Showing posts with label Warren Buffett. Show all posts
Showing posts with label Warren Buffett. Show all posts

Wednesday, December 10, 2014

The Pareto Principle in dividend investing

The Pareto Principle is an economic term invented by an Italian economist Vilfredo Pareto in the 20th century. It is also called the 80-20 principle, meaning that 80% of effects come from 20% of the causes. Vilfredo observed that 80% of the land in Italy is owned by 20% of the people. The ideas behind this principle are wide ranging in multiple fields, including investing. I am a firm believer that a small minority of the investments I make today will end up becoming so successful, that they will produce 80% of my investment gains over the next 40 - 50 years. This is why I am really careful about selling, even if a stock I own is up by 1,000%.

For example, in the book “The Tao of Warren Buffet “ written by Mary Buffett, I read that 90% of Warren Buffett’s returns came from just 10 stocks. I did some research, but unfortunately I was unable to find any detailed data behind this exercise.

For purposes of simplicity, Berkshire Hathaway (BRK.A) has accounted for over 99% of Buffett’s wealth. Before 1970, the Buffett Partnership accounted for majority of his wealth. This statement  is overly simplistic, as Buffeet had to make hundreds if not thousands of stock and business decisions, that compounded partners and shareholders net worths for decades. But the quote from above, discussed the investments that made Berkshire Hathaway what it is today.

Buffett has consistently delivered outstanding results from the mid 1950s, whether for Buffett Partners or Berkshire Hathaway shareholders. So while Coca-Cola (KO) has delivered over $15 billion in capital gains and dividends, this should not be viewed in isolation. In order to come up with the $1.3 billion to purchase Coca-Cola between 1988 & 1994, Buffett had to spend a lifetime making money in a lot of stocks and businesses. His first investments in Sanborn Maps and Demster Manufacturing netted him a few million in the 1960s. His concentrated investment in American Express (AXP) in the early 1960s resulted in some great returns within a few short years. But these and other investments helped him make the sufficient amounts of cash to buy Berkshire Hathaway as well in the early to late 1960s. The business problems at Berkshire made him buy insurance companies such as National Idemnity, which provided him with tens of millions to be invested in the likes of Washington Post (WPO) and See’s Candies. So the point is that his investment results followed a natural progression of things.

If you looked at his Buffet Partners Limited partnership, chances are that the largest contributors to performance could have been Sanborn Maps, Dempster, American Express and Berkshire, in addition to the 300 – 400 special situations he uncovered and made money on during the 13 years he did the partnership. The profits from each and every one of those investments were used to invest in the next big wave of investments.

If you looked at Berkshire’s operations prior to the 1990s, the largest additions were Insurance Operations, Cap Cities, Washington Post, Buffallo News and See’s Candies. The profits from each and every one of those investments were used to invest in the next big wave of investments.

In the 1990s, insurance operations, Coca-Cola, Gillette, American Express have contributed mostly to performance. But because each of these investments has been possible, because of the wit, wisdom and capital, accumulated from the previous cohort of hundreds of investments from the preceding 30 – 40 years. In addition, his knowledge helped focus much more on acquiring whole businesses, rather than partial ownership interests.

In his speeches, Buffett talks how people should be investing as if they could only make 20 investments in their lifetimes. The reality is that he has done a whole variety of things, including purchasing cigar butts, participating in arbitrage situations, actively buying and selling stocks, derivatives, as well as acquisitions of businesses. He has been able to evolve as an investor over time, and select the best opportunities at the time, while also having adequate margin of safety. For ordinary investors like you and me however, his advise on selecting investments as if we have a limited number of slots in our lifetime is relevant.

I believe that in a typical investors career, out of the 50 – 80 investments one does make, probably less than 20 or so would end up accounting for the majority of investment gains. Even if you purchased stakes in 100 dividend paying stocks today, chances are that less than one quarter of those would account for majority of the gains in 30 – 40 years. This is because things change, companies merge, get acquired, go bankrupt and only a few prosper. But those who stay riding a big trend and manage to expand their operations by steady reinvestment into the business, could deliver outstanding returns to their shareholders, which could lift up total portfolio returns substantially. If you look at the original dividend aristocrats from 1989, you can see that those companies that at least maintained dividends did much better as a whole relative to those who cut dividends. The companies that kept raising dividends throughout the period, provided exceptional returns. If an investor had sold those companies, their returns would have been substantially reduced. It would have been difficult to forecast in 1989 which company would remain an aristocrat, and which would drop off the list.

The important thing is to be able to focus and uncover quality dividend paying businesses with staying power. Those companies with staying power should have an above average chance of continuing to earn more and pay more for the next 20 - 30 years. Purchasing those great businesses at attractive prices is as important as identifying them in the first place. Overpaying for them is a bad idea. The reality is that an investor does not to be right all the time to make money in dividend investing.

A few investments you make will do the heavy lifting for the whole portfolio for 20 - 30 years, while others will be average, and a few will fail outright. The nice thing about dividend stock investments is that the downside is zero, while the upside is unlimited. This is why it is also very important to hold on to the companies in a portfolio for as long as possible. In my case, I have learned that it is best to simply hold on to companies once I have acquired them, and ignore any short term noise. The main reason why I would consider selling is either after a dividend cut or extreme overvaluation such as a stock selling for 30 - 40 times earnings. Actually, the downside is less than zero, because a company that fails can end up providing a stream of dividends for several years, which could end up exceeding the price paid for the business in the first place, thus acting as a rebate on the purchase price of the stock. This is why diversification also helps, in case the investor made a poor choice or things change for the worse.

It is also interesting to think about the returns of Ben Graham, who is the father of value investing, and who ran his Graham-Newman partnership between 1936 - 1956. Incidentally, his largest gains came from GEICO, which he simply bought and held on for decades. Actually, the amount of profits from GEICO exceeded profits made from his active value investing. The reason I am using this example is that despite all our analytic models for identifying promising investments, a large part of the outcome could be the result of luck. Therefore, a dividend investor should be very patient with a company, and patiently hold it for decades. My study of a few spin-offs from a few weeks ago also showed me that long-term returns could materialize after years of holding on to a good investment that noone appreciates.

After thinking about the Paretto Principle for my dividend investing I think twice before selling a company, even if it is temporary overvalued, freezes dividends, or if there are other comparatively cheaper securities available. Since noone can predict the future accurately, I believe that simply staying the course is the way to go, rather than jump in and out of companies like a trader, and making my broker and Uncle Sam rich with my hard earned money.

Full Disclosure: Long KO, BRK.B,

Relevant Articles:

Warren Buffett Investing Resource Page
Should Dividend Investors own Non-Dividend Paying Stocks?
Dividend Investing Is Not As Risky As It Is Portrayed
Dividends Offer an Instant Rebate on Your Purchase Price.
Should you sell after yield drops below minimum yield requirement?

Friday, August 8, 2014

Why Warren Buffett likes Investing in Bank Stocks

Warren Buffett is the second richest person in the world, a self-made billionaire investor that has a very large following. He is well known for turning struggling textile manufacturer Berkshire Hathaway (BRK.B) into a 300 billion dollar conglomerate, through investing in sound companies like Coca-Cola (KO), American Express (AXP), Geico etc. One of his largest holdings is the bank Wells Fargo (WFC). Warren Buffett has been holding on to Wells Fargo for a little under 2 decades. When I first analyzed the company in 2013, I was not overly impressed. I was more impressed with the big five Canadian Banks. However, as I did some thinking and pondering, I realized my original thesis might have missed out on a lot of other concepts, which is why I initiated a small position in the bank a few months later.

Buffett has claimed that investing in Berkshire Hathaway was a big mistake, because the business was destined for poor profits and required constantly new capital in order to keep up and stay competitive. He has mentioned that had he purchased insurance companies outright, he would have been much richer today. His knowledge of insurance business had started accumulating in the 1950s, after purchasing GEICO, and Western Insurance Company that was selling at less 1 times earnings. Back in the late 1960s, Buffett acquired the National Indemnity company through Berkshire Hathaway. He has been investing in insurance companies for the next five decades.

The reason why he liked insurance companies is due to their float. Per Warren Buffett's words, "Insurers receive premiums upfront and pay claims later. ... This collect-now, pay-later model leaves us holding large sums — money we call "float" — that will eventually go to others. Meanwhile, we get to invest this float for Berkshire's benefit. ..."

Insurance companies usually use proceeds acquired through float, and invest it in safe instruments like government or corporate bonds. If an insurance company ends up paying out less in claims than the premiums it receives, it turns an underwriting profit. In other words, it used those premiums paid by policyholders and earned interest income on it, while also earning a profit on the insurance process. In other words, the premium amounts from policy holders serve as a sort of margin loan, which does not cost anything to the insurance company that at least manages to break even. If that insurance company can at least maintain a break-even point on insurance proceeds, and can at least maintain a stable level of premium amounts, it can end up in a pretty nice position for itself. It is a really nice situation to be when you get almost free cost of capital, that you can then deploy at higher rates of return.

Most other insurance companies tend to keep selling insurance, even if they are no longer compensated well for the risk. Berkshire Hathaway however only does this when they expect to at least earn some money on the policies. This is because if you take on a future potential liability, without being properly compensated, you will lose money. In an industry, where you receive money today in order to pay for claims at an unknown time in the future, taking unprofitable business could have devastating effects on shareholder equity in the business. This is where the concept of having able and honest management comes into play.

As I was looking over the annual reports of Wells Fargo, I realized the reason why Buffett really likes the bank so much. It essentially receives cash from depositors, who are not really getting paid that much. In effect then those banks use those almost free capital to make loans to creditworthy borrowers, and profit from the spread, minus their operating costs.

Of course in either bank or insurance operations, you don’t want management that takes reckless risks,

The other factors that help in Buffett’s investments in Wells Fargo (WFC) and Bank of America (BAC) is the nature of customer relationships. If you bank with your Wells Fargo, you are more likely to consider them when you need a loan for a new car, house, or to start a business. In addition, you are exposed to their cross-selling of investment services, credit card services etc.

Results from insurance operations can be lumpy, and so are earnings from bank operations. Financial crises do happen, which results in dividend cuts in many institutions every so often. However, for the long-term patient accumulator of capital, the holding period of forever should work to their advantage.

Unfortunately, Berkshire Hathaway cannot acquire a bank outright, due to current US regulations. Hence, its ownership in the bank is limited to having a partial ownership interest in financial institutions. However, the lessons should provide an interesting model for investors to have in their minds, as they analyze banks for potential inclusions in their income portfolios.

As I discussed in my previous article on Monday, I recently added to my position in Wells Fargo. In addition, in the past month I also sold some long-dates puts on the bank. I expect to ultimately build this position out slowly over time. I believe that banks like Wells Fargo will continue being a good investment for patient long-term shareholders with a 30 year time horizon. Things could get lumpy, especially during the next crisis. However, I think that banks with prudent management that manage to provide loans to creditworthy borrowers and also manage to earn recurring revenues through their business relationships with clients, will do well over time. After all, while there is obsolescence in many industries, I really doubt that the world would ever work without banks. Therefore, banks like Wells Fargo are the lifeblood of the economy and will keep originating loans, taking deposits and build customer relationships for decades to come.

Relevant Articles:

Warren Buffett Investing Resource Page
How to earn $900 in dividend income per minute
Should you invest in Wells Fargo (WFC)?
Dividend Stocks make great acquisitions
Business Relationships Can Deliver Solid Dividends to Shareholders

Wednesday, July 16, 2014

Dividend Investors Will Make Money Even if the Stock Market Closed for Ten Years

I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years. Warren Buffett

Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years. Warren Buffett

In 1914, the New York Stock Exchange closed for five months. In 2001, the NYSE, Nasdaq and AMEX were closed for a week. Active stock traders did not make any money during those periods. Dividend investors kept receiving their dividend checks, without interruption.

Investors can buy and sell their stock in an instant. This ability to quickly cash out makes stock investing a preferable option for many investors. Compare this to real estate or a private business, where it might take months in order to buy and sell an asset.

Sometimes however this could be a curse as well. While stocks are a very liquid investment, sometimes investors end up being too focused on short-term price fluctuations, while ignoring fundamentals. During bull markets, investors bid up share prices to unsustainable levels. During bear markets, investors who see their portfolio values collapsing panic and sell at the wrong times. Those investors become too emotional, which creates opportunities for the enterprising dividend investors. The emotional investors tend to forget that stocks are not some lottery tickets or numbers blinking on a computer screen, but ownership pieces of real businesses. In a perfectly rational world, the value of business depends on its current and future estimated earnings powers. This is why when entire businesses are sold to a private buyer, the price paid is usually close to the intrinsic value. However, due to the emotional state of Mr Market, the ownership pieces that are exchanged between stock market participants are frequently mispriced.

Dividend investors know that dividend stocks represent ownership stakes in real businesses. As a long-term investor, your success is dependent on the success of the business. If the business manages to grow earnings per share, it would be worth more and would also be able to distribute more in dividend income.

Dividend investors who embrace a buy and hold mentality have an inherently psychological advantage over the average investor. Dividend investors generate a return on investment every time they receive a dividend payment. As a result, many retirees who are living off dividends, concern themselves with the company’s ability to grow earnings to pay higher distributions, than the stock price of the stock. Astute dividend investors focus on fundamentals, understanding the company’s operations and valuing the business as if it were a privately owned corporation.

Dividend investors are in essence much different than the rest of participants, who rapidly exchange little pieces of ownership between each other, in an effort to outwit each other. Dividend investors see stocks as partial ownership pieces of real businesses. They understand that their ultimate success in investment is based on the price they paid and on the success of the business itself. If you own a restaurant along with 10 other partners, you care about making sure the business succeeds, and stays relevant for as long as possible. The goal is to make sure that repeat business is earned, customers are happy, and profit margins are healthy, while trying to constantly increase profits. The advantage of dividend investors is that they focus on the fundamentals of the business, how it earns money, and whether this business has the potential to earn more money in the future. Then they try to purchase that business at an attractive valuation, which takes into consideration a range of potential outcomes, and provide an entry price range which would generate a satisfactory return on investment. If you are the partial owner of a McDonald's franchise, you earn profits whether the stock market is open or closed. In fact, if you have found the right business at the right price, it is highly likely that you will hold this business forever.

This is how I view ownership of high quality companies such as Coca-Cola (KO), Johnson & Johnson (JNJ) and Kinder Morgan Inc (KMI). Those are real businesses, that provide real goods or services to clients, and which generate profits to be distributed to me as the partial share-owner. I expect to hold those businesses forever, and expect to earn ever increasing dividends over time from those ownership stakes. I see the rapid trading as pure madness, which actually doesn't really affect me. Whether I pay $37 for Coca-Cola shares or $37.10/share is irrelevant to me. Let the high-frequency computers make that money. The real money is made by identifying a quality company,  buying it at an attractive price, and then sitting on it for decades. In the meantime, the business will be earning more and more in profits almost every year, and pay you an amount of dividends that will likely exceed the purchase price paid by a factor of a few times the purchase price.  Time is the ally of the long-term, buy and hold dividend investor. The initial results are slow, but eventually, the compounding ends up snowballing into mind-boggling yields on cost and capital appreciation returns.

This is why I spend so much time screening the list of dividend champions and dividend achievers, and then researching companies one at a time. I am looking for companies with strong competitive advantages, strong brands, that would allow those companies to have the potential to be around in 20 years, and still earn more per share over time. For example, if you are a part owner of the local water utility, you know that this business will be around in the next 20 - 30 years, because it would be impossible for someone else to compete with you, due to regulation and cost to set-up and maintain the system. If you are a part owner in a company that provides a unique product or serves, which is largely unregulated, it essentially has a monopoly that could mint profits to the shareholder for decades. A prime example of that is Coca-Cola, which has a strong distribution network throughout the world, is associated in consumers' minds with positive emotions, has over 500 brands globally that quench the thirst of people in 200 countries to the tune of 1.9 billion servings per day. If you believe this business has the staying power to be around in 20 years, then you can make projections on earnings, revenues and dividends with a much larger degree of comfort. You want a business which will not change too rapidly. People will get thirsty 30 years from now. If you have the distribution scale that covers 200 countries, and a portfolio of 500 branded drinks, chances are that consumers will use your products. This is why Buffett invests in quality companies with durable competitive advantages, operated by honest and able managers, which have attractive returns on capital and which are available at attractive prices. If you find such a company, the goal of the dividend investor is to hold on to it for decades, and let the power of compounding do the heavy lifting for them.

In contrast, while I might know that Apple will be around in 20 years, I am not so sure how much profitable the enterprise will be, due to the rapid changes in technology. Sony was another great consumer technology franchise, which has not done so well as of the past decade. Will Apple follow the steps of Sony? I don't know, and chances are that few investors really have the necessary knowledge to make an educated bet today. This is why I am sticking to companies I understand, and focus on their fundamentals for the next 20 - 30 years. As a long term buy and hold dividend investor, my goal is to live off the dividends from my collection of quality enterprises. Therefore, my success will be determined on the success of the businesses I invest in, not on stock price fluctuations. The stock market is only helpful to me as a tool where I find sellers of quality businesses, not as a place to instruct me on how to make my investments.

Full Disclosure: Long KMI, JNJ, KO. One share of BRK.B

Relevant Articles:

Coca-Cola: A wide-moat dividend growth stock to buy and hold
Maintaining Moats in times of Technological Changes
Seven Sleep Well at Night Dividend Stocks
How to analyze investment opportunities?
Let dividends do the heavy lifting for your retirement

Thursday, July 3, 2014

How Warren Buffett earns $900 in dividend income per minute

On July 1, Buffett’s Berkshire Hathaway (BRK.B) received $122 million dollars in dividend income from their 400 million shares of Coca-Cola (KO). This comes out to roughly $928 dollars in dividend income for Berkshire Hathaway every minute, or almost $15.47 every single second. Those shares have a cost basis of $1.29 billion dollars, and were acquired between 1988 – 1994. The annual dividend payment produces an yield on cost of over 37.50%. This doesn’t assume dividend reinvestment and is 4 – 5 times higher than what investors in 30 year US Treasuries would be earning. This is why I believe that Warren Buffett is a closet dividend investor.

This is a testament to the power of long-term dividend investing, where time in market is the investors best ally, not timing the market. If you can select a business which is run by able and honest management, which has solid competitive advantages, and which is available at a good price today, one needs to only sit and let the power of compounding do the heavy lifting for them. As Buffett likes to say, time is a great ally for the good business. In the case of Coca-Cola, the past 26 years have been a great time to buy and hold the stock. The company has been able to tap emerging markets in Eastern Europe, Asia, Africa and Latin America like never before. As a result, it has been able to receive a higher share of the worldwide drinks market, which has also been expanding as well. If you add in strategic acquisitions, new product development, cost containment initiatives and streamlining of operations, you have a very powerful force for delivering solid shareholder returns. With dividend investing your are rewarded for smart decisions you have made years before.

If they closed the stock market for a period of 10 years, Coca-Cola would be one of the companies I would be willing to hold on to. This is because ten years from now, the company would likely be earning double what it is earning today, and would likely be distributing twice as much in dividend income than it is paying to shareholders today. Check my analysis of Coca-Cola for more information.

At the end of the day, if you identify a solid business, that has lasting power for the next 20 – 30 years, the job of the investor is to purchase shares at attractive values, and hold on to it. This slow and steady approach might seem unexciting initially, but just like with the story of the slow-moving tortoise beating the fast moving hare, the power of compounding would work miracles for the patient dividend investor.

Currently, Coca-Cola is selling for 20.20 times forward earnings and yields 2.90%. This dividend champion has managed to increase dividends for 52 years in a row. Over the past decade, Coca-Cola has managed to increase dividends by 9.80%/year, equivalent to dividend payments doubling every seven years. This is much better than the raises I have received at work over the past decade, despite the fact that I have routinely spent 55 - 60 hour weeks at the office.

Full Disclosure: Long KO and one share of BRK.B

Relevant Articles:

Coca-Cola: A wide-moat dividend growth stock to buy and hold
Warren Buffett Investing Resource Page
Seven wide-moat dividends stocks to consider
Warren Buffett’s Dividend Stock Strategy
The importance of yield on cost

Wednesday, March 12, 2014

I admire Investors with Skin in the Game

Anytime I study companies for a potential investment, I always try to do plenty of research on the company, reading annual reports, analyst reports and articles on the firm. Many times I end up reading very positive articles where owning company’s shares is mentioned as a no-brainer decision. After reading the articles however, I am always surprised when authors are not owning shares in this otherwise slam-dunk investment.

That being said there are valid reasons for not owning a company's stock, such as waiting for a pullback or due to conflict of interest. Either way however, I prefer to listen to an investor who has skin in the game. Authors who are good at writing articles, have very little to teach me about investing, where the major part of success is based on investor psychology, rather than neatly organized content. I believe in learning from those who practice their skills, not those who claim to have knowledge of it. After all, if you went for a surgery, would you go for the person that has all the theoretical knowledge, or would you go for the person who has actually practiced their skill?

I do not trust financial advisers whose goal is to sell you products you do not need. I cannot trust a college kid with a degree who has never dealt with psychological dilemmas of investing decisions. I enjoy reading articles written by authors who talk about their own experiences as investors.

I also prefer books from authors who have made it in the investing game, or at least discuss a particular topic from their own experiences. If they failed that is fine with me as well. Sometimes you increase your chances of success and gain more knowledge on a given topic when you learn what not to do, rather than what you should be doing. If you narrow down investing books to only those based on personal experience, rather than the academic ones describing your hypothetical returns, you are only left with a handful.

The reason why I prefer following investors with skin in the game is because you view situations differently when money is on the line, rather than using statistics and pie in the sky models. That is why I respect individuals with stake in the game. Warren Buffett for example, the world’s most renowned investor and the chairman of Berkshire Hathaway (BRK.B) is the epitome of an individual with a stake in the game, who have always treated investors that have trusted him with their money as partners, and looked after their best interests. He made a lot of money for himself in the process as well.

Richard Kinder, the CEO of Kinder Morgan Inc. (KMI) is another individual that I greatly admire. His interests are aligned with the interests of Kinder Morgan (KMI) shareholders and Kinder Morgan Energy (KMP) limited partners. The higher the distributions that Kinder Morgan Energy Partners achieves, the higher the dividends that this CEO with the sky-high salary of $1/year will receive. Compared to Richard Kinder, even Buffett's $100,000/year salary looks excessive.

Compare this to the typical CEO compensation however, which runs into the millions of dollars, no matter what the financial performance of the company they are heading. Some CEO's spend more time gaming the system, and wasting shareholders' money on ill-timed ego boosting acquisitions or share buybacks, while collecting big paychecks. For example, in 2009 I posted a chart of the CEO's that collected enormous bonuses, while their companies were struggling and had to cut distributions to shareholders.

Full Disclosure: Long KMI and KMR

Relevant Articles:

- Complete List of Articles on Dividend Growth Investor Website
Highest paid CEO’s in 2008 didn’t perform that well as a group
The Importance of Corporate Governance for Successful Dividend Investing
Warren Buffett Investing Resource Page
The work required to have an opinion

Saturday, February 8, 2014

Warren Buffett is now working for me

I recently initiated a position in Berkshire Hathaway (BRK.B), which is the holding company of billionaire investor and philanthropist Warren Buffett. Over the past year, I have studied almost everything publicly available on Warren Buffett and how he accumulated his sizeable fortune. This included his early years where he was obsessed with numbers and businesses, his Buffett partnership years, and his latest investments at the helm of Berkshire Hathaway over the past 50 years.

The reason behind my purchase of Berkshire Hathaway is because I want to be able to go to the 2014 Berkshire Hathaway meeting of shareholders in May.There is a 50/50 chance that I will be able to attend the meeting.  I actually purchased just one “B” share with the Loyal3 brokerage service, so technically the amount I invested is immaterial to my net worth. I am a big fan of Warren, and have learned a tremendous amount from his teachings on how to view stocks as ownership pieces of real tangible businesses, not just some abstract concept to speculate on. Incidentally, I have found specific evidence that he is a closet dividend investor, as he is focusing on extracting and deploying excess cashflows from companies he owns into more income generating businesses.

I believe that the Berkshire Hathaway that Warren built from the remains of the old textile mill is a collection of high quality businesses run by good managers. I believe that Berkshire will endure for decades after Warren stops running it. It is very likely that it would be able to at least match the returns of the S&P 500 over the next few decades. However, I would never put a material portion of my portfolio in Berkshire Hathaway. The main appeal behind the company for me would be the man itself, Warren Buffett. Unfortunately, I am not so sure that he would be around for the next 30 years, which is my long-term investing horizon. In addition to that, Berkshire does not pay a dividend, although it might initiate it once the Gates Foundation receives most of it.

That being said, I am writing this post in order to alleviate any potential concerns that I am all of a sudden switching strategies. I am not, and this one share of Berkshire Hathaway is as inconsequential as the silver coin collection that my grandfather gave me several years ago, or the 40 or so euro’s I have left after my trip to Europe last summer. I am also typing this up, because I am slowly trying to be more open on this site, by posting things like recent personal investments for example and my dividend  portfolio holdings.

Relevant Articles:

Warren Buffett Investing Resource Page
Warren Buffett – A Closet Dividend Investor
Warren Buffett on Dividends: Ideas from his 2013 Letter to Shareholders
My Dividend Portfolio Holdings

Wednesday, December 4, 2013

Warren Buffet’s Favorite Exercise

I like learning from super investors of the world. When I think about super investors, the first thought that comes to mind is Warren Buffett.

Buffett’s favorite exercise is going to a certain year, looking at the top 10 - 20 companies by market capitalization, and then determining whether they are still around or not. This fits in perfectly with the long-term investment strategy of the Oracle of Omaha, where he tries to select companies that are still going to be around and doing well 15 – 20 years into the future.

For example, using the Standard & Poor's, I looked at the top ten companies in the index as of 1983:

% OF
Int'l Bus. Machines (IBM)
Exxon Corp (XOM)
General Electric (GE)
General Motors (GM)
American Tel & Tel (T) (new)
Stand'd Oil,Indiana
Schlumberger, Ltd (SLB)
Sears, Roebuck
Eastman Kodak

Thirty years later, only two of these companies went bankrupt (Eastman Kodak and General Motors), while the rest did well for their shareholders. The past 30 years were a tumultuous period for all of the companies however, as it was characterized by a flurry of mergers, acquisitions, reorganizations and changing of business focus. For example, at one point in 1993, International Business Machines (IBM) was very close to falling on the wrong path. In another example, Sears had acquired and then spun-off a handful of companies before merging with Kmart in 2004 to form Sears Holdings (SHLD). An investor who put $1000 equally in each of those ten leading blue chips at the time, did very well 30 years later if they held patiently all the stock they received and reinvested their dividends.

The AT&T you see listed is the long-distance operations of the original Ma Bell, after the split of the 7 regional baby bells. The company was acquired by SBC (one of the 7 baby bells that were split from Ma Bell in 1984) in 2005. Subsequently, SBC changed its name to the AT&T (T) we know today.

Exxon managed to merge with Mobil in 1999, and formed Exxon Mobil (XOM). This was quite interesting, because both companies originated from the break-up of Standard Oil Trust in 1911. You might notice Standard Oil of Indiana in the list, which was also a descendant of the Standard Oil Trust, and was later renamed Amoco. The company was acquired by BP in 1998.

In my investing, I look at the dividend kings, not as a list of recommendation per se, but for learning perspective. It is always a good idea to try and understand how some companies managed to boost earnings, so that they could increase dividends to shareholders for over 50 years in a row. For example, companies like Procter & Gamble (PG) were able to use their scale to their advantage in the new medium of television starting in the 1950s. Then the company managed to ride the wave of prosperity after the fall of the Soviet Union in the 1990s.

Full Disclosure: Long IBM, XOM, PG,

Relevant Articles:

Why Warren Buffett purchased Exxon Mobil stock?
Warren Buffett Investing Resource Page
How Warren Buffett made his fortune
Check the Complete Article Archive

Tuesday, November 26, 2013

Why Warren Buffett purchased Exxon Mobil stock?

I have spent the last year, learning as much as possible about Warren Buffett and his right hand man Charlie Munger. There is plenty of information from both super investors to keep you occupied full-time for months if not years.

The most interesting insight is that if you pay attention to these two investment legends, you can gain a lot of insight about what is going on inside their heads. In addition, by many of their statements, Buffett and Munger can sometimes inadvertently divulge or give away what they think about certain companies, and what they are looking to buy or sell.

For example Charlie discussed US energy independence in a 2013 conference, and some of his statements were widely quoted. While I found his comments to be very weird at the time, I believe Charlie Munger was probably instrumental in the purchase of Exxon Mobil stock in 2013.

Even I succumbed to the frenzy, and dedicated a whole article on the topic. I did not agree with some of his ideas, but concluded that maybe his ideas mean that he is interested in oil as an investment. It seems now that the speech by Munger was definitely inspired by all the research he and Warren had done on the topic of investing in oil. If they spent months researching investments in the oil and gas space, it is not surprise that Munger had oil in his head to talk about. As usual, hindsight is always 20/20 however.

I also previously discussed why the so called peak oil is nonsense. This is because technology is improving, and the ability to discover and tap oil reserves is also improving. Furthermore, as the price of oil and gas increases over time, energy companies would have a higher incentive to explore for energy in areas that are more expensive. In my article I discussed how the estimated reserves of oil and gas left on earth have been increasing over the past several decades.

Another fact that could have shown Berkshire’s intentions that it is researching Exxon Mobil for possible accumulation, is Warren Buffett’s discussion on gold and how he could buy 16 Exxon Mobils and all farmland if he were to own and subsequently sell all the gold in the world. This discussion was listed in the 2011 Letters to Shareholders.

Some of Buffett’s largest buys like Wells Fargo (WFC), Burlington Northern Santa Fe, International Business Machines (IBM), Heinz and now Exxon Mobil (XOM) are truly long-term buy and hold selections. These are core positions, which would likely not be sold for many decades. These are blue chip companies, who will produce an increasing stream of dividends for decades to come to Berkshire Hathaway shareholders. These are the slow and steady type of companies, whose customers repeatedly use their products or services. If you believe the US economy and the World economy are going to be larger 20 -30 years from now, these would be the companies to buy and forget. Once you acquire a shares in a great company at attractive valuations, you can simply afford to sit back and enjoy the dividend checks coming your way for decades. I believe that investing in those companies is one way for Buffett to invest Berkshire’s money for the next generation after him. It is similar to your grandfather leaving his grandson/granddaughter a pile of stock certificates, that would pay for great granddaughters/grandsons college educations. I have analyzed Exxon Mobil before, and have also concluded that it was a sound long-term investment. This is why I have been adding it to my Roth IRA this year.

Essentially, the central idea for buying Exxon Mobil is that oil is a finite resource, which cannot be recovered once it is used up. The easiest oil has already been discovered, leaving oil and gas deposits that are more costly to produce. The world is likely to keep needing carbon energy like oil and gas for several decades, even if renewable energy sources from the sun, wind and water can eventually satisfy worldwide energy demand. This could likely occur in a few decades. Even if that were to happen however, humanity would still need substances like oil, because it is used up in everything that our modern civilization is based upon – plastics, pharmaceuticals, chemicals, etc. Unlike gold however, which is mined and could be reused, once you have used up oil, it is gone forever. You could recycle some of the plastics and other compounds from oil however, but not everything.

Prices for oil and gas will likely increase over time. However, this won’t be a linear and straightforward increase. This would make existing reserves of oil companies like Exxon Mobil more valuable, and its technical know-how of how to successfully explore for and tap reserves, provide it with a competitive advantage in the field. Mostly large companies will be able to succeed in major exploration and production developments in difficult to explore for regions. Their massive scale, access to cheap capital, and experience, will help them overcome the challenges of drilling in inhospitable terrains such as deep seas, and places in the North that have been frozen for millions of years.

Rising prices will likely result in higher profits over time, which would surely result in higher stock prices and higher dividends per share. The company has proven that it is a steward of shareholder capital, as it has managed to increase dividends for 31 years in a row. Over the past decade, Exxon Mobil has managed to also raise dividends at a rate of 9%/year, while also repurchased one third of outstanding shares. As I have mentioned before, Charlie Munger likes carnivores, which are companies that consistently repurchase their shares. IBM and Exxon Mobil are companies with some of the most consistent share repurchases, which didn't stop even during the financial crisis.

If you compare Exxon to the other major energy companies in the world, it is not the cheapest one on the list.

Currently, Exxon Mobil is trading at 12.40 times earnings and yields 2.60%. It is not the best value, based on this table. However, it is the company with the longest streak of consecutive dividend increases. You can probably look equally as well with any of the companies listed above. I am going to speculate why he didn't buy each company, based on information I have gathered from Buffett over the past decade. The likes of Total have withholding taxes, and some uncertainty over increasing taxes for French companies. BP was probably excluded, because of the negative environmental effects of the 2010 oil spill. Buffett probably doesn't want to be associated with this. I am not sure why Royal Dutch was excluded, although it could be due to a scandal a few years ago that had to do with the company overstating reserves. We all know that Buffett wants to deal with able and honest management, and therefore a history of mismanagement of such proportions could be a red flag. This could be a red flag, even if the company has gotten rid of all the people responsible for inflating the company's oil and gas reserves. I would say that Lukoil looks the cheapest, and probably has more room to grow. However, Russia has an image of a very corrupt country, with memories of the government expropriation and bankrupting of Yukos in the mid 2000's still fresh in many investor's memories. For example, during the 2004 Berkshire meeting, Buffett discussed that he had to decide between buying shares of Yukos or Petrochina (PTR). Ultimately, he purchased shares of Petrochina, because he thought that the risk there was lower. I didn't list Petrochina in the table, but with a P/E of 10.37 and yield of 3.90%, although I would not be surprised if Buffett revisits this trade as well.

Interestingly enough, I sold Exxon in late 2012 and replaced it with ConocoPhillips (COP). I guess COP does not have the scale of Exxon, and does not have any Refining & Marketing operations, which were spun-off in 2012. However, it seems to have a very shareholder friendly management, despite the fact that it doesn't have a lengthy history of dividend increases like Exxon.

As for Chevron, it is one of my largest portfolio positions ( top 3), and I am not sure why Buffett would pick Exxon over it. However, I realize that I am biased on that issue. It could be due to the trial in Ecuador, where Chevron has been ordered to pay billions of dollars in fines for damages. However, I have some doubts about the integrity of the trial against Chevron. Check my analysis of Chevron.

I think Buffett likes the valuation, the economics of the business, and the massive scale of the company. In addition, he likes the high amount of cash flows generated, which allow it to return so much in the form of dividends and share buybacks to shareholders. Furthermore, the company is one of the largest in the world, and therefore, further buying by the Oracle of Omaha is not going to materially impact the stock price. The company is also US based, and therefore all earnings and dividends are not going to be subject to foreign withholding taxes, or add increased uncertainty over foreign governments. Last but not least, the company has proven that it can boost dividends to shareholders, consistently buy back stock, and also effectively deploy cash to replace reserves used. With a shareholder friendly management culture like that, it is no wonder the Oracle of Omaha chose the stock.

Full Disclosure: Long XOM, IBM, WFC, CVX, BP, RDS.B, COP

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Saturday, November 16, 2013

Warren Buffett Investing Resource Page

I am a big fan of Warren Buffett, who is the best investor who ever lived. I have studied everything about the Oracle of Omaha that I could get my hands on over the past few years. I also wanted to share the resources I have used to gain knowledge about the investing habits of Warren Buffett. I have organized them into articles I have written about him, books about him, resources such as letters to shareholders, speeches by this super investor, as well as articles from him.

Dividend Growth Investor Articles on Warren Buffett

Books About Warren Buffett

The Snowball: Warren Buffett and the Business of Life

Of Permanent Value: The Story of Warren Buffett/A Trilogy/2010 Edition/Three-volume set

Buffett: The Making of an American Capitalist

Berkshire Hathaway Letters to Shareholders

Tap Dancing to Work: Warren Buffett on Practically Everything, 1966-2012: A Fortune Magazine Book

Berkshire Hathaway Resources

Berkshire Hathaway Letters to Shareholders since 1977

Buffett Partnership Letters

2013 Berkshire Hathaway Meeting Notes (CSInvesting)

2012 Berkshire Hathaway Meeting Notes (Cove Street Capital)

2011 Berkshire Hathaway Meeting Notes (Innoculated Investor)

2010 Berkshire Hathaway Meeting Notes (Innoculated Investor)

2009 Berkshire Hathaway Meeting Notes (J.V. Bruni & Co)

2008 Berkshire Hathaway Meeting Notes (Max Capital)

2007 Berkshire Hathaway Meeting Notes (Tilson Funds)

2006 Berkshire Hathaway Meeting Notes (Value Investor Insight)

2005 Berkshire Hathaway Meeting Notes (Tilson Funds)

2004 Berkshire Hathaway Meeting Notes (Graham & Doddsville)

2003 Berkshire Hathaway Meeting Notes (Tilson Funds)

2002 Berkshire Hathaway Meeting Notes (Tilson Funds)

2001 Berkshire Hathaway Meeting Notes (Tilson Funds)

2000 Berkshire Hathaway Meeting Notes (The Street)

1999 Berkshire Hathaway Meeting Notes (Motley Fool)

1998 Berkshire Hathaway Meeting Notes (Geocities)

1996 Berkshire Hathaway Meeting Notes ( Burgundy Asset Management)

1994 Berkshire Hathaway Meeting Notes ( Burgundy Asset Management)

Speeches by Warren Buffett

Buffett's Lecture at Notre Dame in 1991 (source)

Buffett's Lecture at the University of Nebraska in 1994

Buffett's Talk with University of Florida Students in 1998

Buffett's Speech at Columbia University in 2002

Lecture with Wharton Students in 2003 and in 2004

Buffett's Lecture with Vanderbilt Students in 2005

The source of those lectures was Tilson Funds.

Monday, October 7, 2013

Price is what you pay, value is what you get

In my dividend investing, I typically try to focus on the big picture. This means that in most cases I tend to ignore short-term fluctuation in stock prices. This is because short-term prices are usually driven by fear and greed, and might be totally out of line with the underlying fundamentals of a business for extended periods of time.

For example, during the global financial crisis, shares of Coca-Cola (KO) fell from a high of $32 in early 2008 to a low of $19 by early 2009. Nothing had changed fundamentally in the business however, as it earned $1.29/share in 2007 and $1.25 in 2008. Not surprisingly, people still wanted to have a few of their favorite drinks, even during a recession. Therefore, the underlying earnings power was still intact for this global franchise, and the company managed to keep increasing earnings to $1.47/share in 2009 all the way up to $1.97/share in 2012.  Investors who focused on the underlying fundamentals of the business, should not have been worried about the stock price declines in 2008 - 2009. The lower prices should actually be viewed as good entry opportunities.

This is why I focus my attention to understanding the fundamentals of the business I am monitoring. In general, I focus on businesses that sell a product or service that has a loyal customer base. As a result, I try to gain confidence in purchasing a business, whose products/services have lower chances of being obsolete in 10 – 20 years. This is very difficult to achieve, because there could be factors that are unknown today and would not be in my thought model, but which could derail my plan completely. For example, few investors would have expected that asbestos is so bad for people in the 1950s. However, it was bad for people, which led to poor performance by asbestos companies and a several bankruptcies in the US for companies in the industry.

However, if you find a collection of stable businesses you understand, which have durable competitive advantages, and you believe they will still be around in 20 years, you can add the shares if they are attractively valued. Monitoring such enterprises would involve reading annual reports, checking the financial figures there, and even quarterly filings to keep track of major developments throughout the year. Tracking every press release or analyst comment on a company you own however might result in information overload, which would actually be detrimental to your investment results. The thing that will make you the most money is rising earnings per share, which is why you need to focus on areas that could aid the company in achieving that.

In other words, I focus on the real earnings power and underlying assets per share of the company I am purchasing. Over time, this piece of information can provide much more value and wealth to me, than watching the stock price oscillate between a high and a low on a given year.

For example, I firmly believe that people would keep brushing their teeth with the brand of toothpaste they have been using in the past. If you monitor the toothpaste aisle on Wal-Mart (WMT), you can see plenty of consumers pulling their carts to the aisle, looking for their desired brand of toothpaste, and then proceeding on to the next item on the list. Since people are creatures of habit, chances are they would stick with a similar brand of toothpaste for years if not decades. People care about their teeth, and brush them even when there is a recession. Companies like Colgate-Palmolive (CL) sell millions of tubes of toothpaste to consumers throughout the highs and lows of the economic cycle. These millions of repeat purchases result in stable revenues and earnings streams for Colgate. The only problem is that the stock has been slightly overvalued in 2013.

The fact that I ignore short term price fluctuations does not mean that I ignore prices all the time. I only focus on them in relation to what I believe the value of a business should be. I usually achieve that by looking at price in relation to normalized earnings, after evaluating the earnings per share trends over the preceding decade. I then look at trends in returns on equity, revenues, dividends, payout ratios in this order. I use all of this information to estimate whether I have a good chance of receiving higher earnings and dividends over the next 20 years. I add all of this information to make a reasonable estimate of whether the value I am receiving is higher than the price of the company.

To paraphrase what famous investor Warren Buffett says “Price is what you pay, value is what you get”. My investment strategy is inspired by the Oracle of Omaha. Hopefully, this post serves to show that in order to be successful, you need to be able to pay a reasonable price for a sound business with attractive future prospects.

Full Disclosure: Long CL, KO, WMT

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