Friday, February 28, 2014

The Top 17 Quotes from Buffett's Letter

Earlier this week, Warren Buffett shared an excerpt from the forthcoming Berkshire Hathaway shareholder letter, which sent investing geeks like me poring over every word.

It's all well worth a read, as you might expect, but here are my favorite quotes. I'll let them speak for themselves and provide some commentary at the end. 
  1. "I needed no unusual knowledge or intelligence to conclude that the investment had no downside and potentially had substantial upside."
  2. "You don't need to be an expert in order to achieve satisfactory investment returns. But if you aren't, you must recognize your limitations and follow a course certain to work reasonably well."
  3. "Keep things simple and don't swing for the fences."
  4. "When promised quick profits, respond with a quick 'no.'"
  5. "If you don't feel comfortable making a rough estimate of the asset's future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility." 
  6. "Games are won by players who focus on the playing field -- not by those whose eyes are glued to the scoreboard."
  7. "Forming macro opinions or listening to the macro or market predictions of others is a waste of time." 
  8. "It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings -- and for some investors, it is."
  9. "Owners of stocks...too often let the capricious and irrational behavior of their fellow owners cause them to behave irrationally as well." 
  10. "In the 54 years (Charlie Munger and I) have worked together, we have never forgone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions."
  11. "We recognize the perimeter of our 'circle of competence' and stay well inside of it."
  12. "The goal of the nonprofessional should not be to pick winners...but should rather be to own a cross section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal."
  13. "The antidote to (buying when the market is high) is for an investor to accumulate shares over a long period and never sell when the news is bad and stocks are well off their highs."
  14. "The unsophisticated investor who is realistic about his shortcomings is likely to obtain better long-term results than the knowledgeable professional who is blind to even a single weakness."
  15. "The resulting frictional costs (from advice and trading) can be huge and, for investors in the aggregate, devoid of benefit."
  16. "So ignore the chatter, keep your costs minimal, and invest in stocks as you would a farm." 
  17. "Before reading (The Intelligent Investor)...I tried my hand at charting and using market indicia to predict stock moments...I listened to commentators. All of this was fun, but I couldn't shake the feeling that I wasn't getting anywhere."
Buffett's commentary is broadly consistent with the purpose of this blog -- specifically, using patience and long-term thinking to your advantage, not letting Mr. Market's mood swings influence your decisions, and investing when the odds are in your favor.

It all seems so obvious, doesn't it? As we've discussed before, successful investing might be simple, but it's not easy. Patience, calmness, and selectivity are all ideals that we strive for yet we frequently find overselves coming up short, often getting caught up in market noise or falling into a trap of overconfidence.

Buffett's periodic letters, if anything, remind us where the North Star of investing lies and challenge us to seek simplicity.

Where Buffett meets Bogle

If I have one critique of the letter, it's that Buffett -- who's fully aware that everything he writes will be read for generations to come -- appears to be putting less emphasis on individual security selection and more on index funds at this stage in his career.

Interestingly, Ben Graham also changed his tune regarding security selection toward the end of his career in 1976.
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...To that very limited extent I'm on the side of the "efficient market" school of thought now generally accepted by the professors. 
Similarly, Buffett states in this letter that "the goal of the nonprofessional should not be to pick winners -- neither he nor his 'helpers' (i.e. investment professionals) can do that," and concludes that a low-cost S&P 500 index fund is a better option.

These comments seem to be a departure from his stance in The Superinvestors of Graham & Doddsville (1984) in which he gives examples of value-oriented investors that have consistently outperformed the market and whose track records run contrary to the efficient market hypothesis.
Is the Graham and Dodd "look for values with a significant margin of safety relative to to prices" approach to security analysis out of date?...Well, maybe. But I want to present to you a group of investors who have, year in and year out, beaten the Standard & Poor's 500 stock index.
Don't get me wrong -- I'm an advocate of index funds (indeed, I own a few in my own portfolio) and think that the financial services industry deserves a fair amount of criticism for high fees and underperformance. Still, I think there remain plenty of opportunities for superior stock selection in today's market. Stock picking opportunities didn't disappear after Graham's comments in 1976 and they won't disappear now.

Good reads this week
Quote of the week
"You don't know how easy this game is until you get into the broadcasting booth." - Baseball legend, Mickey Mantle (via Buffett's letter)
Stay patient, stay focused.



(I own shares of BRK.B)

Sunday, February 23, 2014

Has It Come to This Again?

I first learned about WhatsApp a few months ago when a friend coming to Chicago from overseas asked me if I used the program so that we might avoid expensive international text messaging fees while coordinating our plans.

Now, I'm generally a late adopter of technology and wasn't surprised that I hadn't heard about WhatsApp before, but I never expected that I was overlooking a $19 billion enterprise -- the price Facebook is paying to acquire the company.

The initial market reaction to the deal seemed to be one of shock -- Facebook paid how much for a four-year old messaging service? But as the days have passed, the market seems to be rationalizing the deal as reasonable.

Indeed, I've read numerous reports about how the $19 billion Facebook paid actually a pretty good deal relative to other social media transactions...on a price-per-user basis.

When reading these reports, I immediately recalled the valuation metrics used during the Internet boom of the late 90s -- i.e. the "price-per-eyeball" and "price-per-click" metrics that were also taken seriously by analysts at the time. And we all know how that ended.

Whenever investors valuing companies on things other than assets, earnings, and cash flows it's time to be skeptical.

Maybe WhatsApp is a much more valuable asset than I think -- Mark Zuckerberg knows much more about social media than I do, after all -- but I don't believe the price-per-user metric tells us anything about the asset's intrinsic value.

If anything, I'm more concerned that investment community hasn't learned the lessons of the dotcom boom and bust and is taking silly metrics seriously again.

Stay patient, stay focused.



Saturday, February 8, 2014

Why You Need An Investing Partner

My wife, Kate, would have made an excellent financial analyst had she chosen that career path. Fortunately for the world, she chose the much more socially-valuable profession of teaching science.

Once, when we were having dinner with some former work colleagues, out of curiosity, the company's CEO drew some random stock charts on a napkin and asked each one of us -- all trained analysts, except Kate -- to describe what we thought was happening in each chart. 

By far, Kate's answers were the most unique and insightful, as she applied her scientific mind to the question while us analysts searched our minds for clever technical analysis solutions. We were all impressed. In fact, the CEO offered her a job on the spot, which she ever so coolly declined.

Despite Kate's naturally sharp mind, I’ve been the self-appointed manager of the Wenning family portfolios with sole discretion on all investment decisions and portfolio allocations.

This arrangement might seem reasonable given my profession, but I’ve learned over the years -- sometimes the hard way -- that it’s much, much better to make investment decisions with another person -- and ideally, a person with a very different approach and background than your own.

Fortunately, I haven't messed anything up in our accounts, but I probably would have done even better had I consulted with Kate on my investing decisions all along.

A better system

Earlier this week and on her request, I helped Kate research and buy a stock in her "plush" (her words) teaching retirement fund. I wanted to find a company that we could both understand and a company whose products we enjoy buying.

After running some screens for promising dividend-paying stocks, I came upon Cracker Barrel Old Country Store (CBRL) and thought it was a good one for us to research together.

With family scattered across half the country, Kate and I do a bit of traveling for holidays and special occasions and typically stop at a Cracker Barrel restaurant along the way. Cracker Barrels are typically situated off the highways -- indeed, 40% of company revenue comes from travelers making pit stops.

Source: Cracker Barrel

I did some preliminary research on the company and brought the idea to Kate. Her first reaction was, "Hmmmm." I could see the gears turning...

She asked me a number of thoughtful questions like:
  • Where are their stores located around the country?
  • How well do they retain their wait staff?
  • How much can they grow?
  • Can the Southern country-themed restaurant brand translate into new markets like California?
  • How much money do they make from their retail stores?
  • How much do the shares cost? Is that a good price?
  • How have they done recently?
Good questions, right? Certainly all questions you'd want to have answered before investing.

She also made a number of astute observations, such as:
  • The restaurant is usually crowded and there's typically a line to get a table.
  • It's family friendly. Kids, and you, like to play the peg game
  • Of your food options on the road, Cracker Barrel has the best quality and is affordable.
  • Friends we've taken there seem to enjoy it.
The key point here is that some of Kate's questions and observations made me reflect on my initial investment thesis in ways I might not have otherwise. And that's what a good investing partner can do for you.

Where else can you eat your sausage gravy over biscuits while playing checkers in front of a roaring fire?
Financially, the company checked all the boxes for a potential dividend investment, it scored well on the Dividend Compass, and while the stock was by no means "cheap" on a Ben Graham scale, it did seem slightly undervalued with more potential upside than downside.

Kate's insights added to my conviction and she bought some shares at $95.96 on Thursday.

Bottom line

As much as we might try to shake our own emotional and cognitive investing biases, it takes Buddha-like self-awareness and self-discipline to recognize and subdue those biases on your own. Try as you might, you can find yourself making the same mistakes again and again.

In contrast, having an investment partner (or team) can serve as both a mirror and filter for your bias-laden ideas and improve your decision making process. Remember: even Warren Buffett has Charlie Munger.

Will our Cracker Barrel investment work out? Time will tell, but I believe our process was more thorough and effective than if I had done all the research and made the investment decision myself. Over time if our investment process remains sound, our results should also improve.

Note: I'm currently studying for the CFA Level III exam, so the frequency of CEI posts will be a bit slower in the coming months. Thank you for your patience and for following CEI!

Good reads this week
  • Napoleon's Fatal Mistake - Shane Parrish
  • Review: The Wolf of Wall Street - Monevator
  • Why the Middle Class Keeps Giving Itself the Shaft - Mr. Money Mustache
  • Whale Surfing: Why Buy Funds When You Can Ride Their Best Ideas - Ed Croft via Stockopedia
  • Balancing Risk vs. Return, Income vs. Growth, and Quality vs. Value - UK Value Investor
  • Jack Bogle's Advice for a Rocky Market: Follow Ben Franklin - Jack Bogle
Quote of the week


Saturday, February 1, 2014

A Simple Formula for Investing Success

The best time to plant a tree was 20 years ago. The second best time is now. - Anonymous
Investing is simple, but not easy. - Warren Buffett

When my wife and I lived in England, we had the pleasure of visiting her relatives in a small village in Gloucestershire (still can't pronounce that name properly). Her cousins' home sat on a plot of land adjacent to a medieval castle (seriously!) that served as an orchard for longer than the U.S. has been a country.

While much of the land has since found other uses, it still features a handful of the largest apple trees I've ever seen. Come harvest time, the trees have the potential to yield more apples than you would know what to do with.

How did each tree grow to such heights and yield so much fruit? It boils down to a simple formula:

Seed + good soil + right climate + patience 

In fact, I reckon we can apply a similar formula to our investments:

Investment + good company + right price + patience 

Just like with the apple tree, in order for this equation to work, each factor must be present.

Without the investment, for instance, nothing else happens. I know this is obvious, but bear in mind that only about half of American households own stocks at all. Not everyone is taking that first step and planting the seed.

It's also a matter of where the seed is planted. Just as rocky soil wouldn't allow a tree to grow to its full potential, investments in poorly run companies will likely struggle over long periods of time. Instead, look to own good companies -- that is, firms with durable competitive advantages and strong financials that are run by able and trustworthy management teams. It's these companies that will give your investment the best chance to grow over the long-term.

Good companies should also be purchased at the right prices, of course, just as an apple tree needs to be planted in the right type of climate. As I noted in this post, an investment can be made in a good company and held patiently, but if it was bought at too dear of a price, it won't yield as much as the same company bought at a discount.

The final step is the trickiest one of all. Having the patience to hold a single investment for more than a few months isn't easy, let alone a few decades, yet you wouldn't tear down a tree for not producing bushels full of fruit right away, would you? It's only over longer periods of time that both yield great rewards.

Consider a simple portfolio currently generating $1,000 in annual income. Even assuming moderate levels of real dividend growth between 3% and 5% per annum and not considering additional investments, dividend income more than doubles in real terms between 20 and 30 years.

Real Dividend Growth Over Time 

To further illustrate my point, consider these real-world examples:
  • Had you invested $1,000 (about $2,800 in today's money) in Johnson & Johnson in January 1980, your initial dividend income for the year would have been about $40. Meager, right? But if you'd had the patience to hold that investment over the next 33 years and reinvested every dividend, your annual income stream from that single investment would now be $2,458 per year (on top of the $83,353 capital value of your 931 shares). 
  • An equal investment in Procter & Gamble on the same date (not assuming dividend reinvestment) would today generate $1,034 per year in annual dividends 
  • Or, you could have bought Kimberly-Clark, reinvested all the dividends, and generate $2,498 in annual dividends today. Without reinvestment, annual dividends would be a still-impressive $1,296 per year. 
What's encouraging about these examples is that these companies weren't hiding under rocks in 1980 -- they were already well-known, blue chip firms. 

This strategy certainly proved valuable for a number of the ultra-high net worth clients I worked with in a previous job. Indeed, it was after reviewing their portfolios that I became a believer in dividends and patient, long-term investing. 

Many of their portfolio holdings were high quality blue chip names that had been held for decades. The benefits of compounding growth allowed them to live off the dividend income during retirement without needing to sell shares and reduce their capital base. Their examples proved to me that such results are possible and are worth aspiring to.

Their success followed that simple, but hard to follow equation:

Investment + good company + right price + patience

Again, it's the patience that I believe is the most challenging and elusive part of the formula. We're all capable of making an investment, and we can employ our experiences, screening tools, financial statement analysis, and valuation models to select promising stocks at reasonable prices, but it's the patience that proves the most difficult to follow, as it's more emotional and less cognitive. 

I'll leave you with this. In a 1995 interview with 98 year old investor Philip Carret, Louis Rukeyser asked him, "What's the single most important thing you've learned about investing over the past three-quarters of a century?"

His answer was surprisingly simple: "Patience." 

That's sage advice from a man who invested through the Depression, a world war, a cold war, and various booms and busts over seven decades. If he remained patient through those turbulent times, I think we can do so today.

Good reads this week
  • Why the advice "You'll never go broke taking a profit" should be ignored. - Psy-Fi Blog
  • The four horsemen of mediocrity. - Seth Godin
  • An excellent article by The Investor on "How to be a Capitalist". - Monevator
  • Diversifying emotionally. - Abnormal Returns
  • 50 reasons why we're living through the greatest period in world history. - Morgan Housel
Quote of the week

"Nothing is automatic and easy. But if you can find some fairly-priced great company and buy it and sit, that tends to work out very, very well indeed—especially for an individual." Charlie Munger



(I own shares of JNJ and PG)