Chris Davis on WealthTrack

Chris Davis Video (1/18/08) on WealthTrack: http://www.wealthtrack.com/video_player.html

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Related Previous Post: The Davis Research Methodology

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Book: The Davis Dynasty: 50 Years of Successful Investing on Wall Street

Longleaf Partners Funds 4th Quarter Letter

The fourth quarter volatility gave long-term investors terrific opportunities to pursue. Short-term, prices suffered, particularly in the two domestic funds. While negative performance is frustrating, falling prices are not necessarily worrisome. As patient, long-term investors we know that as long as appraisals remain intact, returns should be delayed, not lost. In fact, the prescription for declining stocks often is to buy more. Most of the fourth quarter losses in the Funds were attributable to companies whose values held steady or even rose. A few businesses did have company-specific challenges in the quarter that negatively impacted our appraisals; however, their stocks fell much more steeply than their values.

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Our partners who focus on portfolio returns over the next decade will appreciate the tremendous opportunity that lower prices created during the recent quarter. Across the three Funds we bought six new names and added to eleven existing holdings. These purchases were funded by a combination of cash inflows, sales of three stocks that reached appraisal, and scale-backs of holdings that were overweighted and/or were selling at close to 90% of intrinsic worth. Southeastern's trading desk was busy.

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Related Previous Post: Cash Flow Analysis: A Private Lesson from Staley Cates

Mauboussin - ROIC Patterns and Shareholder Returns: Sorting Fundamentals and Expectations

Our recent piece, “Death, Taxes, and Reversion to the Mean” 2, aimed to provide context for analysts building financial models by documenting return on invested capital (ROIC) patterns for a large sample of companies. But the report was silent on the question most relevant for investors: Does an understanding of ROIC patterns help with stock picking? This piece addresses that question.

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Three main points emerged from the analysis of ROIC patterns. First, analysts need to consider the lessons of history when modeling rather than approaching each model as unique. Analysts should view the experience of a large sample of companies as a rich reference class. Second, the empirical evidence shows ROICs tend to revert to the mean, a level similar to the cost of capital. Randomness plays an important role in the mean-reversion process. Finally, some companies do deliver persistently high or low results beyond what chance would dictate. Unfortunately, pinpointing the causes of persistence is a challenge.

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In an efficient market, stock prices are an unbiased estimate of value. Market efficiency does not say that stock prices are always right; it only asserts that prices are not wrong in a systematic way. For this analysis, we combined our data on ROIC patterns with total shareholder returns to see whether there is a consistent way to generate excess returns.

Jean-Marie Eveillard Interview

Jean-Marie Eveillard interview on Bloomberg News: VIDEO

AmEx gets CEO pay right

With its new incentive plan for Ken Chenault, the card giant has created a better model for executive comp.

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What's key is the way the grant is structured. The first surprise is that it's an options grant at all. Options were all the rage in the '90s as the market roared, but lost favor after the bust. They've been replaced in CEOs' hearts by restricted stock, which is worth money even if the stock price goes nowhere. Since options are worth money only if the stock rises, a big grant is notable at a time when the market looks expensive by many measures and the economy is weak.

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Even more striking are the extraordinarily high hurdles the board requires Chenault to clear if he's to get any of those options. To receive the full grant, he must beat several goals over the next six years, an unusually distant time horizon. AmEx's earnings per share must grow at least 15% a year on average, revenues must grow at least 10% a year, return on equity must average at least 36% per year, and total return to shareholders must beat the S&P 500 average by at least 2.5% a year. Chenault can receive a fraction of the grant for lesser performance, but below certain limits, which are still quite high, he gets nothing.

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Now consider a couple of scenarios. Chenault misses all the targets but the market booms, returning 10% a year, and AmEx stock matches it. After their full term of ten years, his options would be in the money by $258 million - but he wouldn't get any of that. Why? Well, AmEx's stock presumably rode a rising tide, and his shareholders could have done just as well with an index fund while exposed to less risk. Alternatively, the market returns just 6% a year, in line with what many experts predict, but under Chenault's leadership AmEx hits all the targets and the stock returns 9% a year. Chenault collects a pretax gain of $222 million after a decade - an awful lot, but his shareholders are $35 billion richer than if they had chosen an index fund, and he's a hero.

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In either scenario, compensation lines up with performance. That's a goal that CEOs and boards should aim for, and that politicians should vow not to hinder as they try to feel voters' pain this spring.

How Inflation Swindles the Equity Investor - by Warren E. Buffett, FORTUNE May 1977

It is no longer a secret that stocks, like bonds, do poorly in an inflationary environment. We have been in such an environment for most of the past decade, and it has indeed been a time of troubles for stocks. But the reasons for the stock market's problems in this period are still imperfectly understood.

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Five ways to improve earnings

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Must we really view that 12 percent equity coupon as immutable? Is there any law that says the corporate return on equity capital cannot adjust itself upward in response to a permanently higher average rate of inflation?

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There is no such law, of course. On the other hand, corporate America cannot increase earnings by desire or decree. To raise that return on equity, corporations would need at least one of the following: (1) an increase in turnover, i.e., in the ratio between sales and total assets employed in the business; (2) cheaper leverage; (3) more leverage; (4) lower income taxes, (5) wider operating margins on sales.

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And that's it. There simply are no other ways to increase returns on common equity. Let's see what can be done with these.

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The investor's equation

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Even if you agree that the 12 percent equity coupon is more or less immutable, you still may hope to do well with it in the years ahead. It's conceivable that you will. After all, a lot of investors did well with it for a long time. But your future results will be governed by three variable's: the relationship between book value and market value, the tax rate, and the inflation rate.

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Let's wade through a little arithmetic about book and market value. When stocks consistently sell at book value, it's all very simple. If a stock has a book value of $100 and also an average market value of $100, 12 percent earnings by business will produce a 12 percent return for the investor (less those frictional costs, which we'll ignore for the moment). If the payout ratio is 50 percent, our investor will get $6 via dividends and a further $6 from the increase in the book value of the business, which will, of course, be reflected in the market value of his holdings.

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If the stock sold at 150 percent of book value, the picture would change. The investor would receive the same $6 cash dividend, but it would now represent only a 4 percent return on his $150 cost. The book value of the business would still increase by 6 percent (to $106) and the market value of the investor's holdings, valued consistently at 150 percent of book value, would similarly increase by 6 percent (to $159). But the investor's total return, i.e., from appreciation plus dividends, would be only 10 percent versus the underlying 12 percent earned by the business.

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When the investor buys in below book value, the process is reversed. For example, if the stock sells at 80 percent of book value, the same earnings and payout assumptions would yield 7.5 percent from dividends ($6 on an $80 price) and 6 percent from appreciation - a total return of 13.5 percent. In other words, you do better by buying at a discount rather than a premium, just as common sense would suggest.

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During the postwar years, the market value of the Dow Jones industrials has been as low as 84 percent of book value (in 1974) and as high as 232 percent (in 1965); most of the time the ratio has been well over 100 percent. (Early this spring, it was around 110 percent.) Let's assume that in the future the ratio will be something close to 100 percent - meaning that investors in stocks could earn the full 12 percent. At least, they could earn that figure before taxes and before inflation.

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7 percent after taxes

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How large a bite might taxes take out of the 12 percent? For individual investors, it seems reasonable to assume that federal, state, and local income taxes will average perhaps 50 percent on dividends and 30 percent on capital gains. A majority of investors may have marginal rates somewhat below these, but many with larger holdings will experience substantially higher rates. Under the new tax law, as FORTUNE observed last month, a high-income investor in a heavily taxed city could have a marginal rate on capital gains as high as 56 percent. (See"The Tax Practitioners Act of 1976.")

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So let's use 50 percent and 30 percent as representative for individual investors. Let's also assume, in line with recent experience, that corporations earning 12 percent on equity pay out 5 percent in cash dividends (2.5 percent after tax) and retain 7 percent, with those retained earnings producing a corresponding market-value growth (4.9 percent after the 30 percent tax). The after-tax return, then, would be 7.4 percent. Probably this should be rounded down to about 7 percent to allow for frictional costs. To push our stocks-asdisguised-bonds thesis one notch further, then, stocks might be regarded as the equivalent, for individuals, of 7 percent tax-exempt perpetual bonds.

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The number nobody knows

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Which brings us to the crucial question - the inflation rate. No one knows the answer on this one - including the politicians, economists, and Establishment pundits, who felt, a few years back, that with slight nudges here and there unemployment and inflation rates would respond like trained seals.

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What widows don't notice

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The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a 5 percent passbook account whether she pays 100 percent income tax on her interest income during a period of zero inflation, or pays no income taxes during years of 5 percent inflation. Either way, she is "taxed" in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital. She would find outrageous a 120 percent income tax, but doesn't seem to notice that 6 percent inflation is the economic equivalent.

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The way it was

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Let's assume that about half of earnings are paid out in dividends, leaving 6 percent of equity capital available to finance future growth. If inflation is low - say, 2 percent - a large portion of that growth can be real growth in physical output. For under these conditions, 2 percent more will have to be invested in receivables, inventories, and fixed assets next year just to duplicate this year's physical output - leaving 4 percent for investment in assets to produce more physical goods. The 2 percent finances illusory dollar growth reflecting inflation and the remaining 4 percent finances real growth. If population growth is 1 percent, the 4 percent gain in real output translates into a 3 percent gain in real per capita net income. That, very roughly, is what used to happen in our economy.

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Now move the inflation rate to 7 percent and compute what is left for real growth after the financing of the mandatory inflation component. The answer is nothing - if dividend policies and leverage ratios remain unchanged. After half of the 12 percent earnings are paid out, the same 6 percent is left, but it is all conscripted to provide the added dollars needed to transact last year's physical volume of business.

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Link to easier to read (but with some spelling errors) version: HERE.

Interview with Mark Sellers

Interview that Joe Bradley, founder of Investor’s HOTLINE, conducted with Mark Sellers, managing member of Sellers Capital, LLC, and portfolio manager for the Sellers Capital Fund.

Ajit Jain on CNBC

Berkshire Hathaway shocked the world when it jumped into the bond insurance business, and Ajit Jain, president of the reinsurance and specialty risk division at Berkshire Hathaway, discusses the new venture. (Video)

Put Buyers First? What a Concept

When I spoke to analysts and investors, they had all kinds of reasons for Amazon’s performance last year. “They finally reached a point where their R&D spending was not expanding as fast as their revenues,” said Citigroup’s Mark S. Mahaney. He and others also talked about Amazon’s success in international markets, its fast-growing (and high margin) merchant market, which allows merchants to sell goods alongside Amazon, and its rapidly expanding Web services business. Mostly, though, the investing community pointed to those healthier margins as the main reason for the stock’s run-up. Legg Mason’s legendary fund manager, Bill Miller, who has made a small fortune for his investors by betting big on Amazon, told me that “Wall Street is almost fanatically focused on margin expansion and contraction.”

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But I couldn’t help wondering if maybe there wasn’t something else at play here, something Wall Street never seems to take very seriously. Maybe, just maybe, taking care of customers is something worth doing when you are trying to create a lasting company. Maybe, in fact, it’s the best way to build a real business — even if it comes at the expense of short-term results.

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It is almost impossible to read or see an interview with Mr. Bezos in which he doesn’t, at some point, begin to wax on about what he likes to call “the customer experience.” Just a few months ago, for instance, he appeared on Charlie Rose’s talk show to tout Amazon’s new e-book device, the Kindle. Toward the end of the program, Mr. Rose asked the chief executive an open-ended question about how he spent his time, and Mr. Bezos responded with a soliloquy about his “obsession” with customers.

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“They care about having the lowest prices, having vast selection, so they have choice, and getting the products to customers fast,” he said. “And the reason I’m so obsessed with these drivers of the customer experience is that I believe that the success we have had over the past 12 years has been driven exclusively by that customer experience. We are not great advertisers. So we start with customers, figure out what they want, and figure out how to get it to them.”

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Anybody who has spent any time around Mr. Bezos knows that this is not just some line he throws out for public consumption. It has been the guiding principle behind Amazon since it began. “Jeff has been focused on the customer since Day 1,” said Suresh Kotha, a management professor at the University of Washington business school who has written several case studies about Amazon. Mr. Miller noted that Amazon has really had only one stated goal since it began: to be the most customer-centric company in the world.

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Related Links:

• Jeff Bezos on Charlie Rose
• 1997 Amazon.com Case Study from Professor Suresh Kotha
• The Amazon Kindle
• Jeff Bezos' Letters to Shareholders

Misguided Guidance

MANY MANAGERS DON'T UNDERSTAND the difference between promoting their products and touting their companies' stock.

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The best managers increase shareholder value by operating the business smartly and allocating capital wisely, so that intrinsic worth grows over time. Almost without exception, the market recognizes this kind of performance, even without any nudging.

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Other managers too often have skipped the most difficult step in the process -- running the business to optimize intrinsic worth -- and try to cut to the chase by engaging in all manner of sleight-of-hand tactics to jack up the share price. This has made some of them very rich, and sent the more flagrant to stand before a magistrate, sullying the already-tarnished name of capitalism. They are neglecting the extra duty of care -- the fiduciary responsibility required of those who sell or promote an uncertain and intangible future promise, rather than a consumer product such as a personal computer or stick of deodorant.

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For the well-managed company, there are compelling psychic compensations and often impressive long-term financial rewards for cultivating a constituency of investors rather than speculators. If a board and its executives desire a shareholder base made up largely of investors rather than speculators, they must act accordingly.

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Warren Buffett, second to none in his respect for the outside shareholder, is unabashedly promotional when it comes to selling Berkshire Hathaway company goods at the annual meeting, yet he won't utter a peep to hawk the shares of Berkshire. He talks in general terms about business and the businesses that Berkshire owns, but never gets specific about earnings.

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Berkshire Hathaway's share-turnover rate is the lowest in America, averaging roughly 15%. No other public corporation's annual meeting attracts more than a small fraction of its shareholders. Berkshire Hathaway, on the other hand, draws an amazing 24,000-plus enthusiastic shareholders who annually make their pilgrimage to Omaha.

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Book: Speculative Contagion: An Antidote for Speculative Epidemics