Tag Archives: income

Base Hits Vs. Swinging For The Fences

I just got done reading Jeff Bezos’ annual letter to shareholders , which is outstanding as it always it. As I finished it, I spent a few minutes thinking about it. He references Amazon’s (NASDAQ: AMZN ) style of “portfolio management”. He doesn’t call it that, of course, but this passage got me thinking about it. Since I wrote a post earlier in the week about portfolio management, I thought using Bezos’ letter would allow me to expand on a few other random thoughts. But here is just one clip from many valuable nuggets that are in the letter: Bezos has always gone for the home run ball at Amazon, and it’s worked out tremendously for him and for shareholders. Would this type of swinging for the fences work in investing? I’ve always preferred trying to go for the easy bets in investing. Berkshire Hathaway ( BRK.A , BRK.B ) is an easy bet . The problem, though (or maybe it’s not a problem, but the reality), is that the easy bets rarely are the bets that become massive winners. Occasionally, they do – Peter Lynch talked about how Wal-Mart’s (NYSE: WMT ) business model was already very well known to investors in the mid 1980s, and it had already carved out significant advantages over the dominant incumbent, Sears (NASDAQ: SHLD ). You could have bought Wal-Mart years after it had already proven itself to be a dominant retailer, but also when it still had a bright future and long runway ahead of it. So sometimes, the obvious bets can be huge winners. But this is usually much easier in hindsight. After all, Buffett himself couldn’t quite pull the trigger on Wal-Mart in the mid 1980s – a decision he would regret for decades. At the annual meeting in 2004, he mentioned how, after nibbling at a few shares, he let it go after refusing to pay up: “We bought a little and it moved up a little and I thought maybe it will come back a bit. That thumbsucking has cost us in the current area of $10 billion.” So sometimes, obvious bets can be huge winners. But many times, the most prolific results in business come from bets that are far from sure. Jeff Bezos has always had a so-called moonshot type approach to capital allocation. The idea is simple: there will be many failures, but no single failure will put a dent in Amazon’s armor, and if one of the experiments works, it can return many, many multiples of the initial investment and become a meaningful needle-mover in terms of overall revenue. Amazon Web Services (AWS) was one such experiment that famously became a massive winner, set to do $10 billion of business this year, and getting to that level faster than Amazon itself did. The Fire phone was the opposite – it flopped. But the beauty of the failures at a firm like Amazon is that while they are maybe a little embarrassing at times, they are a mere blip on the radar. No one notices or cares about the Amazon phone. If AWS had failed in 2005, no one today would notice, remember, or care. So this type of low-probability, high-payoff approach to business has paid huge dividends for Amazon. I think many businesses exist because of the success of a moonshot idea. Mark Zuckerberg probably could not have comprehended what he was creating in his dorm room in the fall of 2004. Mohnish Pabrai has talked about how Bill Gates made a bet when he founded Microsoft (NASDAQ: MSFT ) that had basically no downside – something like $40,000 is the total amount of capital that ever went into the firm. “Moonshot” Strategy is Aided by Recurring Cash Flow One reason why I think this approach works for businesses, and not necessarily in portfolio management, is simply due to the risk/reward dynamic of these bets. I think a lot of these bets that Google GOOG , GOOGL ) and Amazon are making have very little downside relative to the overall enterprise. Most stocks that have 5-to-1 upside also have a significant amount of downside. I think lost dollars are usually much more difficult to replace in investing than they are in business, partially because businesses usually produce recurring cash flow. Portfolios have a finite amount of cash that needs to be allocated to investment ideas. Portfolios can produce profits from winning investments, and then these profits can get allocated to other investment ideas, but there is no recurring cash flow coming in (other than dividends). Employees, Ideas, and Human Capital Not only do businesses have recurring cash flow, they also have human capital, which can produce great ideas that can become massive winners. Like Zuckerberg in his dorm room – Facebook (NASDAQ: FB ) didn’t start because of huge amounts of capital, it started because of a really good idea and the successful deployment of human capital (talented, smart, motivated people working on that good idea). Eventually, the business required some actual capital, but only after the idea, combined with human capital had already catapulted the company into a valuation worth many millions of dollars. There was essentially no financial risk to starting Facebook. If it didn’t work, Zuckerberg and his friends would have done just fine – we would have most likely never have heard of them, but they’d all be doing fine. If AWS flopped, it’s likely we would have never noticed. There would be minor costs, and human capital would be redeployed elsewhere, but for the most part, Amazon would exist as it does today – dominating the online retail world. Google will still be making billions of dollars 10 years from now if it never make a dime from self-driving cars. So, I think this type of capital allocation approach works well with a corporate culture like Amazon’s. Bezos himself calls his company “inventive”. They like to experiment. They like to make a lot of bets. And they swing for the fences. But the cost of striking out on any of these bets is tiny. And you could argue that any human capital wasted on a bad idea wasn’t actually wasted. Amazon – like many people – probably learns a ton from failed bets. You could argue that these failures actually have a negative cost on balance – they do cost some capital, but this loss that shows up on the income statement (which, again, is very small) ends up creating value somewhere else down the line due to increased knowledge and productive redeployment of human capital. So, I think there are advantages to this type of “moonshot bet” approach that works well within the confines of a business like Amazon or Google, but might not work as well within the confines of an investment portfolio. This isn’t always the case – I recently watched The Big Short (great movie, but not as good as the book ), and the Cornwall Capital guys used these types of long-shot bets to great success. They used options (which inherently have this type of capped downside, unlimited upside risk/reward) and turned $30,000 into $80 million. But I think this would be considered an exception, not the rule. I think most investors have a tendency to arbitrarily tilt the odds of success (or the amount of the payoff) too much in their favor with these types of long-shot bets. They might think a situation has 6-to-1 upside potential, when it only has 2-to-1. Or they might think there is a 30% chance of success, when there is only a 5% chance. It’s a subjective exercise – this isn’t poker or blackjack, where you can pinpoint probabilities based on a finite set of outcomes. So, I think many investors would be better off not trying to go for the long-shots – which, in investing, unlike business, almost always carry real risk of capital destruction. Berkshire Hathaway manages a business using a completely opposite style of capital allocation. Instead of moonshots, it goes for the sure money, the easy bets. It’s not going to create a business from scratch that can go from $0 to $10 billion in 10 years. But nor does it make many mistakes. There is no right or wrong approach. As Bezos says, it just depends on the culture of the business and the personalities involved. I think certain businesses that possess large amounts of human capital, combined with the right culture, the right leadership, and a collective mindset for the long term can benefit from this type of moonshot approach. They can, and should, use this style of capital allocation. Ironically, I think investments in such well-managed, high-quality companies with great leadership and culture are often the sure bets that stock investors should be looking for. Either way, from a portfolio management perspective, I think it’s easier to look for the low-hanging fruit.

Policy Divergence And Investor Implications

By Mark Harrison, CFA The world’s central banks and treasuries are no longer simply balancing the levers of growth and inflation through a succession of cycles with varying degrees of poise. Karin Kimbrough, a macro-economist at Bank of America Merrill Lynch, explores a world where all the old symmetries of monetary and fiscal policy have evaporated – that era might as well be 100 years ago. Instead, according to Kimbrough, who spoke at the CFA Institute Fixed-Income Managed Conference in Boston, in this new era, central banks are far from scoring top grades. In the United States, the US Federal Reserve’s quantitative easing (QE) trade is beginning to unwind, but QE policies are still underway in other developed economies. There is monetary and fiscal policy divergence, which, together with demographic distinctions among advanced economies, has important implications for interest rates and fixed-income markets. In this question & answer session following Kimbrough’s presentation, concerns are raised about this policy divergence, difficulties controlling inflation, portfolio risk concentrations from investor yield-chasing, and perceived foreign threats. A full version of this presentation is also available in the CFA Institute Conference Proceedings Quarterly . Audience member: What do you think about the concept of good versus bad inflation? Karin Kimbrough: I personally do not ascribe too much value to the good versus bad inflation concept. I think that the good versus bad inflation argument really just reflects where we see growth and demand more tightly. We are making more advances on the consumer side. Growth is looking okay, and services are definitely stronger than manufacturing, so we are seeing more inflation in services. Any sort of price pressure from abroad is just completely disinflationary given the strengthened dollar and the many downward pressures abroad in commodities and import prices. You mention that fiscal policy is not living up to its end of the bargain. What are some policies that you would espouse to help bridge the gap? I am a Keynesian at heart, in the sense that Keynesian is shorthand for correcting deficient demand. I believe that, in the presence of a deep lack of aggregate demand, the government should step in and support it. So, as a Keynesian economist, I would have supported some kind of new deal deploying people who are still unemployed to work on a major infrastructure project. It might be a redo of some of our major highways or getting high-speed internet into more rural areas – some long-term infrastructure investment that would actually pay off in dividends in the long term for the United States in terms of productivity, either through transportation or communication. So, I would have liked to have seen highway bills and infrastructure bills or, as a New Yorker, another tunnel between New Jersey and New York. All of that got delayed because it was deemed too expensive, but I cannot think of a better time to do it than when rates are low and there is a lot of labor to deploy. Yes, it is expensive, but it also puts people back to work. When people are back at work, they are paying taxes, paying their mortgage, and shopping, and businesses make plans and invest. When you grade inflation a D+, you grade it against the Fed’s target of 2%. How do we know 2% is the right number? If 2% is not the right number, what might the right number be, and how would it affect your grade for inflation? I graded it based on the test, and the test was 2%. Should the test be different – say, 1.5%? Maybe. I think of it this way: 2% provides a nice, comfortable margin such that the Fed is not setting a target that is so low that it is constantly flirting with deflation, which is generally a nightmare for central banks. No central bank wants to be constantly resorting to QE and asset purchases. The Fed wants to be able to toggle the pace of our economy using rates, which is hard to do when everything is sitting so close to the zero lower bound. A 1% inflation target would mean that, over the medium term, actual inflation is oscillating at a very low level, which is problematic. The Fed is trying to set inflation expectations that give the central bank ample room to respond without constantly facing a threat of either destabilizing high inflation or managing problematic deflation. No one is quantitatively arguing the Fed get to 2% more robustly than historical behavior. If 2% is just a random number and is not achievable, does it force the Fed to implement policies that might create other risks, such as the systemic risks that come out of an attempt to create something that is not possible? Central banks look at a variety of measures when deciding on policy, and of course, not all measures point in the same direction. For example, the personal consumption expenditure (PCE) index presents a more negative case right now compared with consumer price index (CPI) inflation, which is sitting at 1.7-1.8% – a lot closer to 2%. It depends on how something is measured, and of course, governments and central banks are guilty of occasionally changing their standards. They will give good reasons for changes – for example, they might say, “We think we need to reweight medical costs or housing costs differently” – and they will come up with a different measure of inflation. If 2% is indeed unachievable and we are constantly trying to drive ourselves there, then perhaps we are doing it at the expense of inflating asset price bubbles by keeping rates unusually low. I think about it from a central bank perspective: There are risks of financial instability resulting from inflated asset prices. These risks are worsened when leverage is added into the mix. Right now, I do not think we are at a particularly over-levered position relative to a decade ago. So, the Fed might be willing to tolerate some degree of overvaluation in certain markets, because the leverage does not look like it is there. That said, if leverage were building up, I would be a lot more worried about trying to achieve an unachievable target of 2%. Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

The ETF Monkey Vanguard Core Portfolio: 2016 Q1 Update

This article is an update to the following articles: On July 1, 2015, I wrote an article for Seeking Alpha introducing The ETF Monkey Vanguard Core Portfolio . On January 4, 2016, I wrote the 2015 year-end update for the portfolio. On February 11, 2016, following the severe market decline during the first part of 2016, I wrote a follow-up article that detailed a rebalancing transaction that I executed to bring the portfolio back in line with my target weightings. In this article, I will report on the performance of the portfolio for the quarter ended March 31, 2016. Evaluating the Portfolio: Q1 2016 Here is the corresponding Google Finance page for the portfolio as of the market’s close on 3/31/16. Have a look, and then I will offer a few comments. Click to enlarge First, as a reference point, the S&P 500 index closed at 2,043.94 on December 31, 2015 and 2,059.74 on March 31, 2016, for a gain of .77% for the period. Second, the portfolio received dividends totaling $208.56 during this period, bringing the cash balance in the portfolio to $251.53. This came from the 3 ETFs as follows: Vanguard Total Stock Market ETF ( VTI) – $132.00 Vanguard FTSE All-World ex-US ETF ( VEU) – $45.88 Vanguard Total Bond Market ETF ( BND) – $30.68 So how did the portfolio perform? All told, not too badly. The closing value of the portfolio was $49,076.43 as of March 31 vs. $48,348.37 on December 31, for a gain of 1.51%. Therefore, the portfolio outperformed the S&P 500 by .74% over this period. Let’s break down the performance, and reasons, by asset class. Domestic Stocks – During the period, VTI grew from $27,120.60 to 28,825.50, an increase of $1,704.90. Subtracting the $1,382.85 added from the February 11 rebalancing leaves us with a net gain of $322.05. Add in the $132.00 of dividends and VTI gained $454.05 on a base of $27,120.60, a gain of 1.67%. This is a slight outperformance when compared to the S&P 500 index. Foreign Stocks – During the period, VEU grew from $12,588.90 to 13,376.50, an increase of $787.70. However. removing the $761.40 added in the rebalancing transaction leaves us with a net gain of only $26.30. Add in the $45.88 of dividends and VEU gained $72.18 on a base of $12,588.90, a gain of .57%. As compared to the U.S. market, this reflects the continued underperformance of foreign markets. Bonds – During the period, the value of BND declined from $8,076.00 to $6,623.20. However, if we add back the $1,648.20 used in the rebalancing transaction, BND actually increased in value by $195.40. Add in the $30.68 of dividends received and BND gained $226.08 on a base of $8076.00, a fairly stunning increase of 2.80%. This reflected a firming of bond prices as the signs of economic malaise during Q1 appeared to lead the market to conclude that interest rates would remain low for a longer period of time than previously anticipated, including the likelihood of the Fed having to modify it’s goal of raising rates as often in 2016. No Transactions or Rebalancing This Period Here’s how the portfolio stood in terms of its asset allocations at 3/31/16. Click to enlarge As can be seen, due to my February 11 rebalancing and the strong performance of the domestic stock market through March 31, domestic stocks are a little overweight and bonds are underweight. As noted in my rebalancing article, I did this on purpose. I am going to monitor this as time moves forward. My preference will be to increase the bond weighting by using dividends that I will receive moving forward. However, if the weightings get severely out of line, I may have to effect another rebalancing transaction. Summary and Conclusion The portfolio did very well during the quarter, outperforming the S&P 500, my chosen benchmark, by approximately 3/4 of a percentage point. Sadly, it is still down a little over 3% from its inception date of June 30, 2015. As can be seem from the graphic, weakness in foreign stocks is the main culprit, as these entered a very weak period almost immediately following the establishment of the portfolio. Still, it is my belief that a disciplined allocation to foreign stocks will prove beneficial over the long term. Disclosure: I am not a registered investment advisor or broker/dealer. Readers are cautioned that the material contained herein should be used solely for informational purposes, and are encouraged to consult with their financial and/or tax advisor respecting the applicability of this information to their personal circumstances. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.