Many of the biggest and most common mistakes made by investors happens because they stray from their core competencies and / or lose focus. As evidenced below, a checklist can help tremendously.
“In 2009 the New England Journal of Medicine published the results of a study tracking the rate of complications from surgery before and after the introduction of a checklist. The study was based on data from more than seventy-six hundred operations in eight cities around the world. The researches found that rate of death dropped almost by half when the doctors used the checklist, and that other complications fell by one-third”….taken from the book Think Twice by Michael Maubossin
Mule's Musings
From time to time, when something strikes me that I think will benefit others I'll jot it down or provide a link. The posts are meant to challenge current thinking and to help provide a framework to make better business and investment decisions.
Wednesday, March 17, 2010
Always good to go back and review your thinking..
Wow. I just read my post from 2004 re: real estate in the U.S. As my wife said to me the other day, "Are you upset you had an idea what was going to happen but didn't make a fortune from your insights?" Well, yes, I am....sort of. Even knowing how the scene played out I'm not sure I could have done anything different. I wasn't in a position (or knowledgeable enough) to play it the right way. What most folks don't realize is that even though you may have a good "trade" it is still really hard to get the timing right. In my case I probably would have gone broke waiting from '04 - '07 to have the trade (or any trade) go my way even though I would have eventually been proven correct.
Thursday, June 24, 2004
Real Estate Bubble?
There's a great article in the NY Times today discussing whether or not there is a real estate bubble. The case study was a guy who bought a $360,000 house using two variable rate loans with nothing down. A couple of observations follow:
1. Banks have gotten incredibly lax in their underwriting standards so says Bill Dallas a pioneer in no-money-down loans and a board member of the Cal. Mortgage Bankers Association.
2. What is to prevent the guy in the case study and all of the others who have no equity in their house from walking away if they can't make the payments?
3. It seems the people entering into these loans think that wages will rise as interest rates do - - this doesn't seem to jive with what is actually going in the world today. Wages seem to be going down or staying flat as productivity continues to rise.
I'm not suggesting that if the housing bubble bursts it will be nationwide. It could be a local issue albeit one that is widespread to many localities. I don't think homes on the outskirts of Charlotte for instance (where I now live) will see price compression in the same way that NY will (where I used to live).
The scene is set: A plethora of adjustable mortgages, modest incomes, and an outlook of increasing rates.
This is not a good combination. The best thing I can say is I would bet there will be plenty of great deals in housing the next few years.
1. Banks have gotten incredibly lax in their underwriting standards so says Bill Dallas a pioneer in no-money-down loans and a board member of the Cal. Mortgage Bankers Association.
2. What is to prevent the guy in the case study and all of the others who have no equity in their house from walking away if they can't make the payments?
3. It seems the people entering into these loans think that wages will rise as interest rates do - - this doesn't seem to jive with what is actually going in the world today. Wages seem to be going down or staying flat as productivity continues to rise.
I'm not suggesting that if the housing bubble bursts it will be nationwide. It could be a local issue albeit one that is widespread to many localities. I don't think homes on the outskirts of Charlotte for instance (where I now live) will see price compression in the same way that NY will (where I used to live).
The scene is set: A plethora of adjustable mortgages, modest incomes, and an outlook of increasing rates.
This is not a good combination. The best thing I can say is I would bet there will be plenty of great deals in housing the next few years.
Tuesday, June 22, 2004
2004 Q1 Investment Letter
1st Quarter - 2004 Investment Update
I have received feedback from my letters on a regular basis which I view as a wonderful development. After hearing some of the comments, I can’t help but believe some of you may be thinking of me as a perma-bear on stocks and on almost all other investments. I can assure you that I am not. I believe our country over the long-term is an ideal place to invest. It is the best place in the world, in fact. Thomas Friedman, op-ed columnist for The New York Times, said recently,
“America is the greatest engine of innovation that has ever existed, and it can’t be duplicated anytime soon, because it is the product of a multitude of factors: extreme freedom of thought, an emphasis on independent thinking, a steady immigration of new minds, a risk-taking culture with no stigma attached to trying and failing, a non-corrupt bureaucracy, and financial markets and a venture capital system that are unrivaled at taking new ideas and turning them into global products.”
I couldn’t agree more. But that is not to say investing in the U.S. financial markets is easy or that it does not entail risk. An understanding of these risks in relation to expected return is paramount in achieving investment success over the long-term.
Investment Commentary
When asset prices are low in relation to inherent value, the longer-term risk-reward ratio is asymmetrical. Simply said, this condition results in a significantly higher probability of gain than of loss per dollar invested. My view in the last year was that an investment in the general market could have best been characterized as providing investors with a 50% chance of a 10-15% gain and a 50% chance of a 30-40% loss. It doesn’t take a math major to understand the near impossibility of achieving sustained investment success under this type of condition. As a result, the investments in stocks being made on your behalf in the last year have not been representative of the risk in the general market. However, by and large, they have delivered returns in excess of the market (as defined by the S&P 500).
As always, we continue to do our best to buy stocks when their current price is substantially below our estimate of intrinsic value. In addition, most of you have not been fully invested in stocks over the last year as cash has been a significant holding.
It is our opinion that this greatly reduced the odds of experiencing a negative
long-term return.
I have been reading a great book called Against the Gods: The Remarkable Story of Risk written by Peter Bernstein. The book explores the origins of risk and the resulting leap into forecasting. It is not a topic that gets much attention but most great investors view investing in the context of probabilities. Warren Buffett has said that if given 3:2 odds on the flip of a coin he would wager a billion dollars. This may sound odd at first coming from the world’s greatest investor but in reality it makes perfect sense. Mr. Buffett has an acute awareness that success in investing, in gambling, or even in parlor games for that matter, hinges on having the odds in your favor (or, as in the case with gambling, at least having an understanding as to what extent they are not).
Successful investors choose not to play when there is a higher probability of loss than of gain. As I have said in previous letters, this does not mean they will be “right” in the short-term. They could be seen as being wildly “wrong.” One only has to recall the perceived demise of value investors in the late 1990’s in favor of internet investments to demonstrate this. However, over the long-term, whether investing, gambling, or playing a simple card game like hearts, if the odds favor you a desirable outcome will
likely result.
It is important to note that it is possible to have the “odds in your favor” when investing in securities like stocks. History has proven that astute value investors will have a much higher probability of success than a random investment program or an indexing approach. Rigorous fundamental analysis combined with other factors such as making investments in companies who have an industry advantage, stocks that may be trading at extremely low valuations due to investor misperception, or stocks that may have been sold for uneconomic reasons (spin-offs, S&P 500 deletions, etc.) will produce above-average returns. These types of investments are attractive precisely because risk has become low in relation to expected return.
Thank you very much for your continued confidence. As always, please call or write with any questions or comments.
I have received feedback from my letters on a regular basis which I view as a wonderful development. After hearing some of the comments, I can’t help but believe some of you may be thinking of me as a perma-bear on stocks and on almost all other investments. I can assure you that I am not. I believe our country over the long-term is an ideal place to invest. It is the best place in the world, in fact. Thomas Friedman, op-ed columnist for The New York Times, said recently,
“America is the greatest engine of innovation that has ever existed, and it can’t be duplicated anytime soon, because it is the product of a multitude of factors: extreme freedom of thought, an emphasis on independent thinking, a steady immigration of new minds, a risk-taking culture with no stigma attached to trying and failing, a non-corrupt bureaucracy, and financial markets and a venture capital system that are unrivaled at taking new ideas and turning them into global products.”
I couldn’t agree more. But that is not to say investing in the U.S. financial markets is easy or that it does not entail risk. An understanding of these risks in relation to expected return is paramount in achieving investment success over the long-term.
Investment Commentary
When asset prices are low in relation to inherent value, the longer-term risk-reward ratio is asymmetrical. Simply said, this condition results in a significantly higher probability of gain than of loss per dollar invested. My view in the last year was that an investment in the general market could have best been characterized as providing investors with a 50% chance of a 10-15% gain and a 50% chance of a 30-40% loss. It doesn’t take a math major to understand the near impossibility of achieving sustained investment success under this type of condition. As a result, the investments in stocks being made on your behalf in the last year have not been representative of the risk in the general market. However, by and large, they have delivered returns in excess of the market (as defined by the S&P 500).
As always, we continue to do our best to buy stocks when their current price is substantially below our estimate of intrinsic value. In addition, most of you have not been fully invested in stocks over the last year as cash has been a significant holding.
It is our opinion that this greatly reduced the odds of experiencing a negative
long-term return.
I have been reading a great book called Against the Gods: The Remarkable Story of Risk written by Peter Bernstein. The book explores the origins of risk and the resulting leap into forecasting. It is not a topic that gets much attention but most great investors view investing in the context of probabilities. Warren Buffett has said that if given 3:2 odds on the flip of a coin he would wager a billion dollars. This may sound odd at first coming from the world’s greatest investor but in reality it makes perfect sense. Mr. Buffett has an acute awareness that success in investing, in gambling, or even in parlor games for that matter, hinges on having the odds in your favor (or, as in the case with gambling, at least having an understanding as to what extent they are not).
Successful investors choose not to play when there is a higher probability of loss than of gain. As I have said in previous letters, this does not mean they will be “right” in the short-term. They could be seen as being wildly “wrong.” One only has to recall the perceived demise of value investors in the late 1990’s in favor of internet investments to demonstrate this. However, over the long-term, whether investing, gambling, or playing a simple card game like hearts, if the odds favor you a desirable outcome will
likely result.
It is important to note that it is possible to have the “odds in your favor” when investing in securities like stocks. History has proven that astute value investors will have a much higher probability of success than a random investment program or an indexing approach. Rigorous fundamental analysis combined with other factors such as making investments in companies who have an industry advantage, stocks that may be trading at extremely low valuations due to investor misperception, or stocks that may have been sold for uneconomic reasons (spin-offs, S&P 500 deletions, etc.) will produce above-average returns. These types of investments are attractive precisely because risk has become low in relation to expected return.
Thank you very much for your continued confidence. As always, please call or write with any questions or comments.
2003 Q4 Investment Letter
4th Quarter - 2003 Investment Update January, 2004
Economic Commentary
GDP growth and productivity have proven incredibly strong as of late. As rosy as the picture looks today, there are numerous potential pitfalls that investors are facing in the year ahead. The increased threat of terrorism, our increasing national debt, a falling dollar, abnormally low interest rates (which can lead to higher inflation among other things), and our trade imbalance all loom as we enter 2004. That being said, it is only fair to mention that much could go “right” also. It seems we are getting closer to having peace on fronts unimaginable in past years. Pakistan and India are in talks and Libya seems willing to trade their weapons programs for economic assistance. John Snow, U.S. Treasury Secretary, recently theorized that if the economy continues to chug along the deficit may be greatly reduced as a percentage of GDP in only a few years. I have never read more diverse “expert” opinions on the future of the economy and stock and bond markets as I have this year.
This cartoon (present in the actual letter) correctly points out that there are so many variables at work no one really knows what the year-ahead might bring. While this fact may be unsettling to some, there is good news to be shared. The practice of buying a dollar bill for 50 cents (e.g. getting a good deal) has proven to be an effective investment strategy over extended periods of time regardless of the economic landscape. By sticking to this principle investors are thankfully not reliant on predicting interest rates, economic growth or overall levels of the stock market. However, it is important to be knowledgeable of the forces at work as a backdrop for making sound investment decisions. In essence, the economic overview proves to be less helpful in bubbling up great stock ideas or bond ideas but more helpful in establishing the framework within which decisions are made.
Investment Commentary
"An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative".
-Benjamin Graham. The Intelligent Investor
In periods of stock market euphoria it becomes increasingly difficult to employ the discipline necessary to make a good “investment” versus a “speculation” as defined above. There is an old saying that a bull market makes everyone look like a genius. An article in Barron’s, the financial publication, recently stated “small orders for speculative call options are running at a furious clip of late.” The article went on to say that the investors are emboldened by the “couldn’t-lose” aspect of investing in aggressive stocks in 2003. The risk pendulum seems to clearly have swung to speculative buying. Caution has effectively been thrown to the wind.
The verdict is out on whether or not this is a secular or cyclical bull market but there is no denying the market currently has an upward bias. Importantly, and counter intuitively, the question to be asked is not “how much can be made” but rather “how much can be lost” in today’s market. The combination of fiscal and monetary stimulus, extraordinary low interest rates (it seems the stock market is being viewed as an alternative to money market funds), and increasing earnings has proven a honey pot for even the most ardent bears.
As my previous letter stated, absolute not relative returns are what should really matter to an investor. This approach helps to significantly reduce the chance of making a foolish speculation as opposed to a prudent investment. If one’s analysis finds a company attractive because the stock trades at a significant discount to its peers it really does not give the investor an idea of the true return potential. This lesson was learned (and it seems just as quickly forgotten) by the collapse of the NASDAQ from its lofty levels of a few years ago. Simply put, the fact that Yahoo! is trading at 100x earnings per share doesn’t make Amazon a good value if it is trading at 60x earnings per share. The danger in speculating is the very real risk of losing your capital on a permanent basis. Before the last market correction, permanent loss of capital meant to many investors the stocks or bonds of companies that went bankrupt. This of course is still true but most investors have come to realize that it also includes stocks that hit such lofty heights in the previous bull market that they will never ever see those prices again. The litany of companies that fit this description is unfortunately too long to mention.
Thank you very much for your continued confidence. As always, please call or write with any questions or comments.
Economic Commentary
GDP growth and productivity have proven incredibly strong as of late. As rosy as the picture looks today, there are numerous potential pitfalls that investors are facing in the year ahead. The increased threat of terrorism, our increasing national debt, a falling dollar, abnormally low interest rates (which can lead to higher inflation among other things), and our trade imbalance all loom as we enter 2004. That being said, it is only fair to mention that much could go “right” also. It seems we are getting closer to having peace on fronts unimaginable in past years. Pakistan and India are in talks and Libya seems willing to trade their weapons programs for economic assistance. John Snow, U.S. Treasury Secretary, recently theorized that if the economy continues to chug along the deficit may be greatly reduced as a percentage of GDP in only a few years. I have never read more diverse “expert” opinions on the future of the economy and stock and bond markets as I have this year.
This cartoon (present in the actual letter) correctly points out that there are so many variables at work no one really knows what the year-ahead might bring. While this fact may be unsettling to some, there is good news to be shared. The practice of buying a dollar bill for 50 cents (e.g. getting a good deal) has proven to be an effective investment strategy over extended periods of time regardless of the economic landscape. By sticking to this principle investors are thankfully not reliant on predicting interest rates, economic growth or overall levels of the stock market. However, it is important to be knowledgeable of the forces at work as a backdrop for making sound investment decisions. In essence, the economic overview proves to be less helpful in bubbling up great stock ideas or bond ideas but more helpful in establishing the framework within which decisions are made.
Investment Commentary
"An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative".
-Benjamin Graham. The Intelligent Investor
In periods of stock market euphoria it becomes increasingly difficult to employ the discipline necessary to make a good “investment” versus a “speculation” as defined above. There is an old saying that a bull market makes everyone look like a genius. An article in Barron’s, the financial publication, recently stated “small orders for speculative call options are running at a furious clip of late.” The article went on to say that the investors are emboldened by the “couldn’t-lose” aspect of investing in aggressive stocks in 2003. The risk pendulum seems to clearly have swung to speculative buying. Caution has effectively been thrown to the wind.
The verdict is out on whether or not this is a secular or cyclical bull market but there is no denying the market currently has an upward bias. Importantly, and counter intuitively, the question to be asked is not “how much can be made” but rather “how much can be lost” in today’s market. The combination of fiscal and monetary stimulus, extraordinary low interest rates (it seems the stock market is being viewed as an alternative to money market funds), and increasing earnings has proven a honey pot for even the most ardent bears.
As my previous letter stated, absolute not relative returns are what should really matter to an investor. This approach helps to significantly reduce the chance of making a foolish speculation as opposed to a prudent investment. If one’s analysis finds a company attractive because the stock trades at a significant discount to its peers it really does not give the investor an idea of the true return potential. This lesson was learned (and it seems just as quickly forgotten) by the collapse of the NASDAQ from its lofty levels of a few years ago. Simply put, the fact that Yahoo! is trading at 100x earnings per share doesn’t make Amazon a good value if it is trading at 60x earnings per share. The danger in speculating is the very real risk of losing your capital on a permanent basis. Before the last market correction, permanent loss of capital meant to many investors the stocks or bonds of companies that went bankrupt. This of course is still true but most investors have come to realize that it also includes stocks that hit such lofty heights in the previous bull market that they will never ever see those prices again. The litany of companies that fit this description is unfortunately too long to mention.
Thank you very much for your continued confidence. As always, please call or write with any questions or comments.
2003 Q3 Investment Letter
Q3 - 2003 Investment Update October, 2003
General Commentary
It should be obvious to us all that no one truly knows the direction that the financial markets are going to head in the short-term with any degree of certainty. This fact has led to a nearly unanimous voice on Wall Street that argues for setting an asset allocation (stocks, bonds, hedge funds, etc.) and sticking to it through all seasons. The unintended consequence of this recommendation has been that although investment managers may lose money for their clients they proclaim victory for losing less than the stated benchmarks. In our industry lingo this is called generating relative outperformance. As has been said many times, “you can’t eat relative performance”. Our industry seems to have lost sight that our mandate should be to make our clients money by investing wherever money can be made.
We would not attempt to argue that it is possible to time the market in the short-term. And, we believe that the percentage of assets invested in any one asset class is the main driver of overall performance. However, we do think that it is a very natural process (although not an easy one) for a thoughtful investment professional to have opinions as to whether certain financial instruments are over or under-valued. The willingness to act on this information does not constitute market-timing but rather the ability to allocate capital in a prudent manner. It closely resembles the decision of a CEO when determining where to invest the resources at his/her disposal or in a more specific example whether to issue stock (if he/she feels their stock is overvalued), debt (if the interest rate environment is favorable) or cash to use as currency to buy another company.
In analyzing an investment the first question to ask is not how much can be made but how much can be lost. Considering today’s environment for stocks, the risk of significant loss seems much greater than the incremental gain. On the interest rate front, an improving economy should lift rates higher possibly causing a rate increase by the Fed in 2004. As a result, we will hold our bond positions and not commit new money into fixed income until the early or middle part of 2004. The following commentary provides further thoughts into these observations:
Stocks and the US Economy
It’s official. We have been in an economic recovery for over two years now. No new jobs have been added however so it has hardly felt like things are getting better. Companies have continued to reduce their costs to the point of experiencing profitability with flat or declining sales. When sales do pick up it should bode extremely well for the collective bottom lines of American businesses. The economy is providing mixed signals (although with a positive bias) which has the stock market in a fit of stops and starts. This is not unexpected. If all of the signs were positive and pointed upwards it would take all of the fun out of making predictions! We don’t anticipate businesses hiring additional workers until they are running at full capacity.
In large part due to the productivity gains over the recent years, demand will need to increase sharply before this happens. Adding jobs immediately and substantially is not a necessary ingredient at this stage for the economic recovery to continue. Additionally, business inventories have been run down and their replenishment should extend the recovery’s momentum. Perhaps most importantly, we are living in a time of extraordinary fiscal and monetary stimulus.
We don’t think this market will be characterized by the idea of a “rising tide that will lift all boats”. Well-managed companies, those with a balance sheet that is properly aligned, and those that can continue to manage their cost structure in a period of increasing sales should benefit the most with stock prices that outperform the general market.
Bonds
We recently ended a 20-year cycle of decreasing interest rates that began in 1982. Short-term rates are around 1% and even lower in money-market funds after expenses. They don’t have room to go much lower. So, what happens next? If the cycle for the last 20 years was trending down and we are now near 0% it is logical to conclude that the next cycle should trend up. What is not evident is the period of time over which this will occur. It is not hard to imagine that over the next few years interest rates should be higher than they are today. A period of rising rates and falling bond prices is called a bear market. For those investors who hold bonds they should see the principal value decline. This should not be an issue provided the bonds are held to maturity and do not default before they get there. There should also be an opportunity over the next 12 months for those investors looking to establish new positions in bonds as they will be able to lock in higher rates.
Sometimes very simple observations are the most telling. Berkshire Hathaway, the investment holding company controlled by Warren Buffett, recently issued $1.5 billion in 5 and 10-year notes. The combined factors of his credit rating, which is the highest rating possible by Standard and Poor’s, and the lowest interest-rates in 45 years, have allowed him to borrow money at ridiculously low rates. To say that Buffett has shown aptitude in the past at gauging where to find value in the capital markets is a gross understatement. Berkshire Hathaway’s recent actions send a pretty clear signal that rates are going higher, and soon.
General Commentary
It should be obvious to us all that no one truly knows the direction that the financial markets are going to head in the short-term with any degree of certainty. This fact has led to a nearly unanimous voice on Wall Street that argues for setting an asset allocation (stocks, bonds, hedge funds, etc.) and sticking to it through all seasons. The unintended consequence of this recommendation has been that although investment managers may lose money for their clients they proclaim victory for losing less than the stated benchmarks. In our industry lingo this is called generating relative outperformance. As has been said many times, “you can’t eat relative performance”. Our industry seems to have lost sight that our mandate should be to make our clients money by investing wherever money can be made.
We would not attempt to argue that it is possible to time the market in the short-term. And, we believe that the percentage of assets invested in any one asset class is the main driver of overall performance. However, we do think that it is a very natural process (although not an easy one) for a thoughtful investment professional to have opinions as to whether certain financial instruments are over or under-valued. The willingness to act on this information does not constitute market-timing but rather the ability to allocate capital in a prudent manner. It closely resembles the decision of a CEO when determining where to invest the resources at his/her disposal or in a more specific example whether to issue stock (if he/she feels their stock is overvalued), debt (if the interest rate environment is favorable) or cash to use as currency to buy another company.
In analyzing an investment the first question to ask is not how much can be made but how much can be lost. Considering today’s environment for stocks, the risk of significant loss seems much greater than the incremental gain. On the interest rate front, an improving economy should lift rates higher possibly causing a rate increase by the Fed in 2004. As a result, we will hold our bond positions and not commit new money into fixed income until the early or middle part of 2004. The following commentary provides further thoughts into these observations:
Stocks and the US Economy
It’s official. We have been in an economic recovery for over two years now. No new jobs have been added however so it has hardly felt like things are getting better. Companies have continued to reduce their costs to the point of experiencing profitability with flat or declining sales. When sales do pick up it should bode extremely well for the collective bottom lines of American businesses. The economy is providing mixed signals (although with a positive bias) which has the stock market in a fit of stops and starts. This is not unexpected. If all of the signs were positive and pointed upwards it would take all of the fun out of making predictions! We don’t anticipate businesses hiring additional workers until they are running at full capacity.
In large part due to the productivity gains over the recent years, demand will need to increase sharply before this happens. Adding jobs immediately and substantially is not a necessary ingredient at this stage for the economic recovery to continue. Additionally, business inventories have been run down and their replenishment should extend the recovery’s momentum. Perhaps most importantly, we are living in a time of extraordinary fiscal and monetary stimulus.
We don’t think this market will be characterized by the idea of a “rising tide that will lift all boats”. Well-managed companies, those with a balance sheet that is properly aligned, and those that can continue to manage their cost structure in a period of increasing sales should benefit the most with stock prices that outperform the general market.
Bonds
We recently ended a 20-year cycle of decreasing interest rates that began in 1982. Short-term rates are around 1% and even lower in money-market funds after expenses. They don’t have room to go much lower. So, what happens next? If the cycle for the last 20 years was trending down and we are now near 0% it is logical to conclude that the next cycle should trend up. What is not evident is the period of time over which this will occur. It is not hard to imagine that over the next few years interest rates should be higher than they are today. A period of rising rates and falling bond prices is called a bear market. For those investors who hold bonds they should see the principal value decline. This should not be an issue provided the bonds are held to maturity and do not default before they get there. There should also be an opportunity over the next 12 months for those investors looking to establish new positions in bonds as they will be able to lock in higher rates.
Sometimes very simple observations are the most telling. Berkshire Hathaway, the investment holding company controlled by Warren Buffett, recently issued $1.5 billion in 5 and 10-year notes. The combined factors of his credit rating, which is the highest rating possible by Standard and Poor’s, and the lowest interest-rates in 45 years, have allowed him to borrow money at ridiculously low rates. To say that Buffett has shown aptitude in the past at gauging where to find value in the capital markets is a gross understatement. Berkshire Hathaway’s recent actions send a pretty clear signal that rates are going higher, and soon.
2002 Q4 Investment Letter
2003 Investment Update February 11, 2003
Most investors were very happy to put 2002 behind them. In fact, the S&P 500 lost over 40% for the three-year period ending 12/31/02. Many of you may have stocks that are down significantly during this time. While the temporary loss of capital is never easy to accept, this bear market has presented us with a timely opportunity to reinforce our rationale for the stocks we select. It is very important to realize that bull markets are irrational to the upside in overpricing stocks. In the same way, bear markets push stocks below fair value on the downside. Peter Lynch was recently quoted as saying; “If I calculate fair value at $40 and buy the stock at $12 do I really care in the short-term if the price goes to $2 per share?” The answer is no. To paraphrase Benjamin Graham; the stock market is a voting machine in the short-term and a weighing machine in the long-term. This idea brings us to an important point. The process by which you make investment decisions is the determinant of your long-term performance (notice I didn’t say short-term performance!).
In making an investment the price you pay as it relates to the underlying business will largely determine how profitable your investment will be. To make a purchase decision there needs to be a disconnect between the stock price and the calculated intrinsic value of the business so that you are able to buy the underlying business at a discount to its fair value. Intrinsic value is simply an assessment of the value of a company’s underlying business. This can be done by calculating the stream of future earnings, or better yet, the cashflow that a company generates. It can be calculated using the book value of the business which, in generic terms, is the assets of the company minus its liabilities. Other important factors to be considered before buying a stock are comfort and confidence in the company’s leaders, management that is shareholder-oriented, and a favorable position in an industry which can be understood with a strong degree of confidence. Most of the investments we make contain some combination of these characteristics.
An example of this investment decision-making at work is our past purchase of Best Buy. Best Buy is a leader in electronics retailing. The company possesses many great qualities. They have excellent management. Many retail analysts have gone on record to say that Best Buy’s top management is hands-down the best in retail. The employees are owners of the company. They do not use options in an excessive fashion. The electronics industry is undergoing a revolution. Not since the color TV has so many new television products flooded the market. HDTV (High-Definition TV) and plasma screens are the new rage.
DVD is replacing videocassettes at an incredibly rapid pace. People are purchasing MP3 players, Palm Pilots and Blackberries, and Wi-Fi technology. This is all being done at unbelievably low prices.
We thought Best Buy was priced attractively at prices higher than where it currently trades at just over $27 per share. It actually reached a low of around $18 in October and then again in November. There were concerns about competition from Circuit City and the new entry into the electronic retailing field; Wal-Mart. Consumer spending and confidence were said to be waning. The newspapers ran headlines proclaiming “2002 was the worst retail season in the past 30 years!” What they failed to mention was that this was true strictly in a year-over-year comparison. On an absolute basis, sales were actually quite strong. Because of the lofty expectations set, most of the other electronic retailers did report sales and earnings that disappointed Wall Street. Best Buy, however, issued a press release that said they were very pleased with their sales this past holiday season. They also predicted 10-12% sales growth in 2003. During tough times the better managed, better-capitalized companies usually succeed. As companies lose pricing power, margins get lower. Only those who are extremely efficient and well run can operate at these lower margins and still be profitable.
Best Buy’s financial position is very strong with a billion dollars in cash on their balance sheet. They have less than $800 million in debt. They expect to earn approximately $2.00 per share in 2003 and they produced over $3 of free cashflow per share in 2002. To put their current valuation in perspective, they earned $920 million before interest and taxes on an enterprise value (market cap + debt – cash) of $8 billion versus earning $351 million with a similar enterprise value in 1999. By that measure the company currently earns three times us much as it did three years ago but the trading value of the business is unchanged during that time. As we progress during this upcoming year, we will be watching consumer spending closely. Most importantly, we expect to continue to see Best Buy’s advantage grow in the electronics retailing business.
We recognize that it is not a comfortable feeling owning stocks that are held at a loss. However, it is our belief that business values and stock prices must eventually converge. This is what gives us confidence in our investment selections even as prices have fallen during this bear market.
Thank you for your trust and confidence in the past and we look forward to working with you in the years ahead.
Most investors were very happy to put 2002 behind them. In fact, the S&P 500 lost over 40% for the three-year period ending 12/31/02. Many of you may have stocks that are down significantly during this time. While the temporary loss of capital is never easy to accept, this bear market has presented us with a timely opportunity to reinforce our rationale for the stocks we select. It is very important to realize that bull markets are irrational to the upside in overpricing stocks. In the same way, bear markets push stocks below fair value on the downside. Peter Lynch was recently quoted as saying; “If I calculate fair value at $40 and buy the stock at $12 do I really care in the short-term if the price goes to $2 per share?” The answer is no. To paraphrase Benjamin Graham; the stock market is a voting machine in the short-term and a weighing machine in the long-term. This idea brings us to an important point. The process by which you make investment decisions is the determinant of your long-term performance (notice I didn’t say short-term performance!).
In making an investment the price you pay as it relates to the underlying business will largely determine how profitable your investment will be. To make a purchase decision there needs to be a disconnect between the stock price and the calculated intrinsic value of the business so that you are able to buy the underlying business at a discount to its fair value. Intrinsic value is simply an assessment of the value of a company’s underlying business. This can be done by calculating the stream of future earnings, or better yet, the cashflow that a company generates. It can be calculated using the book value of the business which, in generic terms, is the assets of the company minus its liabilities. Other important factors to be considered before buying a stock are comfort and confidence in the company’s leaders, management that is shareholder-oriented, and a favorable position in an industry which can be understood with a strong degree of confidence. Most of the investments we make contain some combination of these characteristics.
An example of this investment decision-making at work is our past purchase of Best Buy. Best Buy is a leader in electronics retailing. The company possesses many great qualities. They have excellent management. Many retail analysts have gone on record to say that Best Buy’s top management is hands-down the best in retail. The employees are owners of the company. They do not use options in an excessive fashion. The electronics industry is undergoing a revolution. Not since the color TV has so many new television products flooded the market. HDTV (High-Definition TV) and plasma screens are the new rage.
DVD is replacing videocassettes at an incredibly rapid pace. People are purchasing MP3 players, Palm Pilots and Blackberries, and Wi-Fi technology. This is all being done at unbelievably low prices.
We thought Best Buy was priced attractively at prices higher than where it currently trades at just over $27 per share. It actually reached a low of around $18 in October and then again in November. There were concerns about competition from Circuit City and the new entry into the electronic retailing field; Wal-Mart. Consumer spending and confidence were said to be waning. The newspapers ran headlines proclaiming “2002 was the worst retail season in the past 30 years!” What they failed to mention was that this was true strictly in a year-over-year comparison. On an absolute basis, sales were actually quite strong. Because of the lofty expectations set, most of the other electronic retailers did report sales and earnings that disappointed Wall Street. Best Buy, however, issued a press release that said they were very pleased with their sales this past holiday season. They also predicted 10-12% sales growth in 2003. During tough times the better managed, better-capitalized companies usually succeed. As companies lose pricing power, margins get lower. Only those who are extremely efficient and well run can operate at these lower margins and still be profitable.
Best Buy’s financial position is very strong with a billion dollars in cash on their balance sheet. They have less than $800 million in debt. They expect to earn approximately $2.00 per share in 2003 and they produced over $3 of free cashflow per share in 2002. To put their current valuation in perspective, they earned $920 million before interest and taxes on an enterprise value (market cap + debt – cash) of $8 billion versus earning $351 million with a similar enterprise value in 1999. By that measure the company currently earns three times us much as it did three years ago but the trading value of the business is unchanged during that time. As we progress during this upcoming year, we will be watching consumer spending closely. Most importantly, we expect to continue to see Best Buy’s advantage grow in the electronics retailing business.
We recognize that it is not a comfortable feeling owning stocks that are held at a loss. However, it is our belief that business values and stock prices must eventually converge. This is what gives us confidence in our investment selections even as prices have fallen during this bear market.
Thank you for your trust and confidence in the past and we look forward to working with you in the years ahead.
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