Growth Stock Paradox: The more successful the company, the greater are likely to be the fluctuations in the price of its shares.

The development of the stock market in recent decades has made the typical investor

• more dependent on the course of price quotations and 
• less free than formerly to consider himself merely a business owner. 

The reason is that the successful enterprises in which he is likely to concentrate his holdings

• sell almost constantly at prices well above their net asset value (or book value, or  “balance-sheet value”). 
• In paying these market premiums the investor gives precious hostages to fortune, for he must depend on the stock market itself to validate his commitments.†

This is a factor of prime importance in present-day investing, and it has received less attention than it deserves. The whole structure of stock-market quotations contains a built-in contradiction. 

• The better a company’s record and prospects, the less relationship the price of its shares will have to their book value. 
• But the greater the premium above book value, the less certain the basis of determining its intrinsic value—i.e., the more this “value” will depend on the changing moods and measurements of the stock market.  

Thus we reach the final paradox, that the more successful the company, the greater are likely to be the fluctuations in the price of its shares. 

• This really means that, in a very real sense, the better the quality of a common stock, the more speculative it is likely to be—at least as compared with the unspectacular middle-grade issues.*  
• (What we have said applies to a comparison of the leading growth companies with the bulk of well-established concerns; we exclude from our purview here those issues which are highly speculative because the businesses themselves are speculative.)

† Net asset value, book value, balance-sheet value, and tangible-asset value are all synonyms for net worth, or the total value of a company’s physical and financial assets minus all its liabilities. It can be calculated using the balance sheets in a company’s annual and quarterly reports; from total shareholders’ equity, subtract all “soft” assets such as goodwill, trademarks, and other intangibles. Divide by the fully diluted number of shares outstanding to arrive at book value per share.



* Graham’s use of the word “paradox” is probably an allusion to a classic article by David Durand, “Growth Stocks and the Petersburg Paradox,” The Journal of Finance, vol. XII, no. 3, September, 1957, pp. 348–363, which compares investing in high-priced growth stocks to betting on a series of coin flips in which the payoff escalates with each flip of the coin. Durand points out that if a growth stock could continue to grow at a high rate for an indefinite period of time, an investor should (in theory) be willing to pay an infinite price for its shares. Why, then, has no stock ever sold for a price of infinity dollars per share? Because the higher the assumed future growth rate, and the longer the time period over which it is expected, the wider the margin for error grows, and the higher the cost of even a tiny miscalculation becomes. 


Ref:  Intelligent Investor by Benjamin Graham

Investor of marketable shares has a double status, with the privilege of taking advantage of either at his choice.

The impact of market fluctuations upon the investor’s true situation may be considered also from the standpoint of the shareholder as the part owner of various businesses.

The holder of marketable shares actually has a double status, and with it the privilege of taking advantage of either at his choice. 

1.  On the one hand his position is analogous to that of a minority shareholder or silent partner in a private business.

• Here his results are entirely dependent on the profits of the enterprise or on a change in the underlying value of its assets. 
• He would usually determine the value of such a private-business interest by calculating his share of the net worth as shown in the most recent balance sheet. 

2.  On the other hand, the common-stock investor holds a piece of paper, an engraved stock certificate.

• This stock certificate can be sold in a matter of minutes at a price which varies from moment to moment—when the market is open, that is—and often is far removed from the balance sheet value.

Substantial rise in the market: Practical questions and psychological problems confronting the investors

A serious investor is not likely to believe that the day-to-day or even month-to-month fluctuations of the stock market make him richer or poorer.


But what about the longer-term and wider changes in the stock market? Here practical questions present themselves, and the psychological problems are likely to grow complicated.

A substantial rise in the market is 

• at once a legitimate reason for satisfaction and 
• a cause for prudent concern, 
• but it may also bring a strong temptation toward imprudent action.

Your shares have advanced, good!  You are richer than you were, good!

• But has the price risen too high, and should you think of selling? 
• Or should you kick yourself for not having bought more shares when the level was lower? 
• Or— worst thought of all—should you now give way to the bull-market atmosphere, become infected with the enthusiasm, the overconfidence and the greed of the great public (of which, after all, you are a part), and make larger and dangerous commitments? 

Presented thus in print, the answer to the last question is a self-evident no, but even the intelligent investor is likely to need considerable will power to keep from following the crowd.

It is for these reasons of human nature, even more than by calculation of financial gain or loss, that we favor some kind of mechanical method for varying the proportion of bonds to stocks in the investor’s portfolio.

• The chief advantage, perhaps, is that such a formula will give him something to do. 
• As the market advances he will from time to time make sales out of his stockholdings, putting the proceeds into bonds; as it declines he will reverse the procedure. 
• These activities will provide some outlet for his otherwise too-pent-up energies. 
• If he is the right kind of investor he will take added satisfaction from the thought that his operations are exactly opposite from those of the crowd.*

* For today’s investor, the ideal strategy for pursuing this “formula” is rebalancing.

Every investor who owns common stocks must expect to see them fluctuate in value over the years.

Market Fluctuations of the Investor’s Portfolio

Every investor who owns common stocks must expect to see them fluctuate in value over the years. 

The behavior of the DJIA since our last edition was written in 1964 probably reflects pretty well what has happened to the stock portfolio of a conservative investor who limited his stock holdings to those of large, prominent, and conservatively financed corporations.

• The overall value advanced from an average level of about 890 to a high of 995 in 1966 (and 985 again in 1968), fell to 631 in 1970, and made an almost full recovery to 940 in early 1971. 
• (Since the individual issues set their high and low marks at different times, the fluctuations in the Dow Jones group as a whole are less severe than those in the separate components.) 
• We have traced through the price fluctuations of other types of diversified and conservative common-stock portfolios and we find that the overall results are not likely to be markedly different from the above. 
• In general, the shares of second-line companies* fluctuate more widely than the major ones, but this does not necessarily mean that a group of well established but smaller companies will make a poorer showing over a fairly long period. 

In any case the investor may as well resign himself in advance to the probability rather than the mere possibility that most of his holdings will advance, say, 50% or more from their low point and decline the equivalent one-third or more from their high point at various periods in the next five years.†




* Today’s equivalent of what Graham calls “second-line companies” would be any of the thousands of stocks not included in the Standard & Poor’s 500-stock index. A regularly revised list of the 500 stocks in the S & P index is available at www.standardandpoors.com.

† Note carefully what Graham is saying here. It is not just possible, but probable, that most of the stocks you own will gain at least 50% from their lowest price and lose at least 33% from their highest price—regardless of which stocks you own or whether the market as a whole goes up or down. 

• If you can’t live with that—or you think your portfolio is somehow magically exempt from it—then you are not yet entitled to call yourself an investor. 
• (Graham refers to a 33% decline as the “equivalent one-third” because a 50% gain takes a $10 stock to $15. From $15, a 33% loss [or $5 drop] takes it right back to $10, where it started.

Ref:  Intelligent Investor by Benjamin Graham

Various methods of taking advantage of the stock market’s cycles: "Formula Investment Plans"

Formula Plans

In the early years of the stock-market rise that began in 1949–50 considerable interest was attracted to various methods of taking advantage of the stock market’s cycles. These have been known as “formula investment plans.” 

• The essence of all such plans—except the simple case of dollar averaging—is that the investor automatically does  some selling of common stocks when the market advances substantially. 
• In many of them a very large rise in the market level would result in the sale of all common-stock holdings; others provided for retention of a minor proportion of equities under all circumstances.

This approach had the double appeal of sounding logical (and conservative) and of showing excellent results when applied retrospectively to the stock market over many years in the past. Unfortunately, its vogue grew greatest at the very time when it was destined to work least well.

• Many of the “formula planners” found themselves entirely or nearly out of the stock market at some level in the middle 1950s. 
• True, they had realized excellent profits, but in a broad sense the market “ran away” from them thereafter, an their formulas gave them little opportunity to buy back a commonstock position.*

There is a similarity between the experience of those adopting the formula-investing approach in the early 1950s and those who embraced the purely mechanical version of the Dow theory some 20 years earlier.

• In both cases the advent of popularity marked almost the exact moment when the system ceased to work well. 
• We have had a like discomfiting experience with our own “central value method” of determining indicated buying and selling levels of the Dow Jones Industrial Average. 
• The moral seems to be that any approach to moneymaking in the stock market which can be easily described and followed by a lot of people is by its terms too simple and too easy to last.† 
• Spinoza’s concluding remark applies to Wall Street as well as to philosophy: “All things excellent are as difficult as they are rare.”

* Many of these “formula planners” would have sold all their stocks at the  end of 1954, after the U.S. stock market rose 52.6%, the second-highest  yearly return then on record. Over the next five years, these market-timers would likely have stood on the sidelines as stocks doubled.

† Easy ways to make money in the stock market fade for two reasons: 

• the 
  natural tendency of trends to reverse over time, or “regress to the mean,” and,
• the rapid adoption of the stock-picking scheme by large numbers of people, who pile in and spoil all the fun of those who got there first. 

(Note that, in referring to his “discomfiting experience,” Graham is—as always— honest in admitting his own failures.) 

Ref:  Chap 8 Intelligent Investor by Benjamin Graham

Can the average investors benefit by buying AFTER each major decline and selling out AFTER each major advance?

Buy-Low–Sell-High Approach

We are convinced that the average investor cannot deal successfully with price movements by endeavoring to forecast them. Can he benefit from them after they have taken place—i.e., by buying after each major decline and selling out after each major advance?

The fluctuations of the market over a period of many years prior to 1950 lent considerable encouragement to that idea.

• In fact, a classic definition of a “shrewd investor” was “one who bought in a bear market when everyone else was selling, and sold out in a bull market when everyone else was buying.” 
• If we examine the fluctuations of the Standard & Poor’s composite index between 1900 and 1970, we can readily see why this viewpoint appeared valid until fairly recent years.

Between 1897 and 1949 there were ten complete market cycles, running from bear-market low to bull-market high and back to bear-market low.

• Six of these took no longer than four years, four ran for six or seven years, and one—the famous “new-era” cycle of 1921–1932—lasted eleven years. 
• The percentage of advance from the lows to highs ranged from 44% to 500%, with most between about 50% and 100%. 
• The percentage of subsequent declines ranged from 24% to 89%, with most found between 40% and 50%. (It should be remembered that a decline of 50% fully offsets a preceding advance of 100%.)

Nearly all the bull markets had a number of well-defined characteristics in common, such as 

• (1) a historically high price level, 
• (2) high price/earnings ratios, 
• (3) low dividend yields as against bond yields, 
• (4) much speculation on margin, and 
• (5) many offerings of new common-stock issues of poor quality. 

Thus to the student of stock-market history it appeared that the intelligent investor should have been able 

• to identify the recurrent bear and bull markets,
• to buy in the former and sell in the latter, and 
• to do so for the most part at reasonably short intervals of time. 

Various methods were developed for determining buying and selling levels of the general market, based on either 

• value factors or 
• percentage movements of prices or 
• both. 

But we must point out that even prior to the unprecedented bull market that began in 1949, there were sufficient variations in the successive market cycles to complicate and sometimes frustrate the desirable process of buying low and selling high. 

• The most notable of these departures, of course, was the great bull market of the late 1920s, which threw all calculations badly out of gear.* 
• Even in 1949, therefore, it was by no means a certainty that the investor could base his financial policies and procedures mainly on the endeavor to buy at low levels in bear markets and to sell out at high levels in bull markets. 

It turned out, in the sequel, that the opposite was true. 

• The market’s behavior in the past 20 years has not followed the former pattern, nor obeyed what once were well-established danger signals, nor permitted its successful exploitation by applying old rules for buying low and selling high. 
• Whether the old, fairly regular bull-and-bear-market pattern will eventually return we do not know. 
• But it seems unrealistic to us for the investor to endeavor to base his present policy on the classic formula—i.e., to wait for demonstrable bear-market levels before buying  any common stocks. 

Our recommended policy has, however, 

• made provision for changes in the  proportion of common stocks to bonds in the portfolio, 
• if the investor chooses to do so, 
• according as the level  of stock prices appears less or more attractive by value standards.*

Dow Theory for Timing Purchases and Sales - As their acceptance increases, their reliability tends to diminish

In this respect the famous Dow theory for timing purchases and sales has had an unusual history.* Briefly, this technique takes its signal to buy from a special kind of “breakthrough” of the stock averages on the up side, and its selling signal from a similar breakthrough on the down side. 

• The calculated—not necessarily actual—results of using this method showed an almost unbroken series of profits in operations from 1897 to the early 1960s. 
• On the basis of this presentation the practical value of the Dow theory would have appeared firmly established; the doubt, if any, would apply to the dependability of this published “record” as a picture of what a Dow theorist would actually have done in the market.

A closer study of the figures indicates that the quality of the results shown by the Dow theory changed radically after 1938—a few years after the theory had begun to be taken seriously on Wall Street.

• Its spectacular achievement had been in giving a sell signal, at 306, about a month before the 1929 crash and in keeping its followers out of the long bear market until things had pretty well righted themselves, at 84, in 1933. 
• But from 1938 on the Dow theory operated mainly by taking its practitioners out at a pretty good price but then putting them back in again at a higher price.  
• For nearly 30 years thereafter, one would have done appreciably better by just buying and holding the DJIA.

In our view, based on much study of this problem, the change in the Dow-theory results is not accidental. It demonstrates an inherent characteristic of forecasting and trading formulas in the fields of business and finance. 

• Those formulas that gain adherents and importance do so because they have worked well over a period, or sometimes merely because they have been plausibly adapted to the statistical record of the past. 

But as their acceptance increases, their reliability tends to diminish. This happens for two reasons:

• First, the passage of time brings new conditions which the old formula no longer fits. 
• Second, in stock-market affairs the popularity of a trading theory has itself an influence on the market’s behavior which detracts in the long run from its profit-making possibilities. 
• (The popularity of something like the Dow theory may seem to create its own vindication, since it would make the market advance or decline by the very action of its followers when a buying or selling signal is given. A “stampede” of this kind is, of course, much more of a danger than an advantage to the public trader.)

Timing is of no real value to the investor unless it coincides with pricing

The farther one gets from Wall Street, the more skepticism one will find, we believe, as to the pretensions of stock-market forecasting or timing. 

• The investor can scarcely take seriously the innumerable predictions which appear almost daily and are his for the asking. 
• Yet in many cases he pays attention to them and even acts upon them. 

Why? Because he has been persuaded that

•  it is important for him to form some opinion of the future course of the stock market, and 
• because he feels that the brokerage or service forecast is at least more dependable than his own.*

A great deal of brain power goes into this field, and undoubtedly some people can make money by being good stockmarket analysts. But it is absurd to think that the general public can ever make money out of market forecasts. 

• For who will buy when the general public, at a given signal, rushes to sell out at a profit? 
• If you, the reader, expect to get rich over the years by following some system or leadership in market forecasting, you must be expecting to try to do what countless others are aiming at, and to be able to do it better than your numerous competitors in the market. 
• There is no basis either in logic or in experience for assuming that any typical or average investor can anticipate market movements more successfully than the general public, of which he is himself a part.

There is one aspect of the “timing” philosophy which seems to have escaped everyone’s notice.

• Timing is of great psychological importance to the speculator because he wants to make his profit in a hurry. 
• The idea of waiting a year before his stock moves up is repugnant to him. 

But a waiting period, as such, is of no consequence to the investor. 

• What advantage is there to him in having his money uninvested until he receives some (presumably) trustworthy signal that the time has come to buy? 
• He enjoys an advantage only if by  waiting he succeeds in buying later at a sufficiently lower price to offset his loss of dividend income. 
• What this means is that timing is of no real value to the investor unless it coincides with pricing—that is, unless it enables him to repurchase his shares at substantially under his previous selling price.

Two ways to profit from the market swings: Timing or Pricing

Since common stocks, even of investment grade, are subject to recurrent and wide fluctuations in their prices, the intelligent investor should be interested in the possibilities of profiting from these pendulum swings. There are two possible ways by which  he may try to do this:

• the way of timing and 
• the way of  pricing.

By timing we mean the endeavor to anticipate the action of the stock market—

• to buy or hold when the future course is deemed to be upward, 
• to sell or refrain from buying when the course is downward. 

By pricing we mean the endeavor

• to buy stocks when they are quoted below their fair value and 
• to sell them when they rise above such value. 

A less ambitious form of pricing is  the simple effort to make sure that when you buy you do not  pay too much for your stocks. 

• This may suffice for the defensive investor, whose emphasis is on long-pull holding; but as  such it represents an essential minimum of attention to market levels.

We are convinced that the intelligent investor can derive satisfactory results from pricing of either type. 

We are equally sure that if he places his emphasis on timing, in the sense of forecasting, he will end up as a speculator and with a speculator’s financial results. 

This distinction may seem rather tenuous to the layman, and it is not commonly accepted on Wall Street. As a matter of business practice, or perhaps of thoroughgoing conviction, the stock brokers and the investment services seem wedded to the principle that both investors and speculators in common stocks should devote careful attention to market forecasts.

The Investor and Market Fluctuations

To the extent that the investor’s funds are placed

• in high-grade bonds of relatively short maturity—say, of seven years or less—he will not be affected significantly by changes in market prices and need not take them into account. 
• (This applies also to his holdings of U.S. savings bonds, which he can always turn in at his cost price or more.) 
• His longer-term bonds may have relatively wide price swings during their lifetimes, and 
• his common-stock portfolio is almost certain to fluctuate in value over any period of several years.

The investor should know about these possibilities and should be prepared for them both financially and psychologically.  He will want to benefit from changes in market levels—

• certainly through an advance in the value of his stock holdings as time goes on, and 
• perhaps also by making purchases and sales at advantageous prices. 

This interest on his part is inevitable, and legitimate enough. But it involves the very real danger that it will lead him into speculative attitudes and activities. 

• It is easy for us to tell you not to speculate; the hard thing will be for you to follow this advice. 
• Let us repeat what we said at the outset: If you want to speculate do so with your eyes open, knowing that you will probably lose money in the end; be sure to limit the amount at risk and to separate it completely from your investment program.

What can the past record of the market actions promises the investor—

• in either the form of long-term appreciation of a portfolio held relatively unchanged through successive rises and declines, 
• or in the possibilities of buying near bear-market lows and selling not too far below bull-market highs?

Ref:  Intelligent Investor by Benjamin Graham.

Public Bank Berhad (At a Glance)

Public Bank Berhad 2011 2010               Change Operating revenue 12756.360 11035.597 15.6% Interest income 4974.931 4597.420 8.2% Net income (Islamic banking) 868.342 781.288 11.1% 5843.273 5378.708 8.6% Net fee & commission income 1118.909 1031.770 8.4% Net income 7408.570 6838.500 8.3% Operating profit  5199.886 4738.265 9.7% Allowance for impairment -594.061 -659.566 -9.9% Profit before tax and zakat 4610.633 4086.197 12.8% Profit for the year 3524.024 3099.077 13.7% Earning per RM 1 share (sen) 99.500 87.200 14.1% Total assets 249410.982 226328.976 10.2% Total equity 15560.706 13685.088 13.7% Net assets per share 4.24 3.72 14.0% Net profit margin 27.63% 28.08% -1.6% Asset turnover 0.051 0.049 4.9% Financial leverage 16.0 16.5 -3.1% ROA 1.41% 1.37% 3.2% ROE 22.65% 22.65% 0.0% Share Information and Valuation Share Information Per share (sen) Basic earnings 99.5 Diluted earnings 99.5 Net dividend -Cash dividend  48.0 sen -Share dividend  - Net assets 424.4 Share price as at 31.12.2011 (RM) - Local 13.38 - Foreign 13.20 Market capitalisation (RM Million)  47,066 Valuation (Local Share) Net dividend yield (%)  3.6 Net dividend yield (including share dividend) [%] 3.6 Dividend payout ratio (%) 48.3 Dividend payout ratio (including share dividend) [%] 48.3 Price to earnings multiple (times)  13.4 Price to book multiple (times)  3.2 Historical EPS & Net Dividends (sen) 2011 EPS  99.5 Cash Dividend  48.0 Share Dividend - 2010  EPS  87.2 Cash Dividend 45.5 Share Dividend - 2009 EPS  73.3 Cash Dividend  41.3 - Share Dividend  1 for 68 2008 EPS  76.9 Cash Dividend 41.0 Share Dividend  1 for 35 2007 EPS  63.3 Cash  Dividend  55.3 Share Dividend -

Recent Financial Results

Announcement Date		Financial Yr. End		Qtr	Period End		Revenue RM '000		Profit/Lost RM'000		EPS		Amended
30-Jan-12		31-Dec-11		4	31-Dec-11		3,321,633		886,054		25.04		-
17-Oct-11		31-Dec-11		3	30-Sep-11		3,272,466		907,897		25.66		-
25-Jul-11		31-Dec-11		2	30-Jun-11		3,170,654		891,444		25.14		-
18-Apr-11		31-Dec-11		1	31-Mar-11		2,991,607		838,629		23.63		Amended

Silver Bird - Could Fundamental Analysis prevent you from investing into this stock?

Unaudited FY 2011 account of Silver Bird

Revenue

2011  612.746m

2010  593.507m

Earnings

2011  4.934m (Diluted EPS 1.24 sen)

2010  3.655m

Total Asset 382.970m

Total Equity 213.424m  (Net Asset per Share RM 0.52) (Accumulated Losses 44.139m)

Net Profit Margin 0.8%

Asset Turnover 1.6x

Financial Leverage 1.79x

ROA 1.28%

ROTC 1.51%

ROE 2,29%  

Cash 34.699m

Bank balances 3.704m

Cash & Equivalent 38.403m 

LT Borrowings ( 24.694m)

ST Borrowings (126.772m)

Net Debt  (113.063m)

CA 169.083m

CL 144.088m

Working capital 24.995m

CA/CL = 1.729m

Inventories  15.016m

Trade receivables 87.459m (2010:  51.168m)

Other receivables 28.204m (2010: 18.467m)

Trade payables 10.411m

Other paybales 6.732m

Net CFO (25.582m)

CFI (6.259m)

CFF 21.125m

Net decrease in cash (10.716m)

Dividend 0

Valuations

Price 20.5 sen

No. of ordinary shares issued and issuable 396.387m

Market Cap 81.23m

P/E 16,5x

P/BV  0.394x

DY 0%

Could fundamental analysis guide you from investing into this stock?


The answer is YES.  The business fundamentals of this company are extremely lousy and there are enough red flags in its accounts to warrant caution or avoidance of this stock.


Please click below to read the post by BENGRAM for a more detailed explanation.
http://www.investlah.com/forum/index.php/topic,39283.msg770490.html#msg770490

Warren Buffett: Leverage is also a way to get very poor.

Unquestionably, some people have become very rich through the use of borrowed money. However, that’s also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. 

• And as we all learned in third grade – and some relearned in 2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. 
• History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.

Leverage, of course, can be lethal to businesses as well. Companies with large debts often assume that these obligations can be refinanced as they mature. That assumption is usually valid. Occasionally, though, either because of company-specific problems or a worldwide shortage of credit, maturities must actually be met by payment. For that, only cash will do the job.

Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed. When either is missing, that’s all that is noticed.

• Even a short absence of credit can bring a company to its knees. 
• In September 2008, in fact, its overnight disappearance in many sectors of the economy came dangerously close to bringing our entire country to its knees.

By being so cautious in respect to leverage, we penalize our returns by a minor amount. Having loads of liquidity, though, lets us sleep well. 

• Moreover, during the episodes of financial chaos that occasionally erupt in our economy, we will be equipped both financially and emotionally to play offense while others scramble for survival. 
• That’s what allowed us to invest $15.6 billion in 25 days of panic following the Lehman bankruptcy in 2008.

http://www.berkshirehathaway.com/letters/2010ltr.pdf

Buffett: What students should be learning is how to value a business.

John Kenneth Galbraith once slyly observed that economists were most economical with ideas: They made the ones learned in graduate school last a lifetime. University finance departments often behave similarly. Witness the tenacity with which almost all clung to the theory of efficient markets throughout the 1970s and 1980s, dismissively calling powerful facts that refuted it “anomalies.” (I always love explanations of that kind: The Flat Earth Society probably views a ship’s circling of the globe as an annoying, but inconsequential, anomaly.)

Academics’ current practice of teaching Black-Scholes as revealed truth needs re-examination. For that matter, so does the academic’s inclination to dwell on the valuation of options. You can be highly successful as an investor without having the slightest ability to value an option. What students should be learning is how to value a business. That’s what investing is all about.

http://www.berkshirehathaway.com/letters/2010ltr.pdf

Buffett: Ownership of commercial "cows" (first class businesses) over any extended period of time will prove to be rewarding and by far the safest.

Our first two categories, namely cash and gold, enjoy maximum popularity at peaks of fear:

• Terror over economic collapse drives individuals to currency-based assets, most particularly U.S. obligations, and fear of currency collapse fosters movement to sterile assets such as gold. 
• We heard “cash is king” in late 2008, just when cash should have been deployed rather than held. 
• Similarly, we heard “cash is trash” in the early 1980s just when fixed-dollar investments were at their most attractive level in memory. 
• On those occasions, investors who required a supportive crowd paid dearly for that comfort.

My own preference – and you knew this was coming – is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times

-  to deliver output that will retain its purchasing-power value 
- while requiring a minimum of new capital investment. 

• Farms, real estate, and many businesses such as Coca-Cola, IBM and our own See’s Candy meet that double-barreled test.
• Certain other companies – think of our regulated utilities, for example – fail it because inflation places heavy capital requirements on them. To earn more, their owners must invest more.
• Even so, these investments will remain superior to nonproductive or currency-based assets.

Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See’s peanut brittle. In the future the U.S. population will move more goods, consume more food, and require more living space than it does now. People will forever exchange what they produce for what others produce.

Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens. Metaphorically, these commercial “cows” will live for centuries and give ever greater quantities of “milk” to boot. 

• Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. 
• Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased from 66 to 11,497 (and paid loads of dividends as well). 

Berkshire’s goal will be to increase its ownership of first-class businesses.

• Our first choice will be to own them in their entirety – but we will also be owners by way of holding sizable amounts of marketable stocks.
•  I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined. 
• More important, it will be by far the safest.

http://www.berkshirehathaway.com/letters/2011ltr.pdf

Gold: Bubbles blown large enough inevitably pop. “What the wise man does in the beginning, the fool does in the end.”

The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.

The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative.

• True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. 
• Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct.

• Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. 
• As “bandwagon” investors join any party, they create their own truth – for a while.

Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. 

• In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. 
• But bubbles blown large enough inevitably pop. 
• And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.”

Today the world’s gold stock is about 170,000 metric tons.

• If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) 
• At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A.

Let’s now create a pile B costing an equal amount.

• For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). 
• After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). 

Can you imagine an investor with $9.6 trillion selecting pile A over pile B?

Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. 

• Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices.

A century from now

• the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. 
• Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). 
• The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.

Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.

http://www.berkshirehathaway.com/letters/2011ltr.pdf

Cash and related currency assets: Their beta may be zero, but their risk is huge.

Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.”  In truth they are among the most dangerous of assets.

• Their beta may be zero, but their risk is huge. 
• Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. 
• This ugly result, moreover, will forever recur. 
• Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control.

Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire.

• It takes no less than $7 today to buy what $1 did at that time.
• Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. 
• Its managers would have been kidding themselves if they thought of any portion of that interest as “income.”

For tax-paying investors like you and me, the picture has been far worse. During the same 47-year period, continuous rolling of U.S. Treasury bills produced 5.7% annually. That sounds satisfactory.

• But if an individual investor paid personal income taxes at a rate averaging 25%, this 5.7% return would have yielded nothing in the way of real income. 
• This investor’s visible income tax would have stripped him of 1.4 points of the stated yield, and 
• the invisible inflation tax would have devoured the remaining 4.3 points.
• It’s noteworthy that the implicit inflation “tax” was more than triple the explicit income tax that our investor probably thought of as his main burden. 
• “In God We Trust” may be imprinted on our currency, but the hand that activates our government’s printing press has been all too human.

High interest rates, of course, can compensate purchasers for the inflation risk they face with currency-based investments – and indeed, rates in the early 1980s did that job nicely. 

• Current rates, however, do not come close to offsetting the purchasing-power risk that investors assume. 
• Right now bonds should come with a warning label.

Under today’s conditions, therefore, I do not like currency-based investments. Even so, Berkshire holds significant amounts of them, primarily of the short-term variety.

• At Berkshire the need for ample liquidity occupies center stage and will never be slighted, however inadequate rates may be.  
• Accommodating this need, we primarily hold U.S. Treasury bills, the only investment that can be counted on for liquidity under the most chaotic of economic conditions. 
• Our working level for liquidity is $20 billion; $10 billion is our absolute minimum.

Beyond the requirements that liquidity and regulators impose on us, we will purchase currency-related securities only if they offer the possibility of unusual gain – either

• because a particular credit is mispriced, as can occur in periodic junk-bond debacles, or
• because rates rise to a level that offers the possibility of realizing substantial capital gains on high-grade bonds when rates fall. 

Though we’ve exploited both opportunities in the past – and may do so again – we are now 180 degrees removed from such prospects. Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.”


http://www.berkshirehathaway.com/letters/2011ltr.pdf

Volatility is not risk. Risk is the reasoned probability of that investment causing it's owner a loss of purchasing power over his contemplated holding period.

Investing is often described as the process of laying out money now in the expectation of receiving more money in the future.

At Berkshire we take a more demanding approach, defining investing as

•  the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future. 
• More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.

From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period. 

• Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. 
• And as we will see, a non-fluctuating asset can be laden with risk.

Investment possibilities are both many and varied.



http://www.berkshirehathaway.com/letters/2011ltr.pdf

Interesting to Note that this is a development that hurts Berkshire Hathaway during 2011

-  Three large and very attractive fixed-income investments were called away from us by their issuers in 2011. Swiss Re, Goldman Sachs and General Electric paid us an aggregate of $12.8 billion to redeem securities that were producing about $1.2 billion of pre-tax earnings for Berkshire. That’s a lot of income to replace, though our Lubrizol purchase did offset most of it.

http://www.berkshirehathaway.com/letters/2011ltr.pdf


Comment:  Buffett emphasizes increasing the aggregate pre-tax earnings and incomes.  He reinvests into or replaces companies, to achieve growth in aggregate pre-tax earnings and incomes.   This is very sound strategy to follow.

Buffett: In my early days I, too, rejoiced when the market rose. Now, low prices became my friend.

Buffett highlights the irrational reaction of many investors to changes in stock prices.


Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%.  Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us.  Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period?

I won’t keep you in suspense. We should wish for IBM’s stock price to languish throughout the five years.

----



The logic is simple: 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. And here
a confession is in order: In my early days I, too, rejoiced when the market rose. Then I read Chapter Eight of Ben Graham’s The Intelligent Investor, the chapter dealing with how investors should view fluctuations in stock prices. Immediately the scales fell from my eyes, and low prices became my friend. Picking up that book was one of the luckiest moments in my life.

In the end, the success of our IBM investment will be determined primarily by its future earnings. But an important secondary factor will be how many shares the company purchases with the substantial sums it is likely to devote to this activity. And if repurchases ever reduce the IBM shares outstanding to 63.9 million,  I will abandon my famed frugality and give Berkshire employees a paid holiday. 

-----


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. A corollary to this second point: “Talking our book” about a stock we own – were that to be effective – would actually be harmful to Berkshire, not helpful as commentators customarily assume.

http://www.berkshirehathaway.com/letters/2011ltr.pdf

Share Buybacks: Mixed Emotions evoked when Berkshire shares sell well below Intrinsic Value

Share Repurchases


Last September, we announced that Berkshire would repurchase its shares at a price of up to 110% of book value. We were in the market for only a few days – buying $67 million of stock – before the price advanced beyond our limit. Nonetheless, the general importance of share repurchases suggests I should focus for a bit on the subject.

Charlie and I favor repurchases when two conditions are met: 

• first, a company has ample funds to take care of the operational and liquidity needs of its business; 
• second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated. 

We have witnessed many bouts of repurchasing that failed our second test. Sometimes, of course, infractions – even serious ones – are innocent; many CEOs never stop believing their stock is cheap. In other instances, a less benign conclusion seems warranted.

• It doesn’t suffice to say that repurchases are being made to offset the dilution from stock issuances or simply because a company has excess cash. 
• Continuing shareholders are hurt unless shares are purchased below intrinsic value. 

The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another. (One CEO who always stresses the price/value factor in repurchase decisions is Jamie Dimon at J.P. Morgan; I recommend that you read his annual letter.)

Charlie and I have mixed emotions when Berkshire shares sell well below intrinsic value. We like making money for continuing shareholders, and there is no surer way to do that than by buying an asset – our
own stock – that we know to be worth at least x for less than that – for .9x, .8x or even lower. (As one of our directors says, it’s like shooting fish in a barrel, after the barrel has been drained and the fish have quit flopping.)

Nevertheless, we don’t enjoy cashing out partners at a discount, even though our doing so may give the selling shareholders a slightly higher price than they would receive if our bid was absent. 

• When we are buying, therefore, we want those exiting partners to be fully informed about the value of the assets they are selling. 
• At our limit price of 110% of book value, repurchases clearly increase Berkshire’s per-share intrinsic value. 
• And the more and the cheaper we buy, the greater the gain for continuing shareholders. 

Therefore, if given the opportunity, we will likely repurchase stock aggressively at our price limit or lower.

You should know, however, that

• we have no interest in supporting the stock and that our bids will fade in particularly weak markets.
• Nor will we buy shares if our cash-equivalent holdings are below $20 billion. At Berkshire, financial strength that is unquestionable takes precedence over all else.

http://www.berkshirehathaway.com/letters/2011ltr.pdf

Boosting Berkshire Hathaway Profits: Through organic growth and through purchasing some large operations.

-  I also included two tables last year that set forth the key quantitative ingredients that will help you estimate our per-share intrinsic value. I won’t repeat the full discussion here; you can find it reproduced on pages 99-100. To update the tables shown there, our per-share investments in 2011 increased 4% to $98,366, and
our pre-tax earnings from businesses other than insurance and investments increased 18% to $6,990 per share.

Charlie and I like to see gains in both areas, but our primary focus is on building operating earnings. Over time, the businesses we currently own should increase their aggregate earnings, and we hope also to purchase some large operations that will give us a further boost. We now have eight subsidiaries that would each be included in the Fortune 500 were they stand-alone companies. That leaves only 492 to go. My task is clear, and I’m on the prowl.


Comment:  In managing Berkshire Hathaway, Buffett's primary focus in on building operating earnings.  He expects his existing companies can increase their aggregate earnings.  He hopes to boost these earnings further through purchasing some large operations.

Intrinsic Business Value - Look for the long term growth in the intrinsic values of your invested businesses.

Intrinsic Business Value


Charlie and I measure our performance by the rate of gain in Berkshire’s per-share intrinsic business value. If our gain over time outstrips the performance of the S&P 500, we have earned our paychecks. If it doesn’t, we are overpaid at any price.

We have no way to pinpoint intrinsic value. But we do have a useful, though considerably understated, proxy for it: per-share book value. This yardstick is meaningless at most companies. At Berkshire, however, book value very roughly tracks business values. That’s because the amount by which Berkshire’s intrinsic value exceeds book value does not swing wildly from year to year, though it increases in most years. Over time, the divergence will likely become ever more substantial in absolute terms, remaining reasonably steady, however, on a percentage basis as both the numerator and denominator of the business-value/book-value equation increase.

Comment:  It is not easy to determine intrinsic value.  The best PROXY for intrinsic value of Berkshire Hathaway is its book value.  Though this closely tracks the intrinsic value of Berkshire Hathaway,  it actually understates the intrinsic value of the company.  Nevertheless, Buffett opines that using book value to denote intrinsic value is meaningless for most other companies.


We’ve regularly emphasized that our book-value performance is almost certain to outpace the S&P 500 in a bad year for the stock market and just as certainly will fall short in a strong up-year. The test is how we do over time. Last year’s annual report included a table laying out results for the 42 five-year periods since we took over at Berkshire in 1965 (i.e., 1965-69, 1966-70, etc.). All showed our book value beating the S&P, and our string held for 2007-11. It will almost certainly snap, though, if the S&P 500 should put together a five-year winning streak (which it may well be on its way to doing as I write this)

Comment:  Psychological forces trump the fundamental forces in the short term.  In the long term, the fundamental forces always trump the psychological forces that affect the stock price of a company.  Buffett looks at long term performances.  He highlighted that in any given 5 year period, the percentage gains in book value of Berkshire Hathaway have beaten those offered by the S&P 500.

http://www.berkshirehathaway.com/letters/2011ltr.pdf

Buffett's Big 4 Investments in Marketable Securities - American Express, Coca Cola, IBM and Wells Fargo

-  Finally, we made two major investments in marketable securities:

• (1) a $5 billion 6% preferred stock of Bank of America that came with warrants allowing us to buy 700 million common shares at $7.14 per share any time before September 2, 2021; and 
• (2) 63.9 million shares of IBM that cost us $10.9 billion. 

Counting IBM, we now have large ownership interests in four exceptional companies:

• 13.0% of American Express, 
• 8.8% of Coca-Cola, 
• 5.5% of IBM and 
• 7.6% of Wells Fargo. 
• (We also, of course, have many smaller, but important, positions.)

Comment:  "Buying wonderful company at fair price" and "holding period is forever".   This is classically Buffett's style.


We view these holdings as partnership interests in wonderful businesses, not as marketable securities to be bought or sold based on their near-term prospects. Our share of their earnings, however, are far from fully reflected in our earnings; only the dividends we receive from these businesses show up in our financial reports. Over time, though, the undistributed earnings of these companies that are attributable to our ownership are of huge importance to us. That’s because they will be used in a variety of ways to increase future earnings and dividends of the investee. They may also be devoted to stock repurchases, which will increase our share of the company’s future earnings.

Comment:  Buffett buys and holds for the long term.  He keeps these companies for their long-term prospects, knowing that he will obtain good returns from these companies, either through the dividends they distribute or through the undistributed growing earnings attributable to the owners from its reinvested retained earnings.


-  Had we owned our present positions throughout last year, our dividends from the “Big Four” would have been $862 million. That’s all that would have been reported in Berkshire’s income statement. Our share of this quartet’s earnings, however, would have been far greater: $3.3 billion. Charlie and I believe that the $2.4 billion that goes unreported on our books creates at least that amount of value for Berkshire as it fuels earnings gains in future years. We expect the combined earnings of the four – and their dividends as well – to increase in 2012 and, for that matter, almost every year for a long time to come. A decade from now, our current holdings of the four companies might well account for earnings of $7 billion, of which $2 billion in dividends would come to us.


Comment:  Only the dividends received are reported in Berkshire Hathaways account.  This is only a fraction (36%) of the actual earnings of $3.3 billion.  Buffett opines that these dividends will continue to grow as the retained earnings fuel earnings gains in future years.  I like the way Buffett projects the future earnings of these companies.

• For present earnings of $3 billion to grow to $7 billion in 10 years, he is projecting a CAG of 8.84%.  
• Projecting the dividends of $862 million growing to $2 billion in a decade is the equivalent of the dividends growing at a CAG of  8.77% for the same period.  
• The growth rates used in his projections are very conservative (8.84% and 8.77%).  Maybe Buffett just uses his simple rule of thumb of doubling the earnings or dividends every 10 years.
• Once again, he reiterates that $1 retained earnings by the company should deliver at least $1 value to the shareholder.

http://www.berkshirehathaway.com/letters/2011ltr.pdf

Buffett Loves The Insurance Operations that deliver "float" or costless capital of $70 BILLION .

• Our insurance operations continued their delivery of costless capital that funds a myriad of other opportunities.

• This business produces “float” – money that doesn’t belong to us, but that we get to invest for Berkshire’s benefit. 
• And if we pay out less in losses and expenses than we receive in premiums, we additionally earn an underwriting profit, meaning the float costs us less than nothing. 
• Though we are sure to have underwriting losses from time to time, we’ve now had nine consecutive years of underwriting profits, totaling about $17 billion. 
• Over the same nine years our float increased from $41 billion to its current record of $70 billion. Insurance has been good to us

http://www.berkshirehathaway.com/letters/2011ltr.pdf

Growth Investing Examples from Berkshire Hathaway

-  On September 16th we acquired Lubrizol, a worldwide producer of additives and other specialty chemicals. The company has had an outstanding record since James Hambrick became CEO in 2004, with pre-tax profits increasing from $147 million to $1,085 million. Lubrizol will have many opportunities for “bolt-on” acquisitions in the specialty chemical field. Indeed, we’ve already agreed to three, costing $493 million. James is a disciplined buyer and a superb operator. Charlie and I are eager to expand his managerial domain.

Comment:  Lubrizol grew its pre-tax profits from $147 million from 2004 to $1,085 million.   Thus its pre-tax profit has grown at the compound annual growth rate of 33.05% over 7 years.

• Buffett likes this company for its good earnings growth.  
• The good earnings growth rate also is reflective of the good business fundamentals of this company.
• Buffett loves buying / owning wonderful company (that are growing).

-  Our major businesses did well last year. In fact, each of our five largest non-insurance companies – BNSF, Iscar, Lubrizol, Marmon Group and MidAmerican Energy – delivered record operating earnings. In aggregate these businesses earned more than $9 billion pre-tax in 2011. Contrast that to seven years ago, when we owned only one of the five, MidAmerican, whose pre-tax earnings were $393 million. Unless the economy weakens in 2012, each of our fabulous five should again set a record, with aggregate earnings comfortably topping $10 billion.

Comment:  

1994:  Mid American contributed pre-tax earnings of $393 million.

2011:  BSNF, Iscar, Lubrizol, Marmon Group and MidAmerican Energy earned $9 billion pre-tax.

• BSNF and Lubrizol are recent acquisitions of Buffett.  
• Buffett likes these companies for their earnings and growth.  
• Buffett even projected that their aggregate earnings will top $10 billion next year, 2012 (a growth rate of 11%).

-   In total, our entire string of operating companies spent $8.2 billion for property, plant and equipment in 2011, smashing our previous record by more than $2 billion. About 95% of these outlays were made in the U.S., a fact that may surprise those who believe our country lacks investment opportunities. We welcome projects abroad, but expect the overwhelming majority of Berkshire’s future capital commitments to be in America. In 2012, these expenditures will again set a record.

Comment:  

Yes, to grow one has to re-invest.  Looks like Buffett reinvest all the free cash flows ($8.2 billion capital expenditure) for future growth.

http://www.berkshirehathaway.com/letters/2011ltr.pdf