Saturday 18 April 2015

Buffett: How inflation swindles the equity investor (Fortune Classics, 1977)

by Warren Buffett

JUNE 12, 2011, 1:15 PM EDT


The central problem in the stock market is that the return on capital hasn’t risen with inflation. It seems to be stuck at 12%.

Editor’s Note: Every Sunday, Fortune publishes a favorite story from our archive. As controversy swirls around whether Fed Chair Ben Bernanke is downplaying inflation predictions, we turn back to May 1977 for timely advice from Warren Buffett. The Oracle of Omaha has clashed with Bernanke over inflation time and time again, and here Buffett warns how rising prices can hamper growth “not because the market falls, but in spite of the fact that the market rises.”
It is no longer a secret that stocks, like bonds, do poorly in an inflationary environment. We have been in such an environment for most of the past decade, and it has indeed been a time of troubles for stocks. But the reasons for the stock market’s problems in this period are still imperfectly understood.
There is no mystery at all about the problems of bondholders in an era of inflation. When the value of the dollar deteriorates month after month, a security with income and principal payments denominated in those dollars isn’t going to be a big winner. You hardly need a Ph.D. in economics to figure that one out.
It was long assumed that stocks were something else. For many years, the conventional wisdom insisted that stocks were a hedge against inflation. The proposition was rooted in the fact that stocks are not claims against dollars, as bonds are, but represent ownership of companies with productive facilities. These, investors believed, would retain their value in real terms, let the politicians print money as they might.
1977_buffett_opener
And why didn’t it turn out that way? The main reason, I believe, is that stocks, in economic substance, are really very similar to bonds.
I know that this belief will seem eccentric to many investors. They will immediately observe that the return on a bond (the coupon) is fixed, while the return on an equity investment (the company’s earnings) can vary substantially from one year to another. True enough. But anyone who examines the aggregate returns that have been earned by companies during the postwar years will discover something extraordinary: the returns on equity have in fact not varied much at all.
The coupon is sticky
In the first 10 years after the war — the decade ending in 1955 — the Dow Jones industrials had an average annual return on year-end equity of 12.8%. In the second decade, the figure was 10.1%. In the third decade it was 10.9%. Data for a larger universe, theFortune 500 (whose history goes back only to the mid-1950s), indicate somewhat similar results: 11.2% in the decade ending in 1965, 11.8% in the decade through 1975. The figures for a few exceptional years have been substantially higher (the high for the 500 was 14.1% in 1974) or lower (9.5% in 1958 and 1970), but over the years, and in the aggregate, the return in book value tends to keep coming back to a level around 12%. It shows no signs of exceeding that level significantly in inflationary years (or in years of stable prices, for that matter).
For the moment, let’s think of those companies, not as listed stocks, but as productive enterprises. Let’s also assume that the owners of those enterprises had acquired them at book value. In that case, their own return would have been around 12% too. And because the return has been so consistent, it seems reasonable to think of it as an “equity coupon.”
In the real world, of course, investors in stocks don’t just buy and hold. Instead, many try to outwit their fellow investors in order to maximize their own proportions of corporate earnings. This thrashing about, obviously fruitless in aggregate, has no impact on the equity coupon but reduces the investor’s portion of it, because he incurs substantial frictional costs, such as advisory fees and brokerage charges. Throw in an active options market, which adds nothing to the productivity of American enterprise but requires a cast of thousands to man the casino, and frictional costs rise further.
Stocks are perpetual
It is also true that in the real world investors in stocks don’t usually get to buy at book value. Sometimes they have been able to buy in below book; usually, however, they’ve had to pay more than book, and when that happens there is further pressure on that 12%. I’ll talk more about these relationships later. Meanwhile, let’s focus on the main point: as inflation has increased, the return on equity capital has not. Essentially, those who buy equities receive securities with an underlying fixed return just like those who buy bonds.
Of course, there are some important differences between the bond and stock forms. For openers, bonds eventually come due. It may require a long wait, but eventually the bond investor gets to renegotiate the terms of his contract. If current and prospective rates of inflation make his old coupon look inadequate, he can refuse to play further unless coupons currently being offered rekindle his interest. Something of this sort has been going on in recent years.
Stocks, on the other hand, are perpetual. They have a maturity date of infinity. Investors in stocks are stuck with whatever return corporate America happens to earn. If corporate America is destined to earn 12%, then that is the level investors must learn to live with. As a group, stock investors can neither opt out nor renegotiate. In the aggregate, their commitment is actually increasing. Individual companies can be sold or liquidated and corporations can repurchase their own shares; on balance, however, new equity flotations and retained earnings guarantee that the equity capital locked up in the corporate system will increase. So, score one for the bond form. Bond coupons eventually will be renegotiated; equity “coupons” won’t. It is true, of course, that for a long time a 12% coupon did not appear in need of a whole lot of correction.
The bondholder gets it in cash
There is another major difference between the garden variety of bond and our new exotic 12% “equity bond” that comes to the Wall Street costume ball dressed in a stock certificate. In the usual case, a bond investor receives his entire coupon in cash and is left to reinvest it as best he can. Our stock investor’s equity coupon, in contrast, is partially retained by the company and is reinvested at whatever rates the company happens to be earning. In other words, going back to our corporate universe, part of the 12% earned annually is paid out in dividends and the balance is put right back into the universe to earn 12% also.
The good old days
This characteristic of stocks — the reinvestment of part of the coupon — can be good or bad news, depending on the relative attractiveness of that 12%. The news was very good indeed in the 1950s and early 1960s. With bonds yielding only 3 or 4%, the right to reinvest automatically a portion of the equity coupon at 12% was of enormous value. Note that investors could not just invest their own money and get that 12% return. Stock prices in this period ranged far above book value, and investors were prevented by the premium prices they had to pay from directly extracting out of the underlying corporate universe whatever rate that universe was earning. You can’t pay far above par for a 12% bond and earn 12% for yourself.
But on their retained earnings, investors could earn 12%. In effect, earnings retention allowed investors to buy at book value part of an enterprise that, in the economic environment then existing, was worth a great deal more than book value.
It was a situation that left very little to be said for cash dividends and a lot to be said for earnings retention. Indeed, the more money that investors thought likely to be reinvested at the 12% rate, the more valuable they considered their reinvestment privilege, and the more they were willing to pay for it. In the early 19601s, investors eagerly paid top-scale prices for electric utilities situated in growth areas, knowing that these companies had the ability to re-invest very large proportions of their earnings. Utilities whose operating environment dictated a larger cash payout rated lower prices.
If, during this period, a high-grade, noncallable, long-term bond with a 12% coupon had existed, it would have sold far above par. And if it were a bond with a further unusual characteristic — which was that most of the coupon payments could be automatically reinvested at par in similar bonds — the issue would have commanded an even greater premium. In essence, growth stocks retaining most of their earnings represented just such a security. When their reinvestment rate on the added equity capital was 12% while interest rates generally were around 4%, investors became very happy — and, of course, they paid happy prices.
Heading for the exits
Looking back, stock investors can think of themselves in the 1946-66 period as having been ladled a truly bountiful triple dip. First, they were the beneficiaries of an underlying corporate return on equity that was far above prevailing interest rates. Second, a significant portion of that return was reinvested for them at rates that were otherwise unattainable. And third, they were afforded an escalating appraisal of underlying equity capital as the first two benefits became widely recognized. This third dip meant that, on top of the basic 12% or so earned by corporations on their equity capital, investors were receiving a bonus as the Dow Jones industrials increased in price from 133% of book value in 1946 to 220% in 1966. Such a marking-up process temporarily allowed investors to achieve a return that exceeded the inherent earning power of the enterprises in which they had invested.
This heaven-on-earth situation finally was “discovered” in the mid-1960s by many major investing institutions. But just as these financial elephants began trampling on one another in their rush to equities, we entered an era of accelerating inflation and higher interest rates. Quite logically, the marking-up process began to reverse itself. Rising interest rates ruthlessly reduced the value of all existing fixed-coupon investments. And as long-term corporate bond rates began moving up (eventually reaching the 10% area), both the equity return of 12% and the reinvestment “privilege” began to look different.
Stocks are quite properly thought of as riskier than bonds. While that equity coupon is more or less fixed over periods of time, it does fluctuate somewhat from year to year. Investors’ attitudes about the future can be affected substantially, although frequently erroneously, by those yearly changes. Stocks are also riskier because they come equipped with infinite maturities. (Even your friendly broker wouldn’t have the nerve to peddle a 100-year bond, if he had any available, as “safe.”) Because of the additional risk, the natural reaction of investors is to expect an equity return that is comfortably above the bond return — and 12% on equity versus, say, 10% on bonds issued by the same corporate universe does not seem to qualify as comfortable. As the spread narrows, equity investors start looking for the exits.
But, of course, as a group they can’t get out. All they can achieve is a lot of movement, substantial frictional costs, and a new, much lower level of valuation, reflecting the lessened attractiveness of the 12% equity coupon under inflationary conditions. Bond investors have had a succession of shocks over the past decade in the course of discovering that there is no magic attached to any given coupon level: at 6%, or 8%, or 10%, bonds can still collapse in price. Stock investors, who are in general not aware that they too have a “coupon,” are still receiving their education on this point.
Five ways to improve earnings
Must we really view that 12% equity coupon as immutable? Is there any law that says the corporate return on equity capital cannot adjust itself upward in response to a permanently higher average rate of inflation? There is no such law, of course. On the other hand, corporate America cannot increase earnings by desire or decree. To raise that return on equity, corporations would need at least one of the following: (1) an increase in turnover, i.e., in the ratio between sales and total assets employed in the business; (2) cheaper leverage; (3) more leverage; (4) lower income taxes; (5) wider operating margins on sales.
And that’s it. There simply are no other ways to increase returns on common equity. Let’s see what can be done with these.
We’ll begin with turnover. The three major categories of assets we have to think about for this exercise are accounts receivable, inventories, and fixed assets such as plants and machinery.
Accounts receivable go up proportionally as sales go up, whether the increase in dollar sales is produced by more physical volume or by inflation. No room for improvement here.
With inventories, the situation is not quite so simple. Over the long term, the trend in unit inventories may be expected to follow the trend in unit sales. Over the short term, however, the physical turnover rate may bob around because of special influences — e.g., cost expectations, or bottlenecks.
The use of last-in, first-out (LIFO) inventory-valuation methods serves to increase the reported turnover rate during inflationary times. When dollar sales are rising because of inflation, inventory valuations of a LIFO company either will remain level (if unit sales are not rising) or will trail the rise in dollar sales (if unit sales are rising). In either case, dollar turnover will increase.
During the early 1970s, there was a pronounced swing by corporations toward LIFO accounting (which has the effect of lowering a company’s reported earnings and tax bills). The trend now seems to have slowed. Still, the existence of a lot of LIFO companies, plus the likelihood that some others will join the crowd, ensures some further increase in the reported turnover of inventory.
The gains are apt to be modest
In the case of fixed assets, any rise in the inflation rate, assuming it affects all products equally, will initially have the effect of increasing turnover. That is true because sales will immediately reflect the new price level, while the fixed asset account will reflect the change only gradually, i.e., as existing assets are retired and replaced at the new prices. Obviously, the more slowly a company goes about this replacement process, the more the turnover ratio will rise. The action stops, however, when a replacement cycle is completed. Assuming a constant rate of inflation, sales and fixed assets will then begin to rise in concert at the rate of inflation.
To sum up, inflation will produce some gains in turnover ratios. Some improvement would be certain because of LIFO and some would be possible (if inflation accelerates) because of sales rising more rapidly than fixed assets. But the gains are apt to be modest and not of a magnitude to produce substantial improvement in returns on equity capital. During the decade ending in 1975, despite generally accelerating inflation and the extensive use of LIFO accounting, the turnover ratio of the Fortune 500 went only from 1.18/1 to 1.29/1.
Cheaper leverage? Not likely. High rates of inflation generally cause borrowing to become dearer, not cheaper. Galloping rates of inflation create galloping capital needs; and lenders, as they become increasingly distrustful of long-term contracts, become more demanding. But even if there is no further rise in interest rates, leverage will be getting more expensive because the average cost of the debt now on corporate books is less than would be the cost of replacing it. And replacement will be required as the existing debt matures. Overall, then, future changes in the cost of leverage seem likely to have a mildly depressing effect on the return on equity.
More leverage? American business already has fired many, if not most, of the more-leverage bullets once available to it. Proof of that proposition can be seen in some other Fortune 500 statistics: in the 20 years ending in 1975, stockholders’ equity as a percentage of total assets declined for the 500 from 63% to just under 50%. In other words, each dollar of equity capital now is leveraged much more heavily than it used to be.
What the lenders learned
An irony of inflation-induced financial requirements is that the highly profitable companies — generally the best credits — require relatively little debt capital. But the laggards in profitability never can get enough. Lenders understand this problem much better than they did a decade ago — and are correspondingly less willing to let capital-hungry, low-profitability enterprises leverage themselves to the sky.
Nevertheless, given inflationary conditions, many corporations seem sure in the future to turn to still more leverage as a means of shoring up equity returns. Their managements will make that move because they will need enormous amounts of capital — often merely to do the same physical volume of business — and will wish to get it without cutting dividends or making equity offerings that, because of inflation, are not apt to shape up as attractive. Their natural response will be to heap on debt, almost regardless of cost. They will tend to behave like those utility companies that argued over an eighth of a point in the 1960s and were grateful to find 12% debt financing in 1974.
Added debt at present interest rates, however, will do less for equity returns than did added debt at 4% rates in the early 1960s. There is also the problem that higher debt ratios cause credit ratings to be lowered, creating a further rise in interest costs.
So that is another way, to be added to those already discussed, in which the cost of leverage will be rising. In total, the higher costs of leverage are likely to offset the benefits of greater leverage.
Besides, there is already far more debt in corporate America than is conveyed by conventional balance sheets. Many companies have massive pension obligations geared to whatever pay levels will be in effect when present workers retire. At the low inflation rates of 1955-65, the liabilities arising from such plans were reasonably predictable. Today, nobody can really know the company’s ultimate obligation. But if the inflation rate averages 7% in the future, a 25-year-old employee who is now earning $12,000, and whose raises do no more than match increases in living costs, will be making $180,000 when he retires at 65.
Of course, there is a marvelously precise figure in many annual reports each year, purporting to be the unfunded pension liability. If that figure were really believable, a corporation could simply ante up that sum, add to it the existing pension-fund assets, turn the total amount over to an insurance company, and have it assume all the corporation’s present pension liabilities. In the real world, alas, it is impossible to find an insurance company willing even to listen to such a deal.
Virtually every corporate treasurer in America would recoil at the idea of issuing a “cost-of-living” bond — a noncallable obligation with coupons tied to a price index. But through the private pension system, corporate America has in fact taken on a fantastic amount of debt that is the equivalent of such a bond.
More leverage, whether through conventional debt or unhooked and indexed “pension debt,” should be viewed with skepticism by shareholders. A 12% return from an enterprise that is debt-free is far superior to the same return achieved by a business hocked to its eyeballs. Which means that today’s 12% equity returns may well be less valuable than the 12% returns of 20 years ago.
More fun in New York
Lower corporate income taxes seem unlikely. Investors in American corporations already own what might be thought of as a Class D stock. The Class A, B, and C stocks are represented by the income-tax claims of the federal, state, and municipal governments. It is true that these “investors” have no claim on the corporation’s assets; however, they get a major share of the earnings, including earnings generated by the equity buildup resulting from retention of part of the earnings owned by the Class D shareholders.
A further charming characteristic of these wonderful Class A, B, and C stocks is that their share of the corporation’s earnings can be increased immediately, abundantly, and without payment by the unilateral vote of any one of the “stockholder” classes, e.g., by congressional action in the case of the Class A. To add to the fun, one of the classes will sometimes vote to increase its ownership share in the business retroactively — as companies operating in New York discovered to their dismay in 1975. Whenever the Class A, B, or C “stockholders” vote themselves a larger share of the business, the portion remaining for Class D — that’s the one held by the ordinary investor — declines.
Looking ahead, it seems unwise to assume that those who control the A, B, and C shares will vote to reduce their own take over the long run. The Class D shares probably will have to struggle to hold their own.
Bad news from the FTC
The last of our five possible sources of increased returns on equity is wider operating margins on sales. Here is where some optimists would hope to achieve major gains. There is no proof that they are wrong. But there are only 100 cents in the sales dollar and a lot of demands on that dollar before we get down to the residual, pretax profits. The major claimants are labor, raw materials, energy, and various non-income taxes. The relative importance of these costs hardly seems likely to decline during an age of inflation.
Recent statistical evidence, furthermore, does not inspire confidence in the proposition that margins will widen in a period of inflation. In the decade ending in 1965, a period of relatively low inflation, the universe of manufacturing companies reported on quarterly by the Federal Trade Commission had an average annual pretax margin on sales of 8.6%. In the decade ending in 1975, the average margin was 8%. Margins were down, in other words, despite a very considerable increase in the inflation rate.
If business was able to base its prices on replacement costs, margins would widen in inflationary periods. But the simple fact is that most large businesses, despite a widespread belief in their market power, just don’t manage to pull it off. Replacement cost accounting almost always shows that corporate earnings have declined significantly in the past decade. If such major industries as oil, steel, and aluminum really have the oligopolistic muscle imputed to them, one can only conclude that their pricing policies have been remarkably restrained.
There you have the complete lineup: five factors that can improve returns on common equity, none of which, by my analysis, are likely to take us very far in that direction in periods of high inflation. You may have emerged from this exercise more optimistic than I am. But remember, returns in the 12% area have been with us a long time.
The investor’s equation
Even if you agree that the 12% equity coupon is more or less immutable, you still may hope to do well with it in the years ahead. It’s conceivable that you will. After all, a lot of investors did well with it for a long time. But your future results will be governed by three variables: the relationship between book value and market value, the tax rate, and the inflation rate.
Let’s wade through a little arithmetic about book and market value. When stocks consistently sell at book value, it’s all very simple. If a stock has a book value of $100 and also an average market value of $100, 12% earnings by business will produce a 12% return for the investor (less those frictional costs, which we’ll ignore for the moment). If the payout ratio is 50%, our investor will get $6 via dividends and a further $6 from the increase in the book value of the business, which will, of course, be reflected in the market value of his holdings.
If the stock sold at 150% of book value, the picture would change. The investor would receive the same $6 cash dividend, but it would now represent only a 4% return on his $150 cost. The book value of the business would still increase by 6% (to $106) and the market value of the investor’s holdings, valued consistently at 150% of book value, would similarly increase by 6% (to $159). But the investor’s total return, i.e., from appreciation plus dividends, would be only 10% versus the underlying 12% earned by the business.
When the investor buys in below book value, the process is reversed. For example, if the stock sells at 80% of book value, the same earnings and payout assumptions would yield 7.5% from dividends ($6 on an $80 price) and 6% from appreciation — a total return of 13.5%. In other words, you do better by buying at a discount rather than a premium, just as common sense would suggest.
During the postwar years, the market value of the Dow Jones industrials has been as low as 84% of book value (in 1974) and as high as 232% (in 1965); most of the time the ratio has been well over 100%. (Early this spring, it was around 110%.) Let’s assume that in the future the ratio will be something close to 100%, meaning that investors in stocks could earn the full 12%. At least, they could earn that figure before taxes and before inflation.
7% after taxes
How large a bite might taxes take out of the 12%? For individual investors, it seems reasonable to assume that federal, state, and local income taxes will average perhaps 50% on dividends and 30% on capital gains. A majority of investors may have marginal rates somewhat below these, but many with larger holdings will experience substantially higher rates. Under the new tax law, as Fortune observed last month, a high-income investor in a heavily taxed city could have a marginal rate on capital gains as high as 56%.
So let’s use 50% and 30% as representative for individual investors. Let’s also assume, in line with recent experience, that corporations earning 12% on equity pay out 5% in cash dividends (2.5% after tax) and retain 7%, with those retained earnings producing a corresponding market-value growth (4.9% after the 30% tax). The after-tax return, then, would be 7.4%. Probably this should be rounded down to about 7% to allow for frictional costs. To push our stocks-as-disguised-bonds thesis one notch further, then, stocks might be regarded as the equivalent, for individuals, of 7% tax-exempt perpetual bonds.
The number nobody knows
Which brings us to the crucial question — the inflation rate. No one knows the answer on this one — including the politicians, economists, and Establishment pundits, who felt, a few years back, that with slight nudges here and there unemployment and inflation rates would respond like trained seals.
But many signs seem negative for stable prices: the fact that inflation is now worldwide; the propensity of major groups in our society to utilize their electoral muscle to shift, rather than solve, economic problems; the demonstrated unwillingness to tackle even the most vital problems (e.g., energy and nuclear proliferation) if they can be postponed; and a political system that rewards legislators with reelection if their actions appear to produce short-term benefits even though their ultimate imprint will be to compound long-term pain.
Most of those in political office, quite understandably, are firmly against inflation and firmly in favor of policies producing it. (This schizophrenia hasn’t caused them to lose touch with reality, however; Congressmen have made sure that their pensions — unlike practically all granted in the private sector — are indexed to cost-of-living changes after retirement.)
Discussions regarding future inflation rates usually probe the subtleties of monetary and fiscal policies. These are important variables in determining the outcome of any specific inflationary equation. But, at the source, peacetime inflation is a political problem, not an economic problem. Human, behavior, not monetary behavior, is the key. And when very human politicians choose between the next election and the next generation, it’s clear what usually happens.
Such broad generalizations do not produce precise numbers. However, it seems quite possible to me that inflation rates will average 7% in future years. I hope this forecast proves to be wrong. And it may well be. Forecasts usually tell us more of the forecaster than of the future. You are free to factor your own inflation rate into the investor’s equation. But if you foresee a rate averaging 2% or 3%, you are wearing different glasses than I am.
So there we are: 12% before taxes and inflation; 7% after taxes and before inflation; and maybe zero percent after taxes and inflation. It hardly sounds like a formula that will keep all those cattle stampeding on TV.
As a common stockholder you will have more dollars, but you may have no more purchasing power. Out with Ben Franklin (“a penny saved is a penny earned”) and in with Milton Friedman (“a man might as well consume his capital as invest it”).
What widows don’t notice
The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a 5% passbook account whether she pays 100% income tax on her interest income during a period of zero inflation, or pays no income taxes during years of 5% inflation. Either way, she is “taxed” in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital. She would find outrageous a 120% income tax, but doesn’t seem to notice that 6% inflation is the economic equivalent.
If my inflation assumption is close to correct, disappointing results will occur not because the market falls, but in spite of the fact that the market rises. At around 920 early last month, the Dow was up 55 points from where it was 10 years ago. But adjusted for inflation, the Dow is down almost 345 points — from 865 to 520. And about half of the earnings of the Dow had to be withheld from their owners and reinvested in order to achieve even that result.
In the next 10 years, the Dow would be doubled just by a combination of the 12% equity coupon, a 40% payout ratio, and the present 110% ratio of market to book value. And with 7% inflation, investors who sold at 1800 would still be considerably worse off than they are today after paying their capital-gains taxes.
I can almost hear the reaction of some investors to these downbeat thoughts. It will be to assume that, whatever the difficulties presented by the new investment era, they will somehow contrive to turn in superior results for themselves. Their success is most unlikely. And, in aggregate, of course, impossible. If you feel you can dance in and out of securities in a way that defeats the inflation tax, I would like to be your broker — but not your partner.
Even the so-called tax-exempt investors, such as pension funds and college endowment funds, do not escape the inflation tax. If my assumption of a 7% inflation rate is correct, a college treasurer should regard the first 7% earned each year merely as a replenishment of purchasing power. Endowment funds are earning nothing until they have outpaced the inflation treadmill. At 7% inflation and, say, overall investment returns of 8%, these institutions, which believe they are tax-exempt, are in fact paying “income taxes” of 87.5%.
The social equation
Unfortunately, the major problems from high inflation rates flow not to investors but to society as a whole. Investment income is a small portion of national income, and if per capita real income could grow at a healthy rate alongside zero real investment returns, social justice might well be advanced.
A market economy creates some lopsided payoffs to participants. The right endowment of vocal chords, anatomical structure, physical strength, or mental powers can produce enormous piles of claim checks (stocks, bonds, and other forms of capital) on future national output. Proper selection of ancestors similarly can result in lifetime supplies of such tickets upon birth. If zero real investment returns diverted a bit greater portion of the national output from such stockholders to equally worthy and hardworking citizens lacking jackpot-producing talents, it would seem unlikely to pose such an insult to an equitable world as to risk Divine Intervention.
But the potential for real improvement in the welfare of workers at the expense of affluent stockholders is not significant. Employee compensation already totals 28 times the amount paid out in dividends, and a lot of those dividends now go to pension funds, nonprofit institutions such as universities, and individual stockholders who are not affluent. Under these circumstances, if we now shifted all dividends of wealthy stockholders into wages — something we could do only once, like killing a cow (or, if you prefer, a pig) — we would increase real wages by less than we used to obtain from one year’s growth of the economy.
The Russians understand it too
Therefore, diminishment of the affluent, through the impact of inflation on their investments, will not even provide material short-term aid to those who are not affluent. Their economic well-being will rise or fall with the general effects of inflation on the economy. And those effects are not likely to be good.
Large gains in real capital, invested in modern production facilities, are required to produce large gains in economic well-being. Great labor availability, great consumer wants, and great government promises will lead to nothing but great frustration without continuous creation and employment of expensive new capital assets throughout industry. That’s an equation understood by Russians as well as Rockefellers. And it’s one that has been applied with stunning success in West Germany and Japan. High capital-accumulation rates have enabled those countries to achieve gains in living standards at rates far exceeding ours, even though we have enjoyed much the superior position in energy.
To understand the impact of inflation upon real capital accumulation, a little math is required. Come back for a moment to that 12% return on equity capital. Such earnings are stated after depreciation, which presumably will allow replacement of present productive capacity — if that plant and equipment can be purchased in the future at prices similar to their original cost.
The way it was
Let’s assume that about half of earnings are paid out in dividends, leaving 6% of equity capital available to finance future growth. If inflation is low — say, 2% — a large portion of that growth can be real growth in physical output. For under these conditions, 2% more will have to be invested in receivables, inventories, and fixed assets next year just to duplicate this year’s physical output — leaving 4% for investment in assets to produce more physical goods. The 2% finances illusory dollar growth reflecting inflation and the remaining 4% finances real growth. If population growth is 1%, the 4% gain in real output translates into a 3% gain in real per capita net income. That, very roughly, is what used to happen in our economy.
Now move the inflation rate to 7% and compute what is left for real growth after the financing of the mandatory inflation component. The answer is nothing — if dividend policies and leverage ratios remain unchanged. After half of the 12% earnings are paid out, the same 6% is left, but it is all conscripted to provide the added dollars needed to transact last year’s physical volume of business.
Many companies, faced with no real retained earnings with which to finance physical expansion after normal dividend payments, will improvise. How, they will ask themselves, can we stop or reduce dividends without risking stockholder wrath? I have good news for them: a ready-made set of blueprints is available.
In recent years the electric-utility industry has had little or no dividend-paying capacity. Or, rather, it has had the power to pay dividends if investors agree to buy stock from them. In 1975 electric utilities paid common dividends of $3.3 billion and asked investors to return $3.4 billion. Of course, they mixed in a little solicit-Peter-to-pay-Paul technique so as not to acquire a Con Ed  ED 0.05%  reputation. Con Ed, you will remember, was unwise enough in 1974 to simply tell its shareholders it didn’t have the money to pay the dividend. Candor was rewarded with calamity in the marketplace.
The more sophisticated utility maintains — perhaps increases — the quarterly dividend and then ask shareholders (either old or new) to mail back the money. In other words, the company issues new stock. This procedure diverts massive amounts of capital to the tax collector and substantial sums to underwriters. Everyone, however, seems to remain in good spirits (particularly the underwriters).
More joy at AT&T
Encouraged by such success, some utilities have devised a further shortcut. In this case, the company declares the dividend, the shareholder pays the tax, and — presto — more shares are issued. No cash changes hands, although the IRS, spoilsport as always, persists in treating the transaction as if it had.
AT&T  T -0.76% , for example, instituted a dividend-reinvestment program in 1973. This company, in fairness, must be described as very stockholder-minded, and its adoption of this program, considering the folkways of finance, must be regarded as totally understandable. But the substance of the program is out of Alice in Wonderland.
In 1976, AT&T paid $2.3 billion in cash dividends to about 2.9 million owners of its common stock. At the end of the year, 648,000 holders (up from 601,000 the previous year) reinvested $432 million (up from $327 million) in additional shares supplied directly by the company.
Just for fun, let’s assume that all AT&T shareholders ultimately sign up for this program. In that case, no cash at all would be mailed to shareholders — just as when Con Ed passed a dividend. However, each of the 2.9 million owners would be notified that he should pay income taxes on his share of the retained earnings that had that year been called a “dividend.” Assuming that “dividends” totaled $2.3 billion, as in 1976, and that shareholders paid an average tax of 30% on these, they would end up, courtesy of this marvelous plan, paying nearly $700 million to the IRS. Imagine the joy of shareholders, in such circumstances, if the directors were then to double the dividend.
The government will try to do it
We can expect to see more use of disguised payout reductions as business struggles with the problem of real capital accumulation. But throttling back shareholders somewhat will not entirely solve the problem. A combination of 7% inflation and 12% returns will reduce the stream of corporate capital available to finance real growth.
And so, as conventional private capital-accumulation methods falter under inflation, our government will increasingly attempt to influence capital flows to industry, either unsuccessfully as in England or successfully as in Japan. The necessary cultural and historical underpinning for a Japanese-style enthusiastic partnership of government, business, and labor seems lacking here. If we are lucky, we will avoid following the English path, where all segments fight over division of the pie rather than pool their energies to enlarge it.
On balance, however, it seems likely that we will hear a great deal more as the years unfold about under investment, stagflation, and the failures of the private sector to fulfill needs

http://fortune.com/2011/06/12/buffett-how-inflation-swindles-the-equity-investor-fortune-classics-1977/

Friday 10 April 2015

Get Stock Quotes in Excel

http://www.excelclout.com/stock-quotes-in-excel/

Ray Dalio - Asset Allocation, Risk Parity, Diversification (CNBC)





Published on 29 May 2013

In this shorter segment of the full CNBC video Bridgewater's CEO Ray Dalio discusses his investment philosophy for achieving a balanced structured portfolio and thereby superior asset allocation. He explains how the macro environment of growth and inflation needs to be carefully matched against the portfolio's volatility of bonds, equities and other assets. 



[Achieving Strategic Asset Allocation with Risk Parity]

"There is the strategic allocation mix which we call 'All Weather'. It has to do with making all the assets the same risk parity. The problem is when people try to diversify and they own equities, and equities have volatility that's large, or they own assets that do well when the economy does well and do badly when the economy does badly, they have a concentration of risks in some assets. They need to do .... so that bonds and equities and pieces have comparable impacts. So that whatever happens in the economy has a balancing effect. That's the All weather piece. 

We have a lot of diversified bets. It's very important for most people to know when not to make a bet! If you come to the poker table you're going to have to beat me. The nature is a very small percentage of people take money in the poker game. They don't know if it's a good investment or a more expensive investment."



[On Bonds vs. Stocks and Diversification of Risk in all periods]

"The problem of a stock and a bond portfolio, if you put 50 per cent of your money in stocks and 50 per cent of your money in bonds, the problem is you have about 80 per cent of your risk in stocks and about 20 per cent of your risk in bonds. So you don't have diversification. Imagine if you had a bond portfolio with the same volatility as stocks and you went through the financial crisis. Most of the decline in your portfolio would have been protected because the stocks would have gone up in value by an amount that would have offset the other. You have to have comparable amounts of risk in that."

Friday 3 April 2015

Investing for Dummies

https://m.youtube.com/watch?v=bjNxiGDXbFM


https://m.youtube.com/watch?v=mU50LcHKYgY


https://m.youtube.com/watch?v=S9zII-z58eg

Sunday 29 March 2015

INVESTMENT MADNESS

INVESTMENT MADNESS























Here’s a question for you: what kind of business becomes more attractive as an investment proposition the more expensive it becomes?

The answer – apparently – is just about any business that has a strategy of acquiring other businesses.
Here’s how the logic works. Suppose you are the CEO of a company whose shares trade at a price/earnings of say 20x. That’s a robust multiple and demands a certain amount of growth. If your business doesn’t have the necessary organic growth, you will need to deliver the expected growth via acquisition. The good news is that you can buy companies in the same line of business from private sellers, and the multiples paid in the private market are much lower than 20x; perhaps even in the single digits.
This difference in multiple means that you can issue your own shares to acquire the privately held businesses, and achieve an automatic Earnings Per Share (EPS) uplift. The earnings attached to the shares you issue (at 20x) are much lower than the earnings you acquire in return, and so by the magic of arbitrage, your shareholders have achieved earnings (and presumably value) uplift.
Some acquisitions create value through synergy benefits, but for this strategy it is probably better to avoid that sort of thing. Integrating the acquired businesses and extracting the synergy benefits is troublesome, and likely to distract you from the main game. You are probably better off focusing on acquisitions that don’t require much integrating. That way you can do more acquisitions in a given space of time, and ….. achieve more EPS uplift!
This is advantageous for your strategy, as faster EPS uplift will justify a higher multiple being ascribed to your shares, and this in turn will increase the ratings differential between your shares and the businesses you are acquiring. A higher rating means a more magical arbitrage value.
In this way, you should be able to see that the more expensive your company’s shares become, the more effective your growth strategy becomes, and the whole thing becomes a kind of virtuous cycle.
…except that the logic is a tiny bit circular.
If for some reason your ratings were to fall, or private acquisition targets at low multiples were to become scarce, the whole charade might just start to unravel in the same way that it came about. A declining share price could wipe out the value creation potential of your strategy and justify an ever decreasing share price.
Here’s my tip: if you see a broker finding virtue in an elevated price/earnings multiple by pointing out that it facilitates EPS accretive acquisitions, it may be wise to count the seats between you and the exit row.
Tim Kelley is Montgomery’s Head of Research and the Portfolio Manager of The Montgomery Fund. 


http://www.montinvest.com/

Thursday 26 March 2015

Take On Risk With A Margin of Safety


When investing, it is well accepted that one of the main things you should focus on is risk. However, modern investment theory mainly focuses on the volatility of an asset in its treatment of risk. The margin of safety theory is a little different - it argues that downward spikes of volatility make stocks less risky. This is an important concept to grasp in depth, because common risk theories can lead to missed opportunities. Investing gurus Benjamin Graham and Warren Buffett were instrumental in developing margin of safety. Read on to find out how this theory helped propel their portfolios to meteoric heights.
Beta's Misgivings

In general, people do not like surprises. More precisely, people do not like adverse surprises. Because investors are assumed to be more averse to losing money than gaining it, modern investment theory views the volatility of an asset, as measured by its beta, as the main component of risk. The theory implies that investors should pay less for an asset with a higher beta.
One problem with beta is that it implies that if an asset's value suddenly drops, even due to irrational market behavior, that it becomes more risky because it will have a higher beta. We'll poke some holes in this view in moment, using an example from Warren Buffett.
An Alternate Strategy of Risk

Introduced by the father of value investing, Benjamin Graham, and notably implemented by Warren Buffett, margin of safety was presented as a different view of risk and how to protect against it. Graham's concept is not new. He first presented his investing style with David Dodd in 1934's "Security Analysis" and later with his more accessible book, "The Intelligent Investor", which was first published in 1949.
Graham characterized volatility as "Mr. Market" coming each day to buy from you or sell to you. Graham hoped to buy assets that Mr. Market would sell to him with a 50% margin of safety. This, essentially, would be like trying to buy a dollar for $0.50.
Graham discussed how companies all have an intrinsic measurable value. When Graham first pitched and practiced this idea, information on companies was not nearly as easy to access. He would search through the financial statements and look for what he called net-nets, or companies trading below their liquidation values.
Graham would take a company's current assets with considerable deductions, and subtract all of the liabilities on the balance sheet. At its heart, Graham's net-net investing is the most conservative value approach, and involves very little risk if done right.
Example - Finding A Company\'s Net-Net
ABC Company has the following balance sheet and market capitalization:
Cash $250
Cash Equivalents $50
Accounts Receivable (A/R) $100
Inventories $100
Total Liabilities $300
Share Price $62.50

Cash and cash equivalents are good to go, we have $300 there. Next, we turn to A/R, some of which will not be paid. Usually we have a net A/R number on the balance sheet, indicating the amount of receivables the company expects to recover. If we have it, this net number is based on the company's history of collecting receivables, and is a good indicator, but we would still discount it a little for added safety.
In this scenario, we have a gross A/R number. Again we don't expect to recover it all, but ABC is known to have a fairly reliable client base and we could easily anticipate recovering around 80% of A/R - to be even more conservative we will only factor in recovering 75%. Many investors may want to take a look at the company's allowance for doubtful accounts in their financial statements as a method for gauging an accurate recovery percentage, but in this case, we'll value A/R at $75 ($100 x 0.75). Finally, there is ABC's inventory. ABC has competitors, which we could assume, at the very least, would buy the inventory for half its value. So we take the inventory's value at $50 ($100 x 0.5).

SEE: Volatility's Impact On Market Returns


We end up with marked down current assets of $425 ($300 + $75 + $50), and total liabilities of $300. This net-net is worth $125 ($425 - $300), not even accounting for any real estate or other long-term assets the company might have. With the company selling at only $62.50 in the market, this is a net-net with a 50% margin of safety. Paying half of a company's net-net value was Graham's goal, and at most, he would pay two-thirds of a company's net-net value, for a 33% margin of safety. In our example, we have a 50% buffer between the market value of the company and our conservative valuation of the company's current assets. By only buying at a steep discount to our valuation, this margin of safety provides its own built-in measure against the risk of mistakes in our calculations.
Let Volatility Be Your Friend

This process of investing did not guarantee success, but with research and hard work, finding one of these scenarios was about as close to a sure thing as you could get. A lot has changed, and Graham's net-nets have essentially disappeared in the modern market. With the quick and widespread dissemination of information, markets have become somewhat more efficient.
While net-nets are disappearing, investors can see that the market provides sales on assets quite often. The concept of buying companies with an adequate margin of safety still remains, and has been practiced with great success by many value investors, most notably Warren Buffett.
Example - Taking the Value of Long-Term Assets Into Account
In the ABC example, we gave absolutely no value to the company\'s long term assets. Let\'s return to the example and suppose that that the company\'s share price is now at $200. We calculated its net-net worth at $125, so according to that it would not be a good value, but we note that ABC also has the following assets on its books:
Plant, Property, & Equipment $200
Long-Term Bonds $100

We notice from some research that the plants on the company's balance sheet have likely appreciated because property values have gone up in that area. However, we will remain very conservative in this example and still value it at $200. Next, with the company's long-term bonds, we may worry about the market value if the bonds need to be sold quickly. We will only accept 75% of the value, and value the bonds at $75 ($100 x 0.75). We end up with an asset value of $400 (net-net worth of $125 + $200 + $75). Again, we can buy the stock of this company with a 50% margin of safety at its current market price of $200.
This again seems like a home run of an investment. We are still being conservative, and we ignored any assets that could be off ABC's books, such as the appreciated value of its real estate. Other hidden assets are brands, exceptional management, competitive advantages, etc. There is much to be said about the market value of hidden assets, but the point will remain the same.
Don't Run From Beta

Now looking strictly at beta, let's say ABC had a beta of 1.5. After all of our work, we decide to go to bed and buy tomorrow. However, the next day, "Mr. Market" decides to take the price of ABC down to $150, while the rest of the market stays pretty flat. This sharp 25% decline in ABC stock makes it riskier according to beta.
However, according to Warren Buffett in his 1993 letter to shareholders this altered perception of risk is misleading:
"Under beta-based theory, a stock that has dropped very sharply compared to the market - as had Washington Post when we bought it in 1973 - becomes "riskier" at the lower price than it was at the higher price. Would that description have then made any sense to someone who was offered the entire company at a vastly-reduced price?"
What this means is that volatility is our friend in this scenario. We did the work to value the company, and now Mr. Market is just offering it to us at a steeper discount and a higher margin of safety. If we had already made the purchase before the decline, we might kick ourselves for bad timing, but according to our research, an investment in ABC is still worth much more than what we paid.
Take a Page From the Masters

The concept of margin of safety as practiced by Warren Buffett is not that complicated. These are fairly simple ideas, and should teach us all not to rely simply on volatility as a judge of risk. Many common theories of risk make volatility out to be a bad thing, and if a stock's sea becomes choppy, some investors may sail for calmer waters. But take a cue from Warren Buffett. He, and other value investors, get excited in volatile and down markets. If you invest carefully, and with an adequate margin of safety, Mr. Market's mood swings can lead to great opportunities.

Follow Warren Buffet’s Road to Riches


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http://www.investopedia.com/articles/financial-theory/08/margin-of-safety.asp?rp=i&utm_source=coattail-buffett&utm_medium=Email&utm_campaign=WBW-3/26/2015

Tuesday 24 March 2015

The Shrinking Ringgit































http://www.theborneopost.com/2013/12/22/the-shrinking-ringgit/

From 1980 until 2012, Malaysia GDP per capita PPP averaged US$9,336.30, reaching an all time high of US$14,774.60 in December of 2012 and a record low of US$5,063.40 in December of 1980.

Maximising your ringgit

With all these in mind, what then can you do to stretch your ringgit to its fullest? Sjimons lists eight tips to help the average consumer trim costs and spend wisely:

A. If you have savings beyond two or three times your monthly income, don’t let them sit idle in a low-interest deposit account.

1) Invest a portion of your monthly income in Amanah Saham Bumiputera/National schemes. These have provided average effective yields of 8.81 and 6.11 per cent respectively over the past three years. Although there is no upside through capital appreciation, there is no risk of capital depreciation either.

2) Invest a portion of your savings in Real Estate Investment Trusts (REITs). By law, at least 90 per cent of taxable income is required to be paid out on a quarterly basis. Some REITs even have monthly payouts to unit holders. Yields range between 4.58 per cent  to 7.52 per cent across all 14 Bursa-listed REITs. This is an especially good project for people looking to retire who want to create a regular income stream.


Saturday 21 March 2015

3 legs of Margin of Safety


Yes, this is the single most important thing you should know in investing.

ALWAYS buy with a margin of safety. Margin of safety issues are both qualitative and quantitative.

Let me show where I look for these margin of safety factors in my stock selection. There are 3 areas where one should look for margin of safety. Let's call these the 3 legs of Margin of Safety. Here they are.

1. QUALITY (Good to great quality growth stocks, with durable competitive advantage)

2. MANAGEMENT (Managers with integrity, intelligence and hardworking. Operational efficiency: Profit margin trends, ROE trends, and D/E trends that are good/great, maintained or improving)

3. VALUATION (Fair to bargain prices for Great companies, Big bargain prices for good companies.)


Well, choose your picks.

Yes, you can get great bargains too in foraging in gruesome companies that are selling at big bargain prices. Often, many of these remain gruesome and the prices may even continue to go down more due to fundamental deterioration in their businesses.

You have a build in margin of safety, IF you have the ability to pick good or great stocks that are selling at bargain or fair prices, especially when your investing horizon in holding these stocks are for the long term (>5 years). Warren Buffett teaches another margin of safety criteria of his own - that it is better to buy a great stock at fair price, than a fair stock at great price. Surely, he did not preach this without a basis.

If you dwell deeper into this statement, although many may look at this from the superior returns that the great stock offer over the good stock, though bought at perceived fair price (instead of bargain prices for a good stock), it is just another way of saying that the margin of safety for great stocks is better than for a good stock as you are more certain of the growth and earnings power of the great companies. This high probability of being right in projecting the earning power of the great companies is where the margin of safety lies.

In the gruesome company, they are termed gruesome because their earning power were non-existent, deteriorating or even un-predictable over the short or the long term.


I advise that if the companies you study fail in the QUALITY AND MANAGEMENT ISSUES, don't bother with the valuation. Keep the study and proceed no further with its valuation since we are only seeking to invest in stocks for the long term. There are so many other stocks to study for your LONG TERM portfolio. Your long term portfolio should only include the best quality stocks that are projected to deliver returns of > 15% or more per year (with reinvestment of the dividends).

When would you buy these stocks that have satisfied the quality and management issues (the first and second legs of the margin of safety) and that you have in your "to invest" list? Yes, you then look for a good price to buy, the third and last leg of margin of safety. This is when the price offered promises safety of capital (upside reward: downside risk of > 3:1) and a projected annualised return of > 15% per year.


Putting the 3 legs of margin of safety issues into perspective.

1. I am looking to populate or invite a company to join my esteem group of great companies in my portfolio for the LONG TERM.

2. I stress on 3 legs of margin of safety issues.

3. The first and second legs of my Margin of Safety issues look at QUALITY AND MANAGEMENT.

4. Why are they important? These qualities will allow me to predict their earning power, the most important thing that is going to deliver great returns to my portfolio.

5. The third or last leg of my Margin of Safety issues is also important. By buying at low prices, my upside: downside ratio is in my favour (I want at least >3:1, needs a lot of patience), thereby protecting my downside. A lower price gives me an additional return when the stock is revalued at its fair price.

6. One is investing for the long term, and often if the stock is a great stock with great earning power, you virtually need not have to sell. The total return after many years is mainly contributed by its earnings power, the great bargain price you bought into offer you an additional short term gain, which contributes a little only to the overall return over the long term, (though it was a big return over jthe short term.)

7. Stay focus on the long term.


Friday 20 March 2015

Valuation in a Business Divorce

THE LEGAL INTELLIGENCER BLOG
Valuation in a Business Divorce
Terry Silver, The Legal Intelligencer
March 19, 2015

My advice to lawyers and CPAs is to prepare your clients for the prospect of a business divorce. A business relationship is no different than a marital one; people change, circumstances change, and people grow (and don’t grow) in different directions. And by “preparing for a business divorce,” I am referring to the need to create an operating agreement from the outset of a business relationship to address the following issues, if and when they arise:

Death of an equity owner;
Disability of an equity owner;
Sale of an equity interest to a third party;
Termination of an equity owner’s employment; and
The subject of this article: the predetermined steps to value an equity interest.

When a new business begins, financial resources are usually devoted to its tangible needs, while intangible needs are usually delayed. An operating agreement is typically recognized as an intangible need that can wait until cash flow improves. I, however, advise both new and newer business owners to negotiate the terms of an operating agreement as early in the business life cycle as possible, as once issues develop, it will be too late to negotiate a mutually acceptable operating agreement.

To address valuation, an operating agreement typically will either provide a specific method to value the business, or will designate the means by which to value the business. For example, the operating agreement can specify a methodology such as 5 x EBITDA or 1.5 x revenue. I strongly advise against this approach for two reasons: (1) The person selecting the valuation approach is most likely not qualified in business valuation, so the method selected may be flawed; and (2) there is no one correct way to value a business. As time and circumstances change, so too may the appropriate method to value a business change.

For these reasons, a fixed valuation method, to be used for all time, is ill-advised. I recommend the operating agreement specify the business be contemporaneously and independently valued, and the valuation be binding, as to avoid time-consuming and costly litigation. I further advise the operating agreement specify the credentials of the business valuator chosen to insure a credible valuation product. Commonly accepted valuation credentials include ASA, CVA, ABV and CFA.

Lastly, there may be a dispute between owners in the selection of the business valuator. This can be avoided by incorporating a provision in the operating agreement that enables each owner to select a business valuator. These two business valuators, in turn, jointly select the final business valuator, whose valuation opinion will be binding. This is a lesser used provision, as it is almost always preferable for the parties in dispute to choose a mutually acceptable valuator.

Taking the time in the early stage of a business to address potential adversarial issues via the operating agreement will save a great deal of time, anxiety and money once problems develop between owners.

Terry Silver is a partner at Citrin Cooperman, a full-service accounting, tax, and consulting firm with offices located throughout the Northeast. Based in Citrin Cooperman’s Philadelphia office, Silver focuses his attention on business valuation services and mergers and acquisitions. To learn more, visit www.citrincooperman.com.

http://www.thelegalintelligencer.com/all-news/id=1202721048001/Valuation-in-a-Business-Divorce?mcode=1202615493286&curindex=0&slreturn=20150220005029

### Attractive Buying Opportunities arise through a Variety of Causes

Attractive buying opportunities for the enterprising investor arise through a variety of causes.

The standard or recurrent reasons are
(a) a low level of the general market and
(b) the carrying to an extreme of popular disfavor toward individual issues. 

Sometimes, but much more rarely, we have the failure of the market to respond to an important improvement in the company's affairs and in the value of its stock.

Frequently, we find a discrepancy between price and value which arises from the public's failure to realise the true situation of a company - this in turn being due to some complicated aspects of accounting or corporate relationships.

It is the function of competent security analysis to unravel such complexities and to bring the true facts and values to light.


Benjamin Graham
Intelligent Investor


Summary:

Attractive buying opportunities (discrepancy between price and value) occur due to various causes:
1.  low level of the general market
2.  extreme of popular disfavour towards individual stocks
3.  failure of market to respond to improvement in the company
4.  failure to realise hidden value in the company due to some complicated aspects of accounting or corporate relationships

Monday 16 March 2015

How Many Mutual Funds Routinely Rout the Market? Zero



The bull market in stocks turned six last Monday, and despite some rocky stretches — like last week, when the market fell — it has generally been a very pleasant time for money managers, who have often posted good numbers.

Look more closely at those gaudy returns, however, and you may see something startling. The truth is that very few professional investors have actually managed to outperform the rising market consistently over those years.

In fact, based on the updated findings and definitions of a particular study, it appears that no mutual fund managers have.

I wrote about the initial findings of that study last summer. It is called “Does Past Performance Matter? The Persistence Scorecard,” and it is conducted by S.&P. Dow Jones Indices twice a year. The edition of the study that I focused on began in March 2009, the start of the bull market.

It included 2,862 broad, actively managed domestic stock mutual funds that were in operation for the 12 months through 2010. The S.&P. Dow Jones team winnowed the funds based on performance. It selected the 25 percent of funds with the best returns over those 12 months — and then asked how many of those funds actually remained in the top quarter in each of the four succeeding 12-month periods through March 2014.

The answer was remarkably low: two.

Just two funds — the Hodges Small Cap fund and the AMG SouthernSun Small Cap fund — managed to hold on to their berths in the top quarter every year for five years running. And for the 2,862 funds as a whole, that record is even a little worse than you would have expected from random chance alone.

In other words, if all of the managers of the 2,862 funds hadn’t bothered to try to pick stocks at all — if they had merely flipped coins — they would, as a group, probably have produced better numbers. Instead of two funds at the end of five years, basic probability theory tells us there should have been three. (If you’re curious, I explained how the math works in a subsequent column, “Heads or Tails? Either Way, You Might Beat a Stock Picker.”

The study seemed to support the considerable body of evidence suggesting that most people shouldn’t even try to beat the market: Just pick low-cost index funds, assemble a balanced and appropriate portfolio for your specific needs, and give up on active fund management.

The data in the study didn’t prove that the mutual fund managers lacked talent or that you couldn’t beat the market. But, as Keith Loggie, the senior director of global research and design at S.&P. Dow Jones Indices, said in an interview last week, the evidence certainly didn’t bolster the case for investing with active fund managers.

“Looking at the numbers, you can’t tell whether there is skill involved in what they do or whether their performance is just a matter of luck,” Mr. Loggie said. “I believe that many of them do have skill. But even if they do have it, based on how they’ve done in the past you really can’t predict how they will perform in the future.”

Still, those two funds did manage to perform splendidly in that study. Their stubborn persistence at the top of the heap over that five-year period suggested that there was some hope for active fund managers. If they could do it, after all, others could, too.

But we’re now about two weeks away from the completion of another 12 months since the end of that study, and it’s been a mediocre stretch, at best, for those two mutual funds. When the month is over, to borrow from Agatha Christie, it looks as though we’ll be saying: And then there were none.

Here are the dismal statistics: The SouthernSun Small Cap fund has actually lost money for investors over the 12 months through Thursday. It was down 3.2 percent, according to Morningstar, and for the nine months through December, it was in the bottom quartile of funds in the S.&P. Dow Jones study. The Hodges Small Cap fund has done better, gaining almost 6 percent through Thursday. S.&.P. Dow Jones Indices says that put it in the third quartile — or second-to-worst one — through December. While it’s mathematically possible, it is highly unlikely that either will climb to the top quartile in the next few weeks, Mr. Loggie said.

Michael W. Cook, the lead manager of the SouthernSun Small Cap fund and the founder of the firm that runs it, was traveling last week and was unavailable to comment for this column. Craig Hodges, manager of the family-run Hodges Small Cap fund in Dallas, spoke to me on the telephone and told me that he wasn’t surprised that his fund had stumbled. “We’re not that good,” he said. “It was going to happen sooner or later. We’ve never expected to outperform all of the time.” And despite disappointing recent returns, both funds are still beating the market handily over the last five years.

Late last year, Mr. Hodges said, his fund was hurt by falling energy prices, which pulled down the returns of several of its holdings. “That kind of thing will happen,” he said. “You can expect that.” Last summer, he told me that over the long run — which he said is probably 50 years or more — he expects that his fund will do better than average. And he reiterated that view last week. “We’ll come out all right in the end,” he said. “I think if you pick a good manager, someone you believe in and you think you can trust, you’ve got to stick with him for a long time, and if he’s good, he’ll perform for you.”

Mr. Loggie and his crew are continuing their regular monitoring of mutual fund performance. Right on schedule, they did another winnowing of mutual funds through the five years that ended in September — and they will do another one for the five years ending this month.

The September performance derby produced more funds that ended up consistently in the top quartile — nine of them, Mr. Loggie said. “That’s not surprising,” he said. “Some periods you have more funds, some periods you have less.”

But what you never have, he said, is any indication that past performance predicts future returns. “It’s possible that any one of these funds will beat the market over the long term,” he said. “Some of them will do that. But the problem is that we don’t know which of them will do that in advance.” And that, in a nutshell, is the kernel of the argument for buying index funds.


http://www.nytimes.com/2015/03/15/your-money/how-many-mutual-funds-routinely-rout-the-market-zero.html?rref=collection%2Fcolumn%2Fbusiness-strategies

Warren Buffett’s Awesome Feat at Berkshire Hathaway, Revisited

Warren Buffett is taking a victory lap, and on the 50th anniversary of his reign at Berkshire Hathaway he is entitled to it. From a failing New England textile company, Berkshire became the vehicle for one of capitalism’s greatest investing feats.

Mr. Buffett is one of the world’s richest men — and he has made his shareholders an astounding amount of money. How much, exactly? He cast a spotlight on that question in his annual letter to shareholders, issued on Feb. 28. In a break with tradition, the letter included a table on its second page that enumerates the market return of Berkshire shares, year by year.

Until now, he has favored another method for measuring success: the change in the book value of the shares. That’s an accounting metric. It is, basically, net assets, and he has said it is better than Berkshire’s transitory market price at tracking the company’s true worth.

However you analyze it, Berkshire’s long-term performance has been awesome. Using market value, he says, its shares gained 21.6 percent annually compared with 19.4 percent for book value and 9.9 percent for the Standard & Poor’s 500-stock index, with dividends. Using market returns, the shares gained a cumulative 1,826,163 percent since he took control.

Consider that at the end of 2014, an investment of $100 in the 1965 Berkshire shares would be worth $1,826,163. For the same period, $100 in the index, with dividends, would have grown to $11,196. That’s not shabby. But it’s a lot less than the Berkshire investment — $1,814,967 less.

So it may seem churlish to quibble. But it’s worth raising some questions, if only because Mr. Buffett has invited them. Performance is critical. He says that if he doesn’t outperform the market, investors shouldn’t trust him with their money.

Until this year, he has invoked book value: Page 2 of his letter would include the book value return, the S.&P. return and a third column, “relative results,” which showed how he was doing in comparison with the index. Now that comparison is gone. If that column existed in the current report, it would show that he trailed the S.&.P. again, using book value.

In fact, counting 2014, Mr. Buffett has underperformed the S.&P. 500, using book value, in five of the last six years. That hasn’t happened before. His 2010 letter to shareholders showed Berkshire’s returns over five-year rolling periods. In every single such period until then, he had outperformed the S.&.P., using book value.

By shifting to the market value metric — for the first time in 50 years — his returns look better. Would he have added a table on his golden anniversary showing market value if it had been a bad year for Berkshire in the stock market, whose judgment he has often disdained? I don’t know. Mr. Buffett declined to comment.

In the current letter, Mr. Buffett says that book value and intrinsic value — his estimate of the true value of the company, which he will not publicly reveal — have diverged since Berkshire’s early years. (Intrinsic value, which is at the core of his investing, represents “the discounted value of the cash that can be taken out of a business during its remaining life,” in his words. That calculation is subjective, depending on judgments about factors like a business’s prospects, its management’s ability now and in the future, and the likely path of interest rates and the economy.)

In that letter, he says: “Our emphasis has shifted in a major way to owning and operating large businesses. Many of these are worth far more than their cost-based carrying value. But that amount is never revalued upward no matter how much the value of these companies has increased. Consequently, the gap between Berkshire’s intrinsic value and its book value has materially widened.”

That makes sense. Berkshire’s subsidiaries, like See’s Candies, Geico, the Burlington Northern Santa Fe Railway and Berkshire Hathaway Energy Company, are being carried on Berkshire’s books at a fraction of their real value, he says. On the other hand, retained earnings from those companies, which are reinvested, do, in large part, show up elsewhere in the ledger. That’s why, over the long run, he has said, book value is a worthwhile metric.

His long-term performance is remarkable, using book value, too. He has handily beaten the market over a long career. Still, in a column last year, relying primarily on a rigorous statistical analysis by Salil Mehta, a statistician, author and blogger, I pointed out that Mr. Buffett’s market-beating heroics had dimmed. Last week Mr. Mehta did preliminary crunching of the new numbers. He still found that Mr. Buffett’s performance had declined.

“The new numbers don’t change my probability analysis,” Mr. Mehta said. “Warren Buffett has been an extraordinary investor. But he hasn’t been doing as well recently.”

Mr. Mehta’s calculations show that over his first 25 years at Berkshire, Mr. Buffett’s average annual return was 24 percent using book value and 30 percent using market value, compared with 10 percent for the S.&P. 500. Over his second 25 years, his performance was still outstanding: 15 percent for book value, 14 percent for market value and 10 percent for the index. The last six years reveal a different picture: 13 percent for book value, 15 percent for market value and 17 percent for the index. That’s no disaster, but Mr. Buffett didn’t meet his own standard: He frequently underperformed the market.

There’s no shame in that. Virtually everyone underperforms the market sometimes. To outperform it consistently, as Mr. Buffett has done over most of his career, is exceedingly rare. That’s worth celebrating, even if it’s also worth asking why the recent years haven’t been extraordinary.


http://www.nytimes.com/2015/03/08/your-money/warren-buffetts-awesome-feat-at-berkshire-hathaway-revisited.html?rref=collection%2Fcolumn%2Fbusiness-strategies



Buffett's remarkable performance over the last 50 years.

“The new numbers don’t change my probability analysis,” Mr. Mehta said.
 “Warren Buffett has been an extraordinary investor. But he hasn’t been doing 
as well recently.”

Mr. Mehta’s calculations show that

over his first 25 years at Berkshire, Mr. Buffett’s average annual return was
24 percent using book value and 30 percent using market value, compared 
with 10 percent for the S.&P. 500. 

Over his second 25 years, his performance was still outstanding:
15 percent for book value, 14 percent for market value and 10 percent 
for the index.

The last six years reveal a different picture:
-  13 percent for book value, 15 percent for market value and 17 percent for 
the index.

That’s no disaster, but Mr. Buffett didn’t meet his own standard: He frequently
underperformed the market.

Saturday 14 March 2015

Saved $1 million and living my dream retirement


Roy Nash long dreamed of retiring at the age of 55.

A self-taught investor, he diligently stashed all the savings he could in stocks and mutual funds. So by 2009, when he did turn 55, he says he had more than $800,000 saved -- enough to step away from his nearly three decade long career at a natural gas distributor in St. Louis.  

Now Nash is 61 and his smart investment choices have helped him grow his retirement savings to more than $1 million.
This sizable nest egg allows him to live the lifestyle he wants. He takes four trips a year to places like Chile and Jamaica and, during the rest of the time, he's volunteering around town, driving the elderly to doctor's appointments or helping poor families file their income taxes.  Now Nash is 61 and his smart investment choices have helped him grow his retirement savings to more than $1 million.
How did he do it?
Nash said he learned about the importance of saving from his mother, who raised him in Marianna, Ark.
"My mom told me when I was real small I should learn how to save some money, because my father was a spendthrift," said Nash. "I took it to heart and went beyond saving. I became an investor."


At the age of 22, he moved to St. Louis and eventually went to work as a controller for the largest natural gas distributor there.

During his free time, he taught himself to invest by reading Money and SmartMoney magazines. That's how he learned to love dividend stocks, high-yield, closed-end funds and mutual funds. He also invests in open-end funds and index funds.
Every year, he socked away between 10% and 15% of his income into his 401(k) plan. Additionally, he also saved another $300 a month in investing accounts with Fidelity.
"I wouldn't consider my savings a sacrifice. I had a good paying job and a budget," Nash said. "I disciplined myself."
And he was mindful about looking after his money and reinvesting gains back into funds and stocks.
"I always reinvested my capital gains," Nash said.
In the beginning, he worked with a brokerage to invest his money. But now he manages his own portfolio.
Nash said he's in an informal retirement club, mostly other retired friends from the office, who he loves teasing about their money managers.
Roy Nash on vacation with his family


"They're paying these guys 1.2% to 2% in fees!" Nash said.
Nash said he collects a healthy sum each year in dividend payouts from his investments in high-yield closed-end mutual funds and preferred stocks.
But still he keeps things simple, living on around $50,000 a year.
Too young for Medicare, Nash gets health insurance through Obamacare, "which has been fantastic," he said.
His retirement income is also enough to satisfy his lust for travel. He takes several trips each year. Often it's just visiting family and friends in Arkansas. But this year, he went to Mardi Gras in New Orleans. He's going to Jamaica in the spring and Santiago, Chile later in the year.
Most days, Nash fills his time by offering his services to the community. During the tax season, he helps the poor prepare their tax forms. And he volunteers for the county, driving housebound elderly residents on much-needed medical errands to doctor's appointments and the pharmacy.
He also plays golf and likes to go fishing, hunting and boating. And he works out at least five days a week, either on a treadmill or a bicycle for between 20 and 30 minutes a day.
"The most important thing I do, is live an active lifestyle," Nash said. "That keeps my doctor bills down."
He has two kids and six grandchildren, ages 3 to 15. Lately, he's become his family's go-to, back-up childcare for sick grandkids.
"If the kids are sick, I go and pick them up, so it doesn't disrupt their parents' work," he said.
And he takes pride in telling his story throughout the community, to help young people learn the importance of saving regularly and early.
"If your income is equal to your expenses, you're not going to save anything," Nash said. "I think anyone making $40,000 a year should be able to save money in St. Louis." 

http://money.cnn.com/2015/03/09/retirement/dream-retirement-million-dollar-saving/index.html?iid=SF_PF_River

Wednesday 11 March 2015

Author of “The Millionaire Next Door” dies — 7 key insights from his book

You may not know the name Thomas Stanley, but chances are you’ve heard of “The Millionaire Next Door,” the blockbuster book Stanley cowrote in the mid-1990s.
Wealthy couple watching polo
The book sold more than two million copies and spawned a slew of spin-offs, including “Millionaire Minds” and “Millionaire Women Next Door.” Sadly, Stanley died last week at the age of 71 in a car accident near his home in Marietta, Ga. At the time of his death, he and his daughter, Sarah Fallaw, a psychologist, were working together on the latest iteration of the “Millionaire” series, with a fresh look at millionaires in post-recession America, according to the Atlanta Journal-Constitution.  
Although Fallaw said she would continue her father’s work posthumously, it will be a while before the results of their research are published.
In the meantime, we decided to crack open “The Millionaire Next Door” and revisit some of Stanley and co-author William D. Danko’s findings.
When the duo set out to create a composite of the modern American millionaire, they conducted their own survey of 1,000 high-net-worth individuals. At the time, Stanley was a professor of marketing at Georgia State University and Danko was Stanley’s former research assistant who would go on to become a marketing professor in his own right. What they found was that most millionaires shared seven key traits in common, all of which create a lifestyle “conducive to accumulating money,” they write:  
1. They live well below their means.

  • In their research, Stanley and Danko found most millionaires weren’t heavy spenders. 
  • The majority spent less than $200 on shoes and only half could justify paying more than $235 for a wristwatch. 
  • Another surprising finding: two-thirds of the millionaires they surveyed said they followed a household budget.
2. They allocate their time, energy and money efficiently, in ways conducive to building wealth. 

  • For example, the authors found that millionaires were more likely to invest time planning their household finances than, say, shopping for a car. 
  • On the flipside, most people would have a lot more fun allocating time comparing car prices than sitting down with a financial planner and figuring out how much more money they have to save to be able to stop working at a certain age.
3. They believe that financial independence is more important than displaying high social status

  • “They inoculate themselves from heavy spending by constantly reminding themselves that many people who have high-status artifacts, such as expensive clothing, jewelry, cars, and pools, have little wealth,” the authors wrote.  
4. Their parents did not provide “economic outpatient care.”

  • Millionaires rarely become millionaires in their own right if their parents are constantly financing their lives. 
  • Otherwise, they risk becoming too financially dependent to make their own way.
5. Their adult children are financially self-sufficient.

  • Teaching kids to be self-sufficient not only encourages them to create their own financial security but ensures that they won’t be draining their parents’ finances later on.
6. They are proficient in targeting market opportunities.

  • Essentially, the wealthy become wealthy often by targeting occupations that serve other wealthy people (that’s their “market”). 
  • That’s where the real money is, Stanley and Danko argue. Jobs that serve the wealthy — for example, estate planning, law, accounting — often come with bigger paychecks.
7. They chose the right occupation. 

  • The authors found that roughly half of the millionaires they interviewed owned a business of some sort, but the vast majority said they would not encourage their children to follow in their footsteps. 
  • Millionaire couples with children were five times more likely to send their children to medical school than other parents in America and four times more likely to send them to law school, according to their findings.

Stanley and Danko’s findings may still ring true today, but the audience couldn’t be more different. When the book was published in 1996, the economy was booming and most people we were blissfully unaware of the pending dot-com bubble and bust. And no one knew that in just over a decade, the Great Recession would squeeze the middle class beyond recognition and deeply divide the rich and the poor.
“The Millionaire Next Door” encourages the view that the real millionaires of America — the frugal spenders, the self-made entrepreneurs, the savers “next door” who don’t seek attention or flaunt their wealth — haven’t actually done anything all that extraordinary to achieve financial success.
But, if we learned anything from the Great Recession, it’s that unanticipated setbacks — a job loss, an unlucky diagnosis, a bad mortgage loan, a spouse’s unexpected death — can send anyone’s personal finances teetering. Not to mention factors beyond most people’s control, such as lagging wage growth and rapidly increased fixed costs like housing, health care and education. Despite all we’ve been through, however, the message that anyone can accumulate wealth if they put the work in is one that still sells in America. Books like Stanley's can help inspire good financial habits, but the reality facing most workers today is that they’ll need much more than a seven-step guide to get them there.

http://finance.yahoo.com/news/author-of-%E2%80%9Cthe-millionaire-next-door%E2%80%9D-dies-%E2%80%94-7-key-insights-from-his-book-213300777.html