Wednesday, April 7, 2021

Warren Buffett and Charlie Munger on Leverage

Warren Buffett and Charlie Munger need no introduction. If you do, please check the Wikipedia entries for each fellow.

I am a big fan of both gentleman, and have been going through old annual reports, speeches and meeting transcripts and interviews to learn more from them about business, investing and life.

They are amazing at summarizing complex financial topics into a few paragraphs that could be understood by anyone.

As both of them has been investing for decades, they have a ton of experience and insights that we can all learn from.

One topic I recently discussed involved short selling. Another one is leverage, or the use of borrowed money to buy securities.

Warren has spoken about the dangers of using leverage. 

He has said the following about Long Term Capital Management, the hedge fund ran by Nobel Prize Laureates and PhD’s, which blew up in 1998. It turned out it was heavily leveraged.

"But to make money they didn’t have and didn’t need, they risked what they did have and did need. That is foolish. That is just plain foolish. It doesn’t make any difference what your IQ is. If you risk something that is important to you for something that is unimportant to you it just does not make any sense."

“If you’re smart you don’t need leverage; if you’re dumb, it will ruin you.”

It is crazy in my view to borrow money on securities. It’s insane to risk what you have and need for something you don’t really need… You will not be way happier if you double your net worth.

Leverage can magnify returns if you are right, but it can also lead to ruin if you are wrong. If you invest smartly you don’t need the leverage to begin with. And if you do use it, watch out below. 

Charlie Munger is also not a fan of leverage:

We’re just not interested in taking a substantial chance of taking a lot of very decent people back to “Go” so we can have one more zero on our net worth.

Buffett has quoted Charlie on leverage as well “My partner Charlie says there is only three ways a smart person can go broke: liquor, ladies and leverage,” he said. “Now the truth is — the first two he just added because they started with L — it’s leverage.”

This interview with Buffett, summarizes his thought process on using leverage when investing in equities.


Buffett has also discussed leverage in more detail during a 1998 speech at Florida University. I have posted the transcript portion that discussed Long-Term Capital Management, the hedge fund that used excessive leverage, and lost almost all money during the summer of 1998, when Russia defaulted on its debt. While history doesn't repeat, the recent news of investor Bill Hwang who used excessive leverage and blew up recently is a stark reminder that smart people should not be using leverage: (Source for Transcript)

The whole Long Term Capital Management – I hope most of you are familiar with it – the whole story is really fascinating because if you take John Meriwether, Eric Rosenfeld, Larry Hillenbrand, Greg Hawkins, Victor Haghani, the two Nobel prize winners Merton Scholes… If you take the 16 of them, they probably have as high an average IQ as any 16 people working together in one business in the country, including Microsoft or where ever you want to name. So an incredible amount of intellect in that room. Now you combine that with the fact that those 16 had had extensive experience in the field they were operating in. These were not a bunch of guys who had made their money, you know, selling men’s clothing and all of a sudden went into the securities business. They had in aggregate, the 16, probably had 350 or 400 years of experience doing exactly what they were doing. And then you throw in the third factor that most of them had virtually all their very substantial net worths in the business. So they had their own money up. Hundreds and hundreds of millions of dollars of their own money up, super high intellect, working in a field they knew, and essentially they went broke. That to me is absolutely fascinating.

If I ever write a book it will be called “Why Smart People Do Dumb Things”. My partner says it should be autobiographical. But this might be an interesting illustration. These are perfectly decent guys. I respect them and they helped me out when I had problems at Salomon. They are not bad people at all.

But to make money they didn’t have and didn’t need, they risked what they did have and did need. That is foolish. That is just plain foolish. It doesn’t make any difference what your IQ is. If you risk something that is important to you for something that is unimportant to you it just does not make any sense. I don’t care whether the odds are 100 to 1 that you succeed or 1000 to 1 that you succeed. If you hand me a gun with a million chambers in it, and there’s one bullet in a chamber and you said, “Put it up to your temple. How much do want to be paid to pull it once,” I’m not going to pull it. You can name any sum you want, but it doesn’t do anything for me on the upside and I think the downside is fairly clear. So I’m not interested in that kind of a game. Yet people do it financially without thinking about it very much.

There was a lousy book written once with a great title by Walter Gutman. The title was “You Only Have to Get Rich Once”. Now that seems pretty fundamental doesn’t it? If you got $100 million at the start of the year and you’re going to make 10% if you are unleveraged and 20% if you are leveraged 99 times out of a 100, what difference does it make at the end of the year whether you got $110 million or $120 million? It makes no difference at all. I mean, if you die at the end of the year, the guy who writes the story might make a typo and he may say 110 even if you have 120. You have gained nothing at all. It makes absolutely no difference. It makes no difference to your family. It makes no difference to anything.

Yet, the downside, particularly managing other people’s money, is not only losing all your money, but it’s disgrace, humiliation, and facing friends whose money you have lost. I just can’t imagine an equation that makes sense for. Yet 16 guys with very high IQs, who were very decent people, entered into that game. You know, I think it’s madness. It’s produced by an over reliance to some extent on things. Those guys would tell me back when I was at Salomon, “A six sigma event wouldn’t touch us. Or a seven sigma event.” They were wrong. History does not tell you the probability of future financial things happening. They had a great reliance on mathematics. They felt that the beta of the stock told you something about the risk of the stock. It doesn’t tell you a damn thing about the risk of the stock in my view. Sigma’s do not tell you about the risk of going broke in my view and maybe in their view now too.

But I don’t even like to use them as an example because the same thing in a different way could happen to any of us probably, where we really have a blind spot about something that is crucial, because we know a whole lot about something else. It is like Henry Kauffman said the other day, “The people who are going broke in this situation are of two types, the ones who knew nothing and the ones who knew everything.” It’s sad in a way.


You do not want to risk everything, merely to have a higher net worth, when that additional net worth won’t improve your standard of living markedly. And if you lose it, your standard of living would be markedly downgraded.

I believe investors should not be in a hurry to get rich quickly, but to enjoy the journey. After all, it usually can take 10 - 15 - 20 years of meticulous saving and smart investing to reach financial independence. There are no shortcuts in investing. While taking on leverage may seem like a way to speed up the journey in some cases, it also exposes the investor to other risks and may cause them to worry about stock price fluctuations, instead of taking advantage of them.

I have used leverage in the past, and generally made money doing it. I used somewhere between 10% - 20% margin, using low cost broker Interactive Brokers

In other words, if I had a portfolio worth $100,000, I would buy $25,000 worth of stock on margin. If my average yield was 3%, and the cost to borrow was 2%, I would essentially increase my dividend income from $3,000 to $3,750, before deducting $500 for interest. My dividend income alone would pay off the margin within a few years, without even considering the impact of dividend increases.

If stocks fell by 50%, that means that the portfolio is worth $62,500, but has $25,000 margin loan against it. That's now a 40% margin. The friendly broker may tighten margin requirements, and start selling your stock to protect themselves. With margin, you are exposing your portfolio to additional risks, namely the risk that a falling stock price may cause you to sell, which is the opposite of what an intelligent investor does. Callable leverage is dangerous, as it increases the requirements on your end, the moment your positions are going against you.

The problem is that brokers do not want to let you have too much borrowed money. If falling stock prices caused the value of my portfolio to fall below a certain amount, I could face a margin call, and the broker would sell my stock. If the stock recovered, I would have ended up trading my my long-term advantage of being a patient long-term investor who can weather any turbulence in the markets and the economy, merely to increase my income by a few basis points. Margin can turn my advantage into a disadvantage.

When I buy a stock, the most I can lose is 100%. If I buy a stock on margin however, my theoretical losses can be higher than 100%, I am margined to the tilt, and if that stock gaps down and the broker is unable to sell it quickly enough. You can also lose money on margin if a stock falls down enough to trigger a margin call, and then bounce back. As we know, stocks do not go up or down in a straight line. The prices oscillate wildly above and beyond what a reasonable business analyst would estimate for their fair value. Dividends on the other hand are much more stable, because they are derived directly from fundamentals. Unlike prices, which are someone's perceptions on what the fundamentals are going to be, dividends are actual fundamental evidence.

When I used margin, I realized that when stock prices went down, I started wondering whether new cash contributions should be used to cover margin or buy more stock. So I gradually used dividends to pay off my margin loan, and stopped doing margin. I also realized that a 10% or 25% margin is not really going to increase my future returns that much, so the risk was not worth it for me. If you decide that you want to try margin, I would try to read up as much as possible on the topic first, and consider the any other risks out there that I have missed. The interesting fact is that using margin made me much more emotional about the ups and downs of the stock market. In other words, I was listening to the manic-depressive Mr Market, instead of ignoring him, unless he offered me an opportunity I cannot resist. Most folks feel safe to use margin when stocks are high, and may be at risk of a correction. If they panic when stocks have that correction, since their losses are amplified by the amount of borrowed money, they may end up buying high and selling low.

At the end of the day, I believe that the quest for financial independence or retirement is a journey that needs to be enjoyed, not a destination. There are no shortcuts to reach your goals and objectives. It takes time, patience, perseverance and focusing on things within your control to reach those goals. Do not be in a hurry to get rich quick. Taking unnecessary risks may actually increase the risk of never reaching the end goal or reaching it at a slower pace, if you get lost along the way. 

In addition, I believe that you only need to get rich once. The habits you formed on your quest to reach your financial goals should hopefully carry you for the next phase of your journey. Which is why I believe that margin is to be avoided.

Relevant Articles:


Monday, April 5, 2021

Three Banks Raising Dividends to Shareholders

As part of my review process, I monitor the list of dividend increases every week. I usually focus on the companies with at least a ten year history of annual dividend increases, in order to focus on more established dividend payers.

During the past week, there were three banks that raised dividends. While large banks cannot raise dividends until June 30, 2021, smaller banks have been delivering raises to their shareholders. Many of these banks also weathered the 2007 – 2009 financial crisis as well. 

The companies raising dividends last week include:

Bank OZK (OZK) provides various retail and commercial banking services.

Bank OZK raised its quarterly dividend by 0.90% to 28 cents/share.  This is a 3.70% raise over the dividend paid during the same time last year.  Over the past decade, Bank OZK has managed to boost dividends at an annualized rate of 21.80%.

Bank OZK is a dividend champion with a 26 year track record of annual dividend increases.

Between 2011 and 2020, Bank OZK managed to grow earnings from $1.47/share to $2.26/share. The bank is expected to earn $3.24/share in 2021.

The stock is selling for 12.54 times forward earnings and yields 2.76%.

Glacier Bancorp, Inc. (GBCI) operates as the bank holding company for Glacier Bank that provides commercial banking services to individuals, small to medium-sized businesses, community organizations, and public entities in the United States.

Glacier Bancorp raised is quarterly dividends by 3.30% to 31 cents/share. The new dividend is up by 6.90% over the payment during the same time last year. This marked the 10th consecutive annual dividend increase for this dividend contender. Over the past decade, the company has managed to increase dividends at an annualized rate of 8.50%.

Between 2011 and 2020, Glacier Bancorp managed to grow earnings from $0.24/share to $2.81/share. The bank is expected to earn $2.63/share in 2021.

The stock is selling for 22.24 times forward earnings and yields 2.12%.

Hingham Institution for Savings (HIFS) provides various financial products and services to individuals and businesses in the United States. 

Hingham Institution for Savings raised its quarterly dividend by 4.30% to 49 cents/share.  This is also a 16.67% increase over the dividend paid during the same time last year.

The bank has consistently increased regular quarterly cash dividends over the last twenty-six years. The Bank has also declared special cash dividends in each of the last twenty-six years, typically in the fourth quarter. Their dividend track record is based on declaration date.

Between 2011 and 2020, HIFS managed to grow earnings from $5.67/share to $23.25/share.  The bank earned $23.25/share in 2020. No forward earnings estimates exist for this bank, as it is not covered by Wall Street Analysts.

The stock is selling for 12 times earnings and yields 0.69%.

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Thursday, April 1, 2021

Happy Coca-Cola Dividend Day Warren Buffett

Warren Buffett’s Berkshire Hathaway just received a  dividend check for $168 million dollar from Coca-Cola.

Berkshire Hathaway owns 400 million shares of Coca-Cola (KO), which are projected to generate $672 million in annual dividend income. 

This comes out to roughly $1.841 million in dividend income per day, $76,712 dollars in dividend income per hour, $1278 dollars in dividend income for Berkshire Hathaway every minute, or almost $21.31 every single second. 

Those shares have a cost basis of $1.29 billion dollars, and were acquired between 1988 – 1994. This comes out to $3.25/share. The annual dividend payment produces an yield on cost of over 51.70%. This means that Berkshire receives its original cost back every other year in dividends alone, while still retaining full ownership of its shares. This is why I believe that Warren Buffett is a closet dividend investor.

Since 1994, Buffett has received $21.45/share in total dividend income from Coca-Cola.

That is $8.580 billion in dividend income, against a total cost of $1.299 billion, which was allocated to buy stakes in other businesses and shares.

His Coca-Cola stock is worth $21.216 billion. Given the fact that Coca-Cola has also repurchased stock over the years, it also means that his ownership in Coca-Cola has increased over time, without adding a single dime.

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 33 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, Buffett would still be earning steady cashflow from his investment in Coca-Cola. This is because ten years from now, the company would likely be earning more than what it is earning today, and would likely be distributing more in dividend income than it is paying to shareholders today. Receiving a huge dividend check every three months is a reminder that you are a shareholder in a real company with real products that are consumed by billions of consumers worldwide. The stock is not a lottery ticket but a partial ownership in a company, which entitles you to a share of the profits being paid out to you as a shareholder in the form of dividends.

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.

In the case of Warren Buffett's investment in Coca-Cola, he is able to recover his original purchase price in dividends alone, every two years. Even if Coca-Cola goes to zero tomorrow, he has generates a substantial returns from dividends alone, which have flown to Berkshire's coffers, and have been invested in a variety of businesses that will benefit Berkshire Hathaway's shareholders for generations to come.

Currently, Coca-Cola is selling for 24.70 times forward earnings and yields 3.17%. This dividend king has managed to increase dividends for 59 years in a row.  

There are only 29 companies in the entire world which have gained membership into the exclusive list of dividend kings. Over the past decade, Coca-Cola has managed to increase dividends by 6.40%/year, equivalent to dividend payments doubling every eight and a half 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

Saturday, March 27, 2021

Dividend Aristocrats for Further Research

 The dividend aristocrats list shows companies in the S&P 500 index that have managed to increase dividends for at least 25 consecutive years in a row. This is an exclusive list, because not every company gets to meet the quality criteria to be included in the S&P 500 index in the first place. It’s also an exclusive list because only a certain type of companies that manage to grow earnings and dividends over long periods of time, spanning several recession and recovery periods, can afford to build a track record of 25 annual dividend increases.

A long streak of consecutive annual dividend increases is an indication of a quality company that has a certain type of moat around its business. Those are companies whose business models are worthy of detailed study. I view membership in the dividend aristocrats list as an indication of quality. 

However, my research does not stop there. Identifying a company as a quality one is just step one in my screening process. 

I have shared my screening process with you for over a decade. 

The screening process usually started out as following:

1) At least a ten year streak of annual dividend increases

2) P/E ratio below 20

3) Dividend Payout Ratio below 60%

4) Earnings and Dividend growth exceeding inflation

While others have been using my screening process without attribution, I have found that they are always missing one or two of the most crucial steps in it. 

Market conditions change over time, hence you need to adjust the screening criteria. This means that as interest rates and P/E ratios change over time, you need to adjust for it. While a P/E of 20 may have worked well a few years ago, it needs to be adjusted. Plus, the P/E should be taken into account along with the earnings and dividend growth rate. In other words, if two companies have a P/E of 20, the better one may be the one with a higher earnings growth.

Furthermore, you need to always dig further into each specific situation, in order to understand the data better. Not all companies are alike, which is why you need to dig into each individual company, in order to understand the nuance and do the best decision when you try to choose between companies. 

In addition, you need to understand industry dynamics, which may cause you to exclude certain companies with defensive earnings streams. For example, utilities typically have high payout ratios, so you need to adjust for it. Companies in the tobacco industry also have high payouts. Last but not least, using earnings per share and dividend payout ratio on REITs misses the fact that a better metric is FFO/share and FFO Payout/share. There is a lot of nuance that is lost when you stick to mere blind quantitative evaluation of a list, without understanding much. 

While it is easy to quantitatively screen the list of dividend aristocrats or champions, I believe that the best nuggets will be found by reviewing each company first. 

Hence, I have moved away from screening the list, but instead focus on the individual companies that I believe have strong business models that I want to hold.

To get to this step, I reviewed the trends in earnings per share for each dividend aristocrat. I focused on the companies that have managed to grow earnings per share or FFO/share over the past decade. Rising earnings per share provide the foundation behind future dividend increases and capital appreciation.

I came up with the following list of companies for further research:

Symbol

Name

Number of Annual Dividend Increases

Ten Year Annualized Dividend Growth

Stock Price

Annual Ddividend

Dividend Yield

Forward P/E

ADP

Automatic Data Proc.

45

11.85%

192.69

3.72

1.93%

32.49

AFL

AFLAC Inc.

39

6.99%

51.56

1.32

2.56%

10.51

APD

Air Products & Chem.

39

10.43%

287.22

6

2.09%

31.67

ATO

Atmos Energy

37

5.74%

97.24

2.5

2.57%

19.26

BF-B

Brown-Forman Class B

37

8.10%

69.38

0.72

1.04%

40.56

CINF

Cincinnati Financial

61

4.06%

105.79

2.52

2.38%

25.95

CLX

Clorox Company

43

7.53%

190.25

4.44

2.33%

22.81

CTAS

Cintas Corp.

39

19.33%

346.61

3

0.87%

34.54

ECL

Ecolab Inc.

29

11.73%

213.33

1.92

0.90%

41.19

ESS

Essex Property Trust

27

7.08%

284.33

8.36

2.94%

23.18

EXPD

Expeditors International

26

10.03%

107.8

1.04

0.96%

25.49

GD

General Dynamics

29

10.17%

181.54

4.76

2.62%

16.39

HRL

Hormel Foods Corp.

54

16.04%

47.91

0.98

2.05%

27.57

JNJ

Johnson & Johnson

58

6.55%

164.93

4.04

2.45%

17.33

KMB

Kimberly-Clark Corp.

49

5.54%

137.13

4.56

3.33%

17.57

LEG

Leggett & Platt Inc.

49

4.30%

46.5

1.6

3.44%

18.84

LOW

Lowe's Companies

58

18.85%

191.61

2.4

1.25%

19.79

MKC

McCormick & Co.

34

9.08%

90.21

1.36

1.51%

30.59

MMM

3M Company

63

10.84%

194.88

5.92

3.04%

20.29

NUE

Nucor Corp.

48

1.12%

79.3

1.62

2.04%

8.79

O

Realty Income Corp.

28

4.93%

64.22

2.82

4.39%

18.99

PBCT

People's United Financial

28

1.51%

18.03

0.72

3.99%

14.07

ROP

Roper Technologies Inc.

28

18.36%

410.36

2.25

0.55%

27.98

SHW

Sherwin-Williams Co.

43

14.05%

759.02

6.6

0.87%

28.04

SPGI

S&P Global Inc.

48

11.05%

359.55

3.08

0.86%

29.07

SWK

Stanley Black & Decker

53

7.57%

202.07

2.8

1.39%

19.87

TGT

Target Corp.

53

12.30%

200.95

2.72

1.35%

23.12

TROW

T. Rowe Price Group

35

12.79%

178.13

4.32

2.43%

14.9


Note that this data is as of March 26, 2021.

This list of course is not an automatic buy. Each company needs to be reviewed in a little more detail. Some of these companies are overvalued, and I would only be willing to buy them at a lower price. Other companies may be attractively valued today, but I may already have a full position in them.

However, this is the type of watchlist I would have, and I would then set some entry prices under which I would be willing to invest.

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