Warren Buffett’s 2017 annual letter

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This is the time of the year where Warren Buffett shares his investment wisdom. As usual he did not disappoint. I’m sharing snippets from his latest annual letter. These are quotes as it would be harmful to change anything from the original text. If you have time and interest, read the full letter; otherwise enjoy what’s below.

On stocks as long-term investments and on market fluctuations

“Charlie and I view the marketable common stocks that Berkshire owns as interests in businesses, not as ticker symbols to be bought or sold based on their “chart” patterns, the “target” prices of analysts or the opinions of media pundits. Instead, we simply believe that if the businesses of the investees are successful (as we believe most will be) our investments will be successful as well. Sometimes the payoffs to us will be modest; occasionally the cash register will ring loudly. And sometimes I will make expensive mistakes. Overall – and over time – we should get decent results. In America, equity investors have the wind at their back.”

And more:

“In the next 53 years our shares (and others) will experience declines resembling those in the table (note: Berkshire’s stock price has suffered 4 major dips of 37%-59% each). No one can tell you when these will happen. The light can at any time go from green to red without pausing at yellow. When major declines occur, however, they offer extraordinary opportunities to those who are not handicapped by debt. That’s the time to heed these lines from Kipling’s If:

If you can keep your head when all about you are losing theirs . . .
If you can wait and not be tired by waiting . . .
If you can think – and not make thoughts your aim . . .
If you can trust yourself when all men doubt you . . .
Yours is the Earth and everything that’s in it.”

And even more:

“Though markets are generally rational, they occasionally do crazy things. Seizing the opportunities then offered does not require great intelligence, a degree in economics or a familiarity with Wall Street jargon such as alpha and beta. What investors then need instead is an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals. A willingness to look unimaginative for a sustained period – or even to look foolish – is also essential.”

On leverage

“This table offers the strongest argument I can muster against ever using borrowed money to own stocks. There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions.”

On risk

“Investing is an activity in which consumption today is foregone in an attempt to allow greater consumption at a later date. “Risk” is the possibility that this objective won’t be attained.

I want to quickly acknowledge that in any upcoming day, week or even year, stocks will be riskier – far riskier – than short-term U.S. bonds. As an investor’s investment horizon lengthens, however, a diversified portfolio of U.S. equities becomes progressively less risky than bonds, assuming that the stocks are purchased at a sensible multiple of earnings relative to then-prevailing interest rates.

It is a terrible mistake for investors with long-term horizons – among them, pension funds, college endowments and savings-minded individuals – to measure their investment “risk” by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk.”

On fees

“Performance comes, performance goes. Fees never falter.”

On portfolio turnover

“Stick with big, “easy” decisions and eschew activity.”

On specific stocks

Not much in this letter. Berkshire’s largest positions are still Wells Fargo, Apple (position significantly increased in 2017), Kraft Heinz, Bank of America, Coca Cola,  American Express. IBM is gone as a key position. Low portfolio turnover in action !

On the current M&A environment

“Prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemed almost irrelevant to an army of optimistic purchasers.

Why the purchasing frenzy? In part, it’s because the CEO job self-selects for “can-do” types. If Wall Street analysts or board members urge that brand of CEO to consider possible acquisitions, it’s a bit like telling your ripening teenager to be sure to have a normal sex life.

Once a CEO hungers for a deal, he or she will never lack for forecasts that justify the purchase. Subordinates will be cheering, envisioning enlarged domains and the compensation levels that typically increase with corporate size. Investment bankers, smelling huge fees, will be applauding as well. (Don’t ask the barber whether you need a haircut.) If the historical performance of the target falls short of validating its acquisition, large “synergies” will be forecast. Spreadsheets never disappoint.”

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Book review: Deep Value Investing (2nd edition) by Jeroen Bos

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I very much enjoyed the first edition of Deep Value Investing, in which the author clearly described his investment process and illustrated it with 15 helpful case studies, focusing on UK small caps. The book was published in 2013 and my initial review can be found here.

The newly published second editionis much more than a refresher; it has 6 additional case studies and walks us through what happened to the old ones in the past 5 years. The case studies are still organised in 3 groups: deep value successes, deep value failures, and deep value shares of tomorrow (Enteq Upstream, Hargreaves Services, Lamprell, Hydrogen Group, Record). The latter group can be found in the author’s fund.

It’s always interesting to see which sector offers deep value opportunities. Recruitment agencies were a fertile ground with the onset of the recession in 2008. Housebuilders offered great opportunities in 2008 and again after Brexit. Most of the current ideas relate to the oil sector.

Deep Value Investing remains one of the only investment books in which the reader can clearly follow the thought process on specific investments of an experienced investment manager, backed with the necessary financial information. As such, I recommend it to bargain hunters.

While reading the book it becomes obvious why deep value invesitng works over time – it’s simple but not easy! There are inevitably big failures (4 case studies); you need loads of patience and perseverence. Also, some of the net-nets are very thinly traded and not always available through a generalist broker. Quality Investing is so much more comfortable…

My conculsion: there is a lot of value in Deep Value Investing, especially today afer a period of underperformance. If you cannot implement the strategy yourself, delegate to a capable manager.

Thoughts on the market selloff

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I put together below some thoughts on the market selloff.

10 things to know about the stock-market selloff by Mohamed El-Eirian. A lot of common sense in these 10 points.

Testing times: market turmoil and investment serenity by Aswath Damodaran. The Professor shares some tips to stay rational and provides a model to value the market.

Why share prices are see-sawing by the Economist’s Buttonwood. “There is room for a lot more choppiness…”

The stock market didn’t get tested – you did by Jason Zweig. Stop trying to make sense of the stock market. “If a 6% daily drop makes you squirm, then you probably have too much invested in stocks for your own psychological good”.

Markets volatile Valentine by John Authers. Key things to watch in the coming days: inflation and bond yields.

Volatility – virus, bubble, or both by M&G. Why did volatility spike in the absence of notable news?

Beware the volatility bubble’s popping by Edward Chancellor.

People get creative when explaining the market correction by Barry Ritholtz. Beware of narrative fallacy and hindsight bias.

And finally, some statistics about “corrections” ie. market declines of 10% to 20%:

Bitcoin

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I’ve rarely had so many people asking about a topic since Internet stocks in 1999…

As my own answer typically frustrates my discussion partner, let me stand on the shoulder of giants and share their thoughts:

Warren Buffett article. Important quote: “There are basically two kinds of assets. One you look to the stream of income it will produce; the other you hope like hell that someone will pay you more for it.”

Charlie Munger video. Less diplomatic than Buffett, Munger says Bitcoin is “total insanity”. I encourage you to watch (at least) 2 minutes of the interview as from 38:40.

Robert Shiller’s piece “What is Bitcoin really worth? Don’t even ask”.

I have more like these but I guess you get the point (unless you agree with Marc Andreesen’s “old white men crapping on new technology they don’t understand”).

For a good tutorial, check out this Bitcoin for Dummies.

And if you’re still convinced Bitcoin is healthy for your wealth, you’ll enjoy this Bill Miller interview. A good rule, even from a believer: “Don’t put more money into Bitcoin than you can afford to lose 100% of because there’s a nontrivial chance it can go to 0”.

Book review: The Deals of Warren Buffett

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If you want to learn about Warren Buffett’s life, you should read his biography by Roger Lowenstein.

If you want to learn about his investment approach, you should read The Warren Buffett Way.

If you want to learn about his investments, check out Glen Arnold’s new book, The Deals of Warren Buffett: Volume 1, The First $100m.

Of course, you may want to go directly to the source, ie. Buffett’s Partnership Letters and Berkshire Hathaway Shareholders Letters, which I warmly recommend.

Glen Arnold’s book covers 22 investments, in chronological order, from Cities Services in 1941 (Buffett was 11 years old) to Wesco Financial in 1974. There is quite some overlap with Yefei Lu’s book, Inside the Investments of Warren Buffett.

Arnold’s book helpfully summarizes Buffett’s thought process for each investment and provides the key figures that Buffett has at his disposal. The author offers at the end of each chapter some useful learning points stemming from these case studies, of which I selected nine:

  • Look for pricing power (Dempster Mill). The ability to spot the potential for raising prices because of some degree of customer captivity was evident time and again in Buffett’s career.
  • When the odds are good, invest a lot (American Express). Buffett invested up to 40% in American Express in the 1960s.
  • Businesses needing little additional capital to generate increased profits can be a goldmine (Disney). Such business can produce very high returns on capital employed.
  • Be prepared to observe a good company for years before investing (National Indemnity Insurance). This is why I keep a watchlist.
  • Hold on to a good thing for years (National Indemnity Insurance).
  • Good jockeys will do well on good horses, but no on broken-down nags (Hochschild-Kohn).
  • Partner with keen cost-cutters (Associated Cotton Shops).
  • Float is a very useful way to leverage (Blue Chip Stamps). Mohnish Pabrai expands on this here.
  • Evaluate what is in the mind of customers (See’s Candies). This is closely linked to the pricing power point.

I recommend The Deals of Warren Buffett to beginner investors who want to develop sound investment principles.

Closed-end funds: still a land of opportunity?

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Closed-end funds remain a fascinating topic and an interesting source of investment opportunities. For an overview of the closed-end puzzle and a behavioural theory, have a look here and here at the papers by Nobel winner Richard Thaler, written in collaboration with Andrei Shleifer and Charles Lee.

My favourite closed-end fund investments meet the following 3 criteria (in this order):

1. The underlying assets are attractive.

2. The fund trades at a significant discount to its net asset value (NAV).

3. There is a catalyst that will lead to a narrowing of the discount.

A couple of examples:

Aberdeen Emerging Markets Smaller Company Opportunities Fund. The fund is managed by the experienced Aberdeen team, has a reasonable TER of 1.55%, and trades with a discount to NAV of around 7%. Whilst the discount is lower than in the past few years, there is now a clear catalyst, as announced here.

Pantheon International Plc. Pantheon invests in private equity funds globally. Over the past 20 years, it has delivered a compound annual return to investors of 12%. It currently trades at discount to NAV of 17% (again, the discount has been wider in the past). Pantheon continues to buy back shares and is working to narrow the discount (see recent announcement).

Edit (Jan 2018): for further info about Investment Trusts, I recommend The Investment Trusts Handbook 2018.

Book review: Big Money Thinks Small

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This book is a solid candidate for the best investment book of the year!

Joel Tillinghast, the author who has successfully managed the Fidelity Low-Priced Stock Fund for almost 3 decades, introduces 5 key investing principles:

 

 

1. Invest patiently and rationally / not emotionally.

2. Invest in what you know / not in things you don’t understand.

3. Invest with capable, honest managers / not with crooks.

4. Invest in resilient businesses with a niche and strong balance sheet / not in faddish, commoditized businesses with a lot of debt.

5. Invest in bargain-priced stocks / not in pricey “story” stocks.

This emphasis on a margin of safety is nothing new. What is enriching, however, are the insights Joel Tillinghast shares when covering a variety of topics including technology stocks, commodities, accounting, psychology. The author’s learnings on Enron / Petrobras / CMGI / Valeant are also very interesting.

Some thoughtful bits and pieces:

“While I generally avoid commodity businesses, if you must invest in one, go with oil, because of the limit on supply and relatively inelastic demand”.

“Contrary to popular wisdom, picking stocks based on low P/Es and high free cash flow yields often works particularly well with technology stocks”.

What could look like anecdotes and unrelated points come together to form a valuable approach to investing – one business at a time (ie. thinking small). This is not a cookbook with recipes; it’s a collection of investment widsom.

I’ll certainly re-read many passages of this book over and over again. Highly recommended for seasoned investors.

Book review: The Best Investment Writing

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In this new book, the editor Meb Faber brings together an eclectic collection of investment texts.

You won’t find here some classics like Warren Buffett’s Superinvestors of Graham-and-Doddsville or Charlie Munger’s Psychology of Human Misjudgment or John Maynard Keynes’ essay.

Rather, this volume 1 includes texts by acclaimed investing journalists (Jason Zweig, Barry Ritholz), bloggers (David Merkel, Ben Carlson), academics (Aswath Damodoran), advisors (Ken Fisher).

The 32 articles are all useful. I especially liked Morgan Housel on competitive advantage, Ben Carlson’s 20 rules of personal finance, and Todd Tresidder’s due diligence questions before making any investment.

As there is hardly a common thread across the articles, I find it hard to write a comprehensive review; suffice to say that this is an interesting collection of articles.

Let’s see what Med Faber has in store for volume 2.

Book review: Invest like a Guru

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I’ve been a user of GuruFocus.com for some time. When looking at a stock, I like to check on the site its Piotroski F-Score, potential warnings signs, and trades of renowned investors. Hence I was interested to better understand the philosophy behind GuruFocus.com, which founder Charlie Tian describes in Invest Like a Guru.

A physicist by training, the tech bubble was a defining moment for Charlie Tian. Following his poor experience with stocks during that period, building on the teachings of Peter Lynch, Warren Buffett and Donald Yacktman, Tian developed one of his core principles: Buy Only Good Companies. By ‘Good Companies’, the author means consistently profitable businesses (with double-digit operating margins and returns on invested capital) that can continuously grow revenues and earnings through their operations.

Chapter 6 provides a useful 20-item checklist for investing in good companies at fair prices (see pages 102-103). Also, the author has developed a series of Warning Signs (e.g., weak Altman Z-Score, asset growth faster than revenue growth, issuance of new shares), which are flagged on GuruFocus.com

The author prefers to stay away from cyclical stocks – especially leveraged cyclicals – and deep value situations where value erodes over time. Based on investors’ experiences with Sears, Weight Watchers, BlackBerry, Tian comes to a surprising conclusion for a value investor: “never buy low-quality companies again, no matter how undervalued they seem to be!”. This is too radical for me.

I find Invest Like a Guru a helpful companion to GuruFocus.com, with useful suggestions to avoid permanent losses of capital.

 

Stocks on the watchlist: an update

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For some time, I’ve been keeping a watchlist of stocks on this blog. This list of 9 companies has not changed since the beginning of the year. Here’s how the stocks have performed year-to-date (for simplicity, in local currency).

Alphabet +17%.

Admiral Group +10%.

Visa +17%.

Ryanair +9%.

Roche +15%.

S&P Global +25%.

Kinepolis +25%.

DeVry +21%.

Van Lanschot +25%.

Some observations:

  • In a bull market, it’s the smaller value plays that perform best (e.g., Van Lanschot, DeVry).
  • Depending on the specific circumstances, both “averaging up” and “averaging down” make sense in a portfolio.
  • It’s time to update the list!