As of the close on September 30, 2009, the yield on the S&P 500 was 5.68%, based on trailing 5-year earnings. This compares to a yield of 4.82% for 10-year AA corporate bonds and 3.31% for the 10-year U.S. treasury. See the sidebar section entitled “Market Valuation” for links to the data. Although stocks don’t look cheap, the yield advantage of the S&P 500 over that of 10-year treasuries compares to that of other bear market lows. Caution: the yield on the S&P 500 changes markedly depending on what period is selected to calculate the earnings portion of the yield. The key here is to think about what normalized earnings would look like for the index.
Here is a worthwhile interview with Whitney Tilson on Charlie Munger. Lot’s of good information and a great intro to Munger’s thinking.
In my judgment, it makes a lot of sense to examine the past purchases of great investors like Warren Buffett. Reviewing past successful investments can help us cement in our minds the types of things that we should be looking for. These items can then be added to our investment checklists.
By any measure See’s Candies was a very successful investment. Here are the facts based on the account given in Snowball, Alice Schroeder’s biography of Buffett.
1. Prior to Buffett’s purchase of See’s in the early 70’s, See’s had a built a strong brand in California over a period of 50 years by being totally committed to uncompromising quality. Here’s what Munger thought of See’s. “See’s has a name that nobody can get near in California. We can get it at a reasonable price. It’s impossible to compete with that brand without spending all kinds of money.”
2. See’s was earning $4 million per year pre-tax. The owners of See’s wanted $30 million. Buffett and Munger offered, and ultimately paid, $25 million. They viewed it as an “equity” bond with a 9% yield.
3. They did not view a 9% yield as providing a sufficient margin of safety over bonds, given the inherent risk in running a business and the lack of guarantee on the coupon.
4. They found their margin of safety in the fact that the “coupon” was growing – on average, at 12% per year – and that See’s enjoyed a very strong brand. (Graham was skeptical that investors could find a margin of safety in future growth and also recognized that investors often overpay for future growth. Buffett, under the influence of Munger, would also be highly skeptical of projections of future growth and would insist on both a long established track record and a clearly identifiable “moat’ around the business that would slow capitalism’s grinding process of creative destruction.)
5. There was another “kicker” with See’s: Buffett and Munger recognized that, by virtue of its stellar brand, See’s had pricing power vis-a-vis its more pedestrian competitors such as Russell Stover. They figured that they could raise See’s prices by $.15 a pound and drive another $2.5 million to the bottom line thereby raising the coupon on “their” equity bond to almost 15%. (Schroeder has said that Buffett’s minimum hurdle for an investment was 15% to start with upside going forward.)
6. The pricing power of See’s would prove decisive in making See’s a spectacular investment, as Buffett was able to raise prices each year. For example, owing to price increases and modest unit growth See’s would earn over $42 million pre-tax in 1989 – a better than 10X increase in earnings in 20 years.
7. Here’s what Buffett said about the investment in the 1991 letter to shareholders, “See’s has been astounding: The company now operates comfortably with only $25 million of net worth, which means that our beginning base of $7 million has had to be supplemented by only $18 million of reinvested earnings. Meanwhile, See’s remaining pre-tax profits of $410 million were distributed to Blue Chip/Berkshire during the 20 years for these companies to deploy (after payment of taxes) in whatever way made most sense.”
8. This shows the huge advantages enjoyed by businesses that require relatively little capital to operate and grow.
9. It is also instructive to note that Buffett and Munger were willing to walk away if the price went above $25 million. In hindsight, this would have been an expensive mistake. Later Buffett would speak of missing Wal-Mart – a $8 billion dollar mistake – because the price moved up after he began to accumulate it and he stopped buying before he could accumulate a meaningful position. Although impossible to prove, it is at least arguable that Buffett’s great discipline has saved/made him more than the cost of his sins of omission by avoiding costly – or possibly ruinous – mistakes and not watering down returns with investments promising only a mediocre return on invested capital.
Donald Yacktman has a stellar track record and a very sound investment process.
According to Morningstar, “Kiplinger’s has ranked his two mutual funds (Yacktman Fund and Yacktman Focus Fund) top in the large-cap value fund category for the past 1, 3, 5, and 10-year.” Also, according to Morningstar, the Yacktman Fund (YACKK) has bested the S&P by 9.66% annually over the past 10 years, through 8/31/09.
Yackman’s approach reminds me of that of Bruce Berkowitz in that they both look at stocks as a kind of equity bond where the key determinant of value is the free cash yield.
Here’s an interview with Yacktman from The Wall Street Transcript. I hope you find it as informative as I did.
“The Wall Street Transcript (TWST): Let’s start with an overview of Yacktman Asset Management and your investment philosophy there.
Donald Yacktman: Yacktman Asset Management was founded in 1992 and we manage two mutual funds and separate accounts. The two mutual funds are The Yacktman Fund and The Yacktman Focused Fund. The investment process or philosophy has evolved over a period of years. Basically, we are investors in businesses and we view the selection process as though we were buying a long-term bond. Our logo is a triangle. The base of the triangle is a low purchase price. We look at businesses as if we were going to buy them and own them for a long period of time. We look at the rate of the return we would earn and the quality of those businesses. The higher the quality is, the lesser the required rate of return. It’s very much like a person buying a bond. But we don’t like to calculate returns to the fourth decimal; we try to make sure we have a lot of room for error. Then we try to get as much as we can of the other two sides of the triangle, namely good businesses run by shareholder-oriented managers.
On the good business side, our sweet spot is businesses that have low capital intensity and low cyclicality. One of our largest holdings, for instance, is Coca-Cola (KO). It fits our criteria very well. We will also move away from those components if the rates of return are adequate for the additional unpredictability that comes with the business, whether it has more fixed assets or more economic sensitivity. We have moved in both directions, but we don’t typically invest in businesses that have both enormous amounts of fixed assets and cyclicality. The airline industry would be the classic example. Coca-Cola is the opposite side of the grid. If you think of it like a bond, we’re buying high coupon bonds.
The third part of the triangle is the management. The difference between a stock and a bond is with a bond, the investor reinvests the cash flow most of the time. In the case of an equity owner, a lot of the reinvestment is done by the manager, so we like to evaluate the manager on the basis of how well he has invested cash in the past. We look at five basic options the manager has. The first option is putting the money back into the business through R&D, marketing, cost reduction, distribution, etc. The second option is making acquisitions, but the acquisitions should be synergistic and the manager should not pay too high a price for them. The problem is, in a lot of cases, the egos of managers get in the way of doing a proper job. Another option is buying back stock, which is buying more of the same. The fourth is paying a dividend and the fifth option is paying down debt or letting it accumulate, which is pretty much the same thing. We also tend to be very concentrated. The top 10 holdings plus cash will typically be 50% in The Yacktman Fund, and 75% in the Yacktman Focused Fund.
Checklists are surprisingly effective at dramatically improving performance, even when those involved are highly trained, smart people. The benefits of improving outcomes are particularly evident when a complex task is involved, however, the benefits can also be dramatic when simple tasks are performed.
The New Yorker ran an article in December of 2007 by Atul Gawande called “The Checklist” that forcefully makes the case for the efficacy of checklists. Take, for example, something as straightforward as preventing infection when a line is inserted into patients at a hospital I.C.U. In 2001, John Hopkins adopted the following checklist to reduce infection: (1) wash hands with soap, (2) clean the patient’s skin with chlorhexidine antiseptic, (3) put sterile drapes over the entire patient, (4) wear a sterile mask, hat, gown, and gloves, and (5) put a sterile dressing over the catheter site once the line is in. It was observed that in more than a third of the patients, at least one step was skipped.
After nurses were empowered to raise the issue if a step was skipped, the rate of infection over the subsequent year dropped from 11% to 0. After fifteen months, it was determined that following this simple checklist was responsible for saving eight lives and generating savings of $2 million. The article gives several other equally compelling examples of how checklists have made a profound positive difference in both medicine and aviation.
In a talk at the Columbia Business School, value investor Monish Pabrai spoke about checklists. He argued that they work because, “Our brains are designed to take short-cuts and arrive at answers quickly. When you see the lion, you run. You don’t process your options, you just run. We are also a mix of rationality and emotions. When we notice a great business, we read up on it, run through a number of concerns/questions and arrive at a decision – not as effective as checklist.” That’s why great investors like Charlie Munger recommend the use of checklists.
Here’s what noted short seller Joe Feshbach had to say about checklists in the book The Art of Short Selling by Kathryn F. Staley. “Money managers make the same mistake over and over – that’s part of the whole reactive process. We’ve developed a check list of good short criteria and a training manual based on successful and unsuccessful actions.” (page 31) I would argue that most investors make recurring mistakes.
Even great investors make mistakes. For example, Buffett has said that he made a mistake not selling Coke when its valuation reached stratospheric levels during the Internet bubble. Perhaps he was unduly influenced by his being on record numerous times as saying he would hold positions like Coke forever. This is known as confirmation bias: the tendency to act in conformity with past statements or commitments.
Charlie Munger purchased Cort during the Internet bubble based on its strong earnings. What he missed was that those earnings were the result of unsustainable tailwinds from the Internet boom. Pabrai thinks we should learn from this mistake and add the following to our own investment checklist, “Are the revenues and cash flows of the business sustainable or overstated / understated due to boom or bust conditions?”
So where do you start if you want to make an effective investment checklist? A good place is your past mistakes. Look at where you’ve lost money in the past and convert the lessons learned into rules you can put on your checklist. Also, as you come across wise investment counsel – such as only buy a stock in a business you understand – add it to your list. Buffett strongly suggests that we all make a written statement of why we’re buying a given stock and why it’s undervalued. Add the written thesis of why a stock is undervalued to your checklist.
I think a good checklist can also save a lot of time. Nobody has time to look at everything. Using a few good checklist questions when searching for prospective investments such as “Can I lose my investment?”, “Is there a sufficient margin of safety?” and “Is the idea within my circle of competence?” can act as a kind of investment triage by quickly filtering out investments that are non-starters. Such a practice can potentially also save you a lot of money.
With the S&P 500 at 1065.49, its yield currently stands at 5.63%, based on an average of its five-year trailing earnings. Although the spread has narrowed, it still enjoys a 2.24% yield advantage over the 3.39% yield of the 10-year U.S. Treasury. This compares favorably to past bear market lows.
Imagine that you wanted to become good at the piano and you studied extensively the best books on piano theory and piano pedagogy, but you actually played the piano very little. Or that you wanted to be a low-handicap golfer, but, instead of practicing and playing golf, you spent your time watching the golf channel and extensively reading books on golf technique. If you wanted to be the best, these things might actually end up helping you – perhaps quite a bit. But they would only do so if you actually practiced your craft intensely over a long period of time.
There is a growing consensus that in order to become world-class at something it requires ten thousand hours of intentional practice. Intentional practice does not mean going through the motions; it means determined, planned practice with complete focus. That’s what it takes to get really good at something, even for those who are judged to have talent.
Last year, I happened to see a program on ESPN that showed a behind the scenes look at a football practice at one of the top BCS programs. Since time was precious, every aspect of the practice was planned in advance and carefully thought through. A specific scenario was practiced for x minutes and then a horn would blow and the players would move on to the next drill. Nothing was left to chance. Afterwards the coaches broke it all down and prepared for the next practice. My point is not that an investor’s day needs to be scripted, but that one should carefully think about how to best spend one’s time and then stick to the plan.
So, what does this have to do with investing? Perhaps the analogy is obvious. Buffett has said that the most important thing we can do to become successful investors (along with learning to think properly about market prices) is to spend our time valuing companies. This means looking beyond them as stocks and actually studying and evaluating them as living, breathing businesses. This takes time and it takes practice. The good news is he tells how he does it: he spends his days reading and thinking – annual reports, 10-Q’s newspapers, business magazines, trades, etc. Of course, it this also assumes a sound search strategy with good filters so you are spending your time valuing businesses that have a chance of being good purchase candidates.
I believe there are no shortcuts.
Zeke Ashston runs Centaur Capital Partners, which is a value-oriented hedge fund in Texas. The following summary is taken from the newsletter The Manual of Ideas.
As the interview points out, “In 2008, the Centaur Value Fund was down 6.9%, trouncing the 37.1% and 40.0% declines of the S&P 500 and Nasdaq Composite indexes. From inception in August 2002 through the end of 1Q09, the Centaur Value Fund gained 134.6%, net of fees and expenses, versus returns of 15.1% for the Nasdaq Composite and -0.3% for the S&P 500 Index.
Here are some “nuggets'” from the interview:
1. Ashton did well in 2008 not because he predicted what was going to happen – something he seems skeptical could be done on a consistent basis – but because he designed a portfolio that incorporated good risk management.
2. He keeps risk management simple. For example, he limits the portfolio’s exposure to any one segment, such as retail, to 20%. If he is at this limit in a given sector and he wants to purchase more, it forces him to sell something.
3. Another risk management rule is to limit exposure to stocks with limited liquidity to no more than 30% of the portfolio.
4. He finds the Kelly Formula interesting on a theoretical level, but flawed when it comes to real-world investing because in a period of severe stress the level of correlation between all asset classes is too high.
5. Notwithstanding the foregoing, he believes in a focused portfolio and typically has 50-60% of the portfolio invested in his top ten ideas.
6. He characterizes his style as “high probability” as opposed to swing for the fences with large, individual bets.
7. Ashton sometimes uses long-term options to establish a position. This gives him a kind of non-recourse loan which limits his downside exposure. Even when he uses options, he sizes his position so that he controls the same amount of stock as if he was long the common.
8. Ashton’s core selection criterion is a meaningful discount to intrinsic value. He prefers high quality businesses where the intrinsic value is growing, but he will settle for mediocre businesses if the discount is great enough.
9. On the short side he looks for businesses that are 1) burning cash, 2) have too much debt to service, 3) fads, 4) use overly aggressive accounting to overstate their true economic value, or 5) are highly overvalued.
10. He generates idea with computer screens, revisiting past ideas, industry overviews, his network of contacts, and specialized research such as The Manual of Ideas.
Those familiar with Lou Simpson, Geico’s head of investments and CEO of capital operations, know he has one of the best longterm investments record around. Simpson averaged annual returns of 24.7% for the 17-year period preceding Berkshire Hathaway’s purchase of GEICO in 1996.
Here are his core investing principles from a 1987 article in the Washington Post:
1. Think independently. We try to be skeptical of conventional wisdom, he says, and try to avoid the waves of irrational behavior and emotion that periodically engulf Wall Street. We don’t ignore unpopular companies. On the contrary, such situations often present the greatest opportunities.
2. Invest in high-return businesses that are fun for the shareholders. Over the long run, he explains, appreciation in share prices is most directly related to the return the company earns on its shareholders’ investment. Cash flow, which is more difficult to manipulate than reported earnings, is a useful additional yardstick. We ask the following questions in evaluating management: Does management have a substantial stake in the stock of the company? Is management straightforward in dealings with the owners? Is management willing to divest unprofitable operations? Does management use excess cash to repurchase shares? The last may be the most important. Managers who run a profitable business often use excess cash to expand into less profitable endeavors. Repurchase of shares is in many cases a much more advantageous use of surplus resources.
3. Pay only a reasonable price, even for an excellent business. We try to be disciplined in the price we pay for ownership even in a demonstrably superior business. Even the world’s greatest business is not a good investment, he concludes, if the price is too high. The ratio of price to earnings and its inverse, the earnings yield, are useful guages in valuing a company, as is the ratio of price to free cash flow. A helpful comparison is the earnings yield of a company versus the return on a risk-free long-term United States Government obilgation.
4. Invest for the long term. Attempting to guess short-term swings in individual stocks, the stock market, or the economy, he argues, is not likely to produce consistently good results. Short-term developments are too unpredictable. On the other hand, shares of quality companies run for the shareholders stand an excellent chance of providing above-average returns to investors over the long term. Furthermore, moving in and out of stocks frequently has two major disadvantages that will substantially diminish results: transaction costs and taxes. Capital will grow more rapidly if earnings compound with as few interruptions for commissions and tax bites as possible.
5. Do not diversify excessively. An investor is not likely to obtain superior results by buying a broad cross-section of the market, he believes. The more diversification, the more performance is likely to be average, at best. We concentrate our holdings in a few companies that meet our investment criteria. Good investment ideas–that is, companies that meet our criteria–are difficult to find. When we think we have found one, we make a large commitment. The five largest holdings at GEICO account for more than 50 percent of the stock portfolio.