Will The Real Value Investor Please Stand Up

[Munger]

"Munger, what you are excluding from those comments is the cost of capital."

 

I'm simply providing updated figures for the metrics Buffett employed in his own analysis.

 

 

 

"It is true that corporate profits will shrink significantly at some point. But probably not for at least a few years."

 

I agree and if you are a long term investor, this reality is critical to any assessment of value today despite not being able to precisely time the eventual decline in corporate profitability.

 

 

[ERICOPOLY]

 

We're not in boom times right now.  What's going to force the switch to generics?  You say "if consumers are feeling poor".  Well, aren't they?  Are they delevering because they feel rich or something?

 

 

You are right they should be feeling poor right now, but many homeowners still have expectations (or hope) that their home values would recover. It might take a few more years of low prices along with sustained high unemployment to change behavior. 

 

Vinod

 

I'm not saying there is no way you are right. 

 

I just think its going to play out differently -- we're in a period of high unemployment currently that will abate in the years ahead.  This will raise animal spirits.

 

I liked Parsad's explanation -- higher interest rates will change the margins.  However an exception would be a company that doesn't lever through borrowed money.  And if the margins are high during this crappy economy I wouldn't think a return to normal will hurt the margins.  There is either a moat everywhere that's been protecting these margins for years, or it's some easy explanation such as interest rates that's floating the market's profit margin boat.

 

 

 

[kevin4u2]

Our disagreement is not necessarily in the timing aspect of it, but on the MOS.  The MOS of US bank investments in aggregate has become even greater because of a collapse in prices.  In fact, there is no other sector that I can see that has a greater MOS.  Downside protection is there.

 

WFC may not currently be a 50-cent dollar, but if it is a 70-cent dollar that increases IV at a rate of, say, 6% over current IV (just throwing out numbers), that gets you a damn good return over three to five years when Mr. Market realizes his mistake.  It's all about lengthening the time of your thinking.

 

I think it's a mistake to completely pass up some of these financials in the hopes that prices will collapse even further, although you can certainly base position sizing on what you think the market will do.  But as you say, this debate is what makes a market.

 

How are you guys getting comfortable with the derivative risk on Wells Fargo's balance sheet?

 

Perhaps this quote from the 2009 annual report will help answer your question.

 

...all banks are not created alike. We’re not a hedge fund disguised as a bank. We’re not a proprietary trader (which produces no customer benefit) disguised as a bank. Nor are we simply a mortgage company or an investment broker or an insurance broker or a credit card company.  What we are at our heart is community-based, and relationship-oriented. We serve our customers online, on the phone or at our ATMs, and we welcome them into our 10,000 stores. We greet them on neighborhood sidewalks. We have breakfast with them at the neighborhood diner. We serve alongside them on local chambers, Rotary, nonprofit boards, at community events. We worship with them in churches, synagogues, mosques and temples. Many of our customers know our tellers by their first names, and we know them by theirs. We want our banking stores to be more than just storefronts, but like community centers where neighbors meet.

 

Best Regards,

Kevin

 

 

 

 

[Grenville]

Our disagreement is not necessarily in the timing aspect of it, but on the MOS.  The MOS of US bank investments in aggregate has become even greater because of a collapse in prices.  In fact, there is no other sector that I can see that has a greater MOS.  Downside protection is there.

 

WFC may not currently be a 50-cent dollar, but if it is a 70-cent dollar that increases IV at a rate of, say, 6% over current IV (just throwing out numbers), that gets you a damn good return over three to five years when Mr. Market realizes his mistake.  It's all about lengthening the time of your thinking.

 

I think it's a mistake to completely pass up some of these financials in the hopes that prices will collapse even further, although you can certainly base position sizing on what you think the market will do.  But as you say, this debate is what makes a market.

 

How are you guys getting comfortable with the derivative risk on Wells Fargo's balance sheet?

 

Perhaps this quote from the 2009 annual report will help answer your question.

 

...all banks are not created alike. We’re not a hedge fund disguised as a bank. We’re not a proprietary trader (which produces no customer benefit) disguised as a bank. Nor are we simply a mortgage company or an investment broker or an insurance broker or a credit card company.  What we are at our heart is community-based, and relationship-oriented. We serve our customers online, on the phone or at our ATMs, and we welcome them into our 10,000 stores. We greet them on neighborhood sidewalks. We have breakfast with them at the neighborhood diner. We serve alongside them on local chambers, Rotary, nonprofit boards, at community events. We worship with them in churches, synagogues, mosques and temples. Many of our customers know our tellers by their first names, and we know them by theirs. We want our banking stores to be more than just storefronts, but like community centers where neighbors meet.

 

Best Regards,

Kevin

 

I appreciate both your replies. I need to sit down and reread the derivative thread and think about the inherent risks. Also I'll go through the annuals soon. Most of the derivative exposure came through the Wachovia acquisition. Thanks for the quote in the 2009 annual!

[watsa_is_a_randian_hero]

Ben I was going to literally do the same thing. Parsad, that is exactly what my definition of a "real" value investor is.

 

Bmichaud I am not sure why that quote discredits the rest of the post. Just because I am viewing a forward PE and you view a trailing PE, the S&P Today is indeed reflecting a 9.9 P/E Ratio.

 

Not that you're viewing a forward PE but rather that you are looking at a PE based on dramatically peak earnings. A 12X on operating eps of $100 (or thereabouts) is not even remotely relevant to a cyclical data set. It's no different than saying CAT is cheap based on $6 eps when in fact mid-cycle eps is probably more like $3.50 or $4.

 

And I won't even get into the danger of relying on Fed "money printing" when in fact the Fed is merely swapping non-interest bearing liabilities (cash) for an interest-bearing liability (treasuries) - that does NOTHING in a deleveraging environment.

 

Just would point out the counterargument here...I wouldn't characterize an environment with over 9% unemployment as "peak" earnings.  Yes we are likely to be in this mess for an extended period of time as deleveraging occurs, but nonetheless I do not think we are at "peak" earnings here.

[hyten1]

this might very simplistic and is not how you should invest

 

but i am comfortable with WFC because of one thing... BRK owns $10bil worth

[ubuy2wron]

Those of you who are worried about the profit margins collapsing.  Your reasoning is something along the lines where capitalism will fail in theory if these margins hold up -- thus competition will move in for sure.

 

Well, lets say a company makes a widget where he's got these huge margins.  And given that the entire market taken as a whole trades at these fat margins, you are worried about competition springing up anywhere and everywhere, essentially.

 

Just remember.  In order for a competitor to spring up, then people need to be hired to create this duplicate competing product, and factories need to be built.  Offices need to be occupied.  But you are worried about the margin for the entire market coming down, so this is going to be the mother of all economic expansions.

 

 

I do not think that is the only way for margins to collapse. I can think of two examples

 

1. Take PG. Many of its brand products sell at a premium price to more generic ones. If consumers are feeling poor, they can switch to non premium brands and margins would collapse at PG. This can occur at any company - actually more likely at other companies that do not have moats like PG.

 

2. Take Apple. Profit margins of iPhone, iPad etc are going to come down as rivals just catch up just enough in quality to erode margins. At some point say iPhone 12, the androids and windows phones of the world are going to be pretty close to iPhone to reduce the premium Apple was able to charge.

 

No huge spending boom needed for either case.

 

Vinod

Take AAPL computer makers have had 30 years to come at AAPL their margins in that space are growing while every one else is facing declining margins. I bought AAPL for the ist time in 2002 because I realized the consumers for their products were rapid devotees. You could not get a MAC user to buy a PC well the cult has grown and now with Steves passing he is already taking on mythic popularity. Its becomming a religion. I aint worried about competition for a few years.

[bmichaud]

Those of you who are worried about the profit margins collapsing.  Your reasoning is something along the lines where capitalism will fail in theory if these margins hold up -- thus competition will move in for sure.

 

Well, lets say a company makes a widget where he's got these huge margins.  And given that the entire market taken as a whole trades at these fat margins, you are worried about competition springing up anywhere and everywhere, essentially.

 

Just remember.  In order for a competitor to spring up, then people need to be hired to create this duplicate competing product, and factories need to be built.  Offices need to be occupied.  But you are worried about the margin for the entire market coming down, so this is going to be the mother of all economic expansions.

 

 

I do not think that is the only way for margins to collapse. I can think of two examples

 

1. Take PG. Many of its brand products sell at a premium price to more generic ones. If consumers are feeling poor, they can switch to non premium brands and margins would collapse at PG. This can occur at any company - actually more likely at other companies that do not have moats like PG.

 

2. Take Apple. Profit margins of iPhone, iPad etc are going to come down as rivals just catch up just enough in quality to erode margins. At some point say iPhone 12, the androids and windows phones of the world are going to be pretty close to iPhone to reduce the premium Apple was able to charge.

 

No huge spending boom needed for either case.

 

Vinod

Take AAPL computer makers have had 30 years to come at AAPL their margins in that space are growing while every one else is facing declining margins. I bought AAPL for the ist time in 2002 because I realized the consumers for their products were rapid devotees. You could not get a MAC user to buy a PC well the cult has grown and now with Steves passing he is already taking on mythic popularity. Its becomming a religion. I aint worried about competition for a few years.

 

There is some great commentary on AAPL on another thread, so I am only reiterating what was previously said, but....

 

The sentence I bolded is an EXTREMELY dangerous way to invest - the terminal value of a company is such a huge, huge portion of intrinsic value that it is absolutely imperative to have a view of what a company is going to look like in ten, 20 and 30 years. Just b/c one doesn't intend to hold something for ten years like Buffett, one must, if investing intelligently, be able to predict within reason what a company will look like in ten years. If Apple grows at 100% a year for ten years, then goes out of business, the stock will be toast (obviously that's extreme, but...).

 

Even if consumers are in love with their products, in the long run, they have ZERO pricing power. Look at what prices are doing on their legacy products. In order to continue their financial performance, they have to continue coming up wtih products that are continuously at the top of their respective product categories, to the point where Apple can command the premium prices they do. As Greenwald says, competitors are eating away at the edges of Apple every single day - it is not a lock AT ALL that the iPhone will be the "it" phone five years from now....Sprint for example is absolutely nuts to sign up to purchase 30MM iPhones over the next four years. As Jonathan Chaplin of Credit Suisse said, four years ago the "it" phone was the Razor - can you imagine buying a Razor now?

[vinod1]

 

I'm not saying there is no way you are right. 

 

I just think its going to play out differently -- we're in a period of high unemployment currently that will abate in the years ahead.  This will raise animal spirits.

 

I liked Parsad's explanation -- higher interest rates will change the margins.  However an exception would be a company that doesn't lever through borrowed money.  And if the margins are high during this crappy economy I wouldn't think a return to normal will hurt the margins.  There is either a moat everywhere that's been protecting these margins for years, or it's some easy explanation such as interest rates that's floating the market's profit margin boat.

 

I have doubts about Parsad's point about higher interest rates changing margins. Look at Japan, even with super low interest rates their margins are at very low levels. Higher interest rates would allow many companies to earn higher margins via greater returns on their cash and investments. Although companies on a net basis have debt so overall costs should increase with higher rates, but not sure if that is really the critical element supporting margins.

 

Vinod

[ERICOPOLY]

 

I'm not saying there is no way you are right. 

 

I just think its going to play out differently -- we're in a period of high unemployment currently that will abate in the years ahead.  This will raise animal spirits.

 

I liked Parsad's explanation -- higher interest rates will change the margins.  However an exception would be a company that doesn't lever through borrowed money.  And if the margins are high during this crappy economy I wouldn't think a return to normal will hurt the margins.  There is either a moat everywhere that's been protecting these margins for years, or it's some easy explanation such as interest rates that's floating the market's profit margin boat.

 

I have doubts about Parsad's point about higher interest rates changing margins. Look at Japan, even with super low interest rates their margins are at very low levels. Higher interest rates would allow many companies to earn higher margins via greater returns on their cash and investments. Although companies on a net basis have debt so overall costs should increase with higher rates, but not sure if that is really the critical element supporting margins.

 

Vinod

 

I asked Prem about Japan's cultural tendency to not fire the personnel when business turns down.  He agreed that it was one of the differences between US and Japan.  So while yes they have low interest rates, they also don't throw the worker under the bus to save margins.

 

Their unemployment peaked at 5.5%.

 

EDIT:  However it very well may be something in addition to interest rates that is helping margins.  Anyhow, I'm heavily long financials so I just smile when people say that competition will move in to take out the margins.  That just sounds like people getting hired left and right (fewer credit losses at the banks), people getting raises, new homes being built to house all these employed workers, and lots of credit growth at the banks to fund all of this activity.

[ubuy2wron]

Those of you who are worried about the profit margins collapsing.  Your reasoning is something along the lines where capitalism will fail in theory if these margins hold up -- thus competition will move in for sure.

 

Well, lets say a company makes a widget where he's got these huge margins.  And given that the entire market taken as a whole trades at these fat margins, you are worried about competition springing up anywhere and everywhere, essentially.

 

Just remember.  In order for a competitor to spring up, then people need to be hired to create this duplicate competing product, and factories need to be built.  Offices need to be occupied.  But you are worried about the margin for the entire market coming down, so this is going to be the mother of all economic expansions.

 

 

I do not think that is the only way for margins to collapse. I can think of two examples

 

1. Take PG. Many of its brand products sell at a premium price to more generic ones. If consumers are feeling poor, they can switch to non premium brands and margins would collapse at PG. This can occur at any company - actually more likely at other companies that do not have moats like PG.

 

2. Take Apple. Profit margins of iPhone, iPad etc are going to come down as rivals just catch up just enough in quality to erode margins. At some point say iPhone 12, the androids and windows phones of the world are going to be pretty close to iPhone to reduce the premium Apple was able to charge.

 

No huge spending boom needed for either case.

 

Vinod

Take AAPL computer makers have had 30 years to come at AAPL their margins in that space are growing while every one else is facing declining margins. I bought AAPL for the ist time in 2002 because I realized the consumers for their products were rapid devotees. You could not get a MAC user to buy a PC well the cult has grown and now with Steves passing he is already taking on mythic popularity. Its becomming a religion. I aint worried about competition for a few years.

 

There is some great commentary on AAPL on another thread, so I am only reiterating what was previously said, but....

 

The sentence I bolded is an EXTREMELY dangerous way to invest - the terminal value of a company is such a huge, huge portion of intrinsic value that it is absolutely imperative to have a view of what a company is going to look like in ten, 20 and 30 years. Just b/c one doesn't intend to hold something for ten years like Buffett, one must, if investing intelligently, be able to predict within reason what a company will look like in ten years. If Apple grows at 100% a year for ten years, then goes out of business, the stock will be toast (obviously that's extreme, but...).

 

Even if consumers are in love with their products, in the long run, they have ZERO pricing power. Look at what prices are doing on their legacy products. In order to continue their financial performance, they have to continue coming up wtih products that are continuously at the top of their respective product categories, to the point where Apple can command the premium prices they do. As Greenwald says, competitors are eating away at the edges of Apple every single day - it is not a lock AT ALL that the iPhone will be the "it" phone five years from now....Sprint for example is absolutely nuts to sign up to purchase 30MM iPhones over the next four years. As Jonathan Chaplin of Credit Suisse said, four years ago the "it" phone was the Razor - can you imagine buying a Razor now?

I think the question is how good is AAPL's moat. It is conceded that AAPL's and any gadgets moat is lesser than say KO or Burlington RR. The value of AAPL 10 years out is absolutely unknown this is why it has not a higher value today. You can even think of AAPL as a cigar butt investment.... but what a cigar.

[vinod1]

 

I asked Prem about Japan's cultural tendency to not fire the personnel when business turns down.  He agreed that it was one of the differences between US and Japan.  So while yes they have low interest rates, they also don't throw the worker under the bus to save margins.

 

Their unemployment peaked at 5.5%.

 

There are quite a bit of differences with Japan so I agree with you point. This leads to one more way for margins to come down. Employment compensation to go up even in a weak economic environment. Outsourcing has enabled companies to cut down on compensation via moving some of the work offshore to lower labor cost locations. As wages increase in those lower cost locations (directly impacting margins) or backlash aganst oursourcing limits or even reverses the outsourcing trend it could cut down on the profit margins. 

 

Vinod

[ERICOPOLY]

 

I asked Prem about Japan's cultural tendency to not fire the personnel when business turns down.  He agreed that it was one of the differences between US and Japan.  So while yes they have low interest rates, they also don't throw the worker under the bus to save margins.

 

Their unemployment peaked at 5.5%.

 

There are quite a bit of differences with Japan so I agree with you point. This leads to one more way for margins to come down. Employment compensation to go up even in a weak economic environment. Outsourcing has enabled companies to cut down on compensation via moving some of the work offshore to lower labor cost locations. As wages increase in those lower cost locations (directly impacting margins) or backlash aganst oursourcing limits or even reverses the outsourcing trend it could cut down on the profit margins. 

 

Vinod

 

Higher labor costs offshore resulting in more domestic sourcing here (less unemployment and more wage pressure)  -- again, great for banks.

 

I can't help but conclude that bank shareholders will be partying when these margins come down. 

 

[anders]

what you are excluding from those comments is the cost of capital

 

So yes, what is the cost of capital..? I have never quite been able to understand the concept.. and never meet anyone that could explain the term without mention some cost of equity based formula, wacc, etc.. To quote Charlie Munger "it's only fair, if you are going to use the cost of capital, to say what it is".. Another quote at BRK annual meeting "Charlie and I have not the faintest idea what our cost of capital is and we think the whole concept is fairly crazy, frankly, but it's something you learn in business school and you have to be able to answer it, or you don't get out of business school... But I've never seen a cost of capital that makes sense to me" - Warren Buffett  ;)

 

About the Margins, Ive attached a small graph i made..

As per 2011-04-01 the after tax profit/gdp was 9.8% compared with historical average since 1947 at 6.1%.

If you go further back to 1929 to date, they typically range between 4-6%..

 

I don't know when the margins will start regress to the mean.. but one thing to remember is that we are talking about AFTER TAX here and there is still no political action like a move to raise corporate taxes.. which evidently starts to become an reality with people demonstrating in the street..

 

With a current portion of 10% of US GDP going to shareholders, the labor component share of GDP has fallen, and I am not sure how long this could progress in this economic environment we are having without becoming a political issue, it wouldn't surprise me if it comes up during the next election.. not to forget, the US budget deficit is around 10.8% of GDP..! Corporate taxes used to be over 50%, now a lot of companies are paying in the low 30s.. Another part of the equation is the delevering process. If you look at some companies i.e. apple, the profit is estimated to rise in a higher rate than sales which indicates a margin increase!  ??? The consuming makes up around 70% of US GDP, how can margins stay at levels when that 70% starts saving more..? This cannot last, the profits wont't stay at 10% much longer.. I dont think market is cheap.. I would say its currently fairly-to modestly overvalued with quite a big risk in contraction of margins.. and if that happens then the multiples would still be over 20x and if history rhymes they could very well come down under 10x.. that is an additional -50% downturn from here.. Im not saying this is going to happen, but this is perhaps why PremW choose to hedge up 90% of the portfolio until the picture clarifies..?

 

People delevering their personal balance sheet, potential rise in corporate taxes, overall corporate financial leverage coming down, potential higher inflation,.. it doesn't look good for the ROE in the Corporate America..

 

Any thoughts.? with regards to Richard Feynman's first principle "that you must not fool yourself, and you are the easiest person to fool" -  I would love if someone could break down all my arguments  ::)

 

Rgds,