Turk Capital Management, Inc.
Letter To Clients
January 9, 2020
In 2019 our consolidated portfolios had satisfactory results on an absolute basis but not relative to the overall stock market. The consolidated total return for TCM assets under management was 23.2%, after management fees. The S&P 500 Index total return with dividends included was 31.5%. Our default benchmark portfolio comprising 90% S&P 500 Index and 10% cash returned 28.3%. Therefore, our relative performance was a negative 8.3% versus the S&P 500 Index and a negative 5.1% versus the default benchmark. Our largest stockholding throughout most of the year, Wells Fargo, was trimmed in November while returning 21.6% including dividends. Our other large holding, Berkshire Hathaway, finished 2019 with a paltry 10.9% advance. The consolidated performance results dating back to 1985 are included in attachment 2. The table represents 35 years of investing history. $1 invested with TCM grew to $55 reflecting an average annual return of 12.1%.
Wells Fargo: Another Tumultuous Year Ends Better
Wells Fargo shareholders had another challenging year in 2019. In March, the bank’s CEO Tim Sloan was suddenly forced to resign after a less than convincing performance before Congressional committees. The Federal Reserve and Office of the Comptroller of the Currency didn’t think that Wells Fargo was making sufficient improvements in risk management and compliance processes under Sloan. Both regulators criticized the bank’s management in unusually stark terms before he departed.
It took until October 21st for an outsider to be hired to begin the task of restoring Well’s tarnished reputation. He is 54-year old Charles Scharf and he is highly regarded having most recently served as the president and chief executive of Bank of New York Mellon and CEO of Visa. Scharf’s to-do list is short, but daunting: get the Federal Reserve to lift its cap on growth; repair relationships with customers; cut expenses; and grow earnings.
Given time, the strength of Wells Fargo’s franchise, with its sprawling national footprint, should give Scharf the ability to drive the bank back towards the front of the big bank pack. Getting the asset cap lifted will provide a huge boost to the stock. Let’s hope Charlie can get it done by ‘21.
Meanwhile, Berkshire Hathaway continues to own 378.4 million shares of WFC, or 9.0% of the bank.
After lagging badly behind the S&P 500 in 2019, Berkshire Hathaway looks poised to do better in 2020, based on rising book value and earnings. The weak showing reflects investor frustration with the continued build-up of cash on Berkshire’s balance sheet. The $128 billion now equals about a quarter of the total market value of Berkshire’s stock. Some investors are also concerned about which direction the company will take when Warren Buffett, who turned 89 in August, is no longer CEO.
Over the past twenty years from January 1, 2000, to December 31, 2019, Berkshire’s Class B shares rose from $36.60 to $226.50 yielding an annualized return of 9.5%. This handily beat the S&P 500’s annualized return of 6% over the same time period (including dividends). One dollar invested in Berkshire at the beginning of the century is worth about $6.14 today vs only $3.21 for a dollar invested in the S&P 500. The difference is even greater because Berkshire, unlike the S&P 500, has accomplished this record without distributing any taxable dividends.
However, in recent years, Berkshire has not performed as well relative to the S&P 500. For the 10 years ending on December 31, 2019, the S&P 500 provided an annualized return of 13.5% (including dividends) vs 13.2% for Berkshire. Berkshire has lagged even more over the past five years with an annualized return of 8.6% vs 11.6% for the S&P 500. And although one-year results are virtually meaningless, Berkshire’s underperformance in 2019 was the worst in a decade.
It has been a tough time for value investors, especially those not invested in technology stocks. Although Berkshire’s largest portfolio holding of Apple shares performed strongly (up 89%) in 2019, its huge cash position is telling investors Buffett has been unable to find suitable investments in today’s environment.
Still, Berkshire’s shares are undervalued trading at only 1.3 times book value and a price to earnings ratio of 21, both historically low and understated because of Berkshire’s equity portfolio and cash position. Buffett’s stated willingness to buy back shares at prices between 1.2 to 1.4 times book value per share should help to provide a bit of a floor for the stock in the event of a correction. More importantly, a good-sized market pullback will work in our favor as Buffett finds opportunities to deploy the cash.
Why Now Dow?
The Dow Jones Industrial Average (DJIA) produced a 25.3% total return in 2019, its best return since 2017. If we had used it as a 90%/10% benchmark instead of the S&P 500, our returns would have been virtually identical. We don’t use the DJIA because it uses an archaic formula based on each component’s stock price. For instance, Boeing is the
most heavily weighted Dow component because it has the highest stock price: $325.76 per share or 7.74% of the DJIA. Meanwhile, Coca-Cola has a stock price of $55.35 and a weighting of only 1.32%. Yet Coca-Cola has a market capitalization (# shares x stock price) of $237.1B and Boeing only $183.3B.
Now, if the Dow Jones Industrial Average had used each constituent’s beginning of the year market capitalizations, the total return would have been a whopping 39% instead of 25%. Why the DJIA has retained its status as a stock market bellwether is curious. For many investors it probably has to do with the fact it has been around since 1896. Also, it does tend to generally track the S&P 500 Index return. But this past year was an outlier. Large capitalization tech stocks such as Apple (+89%); Microsoft (+57.6%) and Netflix (+48.8%) outperformed the rest of the market by a wide margin, leading the S&P 500 Index to beat the DJIA by 6.2%. How long can that continue?
To help keep things in perspective, I’d like to end with a quote from Charlie Munger, Buffett’s longtime partner and Vice Chairman of Berkshire Hathaway:
“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.”
I continue to manage your capital as though it were my own and greatly value your support and trust.
Gregg H. Turk
No clear bell ever rings when the market or the economy starts to roll over. Either way, this maybe a good time to review how we view bear markets:
1) Stock prices can decline at any time, often without warning. Therefore, investors incommon stocks need a long-time horizon: a minimum of five years, and preferablydecades. If one isn’t willing to ride out a 20%-50% market decline, then they probablyshouldn’t be investing in stocks at all. A decline of that magnitude is almost certain tohappen on multiple occasions over an investor’s lifetime.
2) As uncomfortable as # 1 might sound, that doesn’t mean one should try to “time” themarket. No Wall Street professionals can do that consistently. And because stocks tendto increase in value over the long run as companies grow their earnings there is too much“danger” in being out of stocks for any significant period.
3) The best defense against permanent capital loss is to focus on the intrinsic values of thecompanies we study. Lower stock prices are actually good for us because they allow usto increase our ownership stake in competitively advantaged businesses at a lower cost,both directly through add-on purchases or indirectly through the companies’ shrewdlybuying back shares. We may also have an opportunity to swap stocks trading at fullvaluations for shares of wonderful businesses trading at a significant discount to ourconservative estimate of their intrinsic value.
However, having the correct intellectual approach to the stock market is only half the formula forsuccess. The most important requirement is controlling one’s emotions. Understanding theimportance of psychology and its influence on markets is essential to keeping it all inperspective. It’s highly desirable to become more optimistic when others become more fearful,and vice versa. This boils down to delighting in contrarianism without being a “perfect idiot.”Reason For SuccessWhen asked what the most important reason for their success was, Buffett attributed it to a greatteacher and exceptional focus. He also enjoyed the game, which was enormously fun. Investingis an easy game, but it does require a certain emotional stability. Buffett went through stockmanuals when he was young searching for investments. Between ages 7 and 19, he hadenthusiasm for investing but not guiding principles. Then he read The Intelligent Investor byBen Graham, which described an investment philosophy that made total sense. It wasn't morecomplicated than that.Charlie agreed that investing is an easy game if someone has the temperament for it.
Recent past Berkshire Hathaway Letters to Shareholders contain some very important themes that Buffett tends to repeat.
"You Invest in Businesses, Not Stocks"Perhaps the most important theme in Buffett’s letters has been the idea that when you invest in stocks, you are acquiring a partial ownership in a business, not just a ticker symbol. Yet when it comes to stocks, many investors “play the market” knowing very little about the businesses they are buying. Rather than focus on a host of information about the underlying business, investors often become consumed with market quotations. Buffett often likes to say that he is a better investor because he is a businessman and a better businessman because he is an investor. What follows are Buffett's quotes taken from those letters.
"If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so."
"It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings – and for some investors, it is."
"Owners of stocks, however, too often let the capricious and often irrational behavior of their fellow owners cause them to behave irrationally as well. Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits – and, worse yet, important to consider acting upon their comments."
"When Charlie [Munger] and I buy stocks – which we think of as small portions of businesses – our analysis is very similar to that which we use in buying entire businesses. We first must decide whether we can sensibly estimate an earnings range for five years out, or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings – which is usually the case – we simply move on to other prospects. In the 54 years we have worked together, we have never foregone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions."
"Most investors, of course, have not made the study of business prospects a priority in their lives. If wise, they will conclude that they do not know enough about specific businesses to predict their future earning power."
"I have good news for these non-professionals: The typical investor doesn’t need this skill. In aggregate, American business has done wonderfully over time and will continue to do so (though, most assuredly, in unpredictable fits and starts). In the 20th Century, the Dow Jones Industrials index advanced from 66 to 11,497, paying a rising stream of dividends to boot. The 21st Century will witness further gains, almost certain to be substantial. The goal of the non-professional should not be to pick winners – neither he nor his ‘helpers’ can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal."
"That’s the ‘what’ of investing for the non-professional. The ‘when’ is also important. The main danger is that the timid or beginning investor will enter the market at a time of extreme exuberance and then become disillusioned when paper losses occur. (Remember the late Barton Biggs’ observation: ‘A bull market is like sex. It feels best just before it ends.’) The antidote to that kind of mistiming is for an investor to accumulate shares over a long period and never to sell when the news is bad and stocks are well off their highs. Following those rules, the ‘know-nothing’ investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results. Indeed, the unsophisticated investor who is realistic about his shortcomings is likely to obtain better long-term results than the knowledgeable professional who is blind to even a single weakness."
"If ‘investors’ frenetically bought and sold farmland to each other, neither the yields nor prices of their crops would be increased. The only consequence of such behavior would be decreases in the overall earnings realized by the farm-owning population because of the substantial costs it would incur as it sought advice and switched properties."
"Nevertheless, both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm."
"My money, I should add, is where my mouth is: What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit. (I have to use cash for individual bequests, because all of my Berkshire shares will be fully distributed to certain philanthropic organizations over the ten years following the closing of my estate.) My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”
The Bottom Line
Today marks the 30th anniversary of my having the privilege of serving clients as a registered investment advisor. Managing money for others as a sole practitioner working from home beginning January 1, 1985, was an easy decision. Stock brokerage company, A.G. Edwards & Sons, was a suitable “proving” ground the prior four years. But I needed independence, a quiet work environment to read/analyze and most importantly to invest for my clients as I was personally investing using Warren Buffett’s value investing philosophy.
The following quote is taken from Warren Buffett’s annual letter to shareholders dated March 31, 2013 in Berkshire Hathaway’s 2012 Annual Report:
“American business will do fine over time. And stocks will do well just as certainly since their fate is tied to business performance. Periodic setbacks will occur, yes, but investors and managers are in a game that is heavily stacked in their favor. (The Dow Jones Industrials advanced from 66 to 11,497 in the 20th Century, a staggering 17,320% increase that materialized despite four costly wars, a Great Depression and many recessions. And don’t forget that shareholders received substantial dividends throughout the century as well.)
Since the basic game is so favorable, Charlie [Munger] and I believe it’s a terrible mistake to try and dance in and out of it based upon the turn of tarot cards, the predictions of “experts,” or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it.”
What We Focus On
While at The College of William & Mary, one evening I happened to walk into a campus building that housed the performing arts theater. I recall just being curious about what was going on because the parking lot was full. I entered the back of the theater and stood for a few minutes as a motherly, female drama professor was finishing her introduction before the start of a student play. I didn’t stay for the play but what she gleefully said really stuck: “The secret to life: simplify, simplify, simplify.” This wise woman’s counsel, some 40 years ago, is reflected in how we approach the stock market. Filter, filter, filter, almost from a subconscious standpoint, could well be substituted. Of course, having the right framework for filtering is really the key.
Focusing on truly outstanding businesses is a good place to start. Charlie Munger, Berkshire Hathaway’s vice chairman, provides helpful insight with the following quote:
“Over the long term, it’s hard for a stock to earn a much better return than the business, which underlies it, earns. If the business earns six percent on capital over forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with one hell of a result.”
Value investing is not so much about doing smart things as it is about not doing dumb things. Avoiding mistakes, resisting market fads, and focusing on allocating capital into ideas that are highly likely to produce satisfactory returns and that offer a margin of safety against permanent capital loss – these are the dominant themes of the value investing approach.
Warren Buffett’s oft repeated words refer to this phenomenon: “Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”
Our focus is very simple. Read and watch business as much as possible, particularly about individual companies to assess the long-term risks they face. Maintain the discipline to take appropriate action only when the opportunities are understood. This means having the conviction to buy into market weakness and sell into market strength when prices are dramatically unhinged from intrinsic values. Ultimately, it means having the patience to hold onto our positions through a lot of volatility and media noise. Making a few good decisions every few years are what we aspire to do.
Market Volatility and Investor Behavior
It’s as concise an explanation as any I’ve read as to why long-term investing is so difficult. That’s why I chose to simply provide a copy rather than rehash it in my own words. The money paradox states that psychological stress induces poor decision-making by the vast majority of people. Of course, wildly gyrating stock prices can cause psychological stress and at the extremes, when much is at stake, it is rare for one to be able to act completely opposite human instinct.
So how is it that we are resilient enough to have avoided common pitfalls and obtained satisfactory investment results for a very long time? It’s probably because we have been able to employ a simple strategy since the early 1980s. It revolves around the concept that we are buying shares in a business, not a piece of paper, and if you and I own the whole company, what is the business worth? If we can properly value a business and we are able to buy it at a big discount to that value, typically 30-40% or in some cases 50%, and it’s a good business with competitive advantages, it’s hard to lose if we act rationally. But that’s the rub. One of the biggest difficulties anybody has in decision-making, whether it's investing, love, eating, etc. is temperament. To behave rationally one has got to find some way to deal with temperament. Temperament…it often works at cross-purposes with good decision-making. If you can find some way to anchor yourself in a more objective measure so that you can be more rational in your decision-making, then you have a good process. The other thing we have that helps us is we have a very different time horizon then a lot of investors. People are always asking me what the stock market is going to do this year or for the next few months. My reply is always the same. “I don't know. I have no idea and I don't spend much time thinking about it.” But I do have a sense that some time over the next several years, things will probably be better but in the meantime, I think it's important to bear in mind that behind every stock price is a business and so what we do is focus on how the business is doing.
For the past three years however, we have seen a new-normal annual deficit of $1.3-$1.4 trillion. The resulting accumulated debt numbers recall Hemingway's take on going bankrupt in The Sun Also Rises:
“How did you go bankrupt?”
“Two ways. Gradually, then suddenly.”
How Can We Expect to Be Competitive?
Money management is a brutally competitive arena drawing many of the smartest people on the planet. What types of edges exist in the stock market that could allow us to have better results than the person taking the other side of our trade? Those edges or advantages can be summarized into the following four types:
1) Informational Edge: a participant has information that nobody else has
2) Analytical Edge: a participant comes to a different conclusion than the consensus
viewpoint based on information that is available to all
3) Behavioral Edge: a participant is emotionally equipped with a temperament that
allows him to be fearful when others are greedy, and greedy when others are
4) Time Horizon Edge: a participant can take a longer-term
In this day and age of full disclosure and rapid dissemination of company-specific information, it is rare for an individual to legally obtain an informational edge.
Researching a lot of public information and working diligently to draw a better conclusion than most is what most hard-working professionals strive for. As an example, John Paulson made a fortune betting against residential real estate and the mortgage markets based on his understanding of the sub-prime markets and the exposure of various
banks to this market. Sometimes an analytical edge can be obtained by using the same data as everyone else but weighting them differently. For example, a problem division of a large company may temporarily tarnish the company’s image on Wall Street but only be a short-term distraction.
A behavioral edge is an incredibly difficult attribute to develop because humans are naturally (falsely) comforted by a consensus viewpoint. It requires one to become detached from elementary emotions--probably a genetic flaw for those it comes easiest to. An important part of the behavioral edge is the ability to execute, not just theorize and wait (hmm...did I do that this past summer?).
Most professional money managers overseeing large sums have extremely short time horizons because they are measured against benchmarks on a quarterly or annual basis. Individual investors, who have no external pressure to hit near-term benchmarks, usually force short-term limits on themselves encouraged by current Wall Street news. This type of thinking usually results in “momentum” investing--buying what is currently popular and going up in price. It makes no allowance for the time necessary to accumulate stocks that are out of favor, and which may take years to become fully priced even as their underlying values are growing.
In reviewing the four types of edges, it’s not realistic to think we can acquire an informational edge. Nor can we assume to have an analytical edge. We might have a behavioral edge upon review of our long-term results. But without a doubt, our greatest competitive advantage comes from having a time horizon edge--that is, simply having a better perspective than 95% of the active participants in the market.
Why do we have a better perspective? As value investors, we have three very powerful concepts working for us:
1) We know a stock is not a piece of paper, but a piece of ownership in a company. We aren’t paper shufflers who constantly buy and sell securities. We think of ourselves as real owners of a business.
2) We need a margin of safety, so if we are wrong, we won’t lose much. We get that margin of safety through buying at a significant discount to estimated intrinsic value.
3) We think everyone else in the stock market is different from us because they are trading all the time looking for short term moves. Collectively, everyone else is Mr. Market, our partner who periodically suffers from manic/depressive episodes. We ignore him most of the time. This gives us a useful framework for dealing with the day-to-day and month-to-month volatility.
It has been commonly estimated that less than 5% of all money managers are true value investors. They have long been a real minority in the investing world. Stock markets are created for the other 95% of “investors” who are much more active traders seeking immediate, short-term gratification.
Being patient enough to demand a large margin of safety before investing is crucial for us to have an edge. We look at the downside before looking at the upside. The future is
unpredictable and there are sure to be surprises, some positive but most negative. Having the discipline to invest only in wonderful businesses at reasonable prices means our trading will be sparse and we will remain in the minority. But we are comfortable with that.
I was thinning some files a few weeks ago and came across a copy of an email sent to a long-time client and dear friend. It is attached to this letter. It was written at what proved to be the peak of the dot-com bubble in March of 2000. We had just doubled up on a lot of Berkshire Hathaway after watching it fall from $84,000 to $44,000 per share over the preceding nine months. For a few weeks, it traded at hard-to-believe bargain prices as measured against asset values and earnings power.
Also attached is a copy of an old brokerage account statement from my days at AG Edwards. It shows a purchase of five Berkshire Hathaway shares at a price of $485 per share in August of 1982. That month marked the beginning of a generational 18-year Bull Market that culminated in March of 2000. It’s interesting to note the total amount paid was $2,468.27 including a $43.27 commission. Even with the 25% employee discount, the commission was a hefty 1.78% of the purchase price! Today, we can execute orders totaling hundreds of thousands of dollars for $7.95. Those five shares still reside in my personal brokerage account. At current quotes they would fetch over $600,000. That equates to a compounded annual gain of 21.7%.
While anyone could have bought Berkshire 11 years ago or even 28 years ago and held on, very few have. These examples illustrate the edge we have that comes from our longer-term perspective. While it sounds simple, it’s not that easy.
Appreciating the historical significance of the carnage and volatility exhibited by the stock market on October 10th and November 20th last year brings to mind what Ben Graham wrote in his 1949 masterpiece, The Intelligent Investor: “The investor’s chief problem--and even his worst enemy—is likely to be himself.” It is important to understand not only the nature of chaotic markets but also the even more treacherous enemy within ourselves.
For the secret to being a savvy investor is remaining detached and bolstering one’s self control at precisely those times when our emotions are most likely to carry us away. Those dates were as exhilarating and draining as any I’ve experienced.
Warren Buffett has pointed out that investing is much like dieting: “It is simple, but not easy. Everyone knows what it takes to lose weight. (Eat less, exercise more.) Nothing could be simpler, but few things are harder in this world full of chocolate cake and Cheetos.”
Last May at the Berkshire Hathaway annual meeting, Warren Buffett boiled down what it means to be an intelligent investor into two startling sentences: “If a stock (I own) goes down 50%, I’d look forward to it. In fact, I would offer you a significant sum of money if you could give me the opportunity for all of my stocks to go down 50% over the next month.” Knowing he owns good businesses, Buffett wants prices to go down, not up, so he can buy even more shares more cheaply before they bounce back.
What I Have Seen
For over 40 years I have consistently held individual stocks in my own stock account. I started with mutual funds around age 10 but soon switched to owning individual stocks because they “moved more.” I had also noticed that the difference between the 52-week high/low prices for most stocks had at least doubled from the lows. Therefore, I reasoned it shouldn’t be too difficult to double one’s money every year. I can’t tell you the number of times I daydreamed in college classes writing down a column of numbers mimicking how much my brokerage account would be worth doubling each year for the next ten or twenty years. Trying to pick stocks at their annual bottoms and selling them at their annual highs was a fruitless exercise even after diligently studying the “classic” technical analysis books.
Shortly after finishing graduate school, I stumbled on Ben Graham’s real classic The Intelligent Investor and fully embraced value investing. It was 1974 and I was working on Wall Street auditing mutual funds for Price Waterhouse. Dissecting balance sheets and income statements and recognizing statistically undervalued stocks as preached by Graham was not hard. Nothing more than sixth grade math was necessary to prove how inexpensive something was relative to its free cash flow. The key was just doing it and sticking to it.
The chart below lists the bear markets that I have personally experienced while owning stocks as a relatively informed and serious value investor.
Bear Market Peak-to-Trough Dow Performance
Dec. 1972 to Dec. 1974 Apr. 1981 to Aug. 1982 Aug. 1987 to Oct. 1987 Jul. 1990 to Oct. 1990 Jan. 2000 to Oct. 2002 Oct. 2007 to Nov. 2008
25 months -45% 18 months -24% 2 months -41%
3 months -23% 20 months -40% 14 months -47%
1972-74 seemed like a drip, drip, drip with prices slowly grinding lower every day for months with most stocks eventually selling for single digit multiples of earnings. I was invested in one or two small company value stocks and appreciated how well they fared compared to the market.
Starting in 1981, I was managing money for others and very confident about not losing it. It was a propitious time to begin an investment management career. I remember the spring and summer of 1982 as a particularly glorious time because we could buy “name” companies for less than the cash they had in the bank less all liabilities. It was sort of hard to believe at the time, but I just trusted the numbers and bought small positions in many stocks. It was the start of the great 18-year bull run for the market.
1987 was basically a one-day crash with no recession. We bought the investment banking company Salomon Brothers for half of what it traded the day before the crash. It was eventually acquired by Travelers (stock for stock) which was gobbled up by Citigroup (stock for stock) which we eventually sold in 2006 at $46.36; 13 times our original cost. Good thing. On November 21, 2008, it closed at $3.77.
1990 was mostly an unremarkable recession marked by the savings and loan debacle. It seemed that real estate values were more adversely affected than the stock market.
2000-2002 was the bursting of the Internet and NASDAQ bubble which didn’t affect us at all because we owned no high-tech stocks. It did, however, give us a rare opportunity to buy Berkshire Hathaway at book value. Of course, the terrorist attacks on September 11, 2001, occurred during that time and precipitated a brief economic slowdown.
What I See Now
Having experienced firsthand the foregoing bear markets, I believe we are now in by far the most severe one for two reasons. First, the extent of the simultaneous systemic failure of our financial institutions and government regulators is without precedent. Second, this worldwide catastrophe will have a lasting impact. We will not know the consequences or the consequences of the consequences for a long time. However, what is clear is that we are in the midst of the most compelling set of opportunities I have seen in my investing lifetime. Keeping things simple and focusing on those things we are reasonably sure of should hold us in good stead. In this period of high uncertainty, it is a wonderful time to be a value investor. Thank you for your tremendous partnership when being a long-term investor feels the worst. I believe your patience will be generously rewarded in the not-too-distant future.
If we can find equity investments that deliver total returns of just 7%, which is about the historical average rate of profit growth in corporate America, then our money should double roughly every ten years according to the Rule of 72. (To approximate how many years, it would take an investment to double at a given compound growth rate using the Rule of 72, simply divide 72 by that rate.) Over the next 30 years, that 7% compound return would result in three doubles or an eightfold increase on our original investment. With the Dow Jones Industrial Average at 11,000 today, we could see a Dow of 88,000 within the span of a generation. I am far more interested in that long-range possibility than trying to surmise the direction of the market’s next 1,000-point move. As Yogi Berra might say, predictions are difficult to make, especially about the future.
One of the Rothschilds is credited with saying that “Compound interest is the eighth wonder of the world.” Why? Because interest makes money grow supposedly without limit. However, can real wealth compound forever without limit? As we know, persistent events such as inflation and debt repudiation serve to check the real (material) value of money.
For a simple proof that material wealth cannot compound forever let us turn to the Bible. In chapter 27 of the book of Matthew we are told that when Judas regretted betraying Jesus for thirty pieces of silver, he brought the money to the chief priests saying, “I have sinned,” and cast down the pieces of silver as he left the temple. That left the priests with a problem of what to do with the “blood money.” The Bible states they took counsel and decided, rather than add it to the holy treasury, to buy a potter’s field, in which to bury strangers. But suppose a prominent Rothschild had been present to persuade the priests to make their money grow so the temple would be able to do better at a later date. They decide instead, to deposit the money in the Perpetual Jerusalem Gold Bank paying interest at 5% per year. Let’s assume the thirty pieces of silver were equivalent to two grams of gold. Since paper money didn’t exist then, the holy treasury would draw the equivalent of 5% interest in gold each year. Let’s finally assume that the priests and their successors left the gold on deposit and let it compound for the next 2,000 years. How much would such an amount be worth today? At 5% compound interest the total sum would grow to a mass equivalent to approximately 800 trillion earths made of solid gold!
This helps remind us how hard it is in any real sense to compound money for long periods. Material wealth is indeed difficult to grow. The S & P 500 Index has compounded since 1926 at 10.4%. Inflation has compounded since 1926 at 3.1%. That has resulted in real growth of 7.3%. Naturally taxes would remove another few percentage points. But this still leaves long term stock investors compounding at a “high” real rate, creating gold!
The late Benjamin Graham, mentor to Warren Buffett, said it best: “The investor’s chief problem—and even his worst enemy—is likely to be himself.” When it comes to money, our emotions often cause us to take foolhardy, self-defeating actions.
So how do we fight our human tendency to respond in an emotional, irrational way when it comes to our money and end up with a rational strategy for our investments? One way is to remember two words: “mean reversion.” Abnormal moves in stock prices tend to correct themselves over time, in both directions. In the end however, the best way for us to achieve good results and avoid major mistakes is to simply keep our wits about us. Nothing goes up—or down—forever, a little bit of risk is usually worth taking and patience is, without a doubt, our best ally.
The problem the typical investor of the past three years now faces is the insidious math of investing. After a steep loss, it takes a far greater percentage gain to become whole again. When an investment stake drops 10%, for instance, to $9,000 from an initial $10,000, it takes an 11.1% advance to return the stake to its starting size. That’s because investors have less money working for them after the initial drop.
But the recovery percentage grows exponentially as the magnitude of the drop increases. After a 50% drop to $5,000 from $10,000, an investment must double, or rise 100%, to get back to even. With an 80% drop, the recovery percentage is 400%. This is a hard, expensive lesson to learn through experience. Therefore, let it lead us to a most important principle. Warren Buffett said it best when he stated the two most important rules of investing:
Rule # 1 Don’t lose.
Rule # 2 Don’t forget the first rule!
We can now so easily see why this is so. He was really talking about the insidious math! Of course, compounding can work wonderfully on the upside, but it is the downside that must be avoided for compounding to be our friend long term. For once you lose big it is very hard to catch up. Ultimately the true cost is time---the extra time it will take to reach financial targets. Of course, most of us can’t afford to lose much time.
Over the years, our investment philosophy and practices have been almost exclusively influenced by two great teachers and trailblazers in the field of investing, Benjamin Graham, author of the classic textbook on investment analysis, Security Analysis, and his star student, Warren Buffett, who is the world’s most successful investor. All the central ideas we incorporate in our investment decisions are a result of the lessons from Warren Buffett, who along with his partner Charlie Munger have been very generous in publicly sharing their knowledge of business and investing. How many other Forbes Magazine 400 richest American members have attempted to share what they have learned about business and investing? Warren Buffett and Charlie Munger are truly amazing.
What follows are a few of the ideas and principles that Warren Buffett and Charlie Munger talked about last April in answering shareholders’ questions for six hours at Berkshire Hathaway’s annual shareholders meeting.
Warren Buffett has described the ability of some companies to withstand competition as having a “protective moat around their economic castles.” Competitive analysis tries to assess how a competitor could cross the moat and damage the economic castle. The two big models of competitive advantage are 1) a long-run cost advantage that is hard for competitors to duplicate, and 2) a unique, or differentiated product or service that is hard for competitors to duplicate. For example, GEICO has a sustainable cost advantage over its competitors even though auto insurance is not unique. Coca-Cola is unique. It occupies a “share of mind” or brand name awareness that is unmatched. A “wonderful business” will have one or both protective moats that tend to get wider over time.
Buffett stated “anytime there have been bursts of speculation in the market, it does get corrected eventually. Ben Graham was right when he said that in the short run, it’s a voting machine—and in the long run it’s a weighing machine. Sooner or later, the amount of cash a business can disgorge in the future governs the value its stock commands in the market. But it can take a long time.”
Although stocks survive inflation well over long periods of time, they are poor short-term hedges against inflation. Since inflation increases interest rates and since the interest rate on bonds competes with stock yields, inflation must depress prices. Inflation must send stock prices down enough in the near term so the dividend or earnings yield will match higher rate available on bonds.
However, inflation also raises the future cash flows available to stockholders. Corporations can increase the prices of their products to keep up with inflation. Higher future earnings will offset higher interest rates so that over time, the price of stocks will rise at a rate equaling that of inflation. In addition, corporations usually reinvest these earnings in more productive assets to give a further boost to future earnings. This is largely the reason why stocks long term returns are so much higher than the returns from bonds and Treasury bills.
While we just finished another good year, the first week of 1998 has unfolded with a 5% downward fluctuation in the major stock market indices. Is the great bull market over with? I don’t spend much time thinking about it because if more declines come, it will certainly be to our advantage. We may be able to scoop up some superior companies at lower prices. Why not sell our stocks that seem overpriced? Well, tax concerns are one thing. However, even in non-taxable accounts, I believe it is a mistake to sell an interest in a company with a high probability of earning high returns over a long period of time. The evidence against selling when a stock appears to be overvalued is compelling: very few professional managers who trade actively outperform buy and hold. Yet, while a buy and hold strategy is good, a strategy of buying and holding superior companies is even better. Collins and Pouras in the book, Built to Last, state: if you had put $1 in the general market on January 1, 1926, you would have had $415 as of December 31, 1990. With the same $1 invested in a handful of outstanding companies, you would have had $6,356.
This is impressive evidence. However, the real reason it is usually a mistake to sell great companies when their prices are temporarily ahead of their intrinsic value is that a trading mentality would dim our focus on the thing that really generates wealth: finding companies with a strong and durable competitive advantage. A trading mentality would also encourage the gradual replacement of a handful of great companies with a relatively large number of OK companies. In a high market when great companies are expensive, lesser quality but more reasonably priced stocks are tempting. But whether it is the art market, the antique market, or the stock market, over time quality will out (perform). A trading mentality increases the number and decreases the quality of decisions that would have to be made. Since it only takes a few right decisions to create good performance, I should be thinking hard about getting a few big things right.
The consequence of all this is our portfolios will continue to reflect low activity and concentration in a few good companies. This is the surest path to above average returns at below average risk.
When do we sell? We follow the principles described by Philip Fisher in his classic, Common Stocks and Uncommon Profits (also espoused by Warren Buffett). We will sell: 1. when a mistake is made in the original analysis; 2. company or industry conditions have changed for the worse on a long-term basis; 3. an investment is found so compelling that we are willing to substitute it for something we already own.
The following exhibit presents the results of my personal investment account since I became a full-time investor/money manager in the stock market. While I started with modest funds, due to the magic of compounding, the pile has become so large, that I occasionally ask why I still bother to manage other people’s money. I guess the reason is, it really isn’t that much more work, and I can still handle the (what I feel is) enormous pressure to do well by my clients.
YEAR GHT RETURN* S&P 500
1982 105.0% 21.4%
1983 37.5% 22.4%
1984 15.6% 6.1%
1985 32.0% 32.6%
1986 20.5% 18.6%
1987 35.7% 5.1%
1988 17.2% 16.6%
1989 46.8% 31.7%
1990 -19.7% -3.1%
1991 4.2% 30.5%
1992 17.5% 7.6%
1993 21.7% 10.1%
1994 16.1% 1.3%
1995 31.8% 37.6%
1996 23.1% 23.0%
1997 39.7% 33.4%
Annual Return: 25.5% 17.8%
$1 grew to: $37.9 $13.7
*Results shown are after commissions but before management fees. Figures reflect the reinvestment of all dividends and interest payments. There can be no assurance that past performance will be equal.
My reason for showing you this is that Harvard economist Richard Zeckhauser reports that in the long run only 45 mutual funds out of 1100 outperform the S&P 500. Wall Street employs some of the smartest people in the world, who are well trained and work hard. So how is it that a non-genius like me could have not only bested most of Wall Street but also the market for all these years? The answer lies in having the right heroes and staying within a circle of competence.
Many of you know that I was drawn to Ben Graham and then Warren Buffett soon after I became a stockbroker in 1981. Warren Buffett has since become the #1 or #2 wealthiest person in the world depending on where Bill Gates stands. He started with no inherited wealth and got ridiculously rich by picking stocks. I left the brokerage side of the business in 1984 due to Buffett’s influence. Both Graham and Buffett were born with enormous intellects. What really sets them apart from the crowd, however, is their philosophy and common-sense approach to investing. They have broken down an enormously complex task and reduced it to just a few simple ideas. That is the true mark of genius. In another letter I’ll explain why most professional money managers have difficulty following their approach.
Staying within a circle of competence means only investing in companies you think you fully understand and that meet some simple good business, good company tests. This probably rules out 95% of all publicly traded companies and certainly eliminates fast changing industries that involve high technology. I am highly uncertain what Microsoft will look like ten years from now. By contrast, I am very confident that ten years from now, people will be wanting to see Disney creations, wear Nike products and go to Nike-sponsored sports events, eat at McDonald’s hamburgers, and consume Pepsi/Coke products. Owning a dominant company in a stable business with high operating margins, low capital requirements, and moderate sales growth is like having a safe bond whose coupon will grow at a sure and steady pace for an indefinite period. Quoting Buffett: I’d rather be certain of a good result than uncertain of a great one.
Over a long period of time, say ten years, stock price performance will track company performance. So, if we own companies with enduring competitive advantages in businesses with attractive economics, we will do well assuming we have purchased our ownership interest at a favorable price. If we are to have a down year in 1998, it should create some favorable prices for the kinds of companies by which we can grow richer.