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Drivers Of ROE In The Context Of Portfolio Management

Someone on the Corner of Berkshire and Fairfax message board recently posted this comment referencing Buffett’s well-known piece on inflation from 1977 . In the article, Buffett describes the variables that drive a company’s return on equity. There are only five ways that a company can improve returns: Increase turnover Cheaper leverage (reduce interest charges) More leverage (increase the amount of assets relative to a given level of equity) Lower income taxes Wider margins Notice three of the five drivers of ROE have to do with taxes and leverage. So the pretax returns (as opposed to capital structure variations) are really driven by just asset turnover and profit margins. Some executives at the DuPont Corporation (NYSE: DD ) also noticed these drivers in the 1920s when analyzing their company’s financial performance. They broadly categorized the drivers as turnover, margins, and leverage. For now, I want to leave leverage out of it and think about turnover and margins. Portfolio Turnover I wrote a post a while back discussing the misunderstood concept of turnover in the context of portfolio management. Specifically, the topic of realizing gains (and paying those dreaded taxes). Basically, the idea of short-term capital gains is taboo among many value investors. I think it’s very important to try and be as efficient as possible with taxes. However, I think that tax consideration is only one of the (not the only) factors to consider. We could take Buffett’s five inputs that increase or decrease a company’s ROE and apply them to the portfolio. Basically, as investors, we are running our portfolio just like a business . We have a certain level of equity in the portfolio, and we are trying to achieve a high return on that equity over time. The exact same factors that Buffett talks about above apply to our portfolio. Those five factors are the inputs that will increase or decrease our portfolio ROE (aka CAGR) over time. Notice that taxes is one of the (but not the only) factors. Turnover is also one of the (but not the only) factors. Michael Masters is not a value investor, but he runs a fund that has produced fabulous returns over the past 20 years or so (from what I’ve read, north of 40% annually). You can read about him in the book Stock Market Wizards by Jack Schwager . Now, I don’t understand his specific strategy, and I’m not suggesting it’s one that should be cloned, or copied, etc… I’m just focusing on the turnover concept here. Masters, according to the interview, runs a strategy focused on fundamental catalysts, and holds stocks an average of 2-4 weeks. When he was running a smaller amount of money, he was compounding at 80%+ per year. Of course, he was paying a lot of taxes. His investors – the ones in the highest tax bracket – might be “only” netting 40% or so after tax. But who would be upset with paying a lot of taxes if it means achieving a 40% return on the equity in your capital account? Obviously an extreme example, but the concept illustrates the point that just because you hold stocks for years and years and pay very low taxes doesn’t mean that your after tax ROE will be any better than an investor who pays a lot of tax and achieves a much higher pretax return. I think it’s very difficult to compound capital at 20% or more without some amount of turnover in the portfolio. This doesn’t mean I’m promoting higher levels of activity. I’m not. I think making fewer decisions is often better, and trying to do too many things is very often counterproductive. I’m just saying that the math suggests that some level of turnover is needed if your goal is to compound capital at north of 20% over time. This is one of the reasons I love bargains and deep value special situations in addition to the compounders. As I’ve said before, very few companies compound their equity and earnings at 20% or more over years and years. Those that do often are priced expensively in the market. But to achieve portfolio returns of 20% without paying taxes, you’d have to not only properly identify these companies in advance, but you’d have to have the foresight to invest your entire portfolio in them. How Did Buffett and Munger Achieve Their Results? It’s a difficult proposition to be able to seek out in advance the truly great compounders that will compound at 20%+ for a decade or more, and that’s why investors who focus on bargains and special situations often are the ones with the extreme performance numbers (like Buffett doing 50% annual returns in the 50s, Greenblatt doing 40% annual returns in the 80s and 90s, etc…). It’s unlikely to do 20% annual returns by buying and holding great businesses for a decade without selling. It’s basically impossible to do 30%+ without ever selling. Charlie Munger has promoted the idea of low turnover – and I think his reasoning (as usual) is very sound, but I think he was using the Washington Post as an example – and I think that might be (dare I say) somewhat biased in hindsight. But if you’re looking for decent after tax returns, he’s right. If you can find a company that compounds at 13% per year for 30 years, you’re going to achieve good after tax returns on your capital. But, I think finding the Washington Posts of the world are easier said than done in hindsight, especially when thinking about a 30-year time horizon. Another example I’ve discussed before is Disney (NYSE: DIS ). Buffett bought Disney for $0.31 per share and sold a year later for a 50% gain in the mid-60s. He laments that decision as a poor one, but in fact his equity has compounded at a faster rate than Disney’s stock over time, making his decision to sell out for $0.50 a good one. And that is an extreme example using probably one of the top 10 compounders of all time. Not every stock is a Disney, thus making the decision to sell at fair value after a big gain in a year or two much more likely to be the correct one. Back to Munger’s Washington Post example… I like to consider his audience. I don’t necessarily think he was saying this is the highest way to achieve attractive investment results. My guess is he was trying to convey the importance of long-term thinking and lower turnover. However, when Munger ran his partnership, he was trying to compound at very high rates, and for years did 30% annual returns. He didn’t do this by buying and socking away companies like the Washington Post. He may have had a few ideas like that, but he was a concentrated special situation investor who was willing to look at all kinds of mispriced ideas. Buffett/Munger of Old vs. New I think there is a disconnect between the Buffett/Munger of old, and the Buffett/Munger of today. Their strategies have obviously changed, and their thinking has evolved. But their best returns were in the early years when they could take advantage of the (often irrational) pricing that Mr. Market offered. They were partners with the often moody Mr. Market back then and they took advantage of his mood swings. When they came into the office and Mr. Market was downtrodden, they’d buy from him. And on the days when Mr. Market was excited and overly optimistic, they’d sell to him. Their bargain hunting days provided them and their investors with 20-30% annual returns. They made a lot of money. They paid a lot of taxes. As they compounded capital, they began to evolve. Buffett and Munger both have discussed this, but they both have said with smaller amounts of capital, they’d invest very differently. Buffett bought baskets of Korean stocks in his personal account in 2005 when some were trading at 2 times earnings with net cash on the balance sheet. He’s also done arbitrage situations, REIT conversions, and other things in his personal account that provided attractive, low-risk returns (and very high annualized CAGRs). By the way, this is not an indictment against compounders. As I’ve mentioned before, my investments tend to fall into one of two broad categories: compounders and special situations/bargains. I actually enjoy investing in compounders the most, since they do the work for you. But bargains are the ones that often get more glaringly mispriced for a variety of reasons (not the least of which is the fact that the compounders are great businesses – and everyone knows they are great). But I don’t have a dogmatic approach to investing, and I will look for value wherever I can find it. I’m not sure if this post really has a hard conclusion and maybe this is more of a ramble than anything else. I’m not sure how to sum it up, so I’ll just stop here. These are just observations I have had, and the COBF post on Buffett’s 1977 piece ( which is a great piece to read if you haven’t ) prompted some of these thoughts which I decided to write down and share. I think it’s important to understand the drivers of investment results (portfolio returns on equity) are the exact same factors that drive the ROE of a business. Feel free to add to the discussion if you’d like. Have a great week, and for the golf fans, enjoy the US Open.

Whats Wrong With Emerging Markets ETFs?

Summary Major Emerging Markets ETFs (EEM & VWO) are investing in the “legacy economy” and not in the “new economy”. Government owned Chinese banks, Brazilian oil companies and Russian resource companies dominate major ETFs. BABA, BIDU, MELI, YNDX and other US listed EM E-commerce companies are NOT in EEM & VWO. What’s wrong with Emerging Markets ETFs? After years of poor relative returns investors have become disinterested and disenchanted with the leading Emerging Markets ETFs ( EEM , VWO ). While the U.S. stock market has made new highs and posted double digit returns, Emerging Markets haven’t done much, leading many investors to question the value of their Emerging Markets allocations. Adding to the woes are headline risks that are really in the headlines as revolution, war, fraud and corruption have either happened in the recent past or are happening right now. But maybe there is a bigger problem. In spite of all the turmoil and risk, Emerging Markets are growing. In fact they are growing at twice the pace of the U.S. and the rest of the developing world. And some countries and sectors within Emerging Markets are growing at quite spectacular rates. But why then aren’t the indexes and ETFs that track Emerging Markets performing better? A closer look at the indexes reveals some major flaws in the largest Emerging Markets ETFs. SOEs are Not Seeking Alpha Weighing most heavily on the indexes is their enormous allocation to state-owned enterprises (SOEs) which account for nearly 30% of the weight of the largest Emerging Markets ETFs. These companies represent the past of Emerging Markets, but not the future. The largest of these SOEs are Chinese, Brazilian and Russian state owned banks and oil companies. Many adjectives describe SOEs including, monolithic, inefficient, conflicted and corrupt. You don’t need not look far to see the problems with investing in SOEs. Recent news has been filled with reports of the investigation of top Brazilian government officials suspected of plundering state-owned oil giant PetroBras of over $1 billion in kickbacks and bribes. The Chinese government has launched a campaign to return 150 “economic fugitives” living in the U.S. who have fled China after allegedly looting or defrauding state owned businesses. And in Russia, where do you even start? Is South Korea Twice as Big as India? Less widely recognized are some of the other factors that can distort the indexes. Traditional index construction methodology uses market capitalization to determine weightings, an approach that in Emerging Markets tends to overweight countries with large banks and financial companies and small populations. As a result, countries like South Korea and Taiwan end up with about twice the weight of India in the major Emerging Markets despite the fact that India has 25 times the population of Korea and 50 times that of Taiwan. Does that make sense? (click to enlarge) Source: Big Tree Capital LLC (click to enlarge) Source: Big Tree Capital LLC How are 3.4 million Rich People 26% of “the Next Emerging Markets”? Things get even worse in so-called Frontier Markets indexes and ETFs. While often dubbed as “the next Emerging Markets” by the fund companies, Kuwait, with a population of only 3.4 million and per capita GDP on par with the U.S. comprises 26% of the largest Frontier Markets ETF (NYSEARCA: FM ). How much room for growth is there with 3.4 million rich people? Meanwhile, Nigeria, with a population of 173 million gets only a 10% weighting. (click to enlarge) Source: Big Tree Capital LLC (click to enlarge) Source: Big Tree Capital LLC Where the Growth is in Emerging Markets Most Emerging Markets investors know that the real growth opportunity in Emerging Markets is the growth of the consumer class. There are dozens of studies and reports published by investment banks, consulting firms and fund companies describing how billions of humans are moving from subsistence income levels to levels where they begin to consume more and better food, clothing, appliances, cars, etc. It’s a very good story. It’s a big story. In a report titled “Going for Gold in Emerging Markets” McKinsey & Co concludes that the growth of consumption in Emerging Markets is “the biggest growth opportunity in the history of capitalism.” Yet, in the major Emerging Markets ETFs, the consumer sector gets a meager 16% weighting. EEM & VWO are Missing the Best Part Finally and importantly, the major indexes and ETFs are largely missing out on something big that is just starting. As the Emerging Markets consumer wave hits, another wave has formed and is gathering momentum. All over the developing world, consumers are getting internet access via wifi and mobile broadband. At the same time, a new breed of manufacturers is offering smartphones for as low as $40. And prices are going to keep dropping. Consider the case of Xiaomi – a Chinese manufacturer of entry level smartphones. The company – which is less than five years old – will sell about 100 mm smartphones this year, up from 60 million units sold in 2014. In the next 5 years a billion consumers will emerge with a $40 smartphone in their hands. The result of this trend is significant revenue growth and value creation. Estimates are that Ecommerce in Emerging Markets has grown at an average of 41.5% for the past five years. And, while this rate is sure to slow, it still clocked an impressive 39.9% growth in 2014. (click to enlarge) Source: EMQQ Index Yet, Alibaba (NYSE: BABA ), MercadoLibre (NASDAQ: MELI ), Baidu (NASDAQ: BIDU ), JD.com (NASDAQ: JD ), Yandex (NASDAQ: YNDX ), 58.com (NYSE: WUBA ) and most of the 50+ publicly traded Emerging Markets Ecommerce companies benefiting from this growth are not in EEM or VWO because they choose to list on U.S. exchanges. The companies are essentially being “punished” from an indexing perspective for listing on the exchanges that will give investors greater liquidity and transparency than their “home” markets. In short, the major ETFs and indexes are leaving out the future. Investors Should Move On Investors using ETFs to gain exposure to Emerging Markets should re-evaluate their allocations. Using legacy indexes and ETFs that provide exposure to the entire universe of Emerging Markets companies may not be the best way to benefit from the growth of Emerging Markets. Investors should concentrate on identifying the Emerging Markets ETFs that provide them with targeted exposure to sectors and companies that are both growing and seeking to maximize shareholder value. Disclosure: I am/we are long EMQQ, BABA, BIDU, YNDX, WUBA, JD, MELI. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: I have created an Emerging Markets Internet & Ecommerce Index. The index has been licensed as the basis for EMQQ The Emerging Markets Internet & Ecommerce ETF (NYSE:EMQQ). I receive a licensing fee from the ETF.

Revenue Growers In A Late-Stage Stock Bull

I cannot predict when fundamental valuation will matter again, or when economic weakness will create a panicky rush for the exit doors. What I do know is that fear of missing out eventually gives way to fear of loss. Several things become clear about corporate debt binges at record low rates and the subsequent use of cash to reclaim shares. There are a few ways in which an investor might attempt to circumvent the artificial earnings dilemma. Some facts are more disconcerting than others. For instance, top-line sales at S&P 500 corporations will decline for the second consecutive quarter for the first time since 2009. Equally discouraging? Roughly 70% of these companies (77/106) have reported negative profit-per-share outlooks. Meanwhile, earnings-per-share (EPS) prospects are expected to fall across the entire S&P 500 space. It follows that price-to-earnings (P/E) and price-to-sales (P/S) ratios will place stock assets at even more ridiculously overvalued levels. Few market participants care about the so-called fundamentals in late-state bull markets. Indeed, traditional metrics of stock valuation simply don’t matter (until they do) and complacency reigns supreme (until it does not). Those with extremely bullish biases attempt to spit shine the lusterless economy. However, the Federal Reserve itself downgraded its 2015 forecast for economic expansion. The downgraded pace that the Fed now offers is 1.8%-2.0% – a pace that is slower than the stimulus-stoked 2.1% achieved since the end of the Great Recession. In truth, bulls should hang their collective hat on the $2.7 trillion that S&P 500 corporations borrowed at ultra-low rates over the last past six years. These companies bought back their own stock shares at the highest percent-of-total-cash available since 2007. Several things become clear about corporate debt binges at record low rates and the subsequent use of cash to reclaim shares. First, companies are not particularly talented at judging when to plow dollars into the acquisition of their stock shares. They spent an ever-increasing percentage in the 2003-2007 stock market bull when they might have been better served to spend more modestly on shares and/or use the cash more productively (e.g., hiring, training, R&D, equipment, etc.). Moreover, they spent lower and lower percentages as the 2008-09 bear market raged on when acquiring shares during the bulk of the bear would have been far more favorable. Second, the primary use of stock buybacks has been to manipulate profitability perception. Companies reduce the number of outstanding shares in existence such that less supply of shares are available, even when demand is flat or waning; effectively, prices have a floor underneath them. What’s more, when there are less shares in existence, corporations appear more profitable than they really are. Now let us go back to the earlier reality that, earnings-per-share (EPS) are still expected to decline in Q2. So even with record levels of share buybacks, profitability per share will not rise. Nor will revenue. In fact, sales have been flat for years at many of the big-time Dow components and most in the media fail to highlight revenue shortfalls. There are a few ways in which an investor might attempt to circumvent the artificial earnings dilemma. One possibility is to rely on revenue generating firms, since sales-per-share is more difficult to manufacture than earnings-per-share. The RevenueShares Large Cap ETF (NYSEARCA: RWL ) weights each component of the S&P 500 by revenue rather than market capitalization. The RWL:S&P 500 price ratio below demonstrates that there may be value in overweighting top-line sales winners. One should recognize that outperformance in a bull market is less critical to long-term investing success than losing less in a bear market . Owning RWL won’t be of much service if the “fit hits the shan.” In other words, in an overvalued stock bull where there is high probability of a severe selloff in the not-so-distant future, one might wish to increase his/her allocation to assets on the lowest end of the risk spectrum. Consider employing the iShares 1-3 Year Credit Bond ETF (NYSEARCA: CSJ ), the SPDR Nuveen Barclays Short-Term Municipal Bond ETF (NYSEARCA: SHM ) and/or your money market account. Nobody knows when the global investing community will wake up. I certainly cannot predict when fundamental valuation will matter again, or when economic weakness will create a panicky rush for the exit doors. What I do know is that fear of missing out eventually gives way to fear of loss. The typical U.S. stock bear will destroy 30% of capital that is allocated to the asset class. That is the history of the financial markets. Those who don’t recognize 150 years of equity market activity are doomed to experience similar price depreciation. Raising cash when the prices are higher and buying when the prices are lower may be one’s best defense. Click here for Gary’s latest podcast. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.