Photo Credit: Moyan Brenn || Relax, you know less than you think…
So, the Republicans swamped the Democrats in the midterm elections.
Big deal.
The differences between the varying wings of the Purple Party are smaller than you think. ?What’s more, their willingness to magnify those differences and do little as a result is a high probability outcome.
Add in that the Republicans don’t have a coherent set of policies as a group. Will the t-party and Establishment wings of the GOP come to a meeting of the minds? (Democrats may insert easy cheap joke here.) ?Even if they do, who will take the blame when Obama vetoes their bills? ?They aren’t called the “stupid party” for nothing. ?They have a peculiar knack for snatching defeat from the jaws of victory, and letting their less presentable members define them.
Even if in theory, the markets do better from Republicans, in practice the reverse seems to be true. ?But the track record has so few data points that statistical credibility is low.
And, if there is something to the Republicans being in power moving the markets, how would you know if it wasn’t anticipated in the recent run-up of prices? ?Many parties may have bought into the concept of greater prosperity as result of the then-forthcoming elections. ?The time to buy?the rumor is gone. ?The time to sell the news may be here.
The same applies to the presidential cycle. ?Many argue that we are heading into a good time for the markets in the third and fourth year of a presidential term. ?Too many are arguing this in my opinion, and even if there is some real impact from presidential terms, perhaps the market is anticipating this as well. ?After all, the bad part of the presidential cycle looked pretty good this time around.
Add in that again we are working with the law of small numbers — the presidential cycle could just be due to?randomness. ?Some part of the presidential cycle had to look better. ?Is it so much better than any other subset could have been?
The same thing applies to the argument I am seeing trotted around that we are coming into the best six months?of the year. ?Cue the comments on the law of small numbers and randomness. ?Even if there is a structural reason like tax-based selling, might it have been anticipated this time around? ?Markets tend to anticipate. ?Some six month period had to be best… but is it due to randomness?
Going back to politics, I would point out that few significant things change in politics off of party affiliation. ?How many states have their budgets balanced on an accrual basis, taking into account the need to spread out the cost of infrastructure projects, and?pensions funded assuming a realistic 5% earnings assumption on assets, together with fully funded accrual accounts? ?None. ?All of the states put off paying for the accruals of what should be current expenses.
We’ve talked about entitlement reform, but action never happens, except further expansion, as under Bush, Jr. ?Will we see GSE reform, or will Congress continue to use the GSEs for their own ends? ?Will there ever be significant cuts in defense? ?Will we ever see truly balanced budgets on an accrual basis?
Beyond that, consider the Fed, the Supreme Court, and the bureaucracy generally… they don’t change rapidly, if at all. ?Admittedly, the Supreme Court has been more activist over the recent past… so maybe I am wrong there.
And truly, Congress changes only at the edges. ?The grand majority?of the same faces will be there, only the majority and committee assignments shift. ?That may not mean much.
But do we want lots of change? ?Individually, many of us do, but if you add us all together, it often nets to something near zero. ?Perhaps most of us are happy with that, given the alternative that those of us with the opposite views might impose them on the rest of us.
I leave you with this: don’t make too much out of the election results, the presidential cycle, the “sell in May and go away” phenomenon, etc. ?The world is complex, with many people trying to anticipate market reactions. ?Untangling them is close to impossible, so stay calm, and pursue the ordinary strategies that you always do. ?For me, I will continue my value investing.
I really appreciated being on the show. ?Hope you enjoy the videos. ?Thinking fast is a challenge, and you can often see me trying to gather my thoughts.
My thanks to Erin, the producer Ed Harrison, and their segment producer, Bianca.
Full disclosure: long LUKOY, ESV, NAVI and SBS for clients and me
It’s time to change what Warren Buffett supposedly said about his mentors:
“I’m 85% Ben Graham, and 15% Phil Fisher.”
For those who don’t know, Ben Graham is regarded to be the father of value investing, and Phil Fisher the father of growth investing. ?Trouble is, Warren Buffett changed in his career such that this is no longer accurate. ?Most of Buffett’s economic activity does not stem from buying and selling?portions of public companies, but by buying and managing whole companies. ?Buffett is the manager of a conglomerate that uses insurance reserves as a funding vehicle.
As a result, this would be more accurate about the modern Buffett:
Buffett is?70% Henry Singleton,?15% Ben Graham, and 15% Phil Fisher.
Henry Singleton was the CEO of Teledyne, a very successful conglomerate, and one of the few to do well over a long period of time. ?It is very difficult to manage a conglomerate, but Teledyne survived for around 40 years, and was very profitable. ?Buffett thought highly of Singleton as a allocator?of capital, though the conglomerate that Buffett created is very different than Teledyne.
Tonight, I am reviewing a book that describes Buffett as a manager of a special conglomerate called Berkshire Hathaway [BRK] — Berkshire Beyond Buffett. ?This Buffett book is different, because it deals with the guts of how Buffett created BRK the company, and not the typical and misleading Buffett as a value investor.
Before I go on, here are three articles that could prove useful for background:
The Forever Fund?– deals with the Burlington Northern Acquisition, and Buffett’s efforts to create a firm that will thrive long after he is gone.
On the Structure of Berkshire Hathaway?– describes how the insurance enterprises, particularly National Indemnity, own and fund many of the industrial subsidiaries.
The main point of Berkshire Beyond Buffett is that Buffett has created a company that operates without his detailed oversight. ?As a result, when Buffett dies, BRK should be able to continue on without him and do well. ?The author attributes that to the ethical values that Buffett has?selected for when acquiring companies. ?He manages to cram those values into an acronym BERKSHIRE.
I won’t spoil the acronym, but it boils down to a few key ideas:
Do you have subsidiary managers who are competent, ethical, and love nothing better than running the business? ?Do they act as if they are the sole proprietors?of the business, and act only to maximize its long-term value consistent with its corporate culture? ?These are the ideal managers of BRK subsidiaries.
Acquiring such companies often comes about because a founder or significant builder of the company is getting old, and there are family, succession, taxation, funding or other issues that being a part of BRK would solve, allowing the management team to focus on running the business.
Do the businesses have sustainable competitive advantages in markets that are likely to be relevant several generations from now?
The beauty of a company coming under the Berkshire umbrella is that Buffett leaves the culture alone, and so long as the company is producing its profits well, he continues to leave them alone. ?Thus, the one selling a company to Buffett gets the benefit of knowing that the people and culture of the company will not change. ?In exchange, Buffett does not pay top dollar, but gets deals done faster than almost anyone else.
This is a very good book, and its greatest strength is that it talks about Berkshire Hathaway the company as built by Buffett to endure. ?If you want to understand?Buffett’s corporate strategy, it is described ably here.
Quibbles
Now, my three ideas above?*might* have been a better way to organize the book, rather than the hokey BERKSHIRE. ?Also, a lot more could have been done with the insurance enterprises of BRK, which are a critical aspect of how the company owns and finances many of the other subsidiaries.
But will BRK do so well without Buffett? ?Yes, his loyal son Howard will guard the culture. ?The Board is loyal to the ethos that Buffett has created. ?Ted Weschler and Todd Combs will continue to invest the public money. ?The all-star subsidiary managers will soldier on, at least in the short-run.
But will the new CEO be the person that “you don’t want to disappoint,” as some subsidiary managers think of Buffett? ?As a result, how will BRK deal with underperformers? ?What new structures will they set up? ?Tracy Britt Cool is smart, but will BRK need many like her, and how will they be organized?
Will he be a great capital allocator? ?Will he maintain the “hands off” policy toward the culture of subsidiaries, or will the day come when some centralization takes place to save money?
Will Buffett’s replacement be equally intuitive with respect to acquisition prices, and sustainable competitive advantage?
Buffett’s not perfect — he has had his share of errors with textiles, shoe companies, airlines, Energy Future, and a variety of other investments, but his record will be tough to match, even if replaced by a team of clever people. ?Say what you will, but teams are not as decisive as a single manager, and that may be a future liability of BRK.
Summary / Who Would Benefit from this Book
Most people will not benefit from this book if they are looking for a way to make more money in their life. ?There are no magic ways to apply the insights of the book for quick gains. ?Also, readers are unlikely to use Buffett’s “hands off” methods in building their own conglomerate. ?But readers will benefit because they will get to consider the building of the BRK enterprise from the basic principles involved. ?There will be?indirect benefits as they analyze other business situations, perhaps using BRK as a counterexample — a different way to acquire and run a large enterprise.
But as for getting any direct benefit from the book? There’s probably not much, but you will understand business better at the end. ?If you still want to buy it, you can buy it here:?Berkshire Beyond Buffett: The Enduring Value of Values.
Full disclosure:?I?received a?copy from the author?s PR flack.
If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)
Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.
Full Disclosure: long BRK/B for clients and myself
Photo Credit: Brett Davies || Waiting, but to what end?
When I worked in the investment department of a number of life insurers, every now and then I would hear one of the portfolio managers say, “We know that the rating agencies are going to downgrade the bonds of XYZ Corp, but?we like the story. ?We’re just waiting until after the downgrade, and then we will buy, because they will be cheaper then.”
And, sometimes it would work. ?Other times, nothing would happen at the downgrade, and they would buy at the same price. ?But more interesting and frequent were the times when the bonds would rally after the downgrade, which would make the portfolio managers wince and say, “Guess everyone else was waiting to buy also.”
Now, there was a point in time where the corporate bond market was more strictly segmented, and getting downgraded, if was severe enough, would mean there was a class of holders that would become forced sellers, and thus it paid to wait for downgrades. ?But as with many market inefficiencies, a combination of specialists focusing on the inefficiency and greater flexibility on the part of former forced sellers made it disappear, or at least, make it unpredictable.
But so what? ?Bonds are dull, right? ?Well, no, but most think so. ?What about stocks? ?What if you want to buy a stock that you think is going to rise, but you are waiting for a pullback in order to buy?
In order to to get this one right, you have to get multiple things right:
The stock is a good buy long term, and not enough parties know it
The stock is short-term overbought by flexible money
Other longer-term buyers aren’t willing to buy it at the current level and down to the level where you would like to buy.
The correction doesn’t make quantitative managers panic, sell, and the price overshoots your level.
Maybe the last one isn’t so bad — no such thing as a bad trade, only an early trade, if the stock is good long term?
That’s one reason why I do two things:
I tend to buy the things I like now. ?I don’t wait. ?Timing is not a core skill of mine, or of most investors — if you are mostly right, go with it.
I pursue multiple ideas at the same time. ?If I have multiple ideas to put new money into, the probability is greater that I get a good deal on the one that I choose.
The same idea would?apply to waiting to sell. ?Maybe you think it is fully valued, but will have one more good quarterly earnings number, and somehow the rest of the world doesn’t know also.
Hint: do it now. ?If you are truly uncertain, do half. ?It’s tough enough to get one thing right. ?Getting short-term timing right verges on the impossible. ?Better to act on your strongest long-term sense of value than trying to get the short-run perfect. ?You will do best in the long run that way.
This is another episode in my continuing saga on dollar-weighted returns. We eat dollar-weighted returns.? Dollar-weighted returns are the returns investors actually receive in a open-end mutual fund or an ETF, which includes their timing decisions, as opposed to the way that performance statistics are ordinarily stated, which assumes that investors buy-and-hold.
In order for active managers to have a reasonable chance of beating the market, they have to have portfolios that are significantly different than the market. ?As a result, their portfolios will not behave like the market, and if they are good stockpickers, they will?beat the market.
Now, many of the active managers that have beaten the market run concentrated portfolios, with relatively few stocks comprising a large proportion of the portfolio. ?Alternatively, they may concentrate their portfolio in relatively few industries at a time, as I do. ?Before I begin my criticism, let me simply say that I believe in concentrated portfolios — I do that myself, but with a greater eye for risk control than some managers do.
Legg Mason Value Trust enthused investors as they racked up significant returns in the late 90s, and the adulation persisted through 2006.? As Legg Mason Value Trust grew larger it concentrated its positions.? It also did not care much about margin of safety in financial companies.? It bought cheap, and suffered as earnings quality proved to be poor.
Eventually, holding a large portfolio of concentrated, lower-quality companies as the crisis hit, the performance fell apart, and many shareholders of the fund liquidated, exacerbating the losses of the fund, and their selling pushed the prices of their stocks down, leading to more shareholder selling.? I?m not sure the situation has stabilized, but it is probably close to doing being there.
Investors in the Legg Mason Value Trust trailed the returns of a buy-and-hold investor by 6%/year over the time my article covered. ?Investors bought late, and sold late. ?They bought after success, and sold after failure. ?That is not a recipe for success.
Tonight’s well-known fund with a great track record is the Fairholme Fund. Now, I am not here to criticize the recent performance of the fund, which due to its largest positions not doing well, has suffered of late. Rather, I want to point out how badly investors have done in their purchases and sales of this fund.
As the fame of Bruce Berkowitz (a genuinely bright guy) and his fund grew, money poured in. ?During?and after relatively poor performance in 2011, people pulled money from the fund. ?Even with relatively good performance in 2012 and 2013, the withdrawals have continued. ?The adding of money late, and the disproportionate selling after the problems of 2011 led the dollar weighted returns, which is what the average investors get, to lag those of the buy-and-hold investors by 5.57%/year over the period that I studied.
(Note: in my graph, the initial value on 11/30/2003 and the final value on 5/31/2014 are the amounts in the fund at those times, as if it had been bought and sold then — that was the time period I studied, and it was all of the data that I had. ?Also, shareholder money flows were assumed to occur mid-period.)
Lessons to Learn
Good managers who have ideas that will work out eventually need to be bought-and-held, if you buy them at all.
Be wary of managers who are so concentrated, that when they receive a lot of new cash after good performance, that the new cash forces the prices of the underlying stocks up. ?Why be wary? ?Doesn’t that sound like a good thing if new money forces up the price of the mutual fund? ?No, because the fund has “become the market” to its stocks. ?When the time comes to sell, it will be ugly. ?If you are in a fund like this, where the fund’s trading has a major effect on all of the stocks that it holds, the time to sell is now.
There is a cost to raw volatility in large concentrated funds. ?The manager may have the guts to see it through, but that doesn’t mean that the fundholders share his courage. ?In general, the more volatile the fund, the less well average investors do in buying and selling the fund. ?(As an aside, this is a reason for those that oversee 401(k) plans to limit the volatility of the choices offered.
Even for the buy-and-hold investor, there is a risk investing alongside those who get greedy and panic, if the cash flow movements are large enough to influence the behavior of the fund manager at the wrong times. ?(I.e., forced buying high, and forced selling low.)
The forced buying high should be avoidable — the manager should come up with new ideas. ?But if he doesn’t, and flows are high relative to the size of the fund, and the market caps of investments held, it is probably time to move on.
When you approach adding a new mutual fund to your portfolio, ask the following questions: Am I late to this party? ?Does the manager have ample room to expand his positions? ?Is this guy so famous now that the underlying investors may affect his performance materially?
Finally, ask yourself if you understand the investment well enough that you will know when to buy and/or sell it, given you investing time horizon. ?This applies to all investments, and if you don’t know that, you probably should steer clear of investing in it, and learn more, until you are comfortable with the investments in question.
One final note: I am *not* a fan of AIG at the current price (I think reserves are understated, among other things), so I am not a fan of the Fairholme Fund here, which has 40%+ of its assets in AIG. ?But that is a different issue than why average investors have underperformed buy-and-hold investors in the Fairholme Fund.
I use factors in my investing. What *are* factors, you ask? ?Factors are quantitative variables that have been?associated with potential outperformance. ?What are some of these factors?
Valuation (including yield)
Price Momentum (and its opposite in some cases)
Insider Trading
Industry factors
Neglect
Low Volatility
Quality (gross margins as a fraction of assets)
Asset shrinkage
Share count shrinkage
Measures of accounting quality
and more…
This is a large portion of what I use for screening in my eighth portfolio rule. ?I’m not throwing this idea out of the window, but I am beginning to call it into question. ?Why?
I feel that the use of the most important factors are getting institutionalized, such that many major investors are giving their portfolios a value tilt, sometimes momentum tilts, and other sorts of tilts. ?I?also see this in ETFs, where many funds embrace value, yield, momentum, accounting, or?other tilts.
Now, we have been through this before. ?In 2007, momentum with value hedge funds became overinvested in the same names, with many of the funds using leverage to goose returns. ?There was quite a washout in August of that year as many investors exited that crowded trade.
I’m not saying we will see something like that immediately, but I am wary to the point that when I do my November reshaping, I’m going to leave out?the valuation, yield and momentum factors, and spend more time analyzing the industry and idiosyncratic company risks. ?If after that, I find cheap stocks, great, but if not, I will own companies that are hopefully not owned by a lot of people just because of a few quantitative statistics.
I may be a mathematician, but I try to think in broader paradigms — when too many people are looking at raw numbers and making decisions off of them solely, it is time to become more qualitative, and focus on strong business concepts at reasonable prices.
Every now and then, a piece of good news gets announced, and then something puzzling happens. ?Example: the GDP report comes out stronger than expected, and the stock market falls. ?People scratch their heads and say, “Huh?”
A friend of mine who I haven’t heard from in a while, Howard Simons, astutely would comment something to the effect of: “The stock market is not a futures contract on GDP.” ?This much is true, but why is it true? ?How can the market go down on good economic news?
Some of us as investors use a concept called a discounted cash flow model. ?The price of a given asset is equal to the expected cash flows it will generate in the future, with each future cash flow?discounted to reflect to reflect the time value of money and the riskiness of that cash flow.
Think of it this way: if the GDP report comes out strong, we can likely expect corporate profits to be better, so the expected cash flows from equities in the future should be better. ?But if the stock market prices fall, it means the discount rates have risen more than the expected cash flows have risen.
Here’s a conceptual problem, then: We have estimates of the expected cash flows, at least going a few years out but no one anywhere publishes the discount rates for the cash flows — how can this be a useful concept?
Refer back to a piece I wrote earlier this week. ?Discount rates reflecting the cost of capital reflect the alternative sources and uses for free cash. ?When the GDP report came out, not only did come get optimistic about corporate profits, but perhaps realized:
More firms are going to want to raise capital to invest for growth, or
The Fed is going to have to tighten policy sooner than we?thought. ?Look at bond prices falling and yields rising.
Even if things are looking better for?profits for existing firms, opportunities away from existing firms may improve even more, and attract capital away from existing firms. ?Remember how stock prices slumped for bricks-and-mortar companies during the tech bubble? ?Don’t worry, most people don’t. ?But as those prices slumped, value was building in those companies. ?No one saw it then, because they were dazzled by the short-term performance of the tech and dot-com stocks.
The cost of capital was exceptionally low for the dot-com stocks 1998-early?2000, and relatively high for the fuddy-duddy companies. ?The economy was doing well. ?Why no lift for all stocks? ?Because incremental dollars available for finance were flowing?to the dot-com companies until?it became obvious that little to no cash would ever flow back from them to investors.
Afterward, even as the market fell hard, many fuddy-duddy stocks didn’t do so badly. ?2000-2002 was a good period for value investing as people recognized how well the companies generated profits and cash flow. ?The cost of capital normalized, and many dot-coms could no longer get financing at any price.
Another Example
Sometimes people get puzzled or annoyed when in the midst of a recession, the stock market rises. ?They might think: “Why should the stock market rise? ?Doesn’t everyone?know that business conditions are lousy?”
Well, yes, conditions may be lousy, but what’s the alternative for investors for stocks? ?Bond yields may be falling, and inflation nonexistent, making money market fund yields microscopic… the relative advantage from a financing standpoint has?swung to stocks, and the prices rise.
I can give more examples, and maybe this should be a series:
The Fed tightens policy and bonds rally. (Rare, but sometimes…)
The Fed loosens policy, and bonds fall. (also…)
The rating agencies downgrade the bonds, and they rally.
The earnings report comes out lower than last year, and the stock rallies.
Etc.
But perhaps the first important practical takeaway is this: there will always be seemingly anomalous behavior in the markets. ?Why? ?Markets are composed of people, that’s why. ?We’re not always predictable, and we don’t predict?better when you examine us as groups.
That doesn’t mean there is no reason for anomalies, but sometimes we have to take a step back and say something as simple as “good economic news means lower stock prices at present.” ?Behind that is the implied increase in the cost of capital, but since there is nothing to signal that, you’re not going to hear it on the news that evening:
“In today’s financial news, stock prices fell when the GDP report came out stronger than expected, leading investors to pursue investments in newly-issued bonds, stocks, and private equity.”
So be aware of the tone of the market. ?Today, bad news still seems to be good, because it means the Fed leaves interest rates low for high-quality short-term debt for a longer period than previously expected. ?Good news may imply that there are other places to attract money away from stocks.
Ideas for this topic are welcome. ?Please leave them in the comments.
Photo Credit: Sepehr Ehsani — Which project is better, project A or project B?
I can’t remember where I ran into it, but I found this article on a blog that I had not run into before on Calculating [the] Cost of Equity for Value Investors. ?I think it gets close to the right answer, and I would like to sharpen it here.
My answer to a lot of economic questions is: what’s the alternative? ?Many people look at the shiny formulas in investing but don’t ask what they really mean. ?(More people just don’t look at the formulas… which has its pluses and minuses. ?The math reveals, but it also conceals hidden assumptions.)
After wisely dismissing how to calculate the cost of equity from Modern Portfolio Theory [beta] and the Gordon model, he considers cost of equity based off of return on equity, and begins to get tied up in problems. ?Let me try.
The cost of equity is important for a number?of reasons:
It helps answer the question, “When should a company issue?or buy back?stock?”
It provides a measure for the alternative use of equity capital on competing unlevered projects/investments of equivalent riskiness.
Note the each of the reasons is structured as a series of comparisons. ?I’ll use a discounted cash flow [DCF] analysis as an example. ?Imagine a simple project requiring an investment of equity capital. ?There is a certain cost, and the risk is enough that you can’t borrow money for financing — it must be funded by equity. ?There are expected after-tax cash flows from the project that you think are a best estimate of returns. ?When would you invest in the project?
I would compare investments versus other similar investments, and look at as many similar projects from a riskiness perspective, and see which investment yielded the best return. ?The second place project as returns go is the alternative project for investment by which the winning project is judged, and surprise, the winning project?has a positive net present value evaluated at the rate of the alternative project.
(An aside: it just hit me that I am recreating part of the learning process that I went through back when I was a TA at UC-Davis 31 years ago, helping teach Corporate Financial Management [CFM], while taking quadratic programming [QP] course at the same time — I ended up doing my QP paper on using QP to choose investments to maximize returns without explicitly calculating internal rates of return, thus quietly solving a problem that the undergrad CFM textbook said could not be done. ?FWIW, which isn’t much.)
Now, I’m waving my hands at what I mean by risk, but to me it is the best estimate of the probability distribution of outcomes, thus giving you estimates of what the likelihood and severity of adverse outcomes could be. ?The thing is, in real life we know these figures poorly at best, but the framework is still useful because the investor making the decision needs to choose the project of a class of projects with roughly the same risk profile. ?Though my initial example included only equity-financed projects, this could be expanded to consider all projects, where the amount of debt on projects affects their risk, and the tax-affected?debt cash flows are?a deduction from returns.
The process would remain the same:?look at as many similar projects from a riskiness perspective, and see which investment yielded the best return on the equity. ?The second place project as returns on the equity go is the alternative project for investment by which the winning project is judged.
Back to Stocks
Where does that leave us as stock investors? ?I subscribe to the “pecking order” theory of the cost of capital, which says that firms use the cheapest form(s) of capital to fund their incremental financing needs, which means they should rarely issue equity.?The exception would be if?they are undertaking a project so large that it would make the company significantly more risky if they were to issue only debt for financing.
We do see companies engaging in buyback activity when they can’t find better uses for slack capital. ?In many cases, there are few large projects begging for the attention of management. ?Buying back stock earns the earnings yield for?the firm. ?Managements buying back stock make the statement that there are no more incremental projects of equivalent risk that would have an unlevered return on equity greater than the earnings yield for the firm.
Now maybe shareholders may have a bigger set of investment choices than the firm does, so perhaps dividends could be a better choice for shareholders, but it will have to be a lot better, because?dividends are taxable.
In general, we want to see management teams be careful users of equity capital, taking note of its cost for the benefit of shareholders. ?Every good management team should have their schedule of possible projects for investment, but always recognize there is the alternative of buying back stock as a last resort. ?In that limited sense, the earnings yield is the cost of equity for the firm, unless big profitable projects beckon.
There’s more to say here, but maybe this is a good start. ?Thoughts?
Recently I was approached by Moneytips to ask my opinions about retirement. They sent me a long survey of which I picked a number of questions to answer. You can get the benefits of the efforts of those writing on this topic today in a free e-book, which is located here: http://www.moneytips.com/retiree-next-door-ebook.??The eBook will be available free of charge?through September 30th. ?I have a few quotes in the eBook.
Before I move onto the answers, I would like to share with you an overview regarding retirement, and why current and future generations are unlikely to enjoy it to the degree that the generations prior to the Baby Boomers did.
The first thing to remember is that retirement is a modern concept. That the world existed without retirement for over 5000 years may mean that it is not a necessary institution. For a detailed comment on this, please consult my article, “The Retirement Tripod: Ancient and Modern.” Here’s a quick summary:
In the old days, when people got old, they worked a reduced pace. They relied on their children to help them. Finally, they relied on savings.
Savings is the difficult concept. How does one save, such that what is set aside retains its value, or even grows in value?
If you go backwards 150 years or further in time, there weren’t that many ways to save. You could set aside precious metals, at the risk of them being stolen. You could also invest in land, farm animals, and tools, each of which would be the degree of maintenance and protection in order to retain their value. To the extent that businesses existed, they were highly personal and difficult to realize value from in a sale. Most businesses and farms were passed on to their children, or dissolved at the death of the proprietor.
In the modern world we have more options for when we get old ? at least, it seems like we have more options. In retirement, we have three ways to support ourselves: we have government security programs, corporate security programs, and personal savings.
Think of this a different way, and ignore markets for a moment.? How do we take care of those that do not work in society?? Resources must be diverted from those that do work, directly or indirectly, or, we don?t take care of some that do not work.
Back to?markets: Social Security derives its ways of supporting those that no longer work from the wages of those that do work.? That?s one reason to watch the ratio of workers to retired.? When that ratio gets too low, the system won?t work, no matter what.? The same applies to Medicare.? With a population where growth is slowing, the ratio will get lower. If the working population is shrinking, there is no way that benefits for those retiring will be maintained.
Pensions tap a different sort of funding.? They tap the profit and debt servicing streams of corporations and other entities.? Indirectly, they sometimes tap the taxpayer, because of the Pension Benefit Guaranty Corporation, which guarantees defined benefit pensions up to a limit.? There is no explicit taxpayer backstop, but in this era of bailouts, who can tell what will be guaranteed by the government in a crisis?
That said, not many people today have access to Defined-Benefit pensions. Those are typically the province of government workers and well-funded corporations. That leaves savings as the major way that most people fund retirement aside from Social Security.
One of the reasons why the present generations are less secure than prior generations with respect retirement is that the forebears who originally set up defined-benefit pensions and Social Security system set up in such a way that they gave benefits that were too generous to early participants, defrauding those who would come later. Though the baby boomers are not blameless here, it is their parents that are the most blameworthy. If I could go back in time and set things right, I would’ve set the defined-benefit pension funding rules to set aside considerably more assets so that funding levels would’ve been adequate, and not subject to termination as the labor force aged.
I also would’ve required the US government to set benefits at a level equal to that contributed by each generation, and given no subsidy to the generations at the beginning of the system. Truth, I would eliminate the Social Security system and Medicare if I could. I think it is a bad idea to have collective support programs. There are many reasons for that, but a leading reason is that it removes the incentive to marry and have children. Another reason is that it politicizes generational affairs, which will become obvious to the average US citizen over the next 10 to 15 years.
Back to Savings
As for personal savings today we have more options than our great-great-great-grandparents did 150 years ago. We can still buy land and we can still store precious metals ? both of those have a great ability to retain value. But, we can buy shares in businesses and we can buy the debt claims of others. We can also build businesses which we can sell to other people in order to fund our retirement.
But investing is tricky. With respect to lending, default is a significant risk. Also, at the end of the term of lending, what will the money be worth? We have to be aware of the risks of inflation and deflation.
In evaluating businesses more generally, it is difficult to determine what is a fair price to pay. In a time of technological change, what businesses will survive? Will the business managers be clever enough to make the right changes such that the business thrives?
You have an advantage that your parents did not have, though. You can invest in the average business and debt of public companies in the US, and around the world through index funds. This is not foolproof; in fact, this is a pretty new idea that has not been tested out. But at least this offers the capability of opening a fraction of the productive assets in our world, diversified in such a way that it would be difficult that you end up with nothing, unless the governments of the world steal from the custodians of the assets.
With that, I leave you to read my answers to some of the questions that were posed to me regarding retirement:
What is a safe withdrawal rate?
A safe withdrawal rate is the lesser of the yield on the 10 year treasury +1%, or 7%. The long-term increase in value of assets is roughly proportional to something a little higher than where the US government can borrow for 10 years. That’s the reason for the formula. Capping it at 7% is there because if rates get really high, people feel uncomfortable taking so much from their assets when their present value is diminished.
How should you handle a significant financial windfall?
If you have debt, and that debt is at interest rates higher than the 10 year treasury yield +2%, you should use the windfall to reduce your debt. If the windfall is still greater than that, treat it as an endowment fund, invest it wisely, and only take money out via the safe withdrawal rate formula.
What are some ways to learn to embrace frugality?
This is a question of the heart. You have to master your desires to have goods and services today that are discretionary in nature. Life is not about happiness in the short term but happiness and long-term. Embrace the concept of deferred gratification that your great-grandparents did and recognize that work and savings provide for a secure and happy future.
How can the average worker start earning passive income?
Passive income is a shibboleth. People look at that as a substitute for investing, because they can’t control investment returns, and they think they can control income.
Income comes from debt or a business. If from debt, it is subject to prepayment or default; it is not certain. Also, income that comes from debt is typically fixed. That income may be sufficient today, but it may not be so if inflation rises. Also your capital is tied up until the debt matures. When the debt matures, reinvestment opportunities may be better or worse than they were when you started.
If income comes from a business, it is subject to all the randomness of that business; it is not certain. It is subject to all of the same problems that an investment in the stock market is subject to, except that you have to oversee the business.
There is no such thing as a truly passive income. Get used to the fact that you will be investing and working to earn an income.
What can those workers who are not employed by a large company or the public sector do to maximize their retirement savings?
You can start an IRA. Until the rules change, you can create healthcare savings account, not use it, and let it accrue tax-free until you’re 59 1/2. Oh, you get an immediate income deduction for that too.
If you are a little more enterprising, you can start your own business. If your business succeeds, there are a lot of ways to put together a pension, deferring more income than an individual can. By the time you get there, the rules will have changed, so I won’t tell you how to do it today; at the time, get a good pension consultant.
Why is calculating how much you’ll need for retirement an important exercise?
You have to understand that retirement is a new concept. In the ancient world, retirement meant continued work at a slower pace on your farm, living off of savings (what little was storable then ? gold, silver, etc.), and help from your children whom you helped previously as you raised them.
Today’s society is far more personal, far less family centered, and far more reliant on corporate and governmental structures. Few of us produce most of the goods and services that we need. We rely on the division of labor to do this.? Older people will still rely on younger people to deliver goods and services, as the older people hand over their accumulated assets in exchange for that.
Practically, modern retirement is an exercise in compromise. You will have to trade off:
How long you will work
At what you will work
What corporate and governmental income plans you participate in
How much income with safety your assets can deliver, with an allowance for inflation
How much you will help your children
How much your children will help you
As such, calculating a simple figure how much your assets should be may be useful, but that one variable is not enough to help you figure out how you should conduct your retirement.
Why don’t more people consult investment professionals? What keeps them from doing so?
There are two reasons: first, most people don’t have enough income or assets for investment professionals to have value to them. Second, people don’t understand what investment professionals can do for them, which is:
They can keep you from panicking or getting greedy
They can find ways to reduce your tax burdens
They can diversify your assets so that you are less subject to large drawdowns in the value of your assets
Other than maximizing your annual contribution, what other things can you do to get the most out of your IRA and 401(k)?
Diversify your investments into safe and risky buckets. The safe bucket should contain high quality bonds. The risky bucket should contain stocks, tilted toward value investing, and smaller stocks. New contributions should mostly feed investments that have been doing less well, because investments tend to mean-revert.
Stocks are clearly risky and investors have emotional reactions to that. How can investors rationally manage their stock investments so that they are less likely to regret their decisions?
When I was a young investor, I had to learn not to panic. I also had to learn not to get greedy. That means tuning out the news, and focusing on the long run. That may mean not looking at your financial statements so frequently.
As for me as a financial professional, I look at the assets that I manage for my clients and me every day, but I have rules that limit trading. I do almost all trading once per quarter, at mid-quarter, when the market tends to be sleepy, and not a lot of news is coming out. When I trade, I am making business decisions that reflect my long-term estimates of business prospects.
Closing
And if that is not enough for you, please consult my piece The Retirement Bubble. ?You can retire if you put enough away for it, but it is an awful lot of money given that present investments yield so little.
Before I start, I would like to remind readers of a Q&A that I did with the author, which is available here. [For readers at Amazon: Google “Aleph?Education of a Value Investor”. There are other useful links in the version at my blog. ?Wish Amazon allowed for links…]
This is a good book if you know what you are getting and want that. ?If you want a book to compare it to, I would class it with?Benjamin Graham: The Memoirs of the Dean of Wall Street. ?The reason for this comparison is that the book focuses on character development, and spends relatively little time on detailed value investing methods. ?It spends a lot of time on the good parts of the lifestyle?of?a value investor, and this is where the book has its highest value.
Is it possible to “get rich quick?” ?I don’t think so, but it is possible to become rich if you focus, make few decisions, but they are the right actions to take.
This book describes the transformation of the author, who went from someone trying to get rich quick in the short-run, and failing, to being an investor who could wait until he had a good idea to invest in, and then concentrate his capital in the best ideas that he had, and succeed.
But getting there was not a linear matter. ?First, he had to figure out he was miserable. ?Then, he had to find a new way to support himself, handicapped because the last firm he worked for had a bad reputation.
He picked up an interest in value investing, particularly the style that Buffett follows, which led him to a clutch of contacts in the value investing world who would help to shape his view of the world.
Without spoiling the book, some events happened that enabled him to set up his own investment shop where he does value investing for clients and himself. ?And as such, he lived happily ever after?
Well, not yet. ?He meets one key person, Mohnish Pabrai, who helps him think through the key aspects of his business. ?He makes a number of additional friends who are value investors, and he figures out what he is good at analyzing and acting on, and where he is less capable. ?Armed with that data, he acts to make his entire life more effective for himself, his family, and his clients.
He moved so that he could be out of the “New York Vortex,” where groupthink can carry you along. ?He moved to a quiet?area, and set up an office where he could think, and the odds of being disturbed would be low. ?He set up an action area and a contemplation area. ?He limited electronics to the action area and made it uncomfortable?to stay in the?action area. ?This enabled him to think longer-term, and avoid taking actions because others were doing so. ?He also had to learn how to get advice from other intelligent investors, without letting their views short-circuit his thinking processes.
He enjoyed life a lot more. ?He also realized he had enough assets to manage, and so he didn’t need to market much, which allowed for a focus on serving current clients well. ?About the only thing he needs to do is develop a sell discipline, and that is not an uncommon problem with most asset managers. ?[Two of my articles on the topic: one, two.]
Near?the end of the book, he shares eight?pointers that will improve the investing of most people, if they are willing to think long-term. ?I endorse the principles there, though there may be other ways to achieve the same disciplined attitude. ?He also gives four case studies that affects the checklist that he uses for making investments.
Now, I have purposely left out the most colorful part of the book, the lunch with Warren Buffett, to the end of this review. ?He and Mohnish bid together for the lunch and win. ?The main thing he takes away from the affair was how much Buffett focused on his guests, and not on himself. ?Indeed, at the end of the book, he credits his relationship with Mohnish in?helping him to become more selfless in many of his attitudes. ?To him, that is the real prize, much as he has done well as an investor and a businessman.
Quibbles
Can all of ethics be summed up as being farsighted and unselfish? ?No. ?Those are good things, but the Bible has many more things to teach than that.
Summary
This book will help you understand the internal attitudes of some value investors. ?It may help you invest to some degree, but that is not the main point of the book. ?After all, what is it worth to be a great investor if you aren’t happy? ?Being happy as an investment manager is the main point of the book. ?If you still want to buy it, you can buy it here:?The Education of a Value Investor: My Transformative Quest for Wealth, Wisdom, and Enlightenment.
Full disclosure:?I?received two copies from the author’s PR flack. ?Good thing too, because someone swiped one of them before I finished reading it.
If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)
Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.
