On Buffett Back Riding

Warren Buffett is best known for his work at Berkshire Hathaway (BRK.A) where he grew book value per share 21.1% a year over the last 42 years.

But Buffett was a money manager long before he was a CEO. He earned his super-investor stripes by running an investment partnership. Buffett Partnership Ltd. beat the Dow every year from 1957 to 1969, never had a down year, and posted annual returns of 29.5% a year. The Dow managed just 7.4%.

Those numbers are phenomenal. And Buffett’s record is all the more phenomenal for its length. How many investors have a track record stretching back half a century?

But past results are no guarantee of future returns. And Berkshire’s size is a guaranteed headwind.

So can you really Buffett-back ride your way to investment success?

Maybe.

But there is a right way to do it and a wrong way to do it.

Common Mistakes in Preferred Stock

The wrongest of the wrong is to buy common stock in companies where Buffett holds preferred shares.

Don’t buy General Electric (GE) and Goldman Sachs (GS) because Buffett told you to. He didn’t. He took a senior position with a double-digit yield. If he wanted to buy the common, he would have bought the common.

Buffett has bought preferred stock before. And, to be honest, it is not his strong suit. One of his worst investment decisions was buying preferred stock in US Air. Berkshire nearly lost everything. The investment worked out, but it was a big mistake – and Buffett knows it.

Another, lesser mistake was buying preferred stock in Gillette.

That investment worked out great. But it would have worked out even better if Buffett bought the common stock instead of the preferred.

For details read Buffett’s 1995 letter to shareholders.

Buffett says he “was far too clever” to take the easier, more profitable route – instead insisting on the more complex, and ultimately less profitable preferred stock.

When Buffett makes a preferred stock purchase, he is actually signaling that he does not like the common stock. He may like the company. He may not. But he certainly does not like the stock.

If he did, he would buy the common stock.

So why did Buffett take preferred shares in GE and Goldman?

Some will argue these are sweet-heart deals pure and simple – and that’s why Warren took them. Buffett certainly got in on special terms.

But, it’s not clear those terms were better than what he could get by buying common stock in a business he loves when market prices are low.

In fact, almost all of Buffett’s biggest successes were either common stock purchases or preferred stock purchases that would have worked out as well or better if Berkshire had bought the common stock instead.

I can think of only two exceptions. Berkshire got some GEICO (now fully owned) and some Freddie Mac (long ago sold) in ways that individual investors could not. Other institutions were offered the same …

On Keynes, the Stimulus, and Old Ideas

John Maynard Keynes was a genius. We can all learn from his example. And the first thing we should learn is to end our foolish love affair with his ideas.

Keynes would not have spent his days warming up some dead man’s leftovers. Keynes would have understood the importance of all we have learned in once disparate fields and what this means for macro-economics.

Complex Problems, Simple Solutions

Economies are complex. But macro-economic solutions remain stubbornly simple.

What exactly is the case for government stimulus?

I don’t mean generally. I mean in this specific situation – right now, today, what is the case for government stimulus?

Forget ideology. Forget theories. Forget models. Think only of the situation we face and the actions we might take.

There will be plenty of time for theories later. But to start by imposing a framework, especially a framework that assumes a special case belongs to a general population, is dangerous.

Why do we assume that special cases belong to populations we know something about?

Because that is what experience teaches us. Our everyday experiences teach us to expect normal distributions. More than that, our everyday experiences encourage us to think that all differences are merely quantitative differences – simply matters of degree – rather than qualitative, systematic differences.

To the extent that the problems, populations, and systems we are dealing with are simple and unplanned I have little problem with making such leaps of faith – extrapolating from a few specific cases to create sweeping general theories.

But when we are dealing with complex, planned systems – systems with actors who learn and adapt, systems with actors who make new mistakes, actors who remember pain and pleasure as vividly as we humans do – when we are dealing with such systems, general theories are dangerous precisely because they are so elegant.

In a complex science, general theories are just special theories that win wide acceptance. If wide acceptance within an academic community was convincing evidence of utility, I would say stick with general theories.

A quick check of human history shows that, no, popularity is not a good indicator of utility. A few bad ideas always slip through – and worse yet, most good ideas – ideas like Keynes’ – outlive their usefulness.

The Burden of a Great Idea

Intellectual lifecycles can be painfully long. First, a great man like Keynes leads the way. Then a lot of not so great men follow. They don’t how to think up the new and useful principles the way the great man did; instead they keep applying old principles to new problems – problems the poor, dead man never saw.

Had he seen different problems, he would have found different solutions. But, he’s dead and his ideas aren’t. So the best a follower can do is warm up the dead man’s leftovers.

Ideas are limiting. The great ones are the most limiting of all.

Warren Buffett was limited by Benjamin Graham’s thinking. He had to learn to …

Microsoft is Cheap

Go to 24/7 Wall St. and read great coverage of the Microsoft (MSFT) earnings call.

Here is what I wrote about Microsoft in May of 2006:

What price would I be buying Microsoft at? Like I said, this isn’t normally the kind of company I would be buying. It is definitely in an industry where there is a lot of uncertainty – at least beyond the Windows franchise (which I do think is completely secure).

For the most part, this is a stock I wouldn’t be able to value well enough to buy, because of the future and my lack of understanding of the business.

Having said that, I would certainly buy shares if they reached $17. Before that, I would have some trouble making a decision. The margin of safety simply wouldn’t be wide enough in an area I don’t understand that well. Maybe I will get a better feel for the company and its competitive position as I look into the stock some more (and write about it here). But, unless and until that happens, it would be hard for me to buy at a price much greater than $17 (where I think it would pretty much be a sure thing).

Because of share buybacks and other changes since 2006, my sure thing price would now be more like $17.50.

Earnings power in terms of free cash flow is probably around $1.75 a share.

No entrenched, wide-moat business this size trades for 10 times its cash earnings power.

Is Microsoft a growth stock?

No.

Is it cheap?

Yes.

If you need to buy a big cap stock, buy Microsoft at $17.50 or less.…

Random Thoughts

I haven’t posted in a while and thought I might begin with some random thoughts.

Rick Konrad of Value Discipline has posted after a (similarly) long absence. Value Discipline is one of the best investing blogs. If you’ve never read it – start now.

24/7 Wall St. recently posted on More Recession Carnage for Video Games. I would love to have posted on the video games industry (especially publishing) more often on this blog. I rarely have. The reason’s simple: video game stocks have been pricey for much of the life of this blog (2006-present). That’s not true anymore. Unfortunately, so many stocks are now so cheap on a normalized free cash flow (“earnings power”) basis that it’s hard to argue video game stocks deserve special mention.

Take toys. A basket of three of the largest U.S. toymakers: Mattel (MAT), Hasbro (HAS), and Jakks Pacific (JAKK) looks real reasonable. Do the math on what kind of free cash flow these businesses have produced over the years and what kind of prices you can buy them at today. Answer: You’re getting the American toy industry dirt cheap.

Are their risks? In the long-run, their may be greater risks in toys than video games, because toy companies run a greater risk of becoming inflexible enterprises. Regardless, mankind’s appetite for toys, video games, and just plain fun isn’t going to be permanently impaired by a recession or depression (no matter how “great”).

Are these businesses recession proof? Nothing’s recession proof. But businesses that make products people are passionate about aren’t a bad place to be in any economic environment. The fact that both industries can and have supported multiple, profitable players isn’t a bad sign either. Toys and video game stocks are both worth buying (even if you can’t separate the wheat from the chaff) when you can get an acceptable no-growth normalized FCF yield on your purchase price.

Focus on free cash flow. Not earnings. I don’t envy anyone who has to tell us what a video game company (or toy company) made this year much less what they’ll make next year. Current sales and expected (normalized) FCF margins are a better way to value these businesses than EPS. Be conservative but realistic. And either buy the best or buy them all whenever you get the right price. In other words, don’t rush out and buy a troubled, hurting quagmire (THQ) at the first twinkling of a turnaround. That’s not necessary when real quality is on sale the way it is today.

Note: Yes. THQ (THQI) is cheap. But ask yourself: do I really need that kind of cheap in my life, when real quality’s on sale.

Video game and toy stocks aren’t the only ones being offered at low prices to demonstrated free cash flow. See Microsoft (MSFT) or Energizer Holdings (ENR) for evidence of this market wide phenomenon.

But those are posts for another day.…

On a Return to Normalcy

It might not feel like it, but yesterday marked the Dow’s return to normal.

Normal valuations that is.

A little under two years ago (December 2006), I wrote a series of posts on normalized P/E ratios. In my most important post in that series, “In Defense of Extraordinary Claims”, I argued that future returns would not match historical returns, because normalized valuations from 1996 to the present were too high:

Stocks are not inherently attractive; they have often been attractive, because they have often been cheap.

That statement neatly sums up my argument. Buying stocks blindly worked during most of the 20th century because stocks were cheap during most of the 20th century.

That all changed in 1996. In every year from 1996 through 2007, the Dow was more expensive relative to its normalized earnings than it had been in any year from 1935 through 1995. The closest comparison was 1965. But every year: ’96, ’97, ’98, ’99, 2000, 2001, 2002, 2003, 2004, 2005, 2006, and 2007 was more expensive than ’65.

As a result, historical return data from the 20th century was an inappropriate guide for expected returns on an initial investment made at any point from 1996 – 2007.

We were in unchartered territory.

Not any more.

Yesterday, the Dow dropped below 8,750. That number is the point at which the Dow would be trading at the average 15-year normalized P/E ratio for 1935-2005. In those seven decades the Dow posted a compound annual point gain of 6.6%. Back it up ten years to 1995, the last year before the paradigm shift I wrote about and you still get annual point growth of 6.2%.

So at yesterday’s close of 8,579 the Dow is priced to grow at a quite historical six to six and a half percent a year.

That may not sound like much to those weaned on the 1982 – 1999 bull market. However, it’s a lot better than the “new paradigm” market that began in 1996. Since we broke into unchartered territory twelve years ago, we’ve done something like 3.4% in point terms.

And over the last ten years: zilch.

Here’s what I wrote about the possibility that the post 1995 (i.e., permanently higher normalized P/E) environment could be maintained:

Is it possible that the surge in normalized P/E ratios beginning in 1995 was simply the culmination of a crisis within the investment discipline? Maybe normalized P/E ratios have reached “a permanently high plateau” now that a new paradigm has taken hold.

I won’t dismiss this argument entirely. There is some logic to it. After all, stocks have been an unbelievable bargain for most of the 20th century. Why should that continue to be the case? Eventually, won’t enough investors wise up to this fact and cause the so-called “equity-risk premium” to disappear.

If the normalized P/E ratio remains extremely high, there will be no need for stock prices to fall. Of course, these higher valuations must necessarily cause future

On Ben Graham, Bank Stocks, and Tom Brown

I wrote a response to Jason Zweig’s column on Ben Graham and bank stocks. Now, Tom Brown of Bankstocks.com has done the same. I have to admit, Tom’s article is better than mine. Both take Zweig to task for his explanation of why Ben Graham wouldn’t be a buyer of bank stocks today. However, Tom’s post does a better job of presenting the opportunities and challenges in analyzing bank stocks today:

Zweig’s premise seems to be that no one inside or outside a financial services company can ever reasonably value the institution’s assets–particularly if the assets are secured by real estate at a time when real estate values are declining on average. The stock’s valuation? Irrelevant. Investor sentiment? Beside the point. Rather, Zweig sees the companies as no more than black boxes. By his logic, Graham-style investors (as opposed to speculators) would never own these companies. But we know as a matter of fact that that is not true.

Graham saw every investment as a black box – and that didn’t trouble him. A lot of investors spend a lot of their time worrying about the inner workings of the companies they own – Graham never did. He didn’t look inside the “system”, i.e. the company itself; instead he looked only at the outputs – the financial statements. He spent almost no time worrying about a business’s management, corporate culture, or future prospects. He didn’t worry about competitive advantages. He looked to the balance sheet first. When he moved on from there to consider earnings, his usual approach was to rely heavily on the past record in an attempt to discover what “normal” earnings might look like.

Graham was a rear view mirror guy. His margin of safety was based on making purchases at prices that would’ve worked well in the past. He liked sure things. For instance, he knew that NCAV stocks were sure things – and subsequent research continues to support that claim. I mentioned NCAV stocks in my previous post, because they are perhaps Graham’s most characteristic investment category. They combine elementary arithmetic and logic in a potentially lucrative but almost certainly safe investment operation. Also, unlike much of what he wrote about in The Intelligent Investor and Security Analysis, Graham actually made NCAV investments during his Wall Street career.

Before we can answer what Graham would do today, we need to know what he did do in his own lifetime. When writing about Graham, one needs to consider three separate categories: what Graham practiced, what Graham preached, and what Graham’s principles were.

What Graham Practiced

In the Intelligent Investor, Graham lists the five successful techniques his partnership employed from 1926 – 1956: arbitrage, liquidations, related hedges, net-current asset issues, and control investments.

Control Investments
Graham does not discuss control investments in any of his books; however, GEICO is a well-known example of a Grahamian control investment.

Arbitrage
Buffett has discussed this techniques in some detail. See especially Buffett’s discussion of Berkshire’s purchase of Arcata …

Festival of Stocks #99

Welcome to the ninety-ninth Festival of Stocks. The Festival of Stocks is a weekly blog carnival dedicated to highlighting the best recent posts on stock market related topics.

I am proud to present this week’s best entries to the Festival of Stocks. The articles are listed by category. I have included my review of Don Keough’s new book “The Ten Commandments for Business Failure” among the links below.

Enjoy.

Stock Analysis

Number Check on Sears by Circle of Competence

“With its market price declining daily, giving me the opportunity to pick up even more shares, I thought I’d present a very rough look at how the market is valuing Sears (SHLD) right now, putting reasonable numbers to a rather abstract investment idea.”

USG Earnings Conference and Notes by College Analysts

“From a purely operational standpoint, USG’s results were objectively poor but very good contextually. Wallboard volume shipments were down 11% quarter-over-quarter and plant utilization sits just under 70%; until capacity recovers into the mid-80%s, USG won’t have the operating leverage to put up big EPS numbers, and that day is still far off.”

United Technologies Dividend Analysis by Dividend Growth Investor

“UTX is a dividend achiever as well as a component of the S&P; 500 and Dow Jones Industrials indexes. It has been increasing its dividends for the past 14 consecutive years. From 1998 up until 2007 this dividend growth stock has delivered an annual average total return of 17.20 % to its shareholders.”

A.H. Belo: A Value Stock or a Value Trap? by Lollapalooza Investing

The new Lollapalooza Investing blog provides a detailed analysis of A.H. Belo.

Have Your Cake…? By Bootstrap Investing

“I’ve actually been an owner of Cheesecake Factory shares for a couple of years now. But the recent market malaise (aka storm, destruction and rampaging bear as quoted in the financial press) has given us an opportunity to purchase shares at prices not seen since just after the new millennium.”

Commentary

“Dear Bill…” A Letter to Bill Miller by Cheap Stocks

“How is it possible that you are down 32% year to date, or 39% over the past year? Looking back, do you think that your positions were too concentrated in financials? Yes, Bill, I know hindsight is 20/20, and I sound a bit like Captain Obvious here, but Bear Stearns, Washington Mutual, Citigroup, Merrill Lynch, Freddie Mac, AIG, Countrywide? Where was your risk control?”

Jim Grant on the Absence of Outrage by Controlled Greed

Actually, I think people are so irked at $4.00 and up gas prices — and worried about further increases — that their focus is fixed there. And Grant suggests this could be the factor consuming populist anger at the moment.

My Strategies for Weathering a Bear Market by My Wealth Builder

Another way I hedge is to take some profits with a stock that has risen significantly, selling 20 to 50%, and sometimes 100%, of a position to lock in some gains. I recently did this with …

On a Starbucks Shuttered

They say you don’t know what you’ve got ‘til it’s gone.

I don’t know who they are; but I know of what they speak.

I recently lost a coffee place (not a Starbucks). It was a traumatic experience.

Last year, my eye doctor asked if I did a lot of reading at work: “Mostly SEC filings”, I said. “That’ll do it”, he replied, “You have what I like to call computer eyes”. And so, for the first time in my life, I became acutely aware of the occupational hazards of investing.

Now, a few times a month, I take a couple hours off to venture outdoors. Yes, I know the sun’s demonic rays cause cancer; but they also cure electronic induced ennui. Sounds fair to me.

There’s one coffee place I always go. I take my Kindle with me (hopefully there’s no such thing as Kindle eyes), order a double espresso (and since this isn’t a Starbucks I actually say the words “double espresso”), give the cashier three singles, get ninety-five cents back and drop it all in the tip jar (I’m not generous; I just hate change).

Then, I take a table (yes, it’s the same table every time – I told you I hate change) and stay there reading until I feel guilty I only paid three dollars and I’m hogging their table.

At that point, I usually stay another hour.

If my behavior is typical of their customers, it’s not entirely surprising that I should’ve come upon the sight I saw last week, though it came as quite a shock to me.

The place was empty. The tables gone. The signs gone. Everything gone.

This was a change. I did not like it. But I soldiered on. Off I went to the nearest coffee place (again, not a Starbucks). The trek was slightly less than half a block. There I found a handwritten sign in the window:

Closed for vacation. Back next month.

Another change. I did not like it. At that point, I realized it was a summer day, I was hot, and I probably didn’t want coffee anyway. So I walked another half block to a deli, bought a Cherry Coke, gave the cashier two singles, got eighty-three cents back and dropped it all in the tip jar (again, I’m not generous; I just hate change).

I haven’t related this most boring of stories to you for no reason.

Much modern writing (even some blog writing – wink, wink, nudge, nudge) drips with sarconihilism, that especially astringent strain of sarcasm bordering on nihilism. In such writing, not only is nothing sacred – nothing is above casual, comedic contempt. It is occasionally hilarious, often elitist, and indubitably dishonest.

It makes fun of life’s littlest pleasures, especially the ordinary. Starbucks is a frequent target; the coffee chain is nothing if not ordinary:

The green aprons, the blond wood, the safari-themed coffee art and the chalkboards. From Chula Vista, Calif., to Bangor, Me., all Starbucks are more

Book Review: The Ten Commandments for Business Failure

Review by Geoff Gannon

Yesterday, I scampered off (virtually) to Amazon.com, found Don Keough’s new book, and clicked the “Buy Now” button.

Through the sorcery of modern book selling – one minute, nine dollars and ninety-nine cents later – Don Keough’s words were in my hands.

I froze.

Seeing the big, bold print of that title page on my Kindle, I froze. Here was a business book by Don Keough. Yet for some reason I expected the worst. The title was not encouraging: “The Ten Commandments for Business Failure”. It sounded like a book I’d read a few hundred times before.

Would this be a saccharine sleigh ride through Coca-Cola’s golden (Goizueta) years? Or just another listless list of managerial platitudes?

Evenly divided between anticipation, trepidation, and vacillation I pressed the “NEXT PAGE” button and embarked on my journey with Mr. Keough.

At least, I thought it was to be with Mr. Keough, until I read the first few words of the foreword:

“It has been an article of faith for me that I should always try to hang out with people who are better than I. There is no question that by doing so you move yourself up. It worked for me in marriage and it’s worked for me with Don Keough.”

That voice, of course, is Mr. Buffett’s. Warren’s cameo will be appreciated by all business readers, but those of the investing ilk will savor it most. And this is a worthwhile book for investors – though only indirectly so.

Don Keough has written a general business book, not a managerial handbook. As he writes in his introduction:

“…there has never been a shortage of speakers and writers willing to dispense tried and true advice on how to succeed in business without really trying.”

This is not that book.

Nor is this the book for the starry-eyed entrepreneur, the middle manager looking to get ahead, or the executive who wants to become a “leader”. This is not a self-help book.

It’s a business book – and a damn good one. The lessons within provide insights into businesses both good and bad and are as useful to the investor as they are to the executive.

Keough knows the kind of book he’s writing and tells us at the outset who his audience is:

“While these commandments can be applied to any business at any stage in its development, they are mainly intended for businesses and business leaders who have already attained a measure of success. In fact, the more you have achieved the more the commandments apply to you.”

His years at Coke made Keough extremely well-qualified to write a book on how to screw up a sure thing.

Keough’s advice is simple, maybe even trite:

“You will fail if you quit taking risks, are inflexible, isolated, assume infallibility, play the game close to the line, don’t take time to think, put all your faith in outside experts, love your bureaucracy, send

On Ben Graham and Bank Stocks

Jason Zweig writes the Intelligent Investor column for The Wall Street Journal. I’m sorry to say this week’s column is especially unintelligent.

When asked whether Graham would be buying financial stocks today, Zweig says no, and gives the following reason:

You cannot even pretend to be protected against loss while real estate prices – – the wobbly foundation for most financial stocks – – are still crumbling.

False.

You can do more than pretend to be protected – and Graham would have. Crumbling real estate prices alone would not have deterred Graham. He liked to use long-term averages and estimates of what normal conditions would bring. He relied heavily on the past as an indicator of the future. Real estate prices will recover at some point. Even if they don’t anytime soon, land still has value and Graham would have done his best to conservatively estimate that value. He could’ve used estimates based on prices from many years ago, replacement costs, rents, or the value of unimproved land. Then he would have lopped off some of that price and – voila – there’s your margin of safety.

No. The crumbling real estate market wouldn’t have fazed Graham.

Graham wouldn’t have bought financial stocks for a very different reason: they simply aren’t cheap enough.

I know it’s hard to believe, but as Zweig points out, on average, financial stocks are still trading above book value.

Remember, 1.1 times book is still 110% of a bank’s equity. Graham bought net current asset value stocks at less than 67% of their net current asset value (NCAV).

A lot of people think NCAV stocks (or “net/nets”) are risky. Some may be. However, there was one study showing that net/nets sought bankruptcy protection less frequently than non-net/nets. That’s not as shocking as it sounds. Unlike low price to book stocks, low price to NCAV stocks have a built in tendency to be overcapitalized.

Why?

Because there’s no need to have a positive net current asset value at all. Many public companies don’t.

Take Anheuser-Busch. It has about $3.1 billion in book value and NEGATIVE $12.1 billion in net current asset value. Even if BUD’s stock price fell to two bucks a share tomorrow, it would not trade below its net current asset value, because it has no net current asset value. To have a net current asset value, the company would have to be overcapitalized.

Other companies, especially companies with very high inventory needs and rapidly declining sales, can trade below NCAV without actually having much financial wiggle room. However, most companies end up in NCAV territory with strong balance sheets and weak statements of income and cash flow.

The NCAV stocks that fail tend to do so in slow motion and through extreme pig-headedness. Had management wished to, they could have exited unprofitable businesses, stopped treating the company as their own personal piggy bank, or wound down the business at some point without ever facing insolvency. A bankrupt (former) NCAV stock is usually …