Notes – The Warren Buffett Investment Process

[This post is incomplete, and was intended as a collection of Buffett investment process remarks along with my own commentary. It is instead a disjointed collection of Buffett investment process remarks and nothing more.]

Forecasts usually tell us more of the forecaster than of the future

There is nothing at all conservative, in my opinion, about speculating as to just how high a multiplier a greedy and capricious public will put on earnings.

our unwillingness to fix a price now for a pound of See’s candy or a yard of Berkshire cloth to be delivered in 2010 or 2020 makes us equally unwilling to buy bonds which set a price on money now for use in those years. Overall, we opt for Polonius (slightly restated): “Neither a short-term borrower nor a long-term lender be.”

the auction nature of security markets often allows finely-run companies the opportunity to purchase portions of their own businesses at a price under 50% of that needed to acquire the same earning power through the negotiated acquisition of another enterprise.)

we evaluate single-year corporate performance by comparing operating earnings to shareholders’ equity with securities valued at cost.

However attractive the earnings numbers, we remain leery of businesses that never seem able to convert such pretty numbers into no-strings-attached cash.

Small portions of exceptionally good businesses are usually available in the securities markets at reasonable prices. But such businesses are available for purchase in their entirety only rarely, and then almost always at high prices.

For personal as well as more objective reasons, however, we generally have been able to correct such mistakes far more quickly in the case of non-controlled businesses (marketable securities) than in the case of controlled subsidiaries. Lack of control, in effect, often has turned out to be an economic plus.

Logically, a company with historic and prospective high returns on equity should retain much or all of its earnings so that shareholders can earn premium returns on enhanced capital. Conversely, low returns on corporate equity would suggest a very high dividend payout so that owners could direct capital toward more attractive areas.

Beware of “dividends” that can be paid out only if someone promises to replace the capital distributed

we regard the most important measure of retail trends to be units sold per store rather than dollar volume

Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. Businesses needing little in the way of tangible assets simply are hurt the least.

Asset-heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.

In contrast, a disproportionate number of the great business fortunes built up during the inflationary years arose from ownership of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets. In such cases earnings have bounded upward in nominal dollars, and these dollars have been largely available for the acquisition of additional businesses.

During inflation, Goodwill is the gift that keeps giving. But that statement applies, naturally, only to true economic Goodwill.

The buying and selling of securities is a competitive business, and even a modest amount of added competition on either side can cost us a great deal of money

we think an all-bond portfolio carries a small but unacceptable “wipe out” risk, and we require any purchase of long-term bonds to clear a special hurdle. Only when bond purchases appear decidedly superior to other business opportunities will we engage in them. Those occasions are likely to be few and far between.

In many businesses particularly those that have high asset/profit ratios – inflation causes some or all of the reported earnings to become ersatz. The ersatz portion – let’s call these earnings “restricted” – cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.

Unrestricted earnings should be retained only when there is a reasonable prospect – backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners

you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of reinvestment.

Since the long-term corporate outlook changes only infrequently, dividend patterns should change no more often. But over time distributable earnings that have been withheld by managers should earn their keep. If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained.

Only by committing available funds to much better businesses were we able to overcome these origins. (It’s been like overcoming a misspent youth.) Clearly, diversification has served us well.

You must first make sure that earnings were not severely depressed in the base year. If they were instead substantial in relation to capital employed, an even more important point must be examined: how much additional capital was required to produce the additional earnings?

retirement announcements regularly sing the praises of CEOs who have, say, quadrupled earnings of their widget company during their reign – with no one examining whether this gain was attributable simply to many years of retained earnings and the workings of compound interest.

Many stock options in the corporate world have worked in exactly that fashion: they have gained in value simply because management retained earnings, not because it did well with the capital in its hands.

No owner has ever escaped the burden of capital costs, whereas a holder of a fixed-price option bears no capital costs at all. An owner must weigh upside potential against downside risk; an option holder has no downside

First, stock options are inevitably tied to the overall performance of a corporation. Logically, therefore, they should be awarded only to those managers with overall responsibility

owners are not well served by the sale of part of their business at a bargain price – whether the sale is to outsiders or to insiders. The obvious conclusion: options should be priced at true business value

all Berkshire managers can use their bonus money (or other funds, including borrowed money) to buy our stock in the market. Many have done just that – and some now have large holdings. By accepting both the risks and the carrying costs that go with outright purchases, these managers truly walk in the shoes of owners

Berkshire’s strong capital position – the best in the industry – should one day allow us to claim a distinct competitive advantage in the insurance market

we prefer to finance in anticipation of need rather than in reaction to it

Tight money conditions, which translate into high costs for liabilities, will create the best opportunities for acquisitions, and cheap money will cause assets to be bid to the sky. Our conclusion: Action on the liability side should sometimes be taken independent of any action on the asset side

The primary factors bearing upon this evaluation are:

1) The certainty with which the long-term economic characteristics of the business can be evaluated;

2) The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows;

3) The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself;

4) The purchase price of the business;

5) The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor’s purchasing-power return is reduced from his gross return.

The might of their brand names, the attributes of their products, and the strength of their distribution systems give them an enormous competitive advantage

Thirty years ago, I bought silver because I anticipated its demonetization by the U.S. Government. Ever since, I have followed the metal’s fundamentals but not owned it. In recent years, bullion inventories have fallen materially, and last summer Charlie and I concluded that a higher price would be needed to establish equilibrium between supply and demand. Inflation expectations, it should be noted, play no part in our calculation of silver’s value.

If the choice is between a questionable business at a comfortable price or a comfortable business at a questionable price, we much prefer the latter.

Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag.

Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.

It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements

The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money.

Notes – The Great Deformation, Part II “The Reagan Era Revisited” (#politics)

The Great Deformation, by David A. Stockman, published 2013

David Stockman was the director of the Office of Management and Budget (OMB) from 1981 through 1985 until he resigned in frustration from the Reagan White House. The desire to set the record straight on a failed political crusade (“The Reagan Revolution”) by a knight who feels betrayed by the politics of the crusade itself is strongly felt throughout Stockman’s polemical revisionism of the Reagan years and the regimes that set the stage for this period and whose stage was set in turn by Reagan’s failed policies.

In Part II, Stockman asserts that the Reagan defense budget process resulted in an unprecedented commitment to real top line growth that was arbitrary in calculation and resulted in almost no creation of additional anti-Soviet nuclear deterrent capability which was the stated need for the top line increase. Instead of getting more nuclear subs and nuclear-tipped ICBMs (which Stockman insists weren’t needed anyway), the Reagan spending was used to greenlight hundreds of billions of dollars worth of conventional military purchases on DoD shopping lists ranging from naval carrier groups to attack helicopters to tank fleets and front line soldiery. Not only was the supposed Soviet nuclear buildup non-existent due to the Soviet Union’s own decrepit economic system and ill envisaged forays into places like Afghanistan, but this conventional force build-up could do nothing to stop a Soviet nuclear first strike and in time proved to be good for nothing other than projecting American imperial might across the globe via conventional military conquest and occupation of targeted nations. The spending increase accomplished little more than to further exacerbate the problem of federal deficit finance and the future financial bubble of the late 90s and 2000s because the increase in spending was not offset with additional tax increases.

Stockman also challenges the idea that Reagan cut back on welfare entitlements. Stockman argues that he tried but then gave up under political pressure during the failed “Schweicker” gambit. This resulted in Republican acknowledgement that federal welfare entitlements such as the Social Security Administration were political sacred cows, committing the government to continued and growing structural deficits related to their funding and concluding in the short term with a Republican administration stewarding a thinly veiled payroll tax increase under the Greenspan solvency plan. Stockman suggests this was a critical political turning point for the Republican party which led them to shed their last fiscal conservancy feathers in favor of a more Keynesian stance of attempting to juice the economy through periodic tax cuts and business subsidies rather than by imposing fiscal rectitude on the government’s programs by cutting spending.

Now an obvious question at this point is, why didn’t all this spending and deficit finance create hyperinflation in the US as the Fed balance sheet tripled and bank credit expanded by an even greater multiple? Stockman’s answer is that when Nixon screwed the monetary pooch by deciding the freely float the US dollar, he ended up getting a free pass because the major trading partners of the US, especially in Asia (read: China and Japan) engaged in competitive currency devaluation to maintain their currency pegs. And the reason they did this is because their governments and local politics were dominated by mercantilist beliefs and export-oriented structures. Letting their currencies and interest rates rise against the US dollar would have caused painful adjustments to occur in home markets and industries that the various political regimes had no interest in making. The end result is that Nixon’s arbitrary gaming of the US economy via direct monetary manipulation in order to secure an economic boom as he approached reelection did cause problems and inflationary pressures at home (including unprecedented jumps in peacetime cost of living indexes and a commodity price boom) but it did not get completely off the rails because global central banks, guided by their home regimes, wouldn’t let it.

Again, Stockman argues that this was not only a short term economic disaster for the country, but it was also a long term political disaster because the fact that this happened under a Republican administration and was signed off on by the biggest “free market economists” of the day after the meeting with Nixon at Camp David meant that going forward there would be no real political or intellectual resistance to the agenda of perpetual deficit finance and continuous bubble-making in the economy that such a fiscal regime allows for.