight of the principal mechanism of capital allocation, which takes place within companies. Promoting stewardship and good corporate governance is not an incidental function of equity markets."

Not only is it important "that equity markets remain an attractive means of obtaining funding", policies should "ensure there are no unnecessary disincentives to using equity markets, either for companies or for their investors. And we believe that our recommendations to encourage asset managers to act as long-term stewards of more concentrated, less liquid equity portfolios will mean a greater willingness to invest funds across a broader range of companies, including smaller businesses who wish to raise equity finance, but are currently unable to do so."

Warren Buffett's long-term oriented investing behavior -- whether in equity markets or how Berkshire Hathaway's (BRKa) many businesses are operated -- would be a prime example of what would become more commonplace.

This requires no less than a fundamental culture change.

For an example closer to home in the UK, as this article points out, look no further than the way that Neil Woodford operates:

"To many, he [Woodford] is an example of what John Kay, commissioned by the government to encourage long-term investment, should look for in a fund manager, holding shares for 15 years rather than switching in and out in search of a quick buck."

Woodford recently left Invesco after more than 25 years at the firm to start a fund management company and launched a new fund, Woodford Equity Income.

There are certainly a number of other good examples.

The focus of John Kay's work is the UK but many of the same problems, as well as potential solutions, are more than a little bit similar to the US.

IPOs have come back somewhat recently in the US, though still are well below what we saw in the 1990s.

Progress on this front starts with recognizing the costly long-term implications of not making some sensible adjustments.

Adam

Long position in BRKa established at much lower than recent market prices

* Excerpts in this post are from sections 2.6, 2.7, 2.12, 2.13, 2.18, 2.28, 2.32, and 2.33 of the report.
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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 should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, August 15, 2014

Berkshire Hathaway 2nd Quarter 2014 13F-HR

The Berkshire Hathaway (BRKa2nd Quarter 13F-HR was released yesterday. Below is a summary of the changes that were made to the Berkshire equity portfolio during that quarter.
(For a convenient comparison, here's a post from last quarter that summarizes Berkshire's 1st Quarter 13F-HR.)

There was plenty of buying and selling during the quarter. Here's a quick summary of the changes:*

New Positions
Charter Communicatons (CHTR): Bought 2.31 million shares worth $ 361 million
Now Inc. (DNOW): Bought 1.83 million shares worth $ 58.1 million

Berkshire's latest filing did not indicate any activity was kept confidential. Occasionally, the SEC allows Berkshire to keep certain moves in the portfolio confidential. The permission is granted by the SEC when a case can be made that the disclosure may cause buyers to drive up the price before Berkshire makes its additional purchases.

Added to Existing Positions
IBM (IBM): 1.82 million shares worth $ 342 million, total stake $ 13.2 billion
Wal-Mart (WMT): 745 thousand shares worth $ 55.4 million, total stake $ 4.37 billion
U.S. Bancorp (USB): 67.8 thousand shares worth $ 2.82 million, total stake $ 3.33 billion
General Motors (GM): 2.96 million shares worth $ 100 million, total stake $ 1.12 billion
USG Corporation (USG): 4.11 million shares worth $ 113 million, total stake $ 1.07 billion**
Verizon (VZ): 3.98 million shares worth $ 195 million, total stake $ 735 million
Verisign (VRSN): 1.30 million shares worth $ 72.1 million, total stake $ 721 million
Suncor (SU): 3.46 million shares worth $ 133 million, total stake $ 633 million
Chicago Bridge & Iron (CBI): 1.15 million shares worth $ 66.8 million, total stake $ 621 million
Liberty Global Class A (LBTYA): 2.52 million shares worth $ 109 million, total stake $ 428 million
Visa (V): 244 thousand shares worth $ 51.9 million, total stake $ 382 million

Reduced Positions
DirecTV (DTV): 11.0 million shares worth $ 933 million, total stake $ 1.98 billion
National Oilwell Varco (NOV): 1.58 million shares worth $ 127 million, total stake $ 590 million
Liberty Media (LMCA): 1.30 million shares worth $ 184 million, total stake $ 565 million
Phillips 66 (PSX): 3.25 million shares worth $ 272 million, total stake $ 544 million
Precision Castparts (PCP): 101 thousand shares worth $ 24.2 million, total stake $ 451 million
ConocoPhillips (COP): 9.72 million shares worth $ 780 million, total stake $ 109 million
Graham Holdings (GHC): 1.62 million shares worth $ 1.14 billion, total stake $ 76 million

The reduction in shares of Graham Holdings came about as a result of this deal.

Sold Positions
Starz (STRZA): 1.92 million shares worth $ 55.2 million

Todd Combs and Ted Weschler are responsible for an increasingly large number of the moves in the Berkshire equity portfolio, even if they still manage a small percentage of the overall portfolio.

These days, any changes involving smaller positions will generally be the work of the two portfolio managers.
(Though some of the holdings they're responsible for have become more substantial over time.)

Top Five Holdings
After the changes, Berkshire Hathaway's portfolio of equity securities remains mostly made up of financial, consumer and, to a lesser extent, technology stocks (mostly IBM).

1. Wells Fargo (WFC) = $ 23.3 billion
2. Coca-Cola (KO) = $ 16.1 billion
3. American Express (AXP) = $ 13.2 billion
4. IBM (IBM) = $ 13.2 billion
5. Wal-Mart (WMT) = $ 4.37 billion

The Wal-Mart position is only barely larger than Berkshire's position in Procter & Gamble (PG).

As is almost always the case it's a very concentrated portfolio.

The top five often represent 60-70 percent and, at times, even more of the equity portfolio. In addition, Berkshire owns equity securities listed on exchanges outside the U.S., plus cash and cash equivalents, fixed income, and other investments.***

According to their latest filing, the combined portfolio value (equities, cash, bonds, and other investments) at the end of the most recent quarter was ~ $ 233 billion (including the investment in Heinz).

The portfolio, of course, excludes all the operating businesses that Berkshire owns outright with, according to the latest letter, a bit more than 330,000 employees combined.

Here are some examples of the non-insurance businesses:

MidAmerican Energy, Burlington Northern Santa Fe, McLane Company, The Marmon Group, Shaw Industries, Benjamin Moore, Johns Manville, Acme Building, MiTek, Fruit of the Loom, Russell Athletic Apparel, NetJets, Nebraska Furniture Mart, See's Candies, Dairy Queen, The Pampered Chef, Business Wire, Iscar, Lubrizol, Oriental Trading Company, as well as 50% of Heinz.
(Among others.)

In addition, the insurance businesses (BH Reinsurance, General Re, GEICO etc.) owned by Berkshire have naturally provided plenty of "float" for their investments over time and continue to do so.

See page 111 of the annual report for a full list of Berkshire's businesses.

Adam

Long positions in BRKb, WFC, KO, AXP, PG, USB, WMT, DTV, COP, and PSX established at much lower than recent market prices. Small long position in IBM established at slightly less than recent market prices. Also, small long positions in USG and GHC established near current prices.

* All values shown are based upon Thursday's closing price with the exception of Liberty Media. After the 2nd quarter ended, Liberty Media implemented a stock split and spin-off. The numbers shown above for Liberty Media are based upon the closing price as of the last trading day prior to the stock split and spin-off.
** This is resulting from USG notes held by Berkshire that were converted into USG common stock. The SC 13D/A reflects all of the 43.39 million shares (30.4%) of USG owned by Berkshire. 
*** Berkshire Hathaway's holdings of ADRs are included in the 13F-HR. What is not included are the shares listed on exchanges outside the United States. The status of those shares are updated in the annual letter. So the only way any of the stocks listed on exchanges outside the U.S. will show up in the 13F-HR is if Berkshire happens to buy the ADR. Investments in things like the preferred shares (and, where applicable, related warrants) are also not included in the 13F-HR. The same is true for the Heinz common shares (i.e. not just the Heinz preferred shares).
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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 should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, August 8, 2014

Buffett on Autos, Airplanes, and Airlines

In this 1999 Fortune article, Warren Buffett (with some help from Carol Loomis) weighed in with his thoughts on some of the "industries that transformed" over the past century or so.

On Automobiles
"...there appear to have been at least 2,000 car makes, in an industry that had an incredible impact on people's lives. If you had foreseen in the early days of cars how this industry would develop, you would have said, 'Here is the road to riches.' So what did we progress to by the 1990s? After corporate carnage that never let up, we came down to three U.S. car companies--themselves no lollapaloozas for investors. So here is an industry that had an enormous impact on America--and also an enormous impact, though not the anticipated one, on investors.

Sometimes, incidentally, it's much easier in these transforming events to figure out the losers. You could have grasped the importance of the auto when it came along but still found it hard to pick companies that would make you money."

On Airplanes
"The other truly transforming business invention of the first quarter of the century, besides the car, was the airplane--another industry whose plainly brilliant future would have caused investors to salivate. So I went back to check out aircraft manufacturers and found that in the 1919-39 period, there were about 300 companies, only a handful still breathing today. Among the planes made then--we must have been the Silicon Valley of that age--were both the Nebraska and the Omaha, two aircraft that even the most loyal Nebraskan no longer relies upon."

Inevitably, this leads to an industry that has just been terrible for investors for a very long time.

That'd be airlines, of course.

Buffett mentions that no less 129 airlines had filed for bankruptcy over the previous 20 years. That was 1999. There have naturally been many more airline bankruptcies since Buffett made that point.

On Airlines
"As of 1992, in fact--though the picture would have improved since then--the money that had been made since the dawn of aviation by all of this country's airline companies was zero. Absolutely zero.

Sizing all this up, I like to think that if I'd been at Kitty Hawk in 1903 when Orville Wright took off, I would have been farsighted enough, and public-spirited enough--I owed this to future capitalists--to shoot him down. I mean, Karl Marx couldn't have done as much damage to capitalists as Orville did."

Some might view the consolidation of the airline industry in the U.S. is finally going to create attractive economics. Whether that turns out to be the case or not, I'll happily leave it for others to figure out. Even if airlines do become not such terrible businesses at some point, the more general lesson remains valid:

The most dynamic and transformative industries have often NOT been so wonderful for the early investors.

More from Buffett:

"I won't dwell on other glamorous businesses that dramatically changed our lives but concurrently failed to deliver rewards to U.S. investors: the manufacture of radios and televisions, for example. But I will draw a lesson from these businesses: The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."

Too often, when it comes to transformative industries (and individual businesses), it's difficult to avoid big mistakes. This subtracts meaningfully from overall results. Less return; more risk. Exciting prospects can lead to speculative prices. So the current winners quickly become priced for greatness. Well, what happens if they end up being just good or worse? A sufficient margin of safety is paramount because disappointments and misjudgments happen. When the future offers a wide range of outcomes -- and that's usually the case in the most transformative industries -- an even bigger margin is required.

So the price paid should protect against what might go wrong. Yet sometimes the worst likely outcomes can't be understood well enough beforehand. In those instances, no margin of safety will be sufficient.

The right action becomes inaction. The avoidance of exposure altogether.

Paying a speculative price -- even if based on a fundamental view that an investment will someday justify the price paid -- eventually turns into a recipe for permanent capital loss. This approach -- that is, operating without enough margin of safety -- will work right up until it does not.

In fact, early success operating in this manner likely leads to an even bigger speculative disaster down the road. Some are willing to pay a premium upfront on the belief an investment will eventually grow into its valuation. Well, investment is not about whether something can justify its valuation someday; it's about understanding investment specific risk and the potential reward compared to alternatives.

A willingness to pay a premium price for promising prospects quickly becomes expensive if those prospects end up not quite being realized.

At times, even when it happens to be unusually clear who the winner is likely to be, the price of admission makes the future returns unattractive considering the risks and alternatives.

Yet paying too much is only part of the problem.

The other difficulty is that many businesses fail -- or at least fail to produce an attractive return on capital -- in the most dynamic industries. Business economics can be altered in unpredictable ways when there's lots of capable competitors. Not becoming exposed to the capital that's destroyed in the process is easier said than done.

Obviously, the industries exposed to constant change do sometimes produce some big winners. The problem is those same industries also tend to produce a long list of losers. Both possible outcomes should get careful consideration. Those who get too caught up in the "story" may not consider the downside carefully enough. Those who do not scrutinize for flaws in their own thinking, and instead seek confirmation they're right, can make unnecessary mistakes. What appears to have great potential today might just end up on that long list tomorrow.

Keep in mind that, overall, the technology sector has had lower long-term returns than the consumer staples sector.*

Well, it seems more than fair to say that the former has been more transformative than the latter. Yet that didn't translate into above average investor returns.

Competition and the risk of technology shifts can turn sound core business economics into something else altogether. A big new opportunity where lots of innovation is taking place invites disruption from well-financed and capable new entrants to an industry.

What were expected to be high returns on capital today become rather the opposite down the road.

New competitors and capital usually go where there's exciting growth prospects; where there's some new compelling territory to potentially dominate. One or two do well. Many fail.

Subpar overall returns.

This isn't to suggest that some aren't very good at figuring out who the winners are going to be while also not paying too much for the potential. Some certainly do that sort of thing very well.

It's just easy to underestimate how difficult this is to do well on a consistent basis. Some are overly confident that they can reliably pick the winners and mostly avoid the losers.

The things that end up being transformative for the world need not -- and often do not -- enrich the investors who are willing to risk their capital.

There will be exceptions, of course, but an investment approach dependent on being the exception isn't likely to lead to great results.

It's worth noting that each industry has unique characteristics and dynamics that can be far from a static thing. I'll also add that, on occasion, an industry with historically not such great overall economics will settle down or consolidate and a clear winner or two emerges.

Though far from assured, those winners might even end up with sustainable advantages and sound business economics. This makes estimating intrinsic value, within a narrower though hardly precise range, just a bit less difficult (though still not easy).

Also, thanks to the fact that market prices fluctuate far more than intrinsic business values, the shares of these winners will sometimes sell at a nice discount. Risk and reward becomes more manageable.

It's a fallacy that being in on something early is a prerequisite for investment success.

Investing well does require lots of patience followed by decisive action when appropriate.

It requires an awareness of limitations and biases.

It also requires a real willingness to be critical of one's own thinking and decision-making.

Some might think investing well comes mostly down to having some brilliant insight.

Mostly (and fortunately for me) it does not.

Adam

* This article provides returns for ten economic sectors from 1963 to 2014: Among the ten economic sectors, consumer staples had the highest returns at 13.33%. Technology produced the lowest returns at 9.75%. The future may be very different, of course, but the point is that lots of competition and unpredictable technological change isn't necessarily a recipe for exceptional returns.
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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 should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, August 1, 2014

Stocks to Watch: Five Years Later

July 21, 2014 marked five years since my original Stocks to Watch list was created. These were stocks that I liked* at the time -- and mostly continue to like to varying degrees -- at the right price for my own portfolio.

Six of the stocks were originally mentioned on April 9, 2009 (as part of the Six Stock Portfolio then later added to Stocks to Watch). Earlier this year I provided a five year update on just these six stocks.

Well, here's how the total returns look updated through July 21, 2014 for all the stocks on the list:

For the original six, the total return was 214 percent compared to 156 percent for the SPDR S&P 500 (SPY) over the same time frame.

For the stocks first mentioned on July 21, 2009, the total return was 150 percent compared to 129 for the SPDR S&P 500 over the same time frame.

It's not quite five years yet for the stocks later added on December 17, 2009. To date, those two stocks had a total return of 105 percent compared to 97 percent for the SPDR S&P 500 over the same time frame.
(Naturally, dividends are included in that total return calculation for all the above stocks and for the S&P 500 so it is an apples-to-apples comparison.)

Combined, these stocks are up roughly 159 percent since being first mentioned in those three separate posts a few years back.

Most of these stocks had their per share intrinsic value increase nicely over five years or so, but not nearly as much as the market returns would imply. These returns reflect intrinsic value increases plus a closing of the discount to value gap. These businesses certainly did NOT increase per share value 159 percent. Most of the return comes down to what was a temporary mispricing. They were just very undervalued at the time and the recent market returns reflect a "catching up". It's inevitable that the forward rate of return will be much more modest.

Clearly, unless we have another bubble (let's hope not), there's just no way the forward returns will be anything like the recent past.

In fact, it'd be better in the long run if these stocks came down in price somewhat. That way buybacks can have a greater long-term per share effect for each dollar allocated.

The performance of these stocks relative to the S&P 500 is finally starting to, if only barely, become more meaningful.
(In previous posts I've noted that the time frame was still too short to gauge relative performance.)

Keep in mind this list was established with an eye toward minimal trading and very long-term ownership.
(If nothing else a recurring theme on this site.)

Of course, it's not like buying an S&P 500 index fund back then would have worked out too badly. In other words, many things were rather cheap back in 2009.

The real test of relative and absolute performance will come when some future crisis leads to a big drop in the market or, at the very least, after a couple more business cycles. Sound investments should separate themselves from the pack during the tougher economic environments.

These returns also naturally need be looked at in the context of risks (not beta...more qualitative).

I've liked these stocks (if bought at or below the maximum prices noted in prior posts) for the very long haul because my view has been that -- if bought at the once reasonable market prices -- attractive returns could be accomplished at lower risk. I may naturally be very wrong about this.

The substantial moves higher in many of these stocks just makes it harder to accumulate more shares (or for the companies to implement buybacks) below intrinsic value. So there's little reason to be thrilled about these mostly now too-high-to-purchase-with-sufficient-margin-of-safety prices.

That doesn't mean I'll be selling what I do own. I'm mostly not. It does mean I won't be buying more of these shares unless price versus value becomes more favorable.

Since these were first mentioned there were plenty of chances to buy at a nice discount to per share intrinsic business value.

Not now.

Naturally, my objective was to always buy these significantly below intrinsic value when the opportunity presented itself. The prices that were made available by the financial crisis (and the aftermath) allowed this to be largely accomplished.

As always, my intent is to hold long-term unless 1) the economic moat is damaged, 2) prospects were misjudged, 3) valuation gets extreme, and 4) occasionally when a substantial mispricing of another asset presents itself and the capital is needed for it.

Some things to consider:
- These stocks are intended to remain very stable over time with few additions or deletions. I think of it differently than the Six Stock Portfolio. Unlike that portfolio, I use Stocks to Watch as a list of quality businesses to monitor and, over a longer period of time, buy 5 to 10 of the stocks based upon what becomes available at the biggest discount to intrinsic value in the market. After that, the intent is to hold these indefinitely as long-term investments.

- In contrast, I established the Six Stock Portfolio in April 2009 as an example of some quality stocks that could be bought relatively quickly (at prevailing market prices back then) and held long-term. No trading required unless one of the conditions noted above warrants a sale. Otherwise, this concentrated portfolio exists to reject the idea that trading rapidly in and out of different securities is necessary to create above average returns. Basically, owning shares of quality businesses -- those with durable economics that increase intrinsically in value at an attractive rate over time -- bought initially at the right price trumps excessive trading.

- A term used frequently by analysts is a "price target". I never have one. To me, investor returns should be driven by the core economics of the businesses they own compounding in value, ideally over a very long time, not some unique talent to jump in and out of the stock at the right moment/price. The ownership period of shares in a sound business can be indefinite when bought at a fair price. Again, my sell behavior is influenced by the conditions noted above.
(i.e. Permanent damage to the economic moat, misjudgments, extreme mispricings, opportunity costs etc.)

The bottom line is that these are all intended to be long-term investments. A ten year horizon or longer. No trades here.

All of the stocks on this current list were part of the original Stocks to Watch unless otherwise noted.

Stock|Price @ 1st Mention|Recent Price|Total Return (incl. dividends)**
WFC |      19.61          |   51.05      | 187% - 1st mention 4/09/09
PM    |    37.71           |   85.57      |  181% - 1st mention 04/09/09
PEP   |    52.10           |   89.91      |  102% - 1st mention 04/09/09
LOW |    20.32           |   47.58      |  159% - 1st mention 04/09/09
AXP  |    18.83           |   92.88       | 435% - 1st mention 04/09/09
DEO   |    45.54           |  123.82     | 217% - 1st mention 04/09/09
MDLZ|    17.90          |   38.27      | 142% -  Was KFT, cost basis adj. for spin-off 
KO    |    25.18            |    42.40       |  95% - Split 2-1 on 08/13/12
COP  |     33.53           |   84.53       |  215% - Cost basis adj. for spin-off
JNJ   |    59.49           |  101.27      |101%
PG     |    55.49           |   80.28       |  71%
ADP  |    35.72           |   80.98      | 162%
USB  |     18.27           |   42.12       | 153%
MHK|     38.62           |  131.35     | 240%
BRKb|    59.50           | 128.58      | 116%
MO     |    17.33           |  42.01       | 223%
MNST|   14.58            |  64.74      | 344% - Split 2-1 on 02/16/12
PKX   |   93.63            |  74.03       | -14%
RMCF|    8.29             |  13.00       |  92%
NSC  |     52.06           | 105.63      | 129% - 1st mention 12/17/09
MCD |    61.92            |  97.55       |  82% - 1st mention 12/17/09
(Splits, spinoffs, and similar actions inevitably will occur going forward. Will adjust as necessary to make meaningful comparisons.)

Spin-offs
KRFT: total return 121%
PSX: total return 320%

For simplification purposes, both of the above spin-offs will not be considered Stocks to Watch going forward. These aren't necessarily bad businesses, but this list is already plenty long enough and I like many of the others much more.

After five years it's inevitable that some housekeeping will be in order.

Beyond those two, there are three other stocks that are, mostly due to valuation, quite a long way from making sense for a stocks to watch list. Some of this also comes down to the aforementioned simplification preference, but it primarily comes down to market valuation and, to an extent, my current judgment of their prospects compared to more attractive and understandable alternatives.

MNST
MDLZ
RMCF

These three may do just fine (in terms of per share intrinsic value increases) going forward but, unlike when this list was created, they're now far from cheap and, as a result, have become less than an ideal fit for Stocks to Watch. In other words, these stocks are still worth tracking to see how they perform over the long run but hardly represent bargains now. To me, other alternatives offer a better mix of risk and reward. It's tough to understand lots of different businesses and attempting to understand too many can easily lead to being spread too thin. Trying to reliably guess near-term price action is a fool's game; trying to judge price versus value, within limits and with discipline, is not. Sometimes, what's already expensive often goes on to just get more expensive. I'll let others try to play that game. Other times, those that appear expensive now will go on to more than justify what is a seemingly high current valuation. Well, at least they will someday. That doesn't mean the future returns, considering the risks, is more favorable than better understood alternatives.

So the remaining list is plenty long enough even if nothing is truly cheap at this point. I'll remain disciplined about price -- and continue to work hard at better understanding these businesses over time -- in an attempt to produce at least respectable long-term results. There's plenty of work to do even when there's little to buy. I expect plenty of waiting until, once again, some of these sell at a nice discount to value.

Some will still be misjudged. Some will disappoint. I mean, even the best businesses run into unexpected and real difficulties from time to time. That's the nature of equity investing and where margin of safety comes into play.***

The price paid should be such that rather unspectacular business performance will still deliver, in terms of risk and reward, an attractive long-term investment result.

Of course, if some of them do surprisingly well, there'll be no complaints.

Five years or so is enough time that things like management decision-making, changes to the competitive landscape, technology, and other factors can alter how attractive a particular investment is. It's enough time for price versus value to shift dramatically. In some cases, the long-term prospects are now even better. Most are roughly the same.

Yet some, inevitably, have become less attractive.

It'd be safer and easier to invest right now if these stocks were selling at a discount to value. Not only does it allow the investor to accumulate more shares below intrinsic value, the company itself can use excess free cash flow to do the same.

"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 1984 Berkshire Hathaway Shareholder Letter

Many of the above stocks are up substantially. Of these stocks, 20 of 21 have produced positive returns while most have more than doubled and then some. The best of them, American Express (AXP), would have turned a hypothetical $ 10k investment into more than $ 50k in five years. Crucially, the increases are NOT the result of extreme speculative valuations. In fact, prices now simply more fully reflect, give or take, intrinsic value. So, while these are not necessarily overvalued, the margin of safety is generally insufficient (some more than others).

On the other end of the spectrum from American Express is Posco (PKX). It has been, by far, the worst performing stock. Today, the stock closed at $ 81.50 per share. The stock has rallied since July 21st yet, as I write this, it's still not quite break even (incl. dividends). Back in July of 2009, I wrote that I'd be willing to buy the stock if it went below $ 80 per share. It proceeded to rally up to around $ 140 per share in less than 6 months. (Certain traders surely didn't mind this.) So it ended up taking more than two years for the shares to even get cheap enough to buy again. Well, unfortunately, the company by that time had taken on lots of debt. In fact, a bit too much for my taste.

In addition, capital allocation has been at best questionable and some value no doubt was destroyed in the process. We'll see if the new CEO is more disciplined with capital. So, for this to be worth the trouble, capital allocation needs to be improved and the balance sheet needs to be strengthened somewhat. I still like the business but it's not exactly at the top of this list. For now, in small doses, I'll continue to own it. My current cost basis offers a nice margin of safety (against permanent capital losses NOT temporary paper losses). Unlike the others, if it becomes more fully valued, I'll likely sell all or most of it. In the meantime, capital allocation and the balance sheet will be closely monitored.

Essentially, it took a long time for Posco to even get cheap enough to buy and, by that time, it had become less attractive. The stock performance, in itself, is not a problem. A languishing stock is no bother -- in fact, it can be beneficial for long-term owners if the business still has good prospects and per share value is increasing at an attractive rate. The company still has enough cost and other advantages -- through technology and some operational factors -- to be just barely worth some trouble. The weak steel pricing environment doesn't bother me. I don't even begin to try and speculate on such things. Instead, I just figure over a long period of time there'll be both good and bad price environments. Businesses with truly durable advantages are built to handle all environments. I just don't like it when a capital intensive business, one with too little control over raw material costs and the price of its products, carries this much debt.

Ditto for poor capital allocation.

So this will remain a small position and not nearly a favorite among the above stocks. It is in the "penalty box", but I'm not ready to sell it just yet. Compared to the others this stock is, and likely will continue to be, a bit of a wild ride.
(Note: The total return calculation for Posco is based upon a 07/21/09 closing price that was well above what I'd be willing to pay. My actual cost basis is quite a bit lower. Once again, I've done this for simplicity's sake. Essentially, so it's easier to track results over time. This is less than a perfect way to measure performance -- a bit on the tough side, actually, since I was not willing to pay that price -- but still meaningful enough overall, I think. If these are good businesses, bought at or near attractive valuations, this discrepancy shouldn't matter much in the long run. I don't want tracking these results to become more confusing than it needs to be.)

The idea is that good businesses should increase intrinsically in per share value at an attractive rate.

Again, some will disappoint in unforeseen and, sometimes, unforeseeable ways.

Mistakes will get made.

Yet, as a group, these should be able to do okay in terms of risk and reward over the longer haul.

For me, the right approach has been to buy a subset of these 21 based upon what became available at the most attractive market prices.

Some of these stocks really were just extraordinarily cheap when the list was created. Others weren't quite as cheap as I'd like back then, but all were selling at a discount to my own (possibly flawed) estimate of intrinsic value. As they get further away from July of 2009, increases to per share intrinsic value should be the dominant factor since, generally speaking, the mispricing gap on these stocks has been all but eliminated. If this list of stocks is any good, it shouldn't require trading brilliantly in and out of positions. The subset that were bought at attractive prices should do the heavy lifting, as far as generating returns, as they increase intrinsically in value. I definitely don't think attempting to own all 21 stocks is wise or likely to produce spectacular relative results (even if absolute results -- to a great extent due to the once very low market prices compared to intrinsic value -- certainly aren't too bad at all). I do think a subset of the 21 stocks, if bought reasonably well, should do just fine longer term (though, of course, not necessarily over shorter time horizons) with the Six Stock Portfolio being just one good example. As I've noted, it'd be better if these performed a little bit less well (the stock prices...not the businesses) in the near and even intermediate term. That can improve long-term results -- mostly because, even without incremental purchases, the buybacks and dividend reinvestments become more effective -- though it requires some patience and warranted conviction.

I'd add that the maximum price I was willing to pay (as noted in some prior Stocks to Watch posts) attempted to take into account an acceptable margin of safety.

That margin of safety differs for each company.

In other words, I believed these were intrinsically worth quite a bit more than the max price I was willing to pay. I also believe most of these companies generally have favorable long-term economics (i.e. the best of them have high and durable return on capital) and, as a result, intrinsic values will increase nicely over the long haul. The more capital intensive businesses on this list obviously have lower returns on capital but, in my view, are otherwise sound businesses. Of course, I may be misjudging the core economics and that margin of safety could provide insufficient protection against a loss.

Though I could easily be wrong, at the right price I consider these stocks appropriate for my own portfolio (i.e. not for someone else's) given my understanding of the downside risks and potential rewards.

So these don't necessarily make sense for others unless they do their own research and reach their own similar conclusions.

To me , these stocks are mostly just too expensive to buy meaningful amounts right now. There was, in contrast, no shortage of chances to buy these at a nice discount over the past five years or so. That was the time to act. The risk of missing the chance to own a well understood investment when a fair price is available -- an error of omission -- can be more costly than suffering a temporary paper loss (though, due to loss aversion, many focus much more on the latter).

Hopefully some of these stocks will get cheap again. Though I never try to predict such things, considering the current valuation environment, if these stocks do not perform well over the next several years it would be unsurprising.

In fact, if the market prices performed poorly, but otherwise core business characteristics remained in tact, that'd be a good thing.

Here are some thoughts on errors of omission by Warren Buffett from an article in The Motley Fool.

Also, from the 2008 Berkshire Hathaway shareholder letter:

"During 2008 I did some dumb things in investments. I made at least one major mistake of commission and several lesser ones that also hurt... Furthermore, I made some errors of omission, sucking my thumb when new facts came in." - Warren Buffett

Choosing to not buy what's attractively valued to avoid short-term paper losses is far from a perfect solution with your best long-term investment ideas.

If an investment is initially bought at a fair price, and is likely to increase substantially in value over 20 years or so, it makes no sense to be bothered by a temporary paper loss. Of course, make a misjudgment on the quality of a business and that paper loss becomes a real one (error of commission).

There is no perfect answer to this problem. When highly confident that a great business is available at a fair price it's important to accumulate enough while the window of opportunity exists.

Sometimes accepting the risk of short-term losses is necessary to make sure a meaningful stake is acquired.

In any case, the record has been plain to see since I first mentioned the above stocks on this blog. If it turns out I've made dumb decisions it will be obvious over the long haul.

The objective will continue to be good long-term results, at lower risk, accomplished with minimal trading.

For me, performance during a down market and tough economy matters a whole lot. That'd be business performance not stock performance. The truly good businesses are strengthened by the tougher economic environments. Some of the above stocks actually had terrible price action during the financial crisis but actually came out stronger and more valuable as a result of it.

So investment performance shouldn't be measured by the near-term price action. It should, instead, be measured by changes to per share intrinsic business value once the economic environment stabilizes. Sometimes price action reveals something about the business itself; other times that's just not the case.

Market prices eventually at least roughly track intrinsic values even if, in the shorter run, prices can fluctuate rather wildly.

Overall, I'd expect the above stocks to temporarily drop their fair share in a bear market. Yet I'd also expect them to perform just fine on a relative basis once that tough environment is far enough in the rear-view mirror.

Again, the emphasis here is on long run business performance -- and changes to per share intrinsic value -- not short-term stock performance.

I am also never tempted to trade from "defensive" to "cyclical" stocks (or anything similar to that approach) depending on the market environment. Too much trading leads to unnecessary mistakes. This is about part ownership of businesses. I'll let others play the trading game as I believe this approach will do just fine in the long run (even if it offers a little less excitement).

Some may think it's time to add some new Stocks To Watch. Well, the above list, even after the deletions, offers plenty of alternatives for me to consider. Keeping the list short allows one to really get to know what they own or might want to own some day. Some patience and discipline is required. In fact, if anything, I'd still like to have fewer on the list.

In any case, I'm certainly not expecting all that many will find this way of thinking about investment to be of much interest. It's just an approach that happens to be in my comfort zone.

As I mentioned above, these are simply the stocks I like for my own portfolio. In other words, I have no opinion whatsoever as to which stocks others should own.

It's worth considering that, unlike several years back when lots of stocks had a nice margin of safety, errors of commission are much more likely to occur these days.

Market prices would have to adjust downward significantly for some future updated Stocks to Watch list to become relevant and useful again. There's just not much to buy these days with a sufficient margin of safety. While it's impossible to know when this will change, these interludes are a good chance to get more familiar with current and/or potential investments.

The right preparation should make it possible for decisive action the next time others are fearful and market prices once again become attractive.

Adam

* 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 remain long the above stocks (at least those that at some point became cheap enough to buy) unless market prices become significantly higher than intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
** The total return includes dividends and is based upon the closing prices on the date first mentioned compared to the 07/21/14 closing price. 1st mention of each stock was 07/21/09 unless otherwise noted. Removed from the list a while back was BNI; a stock I liked up to $ 80/share. It was bought out by Berkshire Hathaway for $ 100/share in late 2009. Deal closed in early 2010. BNI's stock price when 1st mentioned was $ 74.80. So it ended up being a ~34% return in a relatively short amount of time which was easily greater than the S&P 500.
*** The required margin of safety is naturally larger for a bank than for something like KO. When I make a mistake and substantially misjudge a company's economics, the margin of safety may still not be sufficient. Judging the durability of the economics correctly matters most. If the economics remain intact but the stock goes down -- as was the case for most of these during the financial crisis -- that is a very good thing in the long run.
 
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