scary article

[twacowfca]

Buffett has paid significantly larger P/E's for various businesses over the years, including when he ran the Buffett Partnership.  Think See's Candies, the rest of GEICO, Coca-Cola, Dairy Queen, etc.

 

With the benefit of hindsight, See's, GEICO, and Coca-Cola were actually purchased at dirt cheap valuations given the subsequent growth -- Buffett's genius shined.  I don't think anyone expects today's large caps to achieve similar growth.

 

 

At present, my point is that large-cap, high-quality stocks offer relatively better value than fixed income instruments.

 

Couldn't agree more -- and this is a key point for me as well.  Large-cap, high-quality stocks may in fact offer a good relative value trade but from a fundamental/Buffett/Graham absolute value perspective, the appeal is modest at best.  And if the bond market is correct, the spread may narrow by the earnings (and stock price) declines rather than stock price increases.  Personally, I'll wait for a better risk/reward.  

 

Keep in mind that the most powerful predictor of secular large order changes in the valuation of stocks and other securities is change in fiscal and monetary policy -- especially taxation in relation to stock prices.  The low dividend tax will expire EOY 2010.  Conversions to Roth IRA's, available for high income tax payers this year only, will suck investable capital out of many portfolios in late 2010 through 2012 as large tax bills come due for these conversions.  Thirdly, income tax rates are scheduled to increase in  2011.  This could change if Congress passes major tax cuts, but assuming  that rates won't rise may be wishful thinking.  

 

The prospect of  increases in taxes and tax payments is not exactly bullish for stock prices, to say the least.  Keep your eye on Congress.

[Guest Bronco]

Do I have to watch congress?  Not after I eat.

 

It will be interesting to see if they pass something before the elections on keeping tax cuts, except for the "rich".  By the way, I thought wealth was measured on assets, not income.  If I make $250,000 for one year, am I wealthy? 

 

Anyway, the dividend rate will for sure go up.  This joker in the white house doesn't get it.  Our friends in the UK do - they are lowering their corporate rate down 4 notches.  We in the U.S. needs a 104th congress sort of takeover.  Problem is that the Republicans don't have the ammo (good candidates). 

 

How hard is to get a reformer in this country?  Not a socialist pig, but a real reformer.  Make our companies competitive, increase flow of capital, cut all this red tape and regulation, unwind the joker's policies, cut spending dramatically.  Where is this person?

[Guest broxburnboy]

Also disagree with Parsad, who suggested that the country is in a far better position today than in 2006.

 

Not country...corporations.  Multitude of general risks (housing bubble, credit derivatives, stock and commodity bubbles, trade deficit, corporate and consumer debt leverage) has also been reduced.  Actual risk has been transferred from corporations to government.  Buying shares in Coca-cola is a safer bet than buying U.S. treasuries over the next ten years.  Cheers!

 

I think most  would agree that the risk has transferred to government via the bailouts, subsidies, tax breaks etc. Subsequent to the risk transfer, capital went to equities and the markets have staged an impressive rally.

However the government bond markets have also rallied (more debt sold at lower yields), counterintuitively, as risk has clearly risen even more. There is no end in sight for US govt. debt issuance.

Surely this means that there is a bubble forming (or has been formed) in government bond markets (including state and local government debt), that can only eventually result in a flight to equities, alternate currencies, foreign markets, commodities and precious metals. Government debt would be seriously devalued, interest rates would rise as bond prices drop and the economy would enter a classic inflationary spiral reminiscent and probably more severe than that of the late 70's early 80's.

Deflationists assume that government debt can continue to be issued at every juncture at increasingly lower interest rates and that investors have no other alternative than to purchase that debt. The debt so issued is being used to retire past malinvestments and continue present ones.

The deflation scenario rose during the great depression in the US because there was little alternative to government bonds in a worldwide economic slump. The dollar was pegged to gold and personal gold holdings were outlawed. There was no instant access to foreign or local markets and all currency exchange rates were frozen. Money could be hoarded under the bed, its future value safely assumed.

Such is not the same today, in fact this thread is discussing the various means investors can hedge against a devalued buck. We will continue to see a managed deflation until such point that we run out of buyers for the new debt.

The "getting solvent" ship sailed a long time back.

[rmitz]

Reasonable observation on the surface but if the government wasn't running a budget deficit equal to 14% of GDP, we would be in a depression and corporations would not be better off.  A 14% annual budget deficit is not sustainable and as a result, the current economic environment (which gives the appearance of relatively healthy corporate sector) is not sustainable.  Given that inflated and unsustainable government spending is keeping the economy afloat (barely), risks related to house, credit derivatives, stocks, debt still exist and in fact are greater than before (in my opinion), given that there is now more debt in the system.  Total debt to GDP now equals 358%, greater than the 290% level at the end of WWII.

 

This debt number is misleading at best.  358% is only true if you count very long term commitments to Medicare and other entitlements, which are not current debt at all.  There are three good reasons.  1) The programs can be changed long before the debt is a significant issue.  2) While the debt is higher right now, it's also nowhere near as high as Japan or a bunch of the european countries. The basic point here is that debt is sustainable for a lot longer than most people expect.  3) The GDP will be higher by the time these expenses actually occur.

[Sea Island]

rmitz, why will GDP be higher?

[Munger]

1) The programs can be changed long before the debt is a significant issue.

 

How/when are the programs changed?  And what happens to the economy when the spending related to the programs significantly decreases?

 

2) While the debt is higher right now, it's also nowhere near as high as Japan or a bunch of the european countries.

 

System wide debt is very close to Japan.  Also -- note the sharp difference between domestic and foreign financing of US and Japan gov'ts

 

3)The basic point here is that debt is sustainable for a lot longer than most people expect.

 

Possibly true (no one can predict with certainty).  But it is certain that the current budget deficits are unsustainable and when those go away (either voluntarily or involuntarily), the economy would collapse.  Better to close the gap on own and on our own time frame (which will require significant pain) than have the changes forced upon us.

 

This debt number is misleading at best.

 

No -- debt is debt.  It must be paid or default occurs.

[vinod1]

"Wal-Mart Stores Inc. reported a 3.6 percent increase in second-quarter net income and raised its earnings guidance for the full year as it benefits from cost-cutting and robust global growth in China, Brazil and Mexico."

 

"Walmart U.S. comparable store sales for the second quarter 13-week period declined 1.8 percent. Sam’s Club posted a comparable club sales increase, without fuel, of 1.0 percent."

 

People will say that I only focus on the negatives these days, but I can't ignore this kind of data. Yes, Walmart did beat expectations by a penny (you tell people a tight range and beat that, what a joke!) and raised full year EPS by $0.05 and CNBC and analysts will be all happy. The reality is that things are getting worse in the U.S. economy.

 

The stock is trading at 12.5 times current earnings and 11.5 times next year. The dividend yield is 2.4%. If they can grow earnings at 10% a year for the foreseable future it is a bargain. What if it is only 3 or 4% as these numbers show? Graham once said that stocks with no growth should be worth around 8 times earnings.

 

Still, I agree that the logic is to buy WMT at 3.5% + 2.5% or roughly 6% total return and to sell treasuries at 2.58%. The problem is that this logic fits a static world. Things could change rapidly making this 6% apparent return not satisfactory at all. IMO, something like JNJ has a bigger moat, but they have their own issues.

 

What I think will need to happen with these high quality mega caps is for them to increase their dividend payout to 50% or more. WMT is at 30% now. It will become unacceptable for companies like MSFT to keep sitting on mountains of cash with little growth. Indicated yields will become more important and we may revert to the past where buying many DOW companies at 5 or 6% dividend yields is just normal no matter what treasuries are doing.

 

Cardboard

 

 

I think you made a mistake in your return calculations. With WMT at $50 and earning $4 this year, you are getting a 8% earnings yield. It is paying you $1.25 in dividend this year. It is also likely to repurchase $1.25 in shares out of this year earnings. That leaves about $1.5 for investment. If WMT earns a ROE of 15% on this new investment, that is about $0.225 in earnings for next year. Given that you have retired $1.25 worth of shares this year your EPS for next year would be ($4 + $0.225) x 1.025 (since you retired 2.5% of shares) =$4.33.

 

If PE does not change, that would be a total return of 54.13 + 1.25/50 = 10.75% for next year.

 

You need only these assumptions to come up with this calculation

1. WMT has a strong moat that allows them to earn a high ROE

2. Management does not foolishly waste capital

3. WMT current earnings are sustainable

4. PE does not change

5. WMT would have opportunity to continue to invest at a high ROE

 

If you agree with #1, then #4 should not be any concern for a long term investor at the current PE level. They have Walton family controllong a large stake that should be a check on #2 and in they measure and evaluate ROE so #2 is not something I would worry about all that much for the next few years.

 

#5 is the only assumption that can be questioned over the very long term but I do not see this a concern over the next few years.

 

Thanks

 

Vinod

[Munger]

3. WMT current earnings are sustainable

 

 

IMO, this is the biggest risk to the analysis.  I can see the merit of a WMT investment but not the no-brainer that so many value investors assume.  How sustainable is earnings/cash flow growth when US revenues will experience an extended period of decline -- there is a limit to cost cuts.  Some will argue int'l growth will outweigh US but that math seems challenged.

 

Also -- the earnings yield analysis seems inflated relative to economic reality.  Let's just take FY10 (Jan end).  CFO = $26.2B (with a $5B boost from favorable working cap dynamics)  Cap Exp = $12.2B   So FCF = $14   With a current $191B market cap, the cash flow yield equals 7.3%  Adjusting for the working capital impact, the cash flow yield drops to 4.7%.

 

WMT is probably not a terrible investment (and you may get a tremendous trade, but who knows).  However, not the table pounding screaming buy that some value investors argue.  

[Cardboard]

Vinod1,

 

Yes, you are correct I have made a mistake. I thought that the 3.6% being quoted was EPS growth, but after checking, it was net income growth. The number was actually 9.0%.

 

So if I add 9.0% EPS growth and a 2.4% dividend yield I get 11.4%. So if they can keep this up it looks like quite attractive.

 

My bad.

 

Cardboard

[vinod1]

3. WMT current earnings are sustainable

 

 

IMO, this is the biggest risk to the analysis.  I can see the merit of a WMT investment but not the no-brainer that so many value investors assume.  How sustainable is earnings/cash flow growth when US revenues will experience an extended period of decline -- there is a limit to cost cuts.  Some will argue int'l growth will outweigh US but that math seems challenged.

 

Also -- the earnings yield analysis seems inflated relative to economic reality.  Let's just take FY10 (Jan end).  CFO = $26.2B (with a $5B boost from favorable working cap dynamics)  Cap Exp = $12.2B   So FCF = $14   With a current $191B market cap, the cash flow yield equals 7.3%  Adjusting for the working capital impact, the cash flow yield drops to 4.7%.

 

WMT is probably not a terrible investment (and you may get a tremendous trade, but who knows).  However, not the table pounding screaming buy that some value investors argue.  

 

In a period of sustained sales decline in aggregate in US, WMT should at least be able to maintain their sales. In such an economic scenario I see WMT being able to maintain their sales due to market share gain. We can agree to disagree here.

 

The Cap Ex includes growth Cap ex, so owner earnings are pretty close to net earnings in WMT's case. If sales stagnate I do not see WMT continuing to spend a lot of money on growth.

 

I would be the first to say that WMT is not a table pounding investment. On the other hand for an investor with at least a 10 year horizon, I think it offers strong possibility of at least 8-9% annual returns over this period.

 

Vinod

[vinod1]

Perhaps a bit of Buffett comments might help

 

"We will continue to ignore political and economic forecasts,

which are an expensive distraction for many investors and

businessmen.  Thirty years ago, no one could have foreseen the

huge expansion of the Vietnam War, wage and price controls, two

oil shocks, the resignation of a president, the dissolution of

the Soviet Union, a one-day drop in the Dow of 508 points, or

treasury bill yields fluctuating between 2.8% and 17.4%.

 

    But, surprise - none of these blockbuster events made the

slightest dent in Ben Graham's investment principles.  Nor did

they render unsound the negotiated purchases of fine businesses

at sensible prices.  Imagine the cost to us, then, if we had let

a fear of unknowns cause us to defer or alter the deployment of

capital.  Indeed, we have usually made our best purchases when

apprehensions about some macro event were at a peak.  Fear is the

foe of the faddist, but the friend of the fundamentalist.

 

    A different set of major shocks is sure to occur in the next

30 years.  We will neither try to predict these nor to profit

from them.  If we can identify businesses similar to those we

have purchased in the past, external surprises will have little

effect on our long-term results."

 

http://www.berkshirehathaway.com/letters/1994.html

 

Vinod

[vinod1]

What I do not get about macro worries if say Inflation/deflation/double dip is that none of these events can be predicted with even say a confidence level of 50%. We can have far greater confidence in the business values of several companies and if they are selling at a discount to their IV, why make a low confidence macro bet instead of a higher confidence micro bet on individual companies?

 

I probably need to get my head handed to me on a plate for ignoring macro, but cannot really see why macro worries should take precedence over individual stock valuation. We can incorporate macro factors in valuing individual stocks by not in terms of timing the market. I see this as one of the intellectual foundations of Graham and Buffett's approach to investing.

 

Vinod

[Munger]

On the other hand for an investor with at least a 10 year horizon, I think it offers strong possibility of at least 8-9% annual returns over this period.

 

Personally, I don't view as likely but certainly possible.  

 

As for the Buffett quote, I would just add.

 

Buffett has also said to buy only when there is panic in the streets -- we are nowhere near such an environment today.

 

Further, Graham often told Buffett he was insane to buy stocks at or above P/FCF 10x.

 

So sure, if you can buy stocks at 3-5x FCF, who cares what the macro will do because the margin of safety is huge.  At 10-15x FCF (while lower than the past 30 years), the opportunity is not that great, especially relative to the risk.

 

 

 

[Munger]

What I do not get about macro worries if say Inflation/deflation/double dip is that none of these events can be predicted with even say a confidence level of 50%.

 

 

When the macro risks are extreme, you shouldn't put your head in the sand.  Further, no one is saying not to invest in the face of macro risks.  Rather, you should demand a much higher margin of safety from Mr. Market.  Margin of safety is the foundation of Buffett's investment approach -- he has said numerous times that the three most important words in investing are "margin of safety."  An expect 7-9% return (IF everything goes well) does not provide much margin of safety, if any at all.  Moreover, Buffett didn't become the richest man in the world by investing when the expected return was 7-9%, especially when risks were abnormally high. 

[Parsad]

I'm guessing most of you still haven't seen the Schloss presentation.  ;D  Cheers!

[Partner24]

Well Sanjeev, I remember a sentence that looked like that:

 

"Worry top-down. Invest bottom-up".

 

 

[Parsad]

I have another quote that will become famous one day:

 

"When your next door neighbour becomes your stock market analyst or your economist, then you probably should move."

 

- Sanjeev Parsad, 2010

 

Cheers!   ;D

[Partner24]

Ahah good one.

 

Here is another one:

 

If you want to catch fish, you have first to dip your fishing pole into the water. Watching The Weather Channel will not put food on your table.

 

Partner24, 2010  ;)

 

P.S.: Or you can try to shoot them in a barrel too  ;D

 

 

[Parsad]

I like that one!  I think that's a keeper.  Cheers!

[rmitz]

rmitz, why will GDP be higher?

 

Over 20 years, I think it would be extremely pessimistic to think that GDP will not be higher.  That said, if GDP is NOT higher, likely the projections for future estimate costs for the entitlement programs are too high, so the percentage would be lower either way.

[beerbaron]

Guys, what we all want is a margin of safety. Take the future cash flows and discount it to the present value, compare with the margin of safety...that's all.

 

Just make sure your future cash flows estimates are reflecting what you feel the economy is going to do.

 

BeerBaron

[Munger]

Kyle Bass interview on CNBC today very much worth watching in entirety.  Replay can be found in the video section of the website.  Bass understands the magnitude of the problem and correctly points out that Japan will like be the first domino to fall.  In my humble opinion, the margin of safety currently offered by Mr. Market is not close to sufficient relative to the risks.

[ericd1]

Cardboard,

 

Tis only my opinion, but regarding Walmart's lackluster U.S. revenue growth.  It appears to me that shoppers are trading up to other stores (Target, JCP, etc.) now that the economy has stabilized.

[Myth465]

Here are Bass's comments.

 

I tend to agree with him, should be interesting to watch.

 

http://www.cnbc.com/id/15840232/?video=1568296901&play=1

[Sea Island]

The Kyle Bass video could be summed up: don't spend more than you make. How much will GDP have to grow to meet current and future obligations and why rmitz would you assume that entitlement costs will be lower than estimated?