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

Wednesday, June 24, 2015

The one lesson about Warren Buffett's success that no one wants to hear

Warren Buffett is the most successful investor of all time. Warren Buffett was able to keep learning about investments and business from the age of 11, which allowed him to compound money for decades.

The real secret behind Buffett's success is that the guy worked incredibly hard to achieve his record all his life. Buffett loves learning, thinking and breathing about investments. That is why he has been able to spend 60-70 hours a week for 70 years in a row, doing what he loves best, and building his fortune to over $70 billion. Buffett always liked his freedom to pursue his own passions at his own pace. He was actually financially independent at the ripe age of 25

You cannot put that into a formula. There is a lot of money to be made selling "secret formulas" to investors. Some even write papers, and reach erroneous conclusions that he only made money because of his investment float or because he collected high fees during the days of the Buffett Partnership. In reality, Buffett made money because he is a great investor - the insurance float only magnified his returns. And during the days of the Buffett Partnership, he was paid for performance, and he still trounced all benchmarks.

It is true that his net worth has been greatly enhanced by his hedge-fund like Buffett Partnership, as well as from the float from his insurance operations at Berkshire Hathaway. However, these tools simply added extra layers of returns on his already outstanding investment record. If float was all there is to generating outstanding returns, AIG would have never had to ask for $200 billion from the US treasury in 2008. You need smart capital allocation, and superior risk management when you are dealing with leverage.

Actually, if one had followed the SEC disclosures of Berkshire Hathaway stock investments between 1976 and 2006, they would have made 25% per year. Not too bad.

Buffett reads all the time about business and investments. He has flipped through thousands of pages if Moody's and Standard and Poor's stock manuals. He even did that on his honeymoon. He also is familiar with approximately 1500 - 2000 companies, and skims through their annual reports every year.

This was all possible because Buffett was a learning machine. In a speech in front if students, he mentioned that he reads 500 pages per day. He reads annual reports, industry publications and business press. The one thing to take away from this article is to keep learning about business and investments. When a student asked him how to learn about all investments, Buffett replied, start with the A's.

I know that it is difficult to achieve this with a full time job and a family. It is doable if one applies themselves, and focuses their time on the best value added activities to improve their lives. If you want to be successful in investing, it might pay huge dividends for you to try and find a little bit of extra time to learn about the topic. You can always leverage other resources such as this website and others on the topic like dividend growth stocks or dividend mantra, which could provide with short cuts on information gathering for you. If you keep learning beyond those resources, you might do even better over time in uncovering quality companies selling at attractive valuations. Remember, knowledge accumulates over time just like compound interest.

If I were just starting out as a dividend investor, I would start my research by reviewing the list of dividend champions. There are approximately 100 dividend champions these days. If I were starting out, I would develop my own screening criteria, and develop working knowledge about these companies that meet it. I would try to understand the businesses behind each stock, and determine whether this success in raising dividends can continue in the future. After that, it would be helpful to expand your level of knowledge about the remaining champions. After you learn about enough dividend champions, learn about dividend achievers and possibly even the dividend contenders.

It would be helpful to develop a system to keep learning. I look at dividend increases for undercover dividend gems, analyze individual companies, and other than that think about strategy and how to get the most dividends for my dollars, as safely as possible. Yield and growth plus valuation is always a tradeoff for me.

I have found that it is important to be disciplined, and have some mechanical way for screening out companies. However, it is equally important to learn how to weed out companies that are unsuitable, for one reason or another. This second qualitative method is more subjective, but becomes a little easier once the investor achieves more experience in investing and researching businesses. Unfortunately, there isn't a magic formula or a simple shortcut to easy investment success that applies to everyone.

In summary, I believe that to be successful in investing, one needs to identify their ultimate goals, and select a strategy to reach those goals within a certain timeline. In order to find the strategy that is the right fit for you, you need to do some learning. This will help you stick to your guns when things get tough, and not abandon ship. By continuously learning about investments, companies and business, you will be better prepared when the right opportunity presents itself. By continuously improving on your process, you stand a better chance of attaining your goals.

In Warren Buffett's case, he started out owning farmland, pinball machine businesses and a paper route. He used his earnings to invest in the stock market. In the 1950s and 1960s he focused on pure Graham value investments. Later on, he adapted to changing conditions, and changes in assets under management, and focused on businesses with solid competitive advantages. His success is due to continuous learning, adaptability, and the inner desire to be independently wealthy from a very early age. As we learned from this article, his success is unique to his personality, and not because of a magic formula. If you follow strict formulas for success, you might end up being disappointed down the road. All of us can learn from the Oracle himself however, and apply the thirst for knowledge and financial independence into our own lives.

Full Disclosure: Long BRK/B

Relevant Articles:

The Most Successful Dividend Investors of all time
What would happen to Berkshire Hathaway after Warren Buffett is gone?
Warren Buffett Investing Resource Page
How to become a successful dividend investor
How Warren Buffett built his fortune


Tuesday, February 17, 2015

What would happen to Berkshire Hathaway after Warren Buffett is gone?

Warren Buffett is the super investor who is the hero of ordinary people and investors alike. While he has always been a ruthless businessman, he has also made plenty of people rich, has kept a very clean image of a successful yet folksy billionaire, and is liked and praised by many of his generous donations. Anyone who put $20/share in Berkshire Hathaway stock in the 1960s is now sitting on shares worth north of $200,000/each. We all know the story of Buffett however, and many are familiar with the way he turned around the ailing textile mill Berkshire Hathaway into a diversified conglomerate with interests in insurance, railroads, candy, utilities to name a few sectors. His company also holds a pretty impressive stock portfolio worth tens of billions of dollars. Now that Warren Buffett is about to turn 85 in August, many investors are asking themselves what would happen to Berkshire Hathaway after he is no longer in charge?

The answer of course lies in the way that Berkshire Hathaway was formed in the first place. Berkshire Hathaway was not formed in one single day. Rather, it was built brick by brick, over the course of 50 years. The basic idea has been to invest the excess cash from existing businesses and the float from insurance operations into more businesses, which generated even more cash to be invested. Buffett does not manage each one of those businesses. Instead, he has delegated those day to day management duties to the point of abdication. That doesn’t mean he doesn’t monitor the performance of those businesses. However, he has let the executives from each company under Berkshire’s umbrella to manage the operations in their own way. The only stipulation has been to send excess cash flows back to Omaha for Buffett to allocate. This similarity to what dividend investors do on a regular basis has led me to believe that Warren Buffett is essentially a dividend investor.

This is of course where the genius of Warren Buffett comes – he is trying to allocate that excess capital by purchasing more businesses or shares, and earn a high rate of return. Over the past 60 – 70 years, Buffett has proved his business and investing acumen in allocation of capital in a variety of assets and asset classes such as businesses, stocks in those businesses, and a range of derivatives, currencies, real estate to name a few. The reason for his success is his innate desire to keep learning, and keep a level head on what is actually happening in the world. Unfortunately, this is the one aspect that will be forever gone once Buffett steps down.

If he is no longer in charge of Berkshire, the underlying group of businesses will keep churning out record profits over time, since they are managed by experienced managers. The one drawback will be that capital will no longer be allocated by Buffett himself. As a result, it is very much possible that the future success of Berkshire will not be as good as the past. However, I believe that Buffett has certainly thought about putting systems and procedures in place, in order to address the capital allocation problem. He seems to be grooming Todd Combs and Ted Weschler to take on the role of managing billions of dollars of excess capital. Those two fellows have done very well managing money in the past. Chances are that over long periods of time, they will do well, even with short-term bumps on the road. Buffett’s other responsibilities will likely be split to one or two other persons.

I think that in the future, Berkshire will have to make more sizeable acquisitions, in order to deploy those growing cash piles to work for shareholders. The risk of course is that whoever is in charge, could do something stupid like engage in empire building. Of course, we all know that you cannot simply buy an ever bigger and bigger business every year, since those things take time to accomplish, you need agreement from others, and regulators would have to provide more input in order to prevent a monopoly forming in a certain industry. Plus, a company with $300+ billion in market capitalization has a big disadvantage in terms of size. There are only a few publicly traded companies in the world which are larger than Berkshire. Therefore, at some point in the next decade, it would be very difficult to grow even by acquisitions, since returns would be pulled down by forces of gravity. The important thing of course is that acquisitions never work out as expected, and thus one has to be very careful what they get themselves into. There are only so many good quality businesses in the world, and throwing hundreds of billions at the problem might create some nasty behavior that shareholders could pay for.

Excess cashflows could also be plowed into international acquisitions. Berkshire only has a few international businesses, which is obviously an opportunity for them. If they get more popular internationally, then it is highly likely that business owners who are thinking of disposing of their businesses, could consider selling to Berkshire only.

I think that excess cash could easily be taken out of Berkshire Hathaway by declaring a dividend to shareholders. If you no longer have a super investor handling the capital allocations, it might be wise to send the cash directly to shareholders. Given the depth of operations, I would consider that Berkshire Hathaway will be able to pay and grow its dividend for years into the future. I would not be surprised if Berkshire Hathaway eventually becomes a dividend achiever and even… a dividend champion one day. If General Electric (GE) could do it, or 3M (MMM) could do it, then so can Berkshire.

Even after paying a dividend, there will likely be more cashflow that is left to build up in corporate coffers. I think that Berkshire can use that cash to fund stock buybacks during the next stock market panic. Those usually happen once every 5 years or so, and are tough to predict.

Either way, the major competitive advantage of Berkshire Hathaway will be its massive size of operations. It could be the lender or investor of last resort to other businesses, particularly in times of trouble in the economy. This is due to the diverse streams of income coming from all businesses under the Berkshire Hathaway umbrella. Plus, keeping at least $20 billion in cash at all times will ensure the stability of the organization during the next recession or crisis.

The other option behind Berkshire is that the operation becomes so gargantuan in the one or two decades after Buffett is no longer in charge, that the company is split into pieces. While Buffett and Munger have always said that Berkshire will stay intact, I am not so certain about it. I believe the seeds of a potential break-up of Berkshire Hathaway are planted in the separation of different businesses under different industries under the Berkshire Hathaway corporate umbrella. At some point, it might be more efficient to spin-off the Utility, Railroad, Manufacturing, Retail, Finance & Insurance into separate entities. A company that gets to be too large can become a bureaucracy, become slow to move, and might not allocate capital at best rates for shareholders. While size can be very helpful to weather cyclical storms in the economy, it could also mean that prioritizing investment might be very difficult when you have so many businesses and so many industries. Therefore, it might be better off to split into multiple separate companies, in order to focus effort in a more efficient way.

Of course, we will hear what Buffett and Munger have to say about the next 50 years of Berkshire Hathaway in the next letter to shareholders. I find this topic of interest, mostly because I think about succession planning for my own affairs. My goal is to organize my portfolio in a way that even a few decades after I go to hell, it will still generate a growing stream of dividend income to heirs or charities. In order to ensure that, I need to focus on businesses that are built to last, and therefore I could see doing what they are doing now with minimal changes to their operations and profitability. It is therefore of utmost importance to select only those businesses which are of very good quality, and which I believe will be able to compound earnings, dividends and wealth in the foreseeable future. The most important thing is to buy and hold those quality dividend stocks for the long run, and strive for a holding period of "forever".

Full Disclosure: I own 1 share of BRK.B

Relevant Articles:

Buy and hold dividend investing is not dead
Warren Buffett Investing Resource Page
Myths about Warren Buffett
How Warren Buffett built his fortune
Warren Buffett’s Dividend Stock Strategy

Monday, February 16, 2015

How Ordinary Investors Can Generate Float Like Buffett

Warren Buffett is one of the best investors in the world. The most interesting fact about him is that he started making a lot of money after retiring twice – first time in 1956 and the second time in 1970. The first retirement idea he had was to run a hedge-fund like partnership, which he closed in 1970. The second retirement idea he had started in the 1960s, when he bought a struggling textile factory called Berkshire Hathaway at a heavy discount to book. While he calls this acquisition one of his biggest investment mistakes of his career, he has nevertheless managed to transform Berkshire Hathaway from a struggling company to a thriving conglomerate with a $300 billion market capitalization. This was mostly due to the fact that he is a learning machine that has accumulated business knowledge at a rate of 70 hours per week for 70 years. Accumulated knowledge is like compound interest, which pays tremendous dividends over time. For example, he purchased a massive block of Coca-Cola stock between 1988 and 1994, after using the product for over 50 years. Another example includes his ivnestment in IBM in 2011, after reading the annual report for the preceding 50 years, and investing in a company that competed with Big Blue in the 1950s.

While his investing prowess is unmatched, he has had a few levers within his control that helped him in his ascend to one of the world’s wealthiest people. The major lever that helped him earn his first $20 million were the performance fees he earned on Buffett Partnership partners. In fact, if returns exceeded 6% for a given year, he earned 25% of the profits above that threshold. As the level of assets increased, and as he was able to compound partners’ money at market-beating returns, his share turned him into a millionaire by his early 30s. By the time BPL was closed in early 1970, Buffett was worth over $20 million.

This is where the next chapter of Buffett’s investing prowess started. He was able to transform Berkshire into a powerhouse, by investing heavily into insurance companies like National Indemnity, GEICO, General RE to name a few. Insurance companies generate so called float, which is the amount of premiums received by policyholders. Overall, the amount of insurance premiums received tends to increase over time, which provides cash in the coffers of insurance companies. This cash is ordinarily invested in fixed income instruments like corporate bonds by most insurance companies. In general, his companies have managed to turn a profit in the difference between paying out claims and receiving premiums from policyholders. In the hands of Warren Buffett, that float was golden, as it represented free money he is given to invest, and was being paid to hold it. He was able to use the float generated by insurance companies as a defacto free leverage that allowed him to purchase even more businesses and more stocks, that further magnified his returns. In essence, he is a superinvestor, and his results have benefitted immensely from this free form of leverage.

However, I believe that even an ordinary investor with an ordinary investment records can benefit from the type of leverage, that float provides. The big issue is that as an ordinary investor who does not have tens of millions of dollars to buy an insurance company outright, it is almost impossible to use the same lever as Buffett. However, as I have been thinking about it, I could think of a few scenarios within the reach of ordinary dividend investors, where they have access to float.

1) When you purchase quality dividend paying stocks, the investor receives dividends today. However, as the company earns more, and pays more in dividend income over time, the shares become more valuable over time. If the investor decides to sell, they would have to pay hefty capital gains taxes on their money. In essence, the amount of the unrealized capital gain times the taxable rate of the shareholder is a defacto interest free loan from the US government, that subsidizes the long-term buy and hold investor. As long as the investor never sells, they never have to repay that float.

2) When you put investments in a tax-deferred account such as an IRA or 401 (k), you are receiving a tax deduction today, but promise to pay taxes on distributions at some future point in time. As a result you can end up purchasing dividend paying stocks at an immediate 25% discount. As you earn more dividends on investments, and as they appreciate in value over the course of several decades, the potential liability to the IRS increases. However, until you have to make distributions at the tender age of 70 and ½ years of age, you don’t have to pay taxes. Those tax liabilities are there, and in the eyes of Uncle Sam are not yours, but they nevertheless provide an interest free loan, and a sort of float for you to use in the meantime to propel your family to riches.

3) When you sell puts on a company stock, you are contractually obligating yourself to purchase the stock at a predetermined price and date, if it trades below the strike price. You are paid an option premium for this trade, whose value depends on factors such as interest rates, volatility of the stock, dividend yields and how far the option strike price is from the current stock price. If the stock is above the strike price at options expiration, you can keep the premium. If the stock price is below the strike price at expiration, you have to purchase the stock, even if it is much lower than the market price at the time. The premium you earn can be used to buy more stock. Either way, it is a win-win for the option seller, since they either end up with option premium cash in their account or with shares in a good quality company at a lower price than the competition.

4) The other type of float that ordinary investors can generate includes taking on margin loans and buying stocks on margin. You are therefore using borrowed money from your broker when you buy stock on margin. If you use brokers like Interactive Brokers, you are paying something like 1.60%, which is low. If you purchase a stock like Coca-Cola (KO) or General Mills (GIS), which pay around 3% today, and are expected to grow dividends over time, you could end up having dividends pay off the interest and principal. As long as the dividend is higher than the amount of interest paid on the margin loan, it is possible that eventually the dividend will pay for the stock. The downside to this strategy is if stock prices tank, and you need to put more money into the account. This is the dreaded margin call. If you do not have any more money to put, you can effectively lose everything. This is why purchasing shares on margin is so risky. Even if a stock price declines temporarily, and you know underlying fundamentals are great, the market participants might disagree with you and keep prices low for longer than you can remain liquid.

Full Disclosure: Long GIS, KO, BRK.B

Relevant Articles:

Warren Buffett Investing Resource Page
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Warren Buffett is now working for me
The Most Successful Dividend Investors of all time
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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
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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
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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:

YEAR
COMPANY
%
MARKET
% OF
8312
Int'l Bus. Machines (IBM)
1
$74,346
6.09%
8312
Exxon Corp (XOM)
2
$32,114
2.63%
8312
General Electric (GE)
3
$26,626
2.18%
8312
General Motors (GM)
4
$23,414
1.92%
8312
American Tel & Tel (T) (new)
5
$17,234
1.41%
8312
Stand'd Oil,Indiana
6
$14,848
1.22%
8312
Schlumberger, Ltd (SLB)
7
$14,503
1.19%
8312
Sears, Roebuck
8
$13,150
1.08%
8312
Eastman Kodak
9
$12,603
1.03%
8312
duPont(EI)deNemours
10
$12,405
1.02%

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

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