## Saturday, 25 December 2010

### The Mark of a Good Business: High Returns on Capital

“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” – Warren Buffett, 1992 Berkshire Hathaway Shareholder Letter

It is useful here to remember Buffett’s reminder that it is not necessarily a cause for celebration if a business grows its earnings year after year. The same thing happens to a savings account if you add more capital each year, which does not make a savings account a good investment. It’s the return on this additional capital that determines whether something is a good investment or not.

To illustrate, let’s look at Johnson & Johnson (JNJ). In 2000, JNJ had shareholders’ equity of \$18.8 billion. At the end of 2009, its shareholders’ equity had grown to \$50.6 billion. We can calculate that, since 2000, JNJ invested \$31.8 billion back into the business.

During that same time, earnings grew \$8.1 billion, from \$4.8 billion in 2000 to \$12.9 billion in 2009.

By dividing the additional earnings of \$8.1 billion by the additional \$31.8 billion in capital, we can see that JNJ earned a return of 25.5% on its investment, which is very good.

It is also useful to look at what percentage of its total net earnings JNJ reinvested back into the business. The reason is that this is suggestive of how much of its future earnings JNJ is likely to reinvest. By multiplying the rate of reinvestment by the return on that investment, we can then calculate an expected growth rate for earnings.

Since 2000 through 2009, JNJ earned a total net profit of \$89.7 billion. Since we already know that JNJ reinvested \$31.8 billion over that same time period, we can calculate that JNJ’s rate of reinvestment is 35.5%.

If JNJ can continue to earn 25.5% on equity and reinvest 35.5% of its earnings, earnings should grow at about 9% (.255 x .355).

Keep in mind that this does not include dividends or share repurchases. The latter would cause earnings per share to grow at a faster rate. Also, it does not include an analysis of where JNJ is selling in relation to its intrinsic value which could have a material impact on the expected total return. Finally, this type of analysis works best with a stable business that enjoys durable competitive advantages, such as JNJ.

Another example is Southwest Airlines which is a successful airline that operates in the highly competitive and capital intensive airline industry. Between 2000 and 2009, Southwest’s shareholders’ equity increased by \$2 billion. Earnings were \$140 million in 2009 compared to \$625 million in 2000 and have generally bobbed around over that time period. The return on that additional \$2 billion has been relatively poor.

Calculating the return on incremental equity over a long-period of time should prove a useful tool in your analysis of prospective investments. Coupled with the rate of reinvestment, it can also allow you to get an idea of how fast a company can be expected to grow its earnings.

http://gregspeicher.com/?p=1660

### Knowing a Business Leads to Investing Success. Act Like an Owner

Written by Greg Speicher on September 29, 2010

Great investing may be simple, but it is not easy. It requires that you master not only a number of analytical skills, but also your own emotions.

One of the mistakes that investors make is spending too much time studying investment philosophy and process, and not enough time studying businesses. Investment philosophy and methodology will never be a substitute for knowing a business inside out.

When you come across a “millionaire next door”, he or she probably made their money by mastering a small corner of the business world, not spending endless hours studying management theory or entrepreneurship.

Think Rose Blumpkin. She had an advantage over her competitors because of her relentless focus on the furniture business.

### Buffett on How to Allocate Captital

Buffett on How to Allocate Captital
Written by Greg Speicher on November 20, 2009 - 0 Comments

At the recent CNBC Town Hall Event at Columbia Warren Buffett and Bill Gates: Keeping America Great, Buffett was asked how an individual investor should allocate capital.

QUESTION: Hi, I’m Brian Seedabalker. I’m a second-year student. Mr. Buffett, it’s great to see you again. I was on the trip to Omaha last month. Thank you for hosting us. My question is, how would you recommend an individual investor who follows the Graham and Dodd philosophy to allocate their capital today?

BUFFETT: Well, it depends whether they are going to be an active investor. Graham distinguished between the defensive and the enterprising and that. So if you are going to spend a lot of time on investment, you know I just advise looking at as many things as possible and you will find some bargains. And when you find them, you have to act. It doesn’t — it hasn’t changed at all since I was here in 1950, 1951. And it won’t change the rest of my life. You start turning pages. When I got out of school, I turned every page in Moody’s 10,000-some pages twice, looking for companies. And you have to find them yourself. The world isn’t going to tell you about great deals. You have to find them yourself. And that takes a fair amount of time. So if you are not going to do that, if you are just going to be a passive investor, then I just advise an index fund more consistently over a long period of time. The one thing I will tell you is the worst investment you can have is cash. Everybody is talking about cash being king and all that sort of thing. Most of you don’t look like you are overburdened with cash anyway. [LAUGHTER] Cash is going to become worth less over time. But good businesses are going to become worth more over time. And you don’t want to pay too much for them so you have to have some discipline about what you pay. But the thing to do is find a good business and stick with it.

BECKY: Does that mean you think we are through the roughest times? You had always kept the cash word around, too.

BUFFETT: We always keep enough cash around so I feel very comfortable and don’t worry about sleeping at night. But it’s not because I like cash as an investment. Cash is a bad investment over time. But you always want to have enough so that nobody else can determine your future essentially. The worst — the financial panic is behind us. The economic spillout which came to some extent from that financial panic is still with us. It will end. I don’t know if it will end tomorrow or next week or next month. Or maybe a year. But it won’t go on forever. And to sit around and try and pick the bottom, people were trying to do that last March and the bottom hadn’t come in unemployment and the bottom hadn’t come in business but the bottom had come in stocks. Don’t pass up something that’s attractive today because you think you will find something way more attractive tomorrow.

Key takeaways:
1. To allocate capital, you need a good search strategy. This requires a lot of hard work, “turning pages” as Buffett calls it. See earlier postings on “Search Strategy” for ideas on how to put together an effective search strategy.

2. It is not possible to pick the bottom. Learn how to value companies, practice until you get good, and buy when you find a good business that you understand, with good management, available at a price that has a mathematical expectancy to meet your minimum hurdle rate, for example 20%.

http://gregspeicher.com/?p=106

### How can I make money from Initial Public Offerings (IPOs)?

Why does a company go public?
A public company will be more closely watched by securities regulators. It also has to meet tougher reporting rules. So why would a company go public? Reasons include:
• #### RAISE CAPITAL

- A public company sells shares to raise money to improve its business.
• #### GET FINANCING

- Public companies may be able to borrow more easily and on better terms.
• #### ATTRACT GOOD PEOPLE

- Public companies are more likely to offer stock purchase plans or stock options to keep their top employees or attract new ones.
• #### CREATE A STRONGER BRAND

- A public company often gets more media attention so people get to know its brand better.
• #### WHAT WILL I MAKE?

Most of the time, IPOs are more risky than a stock that’s been on the stock market for a while. It’s very hard to predict how the price of an IPO will change once it goes on sale. Before you decide, read the prospectus from the company issuing the IPO. The prospectus describes the business plan and notes important risk factors. Check whether the company is making money or when it expects to become profitable.

• #### WHAT FEES WILL I PAY?

In most cases, you won’t pay any commission to buy an IPO. That’s because the company issuing the IPO hires underwriters to price and market the new stock. Underwriters get large fees for their services. Their earnings and fees are built into the price of the stock. You can’t avoid these built-in fees. However, you can make sure the costs are in line with what you hope to make.
Remember: Find out as much as you can before you buy an IPO
Make sure you know how much growth you can reasonably expect from the stock and how long you want to hold it.

### Will emerging markets be 2011’s great bubble?

INVESTING
Will emerging markets be 2011’s great bubble?

SUJATA RAO
LONDON— Reuters
Published Friday, Dec. 17, 2010 10:01AM EST
Last updated Wednesday, Dec. 22, 2010 5:50PM EST

Emerging markets, the consensus trade for 2011, look set for further heavy inflows of investment dollars, raising questions over how much more new money they can comfortably absorb without igniting an asset bubble.

Most fund managers at a recent Reuters summit picked emerging markets as a top bet for next year, citing double-digit returns, underpinned by rising incomes and fast economic growth.

Equity portfolio flows to emerging markets are set to reach \$186-billion (U.S.) this year, and, while they are seen falling a touch to \$143-billion next year, according to the Institute for International Finance (IIF), they will still be more than double the \$62-billion annual average seen between 2005 and 2009.

Yet, some are starting to ask if investors are getting carried away. Not only do unbridled portfolio flows risk inflating sector valuations into bubble territory, but the flows may be based on unrealistic expectations of long-term returns.

“The bigger bubble risk is the investor expectation of EM, there’s such euphoria,” said Mark Donovan, chief executive officer of Robeco, which manages €146-billion (\$194.3-billion). “I’m always wary of these herd moves into certain asset classes, generally they are not well-timed.”

SWEET SPOT HIDES BITTER TRUTH

Mr. Donovan does not question the underlying emerging markets growth story. But he and some others believe new investors may be ignoring potential problems, within and outside the sector.

Emerging markets have been in a sweet spot this past year or two as liquidity unleashed by Western central banks has pumped up the market, fuelling double-digit returns.

A Reuters poll forecasts emerging returns will far outstrip U.S. and UK equity gains in 2011. Excess liquidity, however, is fuelling inflation in developing economies, potentially leading to overheating. Higher U.S. Treasury yields could also become a headwind.

“My central scenario is that in 2011 emerging markets will be okay. Given where valuations are you will still get a positive absolute return,” said John-Paul Smith, chief emerging markets strategist at Deutsche Bank in London.

“But some of the outsize returns forecasts are probably way too high ... I’m concerned that if people become too optimistic we could see a bubble-type situation developing. When the bubble bursts, it has horrible repercussions for the real economy.”

EMERGING MARKETS ARE ... STILL EMERGING

One worry, Mr. Smith says, is that the inflows risk encouraging emerging policymakers’ hubris, removing the pressure for reform.

Some doomsayers note big capital inflow peaks often precede crises. This may be especially true of emerging markets which remains a relatively small, illiquid asset class: the market capitalization of the 37-country MSCI emerging index, is less than a third of the U.S. S&P 500.

That means a large-scale cash influx can quickly inflate asset prices to unsustainable levels, risking a repeat of the familiar boom-bust emerging market cycles.

RBC estimates that a 1 per cent re-allocation of global equity and debt holdings will send \$500-billion into emerging markets – more than 10 per cent of the MSCI emerging market cap.

NOT YET A BUBBLE

At present, emerging valuations are not in bubble territory – they trade at a discount to developed markets at around 11.5 times forward earnings.

Valuations are still below 2007 peaks and well off levels during the dot-com bubble in the late 1990s when some stocks were trading at 60-80 times forward earnings. And the volume of securities available for investment is growing.

The MSCI EM’s market capitalisation has grown by around 10 per cent a year in the past decade and emerging markets’ share of the world index has tripled to 14 per cent. The emerging debt universe too has doubled to around \$6-trillion over the past five years, JPMorgan says.

Still, with investors piling in, too much cash could in coming years end up chasing too little market cap.

Global equity fund allocations to emerging markets now stand at 16 per cent of assets under management – in dollar terms that is \$1.5-trillion, Barclays Capital said, noting bond allocations are at 7.2 per cent. Both are close to pre-crisis highs.

“(Positioning) has reached levels at which investors rightly question the sustainability of the EM flows story going into 2011,” Barclays analysts said in a note.

SIGNS OF NERVOUSNESS

There are signs of wariness. Many investors say that instead of increasing outright EM longs, they prefer multinationals such as Unilever that have exposure to emerging markets.

Another tactic has been to hedge EM exposure via Australian bonds, which are seen making big gains in case of a hard landing in China – a scenario feared by many.

Michael Power, global strategist at Investec Asset Management, says 2011 may well shape up to be the year in which investors learn not to be unequivocally bullish on the sector.

“People are looking at EM as a cake and saying ‘I want a slice,’ without looking at the ingredients of that cake. So some countries that are not born equal are being swept along in the trade along with the deserving ones,” he said.

“When bubbles burst, there is a fallout and the deserving emerging markets will be considered guilty by association.”

### BONDS: Investing for the long, long, long term

BONDS
Investing for the long, long, long term
MARTIN MITTELSTAEDT

From Tuesday's Globe and Mail
Published Monday, Nov. 08, 2010 5:16PM EST
Last updated Wednesday, Nov. 24, 2010 11:37AM EST

Goldman Sachs (GS-N167.60----%) just issued a 50-year bond. The Government of Mexico, U.S. railway giant Norfolk Southern Corp. (NSC-N62.44----%), and Dutch banking conglomerate Rabobank Group did one better: They all recently issued bonds with the stupendous term of 100 years.

The clamour from investors for these ultralong bonds is raising eyebrows in the capital market. The Goldman issue is slated to return investors their money way off in 2060, while 100-year bonds won’t pay back their principal until a century from now.

Bonds are basically just a way to lend money, but until recently it was unusual for any investor to be so trusting as to lend money for up to a century. During such an extended period, bond issuers can run into revolutions, depressions, bankruptcies and all manner of other reasons for non-repayment. Up until now, normal terms for long bonds were considered to be 10 and 20 years.

Despite the risks, yield-hungry investors are snapping up these superlong-term securities. While 10-year government bonds are yielding around 2.75 per cent, Goldman and the other issuers of long, long bonds are offering the tempting inducement of rates around 6 per cent.

The high yields explain the popularity of the offerings, but the bonds’ terms are so extreme that many market pros believe they are a signal that the long-running bull market in fixed-income securities has reached the limits of rationality. Investors fixated on finding a good yield are ignoring the dangers that go along with investing in bonds that won’t mature for a couple of generations or more.

Going 'Very, Very Wrong'

“Some of these deals are going to go very, very wrong,” frets Ric Palombi, a fixed-income portfolio manager at McLean & Partners Wealth Management, who oversees approximately \$1-billion in assets.

Mr. Palombi isn’t buying the bonds for his clients, and is surprised they’ve become a hit. “I never thought they would be so prevalent.”

The Goldman issue is a poster child for the continuing frenzy in the capital market for long-dated instruments. The Wall Street bank originally hoped investors might have the appetite for \$250-million (U.S.) worth of the securities, according to market chatter at the time of the issue last month.

But Goldman sold more than five times as much – \$1.3-billion. Ordinary ma and pa investors were the target buyers, signified by Goldman chopping the bonds into minuscule \$25 amounts. This is an unusual size. Bonds typically trade in minimum multiples of \$1,000.

How They Work

It’s not clear how many of the small investors who bought Goldman’s bonds realize the fine points of the deal. According to the prospectus, Goldman has reserved for itself the right to redeem the bonds at their face value of \$25 on five days’ written notice any time after Nov. 1, 2015.

If interest rates stay low, Goldman, which didn’t respond to a request for comment, will likely call the bonds and pay off investors. Those seemingly high yields will then vanish.

Meanwhile, if market interest rates return to more normal levels because the economy recovers or inflation resumes, it’s likely that the cost of borrowing for extremely long terms could rise well above the 6.125 per cent that Goldman is paying. In that case, Goldman won’t redeem them, and buyers will be stuck with losses because bond prices move inversely to interest rates.

It’s telling that, while Goldman has the right to redeem, buyers weren’t given the same right to force Goldman to buy back the securities if interest rates surge.

While investors in any long-term bond face the risk of the issuer defaulting, any strong uptrend in interest rates also poses a problem.

Bond prices are in the midst of the longest bull market on record, having rallied in the United States for the better part of 29 years. Back in 1981, when the bull run began, 10-year U.S. Treasuries were yielding about 15 per cent and were shunned as “certificates of confiscation” by investors. Now the yield is a tad under 3 per cent and investors are snapping up bonds.

What Goes Up...

Nothing goes up forever, some analysts caution.

“Within a couple of years, the bond market probably is going to be entering some kind of [long-term] bear market,” says Frank Hracs, who compiles the Canadian Mutual Fund Analyst, a publication that tracks fund inflows and has found the hottest area is currently in bonds.

Mr. Hracs worries that the “long-term outlook for bond capital gains is negative.”

The losses owing to any rise in rates could be devastating. If rates revisit their 1981 levels, the 50-year and 100-year bonds will collapse in value by about 60 per cent.

### Some passive advice from Benjamin Graham

Benjamin Graham, Mr. Buffett's mentor, is required reading for anyone who is serious about active investing. He died in 1976 and, during that year, he said the following:

“I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook Graham and Dodd was first published; but the situation has changed a great deal since then. In the old days, any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost.”

##### Investor Education Fund

"There are no requirements for managing billions of dollars, but before somebody can trim your sideburns, he or she has to pass some sort of test. Given the record of the average fund manager over the last decade, maybe it should be the other way around." – Peter Lynch, Beating the Street

How do you find a good adviser?
Although Peter Lynch’s comment is focused on fund management, the minimum requirements to become a licensed adviser are easier to get than in some other professions that have much less of an impact on your long-term well-being. In Canada, there are many people that are eager to manage your money but it can be difficult to find somebody that will do it well.
The best ones don’t necessarily drive posh cars, wear expensive suits, or have big corner offices. But they do share these three characteristics:
• superior service
• consistent returns and with reasonable risk
• a focus on your success first, before their own.
Unfortunately, too often you can only learn how an adviser measures up after you have entrusted your money to them. There is no common rating system that lets you sort out the good advisers from everybody else. But there are three things you can -- and should – check before you choose an adviser:
• Qualifications
• Experience
• Performance
After all, it’s your money that’s on the line -- not theirs. Make sure you’re putting it into the right hands.
The fact that an adviser has the basic qualifications to work in the industry will not tell you very much about their skill level. To register as an adviser, he or she only has to meet the bare minimum qualifications to operate in the industry. So when you look at qualifications, look beyond the minimum.
What to look for:
• Check that the adviser and their firm are registered and in good standing with industry regulators. Check now.
• Find out if the adviser has any additional qualifications, such as chartered financial analyst or chartered accountant. It takes considerable work and expertise to achieve these and other professional accreditations. This means they can offer added insight and a richer perspective to you.
• See if the adviser has made a commitment to ongoing professional development and skills development. A person who is committed to continuous learning will more likely serve you as a valued adviser, and not just sell you products.
Merely having experience in the industry does not make someone an excellent adviser. Experience may help an adviser understand and assess financial markets, but it does not guarantee the right focus on client returns. Nor does it necessarily teach advisers to focus on the long-term value of protecting their clients from the intense industry pressure to generate commissions.
The best advisers have learned, through experience, to make sure that costs are reasonable; that returns are fair; that recommended strategies and products are among the best available; and that clients feel comfortable and confident through good markets and bad.
What to look for:
Find out how long the adviser has been working in the industry and how long they have been working for this specific company. Learn about their philosophy and their company's investing philosophy.
Check that the adviser works with a broad range of products, not just one or two specialties, so they can help you find the right investments for your stage in life.
Interview a number of advisers before you choose one and ask them about their experience and investment philosophy. For instance, ask them what lessons they have learned over the years, and what they do differently today than they did five years ago (or when they started in the business). You can have a very interesting conversation with someone if you ask them about mistakes they have made and what they learned from them!
It takes a long-term view and considerable emotional maturity for an adviser to balance making money for themselves with fair returns for their clients. As we will explore in future articles, most advisers are paid by commission -- and that commission often brings an incentive to make certain decisions.
The best advisers focus on returns rather than commissions. They understand the effects of fees and capital losses on client returns. They also know how to prepare clients for the volatility of financial markets.
Unfortunately, this type of adviser is less common than you think and takes a concerted effort to find. Make sure you:
• Take the time to interview advisers to uncover their philosophy, their commitment to their profession, and the type of service that they will provide to you.
• Make it clear to your adviser that you will monitor the relationship based on the relative performance of your portfolio against a reasonable benchmark.
Investors need to demand low-cost and market-comparable performance from their investments. This happens far too rarely today – and investors need to change this.
What to look for:
• Make sure the adviser has good references and a demonstrated track record.
• Check how the adviser has performed in both up and down markets.
• Ask how long they have worked with most of their clients. Talk to at least three clients the adviser has worked with for five years or more.
• Talk about how the adviser is paid. The best situation is where you and the adviser profit or lose together. Next best is an advisor who is paid to provide advice, but has no financial stake in the decisions you make. Neither of these are very common as the commissioned sales model is standard in the industry.
The problem with commission selling
One of the biggest enemies of long-term returns are fees. Commission selling can become problematic when it comes to fees because some of the most popular products are the most expensive for consumer because they are so lucrative for the salesperson.
For example, Canadian equity mutual funds with fees of approximately 2.5% are some of the most popular investment products in Canada. If these funds regularly provided returns that outpaced the Canadian equity market over the long-run, this strategy would make sense. However, this usually isn’t the case- only a handful of funds have outpaced the market consistently over the long run, despite the 1000s of funds (literally!) that are available.
Despite the fact that most mutual funds trail the markets in terms of return, you don’t often see full service brokers that recommend investing in an exchange-traded fund when a similar mutual fund is available. The adviser needs to get paid, and the mutual funds offer higher fees- even if it means generally below market returns for you. This is one example of how commissions create incentives for advisers to do questionable things for your portfolio.
Remember: advisers are important- but they can’t do it all
Investors need to be aware of what their advisers can and can’t do. An adviser can be great at some things, such as: