Thursday, 16 March 2017

The History of Johnson & Johnson

 I have a soft spot for Johnson & Johnson.  What many investors don’t realize is that Johnson & Johnson proper doesn’t actually do anything in the sense that most people think it does.  Rather, it’s a holding company with controlling stakes in 265 individual operating businesses; firms with their own executives, employees, boards of directors, bank accounts, offices, products, and services that do business in every country on the planet.  The parent holding company’s job is to provide operational support for these subsidiary companies, including sourcing low-cost capital through borrowings (it is one of only three industrial businesses with an AAA credit score) and moving money from one to another in a way that allows lucrative opportunities to be seized; e.g., distributions can be declared from a profitable, but slow growing company, and dumped into a new idea that needs to scale quickly.  The holding company itself has increased the dividend payable per share to its stockholders every year, without exception, for 52 years; through recessions, wars, inflation, you name it.
The 265 individual companies that fall under the parent Johnson & Johnson holding company umbrella generally belong to one of three categories:
  • Consumer Healthcare: Things like baby powder, baby shampoo, baby lotion, Listerine mouth wash, Tylenol pain reliever, Rogaine hair loss treatment, Band-Aid bandages, Aveeno face washes, Neutrogena skin care, Lubriderm skin care, Bengay muscle relaxer, Neosporin disinfectant, Pepcid heartburn relief, Nicorette nicotine gum, Motrin, Benadryl, Sudafed, Mylanta, Visine eye drops, and Acuvue contact lenses to name a few.
  • Medical Devices: Everything from sterilization products for hospitals to blood glucose monitoring systems.
  • Pharmaceuticals: World-class drugs treating everything from cancer and diabetes to HIV and schizophrenia.
For example: Have you ever heard of McNeil-PPC, Inc.?  Probably not.  According to Wikipedia, its predecessor was founded on March 16, 1879 by Robert McNeil, who was 23 years old and paid $167 for a drugstore “complete with fixtures, inventory and soda fountain” in Philadelphia.  Decades later, it expanded into pharmaceutical distribution.  In 1959, it was acquired by Johnson & Johnson.  By infusing additional resources into the firm, McNeil-PPC, Inc. setup its own subsidiaries, including one called McNeil Nutritionals LLC.  That latter business entered a joint partnership with Tate & Lyle, the British agricultural giant, to develop an artificial sweetener.  After years of scientific discovery and perfection, the product known as Splenda was born.

If you didn’t know about this, when you visited Splenda’s website and saw “McNeil Nutritionals,
LLC” as the owner, you wouldn’t know some of those earnings are being paid up to McNeil-PPC, Inc., which in turn find their way to the parent Johnson & Johnson company in New Jersey.  If tomorrow, a really promising drug appeared on the horizon, Johnson & Johnson’s parent company could declare dividends from McNeil-PPC, setup a new operating LLC, infuse the cash into it as part of the capitalization structure, reassign executives and talent to get it off the ground, and shave off ten or more years of ramp-up work.

Furthermore, what makes Johnson & Johnson unique is that it is one of the only businesses in the Fortune 500 that explicitly rejects the “shareholder maximization is the highest priority” dogma that arose during the 20th century.  The enterprise is guided by its Credo, which is a work of art.  Quite literally.  The words, engraved at corporate headquarters, were penned prior to the 1944 initial public offering by the firm’s most famous Chief Executive Officer, letting new owners know that, while generating a return for them was important, it was far down the list to serving patients, doctors, suppliers, and employees; the theory being that there are multiple constituents with a vested interest in the prosperity of a firm, and that sometimes, doing the right thing long-term required sacrificing earning power today.  It’s a moral and ethical triumph that, I believe, should be replicated by other corporations and taught in business schools.

Following the Credo is what saved the firm’s reputation during the Chicago Tylenol murders of 1982.  When it became clear someone had tampered with capsules, slipping cyanide in them and killing those who took the pills, Johnson & Johnson immediately put the safety of their customers ahead of the income statement.  They did not attempt to minimize or deny the situation.  It pulled 330 million pills off the shelf and went from 34% market share to 0% overnight, according to Alan Hilburg.  He said they didn’t have a crisis plan, they had the Credo.
The company also immediately retooled their factories to create a visual metaphor for safety, introducing an aluminum tamper-evident seal, plastic coating, and pill capsules that couldn’t be broken apart easily.  Within 90 days, the consumer trust was so high that market share skyrocketed to 46%.
What’s so magical about the Johnson & Johnson credo?  Judge for yourself.

Our Credo

We believe our first responsibility is to the doctors, nurses and patients, to mothers and fathers and all others who use our products and services. In meeting their needs everything we do must be of high quality. We must constantly strive to reduce our costs in order to maintain reasonable prices. Customers’ orders must be serviced promptly and accurately. Our suppliers and distributors must have an opportunity to make a fair profit.
We are responsible to our employees, the men and women who work with us throughout the world. Everyone must be considered as an individual. We must respect their dignity and recognize their merit. They must have a sense of security in their jobs. Compensation must be fair and adequate, and working conditions clean, orderly and safe. We must be mindful of ways to help our employees fulfill their family obligations. Employees must feel free to make suggestions and complaints. There must be equal opportunity for employment, development and advancement for those qualified. We must provide competent management, and their actions must be just and ethical.
We are responsible to the communities in which we live and work and to the world community as well. We must be good citizens — support good works and charities and pay our fair share of taxes. We must encourage civic improvements and better health and education. We must maintain in good order the property we are privileged to use, protecting the environment and natural resources.
Our final responsibility is to our stockholders. Business must make a sound profit. We must experiment with new ideas. Research must be carried on, innovative programs developed and mistakes paid for. New equipment must be purchased, new facilities provided and new products launched. Reserves must be created to provide for adverse times. When we operate according to these principles, the stockholders should realize a fair return.
It’s worked in spades.  Johnson & Johnson has been one of the most successful blue chip stock investments of all time.  The underlying economic engine and incentive systems unleashed by the business model are so superior to most other firms, that even if you bought it at absurd valuation levels, such as during the Nifty Fifty era, you still beat the S&P 500 if you held it for 25+ years.  It has a structural advantage its competitors can’t match.
Specifics are always useful so to give you an idea of real-world numbers, let’s imagine you go back to the early 1980’s when me  and the misses were born.  Say that our parents and grandparents got together and, between them, kicked in $50 a month for us, respectively, by sending a check to the Johnson & Johnson dividend reinvestment program.  It was already one of the biggest healthcare companies in the world.  Nearly every widow in the country owned it.  It had a prominent place in the portfolio of most mutual funds.  This was not some little-known firm but, rather, a global medical conglomerate with the founding family ranking on the then-newly established Forbes 400 list.  This would have taken nearly nothing; hardly any sacrifice; veritable pocket change.
What would we have today had this occurred in some alternate universe?  Ignoring the minor fees which wouldn’t have made much difference, anyway, here’s what each of us would have brought into the marriage property sitting on our joint balance sheet:
    • Mr. Investor: 396 months, at $50 each, for total out-of-pocket savings of $19,800.  It would have grown to 3,719 shares worth around $339,582.97.  I’d be collecting $11,157 in annual cash dividends.
    • Mrs. Investor: 394 months, at $50 each, for total out-of-pocket savings of $19,700.  It would have grown into 3,650 shares worth around $333,272.98.  He’d be collecting $10,950 in annual cash dividends.
Combined, that’s 790 aggregate months of saving, at $50 each, for total out-of-pocket cash contributions of $39,500.  It would have grown to 7,369 shares worth around $672,855.95.  We’d be collecting $22,107 in annual cash dividends.

Here’s the crazier part.  Imagine that our fictional alternate-dimension family handed us the stock certificates today and stopped contributing entirely.  We decided to lock the shares away, ignoring them and never putting any new money into it other than reinvested dividends.  If the firm compounded at less than its long-term average (it is much bigger, after all, so let’s shave off a few points), by the time we were Warren Buffett’s age the stake would have grown to $243,926,664.  That’s not a typo, it’s a quarter-of-a-billion dollars.
Even assuming some higher inflation inputs, the purchasing power equivalent would be just shy of $32,000,000 in today’s money.  Compounding is a nutty thing when you get your hands on a great asset, even in small amounts, and leave those assets alone for almost a century.  I can say with near absolute certainty that Johnson & Johnson will be owned a long time by my family.

How did it come into existence?  By what workings did the modern Johnson & Johnson corporation, with all of its good, arrive on the commercial scene?  Travel with me back in time.

The Birth of Johnson & Johnson

In the 19th century, Sylvester and Louisa Wood Johnson had eleven children.  They were “farmers and cattle breeders in Crystal Lake, Pennsylvania” according to Barbara Goldsmith’s 1987 recounting, Johnson v. Johnson.
One of their sons, Robert Wood Johnson (1845-1910), relocated to East Orange, New Jersey to work with a man named George Seabury, with whom he established a pharmaceutical partnership called, appropriately enough, Seabury and Johnson.  Robert hired two of his younger brothers, Edward Mead Johnson (1853-1934) and James Wood Johnson (1856-1932) to work for him.
In 1883, when Edward Mead was 30 years old, and James Wood was 27, they decided they wanted to be their own bosses.  They quit their brother’s firm and setup a new business called Johnson & Johnson, using a simple logo the latter wrote by hand.  This business prospered.  Robert saw how well they were doing and, again according to Goldsmith’s examination of the family historical record, approached them about working together despite having parted ways not that long ago.  He left Seabury and Johnson, signing a non-compete agreement that banned him from the industry for a decade.  However, in 1886, he sought an exemption from the state that allowed him to discard his earlier promise on the theory that consumers benefited from the competition.

Robert infused his money into Johnson & Johnson and the boys were granted incorporation of their enterprise in 1887.  The “new” Johnson & Johnson consisted of “fourteen workers on the fourth floor of a small New Brunswick, New Jersey, factory”.  Barely a month and a half later, as the controlling stockholder, Robert demoted James from the position of President and assumed the role himself.
A driven, overbearing man, Robert was obsessed with preventing germs and infection, much to the benefit of society.  As Goldsmith put it, “In a time when the post-operative death rate in hospitals ran as high as 90 percent, when the cotton used in surgical dressings was made from the sweepings from the floors of textile mills, the Johnson brothers began to utilize [English surgeon Joseph Lister]’s methods of sterilization on a large scale to produce ‘the most trusted name in surgical dressings’.  Using an India-rubber-based adhesive, the Johnsons manufactured pre-packaged surgical dressings that were the forerunners of the Band-Aid.”
By the time he died in 1910, Robert Johnson had built the Johnson & Johnson company into “a plant consisting of forty buildings” and held 84% of the corporation’s stock.1  All was not lost, though, because back in 1882, he had married a woman named Evangeline who was the daughter of an affluent doctor.  They had three children.
  • The eldest son, Robert Wood Johnson, Jr. was born in 1893.
  • The middle son, John Seward Johnson, was born in 1895.
  • The youngest daughter, Evangeline Armstrong Johnson, was born in 1897.
Though he had little to no interest in his family – all he cared about was the business and couldn’t even be bothered to step away long enough to attend vacations with them – he left the Johnson & Johnson stock to his children.  Specifically, he instructed that his common stock, along with its voting power, be split evenly among the two sons so that each ended up with 42% of the Johnson & Johnson business, and he set aside a small block of preferred stock for his daughter as he didn’t believe women should be involved in running enterprises nor equally inherit; a misogynist belief that ran through the empire up until recent decades when female family members were forced to hand over control of their decision making to their brothers and, at the business, women weren’t even allowed in the executive dining room.
With uncle Edward Mead Johnson already working on his new firm and no longer a part of the Johnson & Johnson he founded (see footnotes), the boys’ uncle and company co-founder, James Johnson, stepped back into the role of President, taking the 17 and 15 year old into his home.  Robert Jr., realizing he was the only living Robert at this point, dropped the diminutive (he would later become “General Johnson” following World War II) and was hired at Johnson & Johnson as a lowly millhand.  Goldsmith says in her research that James used to confide in his daughter at the unpleasant nature of serving as the President of a company he co-founded, yet having to come home to answer to his teenage nephews, who between them were unstoppable due to the combined 84% stake they held.

General Robert Johnson and Seward Johnson Establish the 1944 Johnson & Johnson Family Trusts

It is with these two brothers – General Robert Johnson and Seward Johnson – that the 20th century Johnson & Johnson saga begins.  It is they, and their personalities, mistakes, and behaviors, that caused so much destruction and, in the case of the former, societal good.
For 22 years, James Johnson ran Johnson & Johnson for his nephews, who did things like take trips around the world to scout for new manufacturing plants. He protected and grew the business, churning out earnings and dividends for the stockholders, while providing products that saved lives and eased suffering.  When James died in 1932, the now-experienced-38-year-old Robert Johnson, a brilliant, driven egomaniac, took the reigns of his birthright and named himself President of the firm after coming to agreement with his submissive brother, Seward, that they would always act in concert, and it would be he, and he alone, who sat in the big chair at Johnson & Johnson.
Upon assuming his position, he went about re-telling the history of Johnson & Johnson so that the original two founders, uncles Edward Mead and James, were written out and his late father, Robert Sr., was treated as the founder in newspapers, magazines, and biographies.  One account says that the company portrait of James, who had raised him after his father’s death and loyally served as the President of the business he founded, was shoved in a closet for almost two decades, as if he had never existed.  It was only after his aunt shamed him into rehanging it that it was brought out of storage.

Although he made a total mess of his family, reportedly destroyed his own son before reconciling, and set in motion of series of events responsible for the implosion of the Johnson family clan, General Johnson was one of the greatest corporate executives who ever lived.  He also radically improved civilization through his charitable work.  Today, the Robert Wood Johnson Foundation is the largest health-based philanthropy in the country, with almost $10 billion in assets, distributing around $400 million per annum to do everything from researching ways to develop human capital to finding methods to fight childhood obesity.
One family member described him as charming on the outside but a shark on the inside.  Other than his treatment of women, he followed the Johnson & Johnson credo, which he developed and penned himself, in both spirit and letter.  He would fire anyone, on the spot, who put profits ahead of quality.  He would interview even the lowliest employee so he could figure out what could be improved without the bureaucracy obfuscating his view of ground-level conditions.  He demanded total, complete, and absolute loyalty and control.
General Robert was obsessed, in outcome, anyway, with the power of compounding.  He wanted both the firm, and its stock, to grow so he had a policy of low dividend payouts, reinvesting most profits into growth.  In 1944, he decided an IPO would be the best way to raise capital for expansion, accelerating the rate at which his empire was spreading across the world.  He used this as an excuse to solve three other problems:
  1. Even though he owned 42% of the stock and Seward owned 42% of the stock, Robert wanted majority voting power so he could reign without contest.
  2. He wanted the family to leave the stock untouched so it could compound into a truly impressive amount of wealth.
  3. He wanted the male members of the family to continue holding all of the influence, with the females subjected to them.
He convinced his brother to put 45% of his holdings, or 18.9% of the entire Johnson & Johnson company, into a series of six trusts over which he (Robert) and two “yes-men” associates would serve as trustees including the right to vote the stock (Seward had five children already born and was about to become father to a sixth).  Robert didn’t trust outsiders so he had Johnson & Johnson’s in-house counsel, Kenneth Perry, draw up the trust instruments.  Concerned only with his own power and desire to see the fortune compound, the trust instruments were iron-clad and severe in command, modeled after the now-well-known generation skipping trusts made famous by the Rockefellers.  According to Goldsmith:
  • Each of these trusts contained 15,000 shares of Johnson & Johnson, then valued at $500,000 [Note: This is around $6,779,500 in today’s inflation-adjusted terms.  Also note, one of the heirs insists her trust only began with $250,000, not $500,000, so there is some degree of ambiguity].
  • Seward’s children would receive annual annuities ($6,000 per year, or $81,350 in inflation-adjusted terms) plus discretionary payouts, which Robert clearly didn’t intend to exceed more than token amounts.
  • Each child would have the right to declare beneficiary / beneficiaries for the trust.  Upon their death, the trust would dissolve and the person or people listed as beneficiaries would inherit everything
  • Seward’s son, Seward Jr., would become trustee of his sisters’ trusts upon his 21st birthday, and be entitled to vote their stock on his 33rd birthday.  The women couldn’t be trusted to run their own affairs.
Robert also setup his own, similar trusts for his bloodline at the same time.
The combination of low dividend payouts and high trust retention, along with beneficiaries themselves getting next to nothing relative to the trust value that was accumulating, led to a series of family tragedies, battles, deaths, and scandals that make a Mexican soap opera look tame in comparison.  There was a Polish maid who got her hands on more than $300 million of the family fortune and turned it into $3.6 billion.  There were allegations of rape and incest.  There were drug overdoses and suicides.  There was an alleged murder plot.  There were numerous lawsuits that resulted in tens of millions of dollars going to lawyers.  There were family members who married and divorced as if they were changing coats.  On the plus side, there were staggering charitable donations that benefited civilization.
One of Seward’s children accurately summed up the trusts General Robert convinced his brother to establish as thus: “Those trusts weren’t set up for love and caring, they were done because Uncle Bob wanted to control the vote on ninety thousand shares of stock without experiencing the tax consequences of ownership.  Those trusts were never supposed to take care of us, we were supposed to be taken care of in other ways.  I might sue my trustees.  Every time I ask them for something, they throw it up in my face that they have to protect the remainderment for my heirs.  I wrote them a letter and quoted the trust agreement; it said that this money was being put away for my welfare, my good, not for someone to get after I die.”

The Johnson Family Trusts Were Effective But the Family Culture Was a Failure

The interesting thing about the trust funds that General Johnson had established is they were extraordinarily successful.  They did what they were intended to do – consolidate voting power, transferring significant assets into the grandchildren’s hands as each $500,000 trust blossomed into $600,000,000+ while stopping the second generation from spending it – but the family culture failed due to intractable character flaws of both Robert and Seward.  They hurt, in some form or another, nearly everyone with whom they were involved.  The case study I did of the family fortune for the purposes of learning about the mistakes (and how best to avoid them) is one of the few times I felt physically ill.  Coming from a good family, I can’t wrap my head around the fact people grew up that way, with so much neglect, abuse, entitlement, self-sabotage, and lack of purpose.  There is a brokenness there that seems hopeless.  No amount of capital can possibly compensate for the short end of the stick some of them were handed.  Frankly, I don’t know how a sensible person could grow up in that environment and emerge normal.  I hope some of them find happiness.  While the fortune left behind has done wonders for scientific and healthcare philanthropy, it’s torn asunder their family tree; certainly more of a curse than a blessing in my estimation.
For all of his foresight, General Johnson failed on the wisdom front.  He helped his family amass more money than they could ever spend, but he didn’t help them amass wealth.  In fact, he left them impoverished in a lot of ways that matter.  As I see it, wealth is a combination of several things coming together: Good health, financial independence, achievement, excellence and pride in your work, a loving family that you know has your back and wants the best for you (give me the sound of multiple generations running around laughing and talking, the scent of a roast in the oven, and a good book off in a corner and that’s my idea of heaven), personal integration so you know you’re living your moral and ethical values, surrounding yourself with people who challenge you, an understanding somewhere deep within your soul of who you are as a person that nobody can take away from you – that core identity that makes you who you are.  Wealth is waking up and looking around saying, “There is nowhere else I would rather be, nobody else with whom I would rather be experiencing this moment, and nothing else I would rather be doing.”  Yes, the money is a wonderful tool in facilitating that but that is all it is – a tool.  Alone, it isn’t enough.  It will never be enough.  Money should never be the most interesting thing about you.
In any event, the Johnson family hasn’t had anything to do with Johnson & Johnson, at least in any meaningful sense, for decades.  The $257 billion enterprise is the highest quality, most diversified health care blue chip in the world.  I have little doubt that, all else equal, the probabilities indicate a decent-size block today should be worth an obscene amount in fifty years due to that structural advantage I mentioned, even if there are ugly periods in the interim.  Professional non-family management has had the reins for more than a generation as the Johnson family stake continues to fall in firm importance, crowded out by the shares you, your friends, and your family hold in index funds, mutual funds, dividend reinvestment plans, and brokerage accounts.  If you told me I could only hold ten stocks for the rest of my life, it would be on the list.

1 His brother, Edward Mead, was no longer involved in operations by this point.  In 1895, he started a side business called The American Ferment Company.  In 1897, he left Johnson & Johnson to work on it full time, setting up shop in Jersey City, New Jersey.  In 1905, he formerly incorporated as Mead Johnson & Company; the specialty product being digestive aid.  A few years later, in 1910, Mead Johnson & Company developed a blockbuster infant formula that had the distinction of being the first physician-recommended breast milk replacement in the United States.  The firm ended up moving to Evansville, Indiana, to get better access to the raw agricultural commodities it needed, and grew fantastically.
The role of CEO passed down the line, from father-to-son, for three generations until Bristol-Myers acquired it in a buyout.  The deal, announced in August of 1967, involved an all-stock purchase (both common and preferred) worth $240 million.  Wikipedia, which sources Reckert, Clare M. “Exchange of Stock Set; Merger Deal Set by Bristol-Myers“, The New York Times, August 25, 1967, states that prior year sales were $131 million with earnings of $7.3 million.
In 2009, Bristol Myers Squibb (as it was now known, following other mergers) conducted a two-part split-off (or “carve-out” as it is sometimes called) that involved an initial public offering for 10% of the business.  Mead Johnson, which had expanded to $2.9 billion in sales by this point, raised $720 million in gross proceeds, far exceeding the $562.5 million that had been hoped.  The cash helped strengthen Bristol Myers Squibb’s own balance sheet.  The remaining 90% of the stock was made available to shareholders who were willing to swap their stock in Bristol Myers Squibb for stock in Mead Johnson.  This facilitated what amounted to a tax-free asset exchange and a massive share repurchase.
Today, Mead Johnson is a stand-alone, $18 billion nutritional behemoth. 

Long: JnJ

Sunday, 26 February 2017

The Philip Morris Investment by Fayez Sarofim

Fayez Sarofim is a Houston-based investor that has seen his fortune climb on the coattails of buying-and-holding consumer stock investments. Coke, Nestle, McDonald’s–you name it–he bought it decades ago and holds it on the balance sheet of his Fayez Sarofim & Co. today.

After I published my recent article on Philip Morris International’s recent stock performance, Sarofim’s firm crossed my mind because I know that Philip Morris International (PM) is the investment that catapulted his own way from poverty in Egypt to a gilt-edged life of material success in the United States. To date, Sarofim finds himself sitting on 16,711,214 shares of PM stock.
An aside to precede my commentary: Did you guys see that post on the Mr. Money Mustache website about a year ago when Peter Adeney talks about how it was much easier to build additional wealth once he was financially successful compared to when he was starting out and hungry for it?
It sounds a little bit counterintuitive, but the advantage that comes from pre-existing wealth is that you can afford to take the long view. This advantage was best explained by a character in the Terry Pratchett work “Men At Arms” and is called The Boots Theory of Social Inequity:
“The reason that the rich were so rich, Vimes reasoned, was because they managed to spend less money.

Take boots, for example. He earned thirty-eight dollars a month plus allowances. A really good pair of leather boots cost fifty dollars. But an affordable pair of boots, which were sort of OK for a season or two and then leaked like hell when the cardboard gave out, cost about ten dollars. Those were the kind of boots Vimes always bought, and wore until the soles were so thin that he could tell where he was in Ankh-Morpork on a foggy night by the feel of the cobbles.
But the thing was that good boots lasted for years and years. A man who could afford fifty dollars had a pair of boots that’d still be keeping his feet dry in ten years’ time, while the poor man who could only afford cheap boots would have spent a hundred dollars on boots in the same time and would still have wet feet.”

Put another way, it is a competitive advantage to be able to act upon your intellect and reason. If you calculate that the up-front costs for something are high but are the best option when measured across the entire contemplated use, you want to be able to have the actual cash on hand to pursue the more intelligent option.

The Vimes Theory and the MMM post express a philosophy that I imagine is executed by Fayez Sarofim in the stewardship of the firm’s assets.
If someone only owns 30 shares of Philip Morris International, the lack of price movement over the past four years might make you anxious and impatient. Everyone is talking about a bull market while that stock seems like the proverbial dead money. I’m sure someone on Seeking Alpha is probably putting it on probation or whatever term they use to say “Bad boy!” to their investments nowadays.
So what impulse does this need to get rich quickly trigger? Sell low!

On the other hand, consider how Fayez Sarofim can approach the lack of price movement.
In the past, Sarofim has said that studies of tobacco industry economics have left him breathless because the torrents of cash flows were so tremendous that it could enable Big Tobacco the cash cushion to purchase America’s leading food stocks (which have since been spun off).
He is already extremely rich, so he can afford the long game. He can enjoy the fact that his experience with the stock from a position of wealth is far more enjoyable. Between 2014 and 2016, Philip Morris International paid out $12.04 in dividends. When you own 16,711,214 shares, you do not view this as a “dead money” operation. You got to collect over $200 million in pure cash dividends as your share of profit from the investment. When your cash dividends are so extreme that you could buy hockey teams just by letting the tobacco dividends pile up for a few years, you are not going to fixate on the share price–no one is cursing at their Bloomberg Terminal when their holdings mail them dividend checks with two commas.

But this situation doesn’t only make Sarofim richer in the here and now. He can also look at the fact that Philip Morris International reduced its share count from 2 billion in 2008 to 1.5 billion in 2013 before the global currencies tightened against the dollar. He can see that this situation will temper or reverse, and within the next twenty-four months, Philip Morris will again have the free cash flow to repurchase its own stock. That, in turn, ought to improve earnings growth from 5.5% to 8-9%. That will bring about commensurate capital gains and dividend growth.

Assume that the future expectations in the paragraph above are held by Sarofim and my hypothetical investor. Who do you think is in a better position to actually be around in 2018 and 2019 to reap those higher returns–the frustrated guy with the “dead money” investment that isn’t permitting him to enjoy lifestyle upgrades or the guy that is collecting $70 million per year as the reward for being patient?

Full disclosure: Long KO, Nestle

Tuesday, 21 February 2017

Philip Morris International Stock: What is up with its poor performance

The disparity between reported results at Philip Morris International and the underlying economic reality of this tobacco business is on my mind again.

Aside from the usual moral reasons, it has become unfashionable due to its slow earnings growth during the past three years that has been met with low dividend growth as well. Profits of $4.76 per share back in 2014 are actually down a bit to $4.55 right now. The quarterly dividend payout has only grown from $1 to $1.02 to $1.04 over the same time frame. On a P/E basis, it looks like Philip Morris International is trading at almost 20x earnings while profits aren’t even growing.
My personal view is that investors should be hesitant to extrapolate from that set of data points. Philip Morris is bound by the fact that it reports its earnings in U.S. dollars and is domiciled in the United States while earning 100% of its profits outside the United States. This means that every time there is an earnings report, Philip Morris has to translate all of its profits back into U.S. dollars at whatever the exchange rate is across its currencies.

Comparing the U.S. dollar to the basket of currencies in which Philip Morris generates its profits, the U.S. dollar is 23% stronger today than it was on January 1, 2014. That $4.55 in current profits? It would be $5.59 per share in profits if the U.S. dollar maintained the status quo for the past three years. That would be 5.5% annual earnings growth rather than 1.5% annual declines that have been reported to shareholders of late.
Of course, it is fair to debate whether the current foreign exchange rates are more characteristic of a long-term status quo than the rates that existed in 2014.

But if you are shareholder of Philip Morris (if you own the S&P 500 in any form, this includes you!) then it is important to understand the distortions and constraints that can be created when profits are generated abroad yet reported in a different currency.
First, it is important to remember that the stated earnings reflect the actual cash in the bank which gets used to pay dividends. Even if the stated results of the past three years do not adequately reflect the change in Philip Morris’s earnings power, it does reflect the actual cash in the bank. That is why the dividend has only grown at 2%. It is only working with $4.55 per share right now.
But this insight can be calibrated to recognize that Philip Morris’s business and valuation is a bit better than what you’d think from looking at the stated results. On a constant currency basis, the valuation is 16x earnings rather than 20x earnings. The reported declines of 1.5% each year is really moderate earnings growth of 5.5% when you look at how Marlboro is performing in, say, Britain and the Philippines.

I have offered my opinion before that low interest rates have caused investors to ignore the importance of balance sheets such that cash-rich corporations haven’t traded as high as they should and debt-heavy enterprises haven’t been impaired by their debt load as much as you’d expect. I’ll offer a complementary opinion that companies that earn all their profits in the U.S. have seen their valuations enlarge in recent years while businesses with heavy international operations have been trading at a bit of a discount due to the strength of the U.S. dollar.

Specifically, Altria and Reynolds have climbed in recent years while Philip Morris International has lagged. I expect that trend to reverse between now and the next decade. Philip Morris International performs much better when it comes to annual cigarette volume declines, as the taxation and regulation in Southeast Asian and Eastern European countries is dramatically less than the United States. Philip Morris International get a 4.5% dividend and what I would expect to be 5-9% long-term earnings growth. At a price of $90 or lower, Philip Morris International shareholders have a better chance than not of experiencing 10% annual compounding from here.

Saturday, 10 December 2016

Famous investors - John Templeton

John Templeton was a billionaire mutual fund pioneer that specialized in using a value investing strategy to buy stocks around the world.  By practicing a disciplined version of Benjamin Graham’s teaching on a global scale, Templeton amassed an astounding record that made shareholders of his fund wealthy and earned him hundreds of millions of dollars in well-deserved fees.

Toward the end of his life, John Templeton ran his international investments from his mansion on Lyford Clay in the Bahamas.  Just as he did in his educational background, graduating near the top of his class at Yale University and as a Rhodes Scholar to Oxford University, John Templeton distinguished himself in the world of value investing.  In 1999, he was named by Money magazine as possibly the greatest global stock picker in history.

John Templeton’s Value Investing Philosophy 

Throughout the course of his career, Templeton was quoted as attributing his phenomenal success to the value investing strategy, as well as a few, key principles:
  • Avoid the herd.  Most people are driven by emotional considerations, not valuation.  By focusing on fundamentals, you can use this to your advantage.
  • Buy when there is “blood in the streets”.  The most money is made when you buy at the height of fear.
  • Take your profits when valuations are high.  Don’t be afraid, or feel like you made a mistake if you watch the shares of stock you sold go higher.
  • Pursue additional education.  Despite being one of the most famous practitioners of a value investing strategy, John Templeton still made a point to become a Chartered Financial Analyst.
  • Focus on income taxes.  You don’t have to go as far as Templeton did – as a result of his billions of dollars in wealth, he renounced his U.S. citizenship, thus avoiding income taxes.  He was a dual naturalized citizen of Britain and the Bahamas.
  • Keep your costs low.  Don’t fly first class.  Don’t spend a lot of money on a car.  The more money you have to put into your investments, the more money you will have to compound.  As time goes on, this can lead to millions upon millions of dollars in additional wealth for you, your family, and your favorite charitable organizations.
  • You don’t need to limit yourself to your surroundings.  Growing up in Tennessee, John Templeton told one interviewer that he never knew anyone who owned stocks.  If you limit yourself to the world in which you were born, you may never discover your true passions or the opportunities that lie beyond your horizon.
  • Inflation is a natural byproduct of democracy.  Politicians that are willing to spend more get reelected.  When the government doesn’t have the money, it has to print it.  Managing your portfolio for after-tax inflation is key.
  • Bargains are more and more scarce as information becomes available.  There were only a handful of security analysts in the world back at the dawn of value investing.  Today, there are tens, if not hundreds, of thousands throughout the world.  That means the job is going to be harder, but the rewards are still worth it.

The most important lesson from John Templeton

Perhaps the most important lesson those who follow a value investing strategy can learn from John Templeton is to think globally.  There is no reason to restrict your investments to your home country.  If another nation has more attractive economics and offers higher returns on stocks and bonds, take advantage of it if you are able.  Over a lifetime, you just may build up wealth in countries around the globe, earning dividends and interest in everything from Canadian dollars to Japanese yen.

n the fight for marriage equality, the Templeton foundation, or rather, John Templeton’s son, has been recently identified as the media as one of the biggest opponents of granting civil rights to Americans in same-sex relationships.  There has been considerable controversy around this in the press, notably large cash donations taken from the family fortune for the explicit purpose of prohibiting Californian citizens from enjoying the right to enter into civil marriages.
In time, demographic trends would suggest that this strong anti-gay activism could be viewed by subsequent generations the same way Henry Ford’s intense bigotry and anti-Semiticism toward Jews in now renounced.  I think it has become a rather unfortunate blemish on the Templeton name that will almost certainly be an embarrassment in history.  Considering the notable contributions John Templeton made to the field of investing, it is all rather tragic.

Sunday, 4 December 2016

How Warren Buffett made his first $100 000

Charlie Munger once said that the 1st 100 000 is the hardest so I decided to take a look at how Warren Buffett earned his first $100 000

Here, I'll talk about just the first $100 000 Warren Buffett made investing in stocks.
If you read Alice Schroeder's "The Snowball" you can easily find the investments that generated Warren Buffett's initial wealth.

We'll start after Warren Buffett first read “The Intelligent Investor” but before he started taking Ben Graham's class at Columbia. Buffett already owned Marshall Wells before he took Ben Graham's class. He still owned the stock when he went asked David Dodd (co-author of "Security Analysis") if he could skip Dodd's class and go to Marshall Wells's annual meeting. This is where Buffett first met Walter Schloss.

Let's take a look at Marshall Wells when Buffett owned the stock.

Marshall Wells

· Biggest hardware wholesaler in America
· $200 stock price
· $62 earnings per share

So, the stock was selling for a little over 3 times earnings. The earnings yield - "E" divided by "P" - was about 30%.

This brings me to the first point I need to make about Warren Buffett's early investing career. Warren Buffett worshipped Ben Graham. But there's this idea that Warren Buffett started out as a Ben Graham type investor. That's false. Buffett bought some Ben Graham type stocks - like net-nets. Graham had a big influence on which stocks Buffett picked. But Warren Buffett never invested the way Ben Graham did.

More on that later.

For now, the big difference we need to discuss between early Warren Buffett and Ben Graham is that Warren Buffett is, was, and always will be a return on investment investor. He's not a value investor in the sense that he sees some static value and buys at a 50% discount to that.

Buffett is obsessed with the idea of compounding.

When Warren Buffett started taking Ben Graham's class there was already a big difference between Graham and Buffett in that Graham was thinking about earning a good return on his investment capital, protecting the safety of his principal, and beating the market over time. Warren Buffett was thinking about compounding wealth. He was interested in getting rich.

There's a huge difference there. Ben Graham - and later Walter Schloss - made a habit of returning a lot of their partnership's gains. So, if you had $100 invested in Graham-Newman and they earned 15% on your money - the default idea was not necessarily to take that $115 and try to turn it into $132.25 next year. The first idea in Graham's head was: "I can earn 15% on $100 safely". So, he was concerned with how much capital the partnership could operate with and still beat the market while taking less risk.

Graham was never concerned with compounding the partnership's wealth over time.

This is a huge difference from Warren Buffett. When Buffett ran a partnership, he took $1 and turned it into something like $27. That was always his goal. To grow wealth. Not just earn a decent return safely.

This is something Buffett wanted to do even before he knew anything about value investing. Buffett's obsession with compounding wealth over time predates his conversion to value investing. And it was never something he had to "learn" after his time with Ben Graham. He was always obsessed with return on investment as being the key to compounding. That doesn’t mean he was obsessed with the company’s return on its own capital. But, from the earliest days, he thought of stocks in terms of the return they generated for him – not in terms of the discount to some fixed intrinsic value.

This caused Warren Buffett to invest very differently from Ben Graham - even while he was working for Graham.

It's interesting to note that Buffett managed to invest very differently from Ben Graham even while he bought almost the same exact kinds of stocks Ben Graham bought. In fact, sometimes he literally bought the same stocks Graham bought. But Buffett always got much better results.

Because he focused. Warren Buffett told Charlie Rose that "focus" was the key to his success. He's repeated over and over again that he doesn't necessarily have more good ideas than other investors - he just has fewer bad ideas. Buffett focuses on his very best ideas and puts as much money as possible into those ideas.

If it sounds like I’m exaggerating when I say "as much money as possible" - check out the next stock:


Buffett found out that Ben Graham was the Chairman of GEICO. Graham-Newman bought a huge block of GEICO stock in the past. They got the stock at a Ben Graham type price. But GEICO turned out to actually be a wonderful growth stock. Investors who kept their shares of GEICO when Graham-Newman distributed them made a lot of money over time.

GEICO's headquarters were in Washington. So, one Saturday, Buffett took a train from New York (where he was going to school) down to Washington. You've probably heard this story before. Buffett knocked on the door. The only person there was Lorimer Davidson. Davidson later became CEO of GEICO. He put together the Graham-Newman deal.

Anyway, he knew a lot about GEICO. There was no better person for Buffett to meet. So, Buffett started asking him questions. And he kept answering them. And this went on for hours. Davidson explained to Buffett that GEICO was the low-cost operator in the car insurance business because they did not use agents. Buffett was sold on GEICO’s future prospects. Here is Buffett’s response as described in The Snowball:

That Monday, less than 48 hours after he arrived back in New York, Warren dumped stocks worth three quarters of his net worth and used the cash to buy 350 shares of GEICO…GEICO was trading at $42 per share, a multiple of about 8 times its recent earnings per share…(Buffett) thought the stock would be worth between $80 and $90 per share (within 5 years).”

A few points here. One, we can do some math and see that Buffett believed he was going to make more than 13% a year in GEICO. The low end value estimate ($80) and the longest time Buffett expected the stock to take to reach that value (5 years) would have resulted in about a 14% compound annual growth rate.

It’s likely that Buffett believed he would make at least 15% a year for as long as he held GEICO. Because he meant it would be worth $80 to $90 a share within 5 years. Not that it would actually take a full five years and that $80 to $90 was a perfectly accurate estimate. That’s not what he meant. What he meant is that he thought he was buying something that would most likely return at least 15% a year.

GEICO was not a Ben Graham stock at the time. It was an insurer selling for 8 times earnings. In 1951, an insurer selling for 8 times earnings was probably considered cheap (if it had good growth prospects). But it was not that close to Ben Graham territory. And insurers do sometimes trade for 8 times earnings. Maybe not an insurer with GEICO’s future. But that’s not the way Graham thought about companies.

The issue here is that Buffett believed GEICO was a growth company. He believed its earnings per share would keep rising every 5 years or so. Because he thought they would take share from their higher cost competitors. He thought they had a better model. They didn’t use agents.

Ben Graham never approved of Warren Buffett putting 75% of his net worth into GEICO. That’s something Graham would never do with any stock. And GEICO wasn’t even a liquidation value bargain anymore. It was just a moderately cheap insurance company with a long, wonderful road ahead of it.

Here’s Warren Buffett from The Snowball:

Ben would always tell me GEICO was too high. By his standards, it wasn’t the right kind of stock to buy. Still, by the end of 1951, I had three-quarters of my net worth or close to it invested in GEICO.”

Buffett worshipped Graham. But it didn’t matter. He went ahead and broke two of Graham’s rules:

1. GEICO wasn’t selling for a Ben Graham price

2. Ben Graham would never put 75% of his portfolio into one stock

Why did Buffett do this?

Because Buffett wanted to get rich. He didn’t want to fill his portfolio with 1 great idea (GEICO) and 4 good ideas and then only have 20% of his money in GEICO.

If GEICO rose 50% next year when Buffett had 75% of his portfolio in GEICO he would grow his capital 37.5% just from GEICO’s contribution. If he spread his portfolio evenly over 5 stocks, then a 50% rise in GEICO’s price next year would only increase his capital by 10%.

Buffett wasn’t interested in compounding his money at 10%. He was interested in compounding his money at 30% or 40%. He wasn’t going to buy something in a way that each idea would contribute that little.

From the very beginning of his career, Buffett always felt safer in his best idea (that would compound his money the fastest) rather than spread out over half a dozen slightly lesser ideas.

He would repeat this GEICO pattern over and over again. While Buffett rarely put 75% of his money in one idea – he did try to buy as many shares as possible of his best idea at several points in his first few years investing.

He also borrowed money. Buffett had too many ideas and too little capital. So, he actually got his Dad to cosign a loan for him so he could put more money into his best ideas.

These are things Ben Graham would not have done. Now, Graham did use margin early in his career – everyone did back then. And Graham would borrow against arbitrage positions in the fund. But that’s not what we’re talking about here. Buffett took out a loan from a bank so he could add to the total investment capital he had.

Why did he do this?

If he had a high degree of conviction in ideas he felt were certain to earn at least 15% a year and might earn something crazy like 50% a year (simply because the stock price rose to meet intrinsic value quickly rather than slowly) then why not borrow money?

If you can get at least a 15% return on your assets, it makes sense to add to those assets by borrowing from a bank at much less than 15%.

If you borrow moderately. From the way the loan is described in The Snowball it was a little hard for me to figure out how big the loan was in relation to Buffett’s portfolio when he took the loan. It was clearly a small amount shortly thereafter – but that’s because Buffett’s capital kept growing really, really fast.

Greif Brothers Cooperage

We know Buffett owned this stock in 1951. It was a barrel maker. And a net-net.

For those of you wondering if Greif Brothers Cooperage has any relation to Greif (GEF) – yes. It has every relation. It’s the same exact company. And it’s still in pretty much the same business. They used to just make barrels. Now they make all kinds of different drums, containers, etc. That’s not a very big change for a company to make over 60 years or so.

Philadelphia Reading & Coal

This was Warren Buffett’s biggest position at one point. It was a very cheap company. It actually dropped from $19 a share (when he bought it) to $8 a share. And he bought more after the 50% drop. Philadelphia Reading & Coal went on to be bought by Graham-Newman as a control position. This was a lesson in capital allocation for Warren Buffett.

If you don’t understand why Buffett started to build an investment company on the ashes of a textile mill, you should learn more about Philadelphia Reading & Coal. Because Buffett was at Graham-Newman when they were using the capital in this business to diversify into an investment company of sorts.

Philadelphia Reading & Coal bought Union Underwear Company which sold underwear under the “Fruit of the Loom” name. And then they also bought the Acme Boot Manufacturing Company. The company also stopped paying a dividend. For 4 and a half years, Philadelphia & Reading (they dropped “coal” from the name) didn’t pay any dividends. But they didn’t pour more money into the lousy coal business either. Instead, as they slipped into losses for 1954 and 1955, they actually went ahead and spent money on buying new businesses. This would be a lesson for Buffett.

It also raises the issue of management and control of capital allocation. As we’ll see, many of Warren Buffett’s early investments actually had a strong management aspect to them. Especially where Buffett thought capital was going to be used wisely (or returned to him).

In fact, you could say that in Warren Buffett’s mind management “quality” is synonymous with smart capital allocation. He’s not looking for an operational genius. He’s looking for someone with his kinds of ideas when it comes to return on capital. That’s what he wants in a CEO. Someone who thinks like an investor.

Cleveland Worsted Mills

This one was not a smashing success. Buffett “called it Cleveland’s Worst Mill after they cut of paying the dividend.” It was a net-net with a high dividend yield. The yield didn’t last.

Western Insurance

Buffett sold his GEICO stock to buy Western Insurance. It had earnings of $21.66 in 1949 and $29.09 in 1950. In 1951, the stock’s high price for the year was $13. The low was $3.

It was the cheapest stock with the highest margin of safety he’d ever seen in his life. He bought as much as he could.”

National American Fire Insurance

This company was controlled by Howard Ahmanson. It’s a strange story. The original stock was pretty much worthless. It ended up being taken over as part of Ahmanson’s empire. Ahmanson was from Omaha. Although he’s most associated with California.

Basically, Ahmanson’s father had owned an insurer in Omaha. Ahmanson got started very young (he was a financial services prodigy) and got extremely rich underwriting insurance in California during the Great Depression. He then bought National American Insurance Company (in Omaha) because it was his Dad’s old company. He was retaking control of the family company.

Through this weird coincidence, National American Fire Insurance ended up with some terrific assets. The Ahmansons were very private. And these assets were controlled through different holding companies, trusts, etc.

Anyway, here’s Warren Buffett explaining what he found when he looked into what NAFI really was:

I found National American Fire Insurance…NAFI was controlled by an Omaha guy, one of the richest men in the country, who owned many of the best run insurance companies in the country. He stashed the crown jewels of his insurance holdings in NAFI. In 1950, it earned $29.02. The share price was $27. Book value was $135. This company was located right here in Omaha, right around the corner from (where) I was working as a broker. None of the brokers knew about it.”

What’s weird about this story is that on the surface the stock looked insanely cheap. It was selling for less than 1 times earnings. And about 20% of book value. But that really understates how cheap the company was. The deeper you delved into the story, the cheaper the stock looked. This was a personal holding company for one of the smartest investors in the insurance business. If you look at the book value and the earnings per share in 1950, you can see the company must have had something like a 20%+ ROE. Why would a company with a 20% return on equity ever trade for one-fifth of book value?

Read The Snowball to find out. Basically, it was a super illiquid stock that had once been worth a lot more. The shares ended up spread thinly across a lot of different individual investors. They remembered when the stock was worth $100 a share. That’s where a lot of them bought. And many of them didn’t want to sell until the stock got back to $100 and made them whole. But, because the stock had burned them so bad, they also had no interest in buying more shares. They just clung to what they had.

Now, what’s really fascinating about this story is what Warren Buffett did. So, the stock was last selling for about $27 a share. At first, he tried buying around $30 a share. Then he went to $35. He went to towns where he knew people owned the stock. He talked in person to people to try to get them to sell to him.

Eventually, he offered some people $100 a share. Now, think about this for a minute. That’s still a very, very low price for this stock. At $100 a share, Buffett was paying 3.5 times earnings. And he was still only paying about 75% of book value for what he thought were some of the best insurance companies in America.

But think how many of us would have been unwilling to go up to $100 a share. After all, if you started buying around $27 a share – doesn’t $100 a share seem like too much?

How many times have we thought: “Well, I started buying at $30 a share, do I really want to keep buying at $40 at $50 at…or should I wait for it to come back down to my price.”

Famous last words.

You would probably doubt yourself as you bought and bought and bought at ever higher prices.

But Buffett didn’t. And that’s the difference between Buffett and Graham.

Buffett wanted the highest return on his capital. At $100 a share, he was still going to earn well over 20% a year in this stock. Remember, he was paying less than 4 times earnings and less than 75% of book value for a company that recently earned over 20% on its equity. By either of those measures, you are clearly going to earn more than 20% a year.

So, when you see a clear situation where you will make more than 20% a year in a stock, the right answer is to buy as much of that stock as possible. To compound your wealth, the key is not to focus on whether you are paying $30 or $60 a share or $100 a share. It is to get as much of your money as possible into the stock while it is offering a very high return.

What matters is how high the return on your investment is at the price you pay. Not how much higher or lower the price you pay today is compared to the price the stock was at when you started researching it.


Buffett talks about this investment in his 1988 letter to shareholders.

Rockwood Chocolate had been shopped around to different buyers. Graham-Newman was given a chance to buy the company. But they passed because Rockwood wanted too high a price. Jay Pritzker ended up in control of the company. And he offered 80 pounds of cocoa for each share of Rockwood stock. The exact reasons why he made this offer are complicated.

Cocoa prices spiked in the midst of a shortage. Rockwood used LIFO (Last-in-first-out) inventory accounting. As a result, it carried its cocoa beans at much less than they were worth during the current cocoa bean shortage (prices were about 12 times higher than when Rockwood adopted LIFO). So Rockwood had a big gain on its cocoa beans – but this would be taxable of the beans were sold. However, the transaction would be non-taxable if it was used in a partial liquidation of the business. So, Rockwood initiated a coca bean for stock swap.

Why didn’t they just return beans to shareholders?

Cocoa was tradeable. So why buy back the stock?

Why not just give the beans to shareholders and forget the idea of a stock buyback entirely.

Graham-Newman didn’t ask this question. They, like some others on Wall Street, simply participated in the arbitrage opportunity. Buffett just went ahead and bought Rockwood stock so he could be on the same side of the trade as Jay Pritzker. So, instead of buying his stock, then swapping his stock for beans and then swapping his beans for cash – Buffett just bought Rockwood stock and ignored the offer to sell his shares for beans. Buffett made $58 a share vs. the $2 a share the arbitrageurs made.

At the time of the Rockwood deal Buffett’s two biggest holdings were Rockwood and Philadelphia & Reading. So he was betting on two capital allocation “jockeys” here. Graham-Newman was taking a cheap but misallocated business and turning it into a better business. And Jay Pritzker was taking advantage of high cocoa prices to buy back stock and make remaining Rockwood shareholders rich.

So, capital allocation was very important to Warren Buffett even very early in his career.

Buffett did a lot of “coat tail” riding in those days. He took a lot of other people’s good ideas. Whether it was Ben Graham or Jay Pritzker or Howard Ahmanson.

That’s a strange wrinkle in the early investments by Buffett. It wasn’t always the case that he was betting on superior capital allocation. At GEICO, he was betting on a growth stock. It just happened to be a cheap growth stock.

And at Marshall Wells it didn’t really matter who was allocating the capital. What he cared about there was that the stock was selling for about 3 times earnings. The same thing is true – to some extent – in the last stock we’ll look at: Union Street Railway.

Union Street Railway

This was a bus company. They had some substantial hidden assets. But the most important asset they had was cash net of all liabilities of more than $60 a share versus a stock price of $30 to $35 a share. Graham-Newman had considered the stock. But did not want to take a huge block. Buffett did. He wasn’t interested in diversifying.

The company was also buying back stock at the same time. This was a common feature of Buffett’s investments. Ahmanson was slowly buying up stock around $30 a share when Buffett started buying shares of NAFI. Here, the company was buying back its own stock.

Buffett went to talk to Union Street Railway’s CEO. The CEO told him that they were going to return $50 a share.

Here is my best guess of what Buffett’s investment in Union Street Railway looked like:

· Paid $18 700 for his shares
· Got back $28 800 in cash
· Stock still traded for $11 500 after the special dividend

So, Buffett turned an $18 700 stock purchase into a combination of $28 800 in cash and $11 500 in stock. His return was something like 115%.

Also notice how strange the market’s attitude was toward Union Street Railway’s cash. Before the special dividend it traded at $30 to $35 a share. After $50 a share was paid out in cash, the stock only dropped to $20 a share.

So, even though the company paid $50 in cash, the market only penalized the stock $10 to $15 a share.

The market never gave Union Street Railway full credit for the cash when the company had it. So, it didn’t deduct full value from the stock when the cash was paid out.

From 1949 through 1954 Buffett made his first $100 000. It’s hard to know what his exact annual returns were. That’s because he saved some additional money, paid taxes, took out a loan, etc.

My best guess is that Buffett compounded his money at an annual rate no less than 50% a year and no more than 60% a year.

This is consistent with his own statements. Buffett told students he did make 50% a year on his own portfolio before starting his partnership.

And he said that his returns were lower each decade. Buffett had annual returns on 30% a year when he ran his partnership. It’s clear he did better than that with his own money in the early 1950s.

It’s likely Buffett earned about 50% a year on his investments in his first 5 years as an individual investor.

And he did it in the stocks we just discussed.

Overall, Buffett turned $10 000 into well over $100 000 between the time he first read Ben Graham’s “The Intelligent Investor” and the time he started his partnership.

Wednesday, 30 November 2016

Several ways to accelerate your dividend income

I think there are several ways to turbocharge a dividend income stream. Some of them of are more straightforward than others, but all deserve some consideration.

Accelerate your savings rate

There is no better way that I know of to rapidly increase your dividend income stream than boosting your savings rate. Ultimately the amount that you have to invest has a direct correlation with what you are able to save. If you can boost your net savings rate, then odds are that any surplus that you save can be redeployed into dividend generating stocks to boost your dividend income.
And so how exactly do you boost your savings rate, and what is a good savings rate to aim for?. Unfortunately, there are are no easy answers on this one. How much you save is directly tied in with the lifestyle that you have and the compromises that one is willing to make.
But to put this in some perspective, the average Belgian national savings rate was about 10.1% at the end of 2014. This represents the amount that Belgian households are saving as a % of their income.
If you ask me, anyone that saves such a low percentage is probably not even on track to any sort of comfortable retirement, let alone an accelerated one. It should be possible to save at least save 20-25% of your income if you pay yourself first.
I save close to 50-60% of my income, most of which makes its way back into some sort of investment. And thats after contributions are made into the my pension saving, and the mortgage. .
Adopting the frugal lifestyle will also go quite some ways to helping with expense control and in controlling lifestyle inflation, allowing you to increase your dividend investments over time with increases in income.

Dividend Reinvestment 

Reinvestment of dividends can be a great way to accelerate a dividend income stream. It can put money to work for investment when you otherwise don’t have any spare income to invest. Additionally, where you have a regular investment program, reinvestment of dividends can add significant momentum to your dividend machine.
When combined with a portfolio that consists of high yield dividend income stocks, redeploying high yield dividends into stocks that have higher dividend growth can lead to an ongoing, fast growing dividend income stream. You get the benefit of reduced volatility, from dividend sloths combined with a higher growth dividend income stream.
A common way to reinvest dividends is by way of DRIPs , which is automatically reinvesting the dividends back into the same stocks that paid them. However, blindly reinvesting your dividend income into your portfolio irrespective of prevailing market factors doesn’t make for the most optimized use of dividend income.
The mood of Mr. Market can create valuation opportunities at any point in time, which an investor can take advantage of with a more strategic, optimized dividend reinvestment strategy. Mr. Market’s moments of panic can turn low yielding, high growth dividend stocks into high yielding, high growth dividend stocks.
Selective reinvestment can get you dividend bargains at various times, which can greatly accelerate your dividend income stream and provide significant total return.

Looking overseas

For those that are feeling more comfort with their investing, it can be well worth your while to add some international dividend exposure to the mix. This can be valuable for a few reasons, particularly stronger economic growth overseas as well as favorable exchange rate consequences. Many economies overseas have been experiencing higher rates of growth than the Euro zone and the dividend growth from some of the dividend payers in these economies is indicative of that.
Also, many of the emerging  economies will experience an appreciation of their exchange rate versus the EUR over time as their economies grow and attract additional investment. So investing in an international dividend stock from an emerging economy can not only give you higher organic rates of dividend growth, but you will also be able to ride an exchange rate tailwind over the years.
There are a few considerations to keep in mind with international dividend stocks. If you go with stocks from the US the odds are high they pay quarterly dividends.

Mid Cap Investments

Mid cap dividends help to increase the overall dividend growth in your portfolio. Having some midcaps in provides a natural source of dividend replacement  as dividend growth  from the larger companies in your portfolio declines over time.
In fact, I expect that  midcap and small cap dividend payors will make up an increasing portion of my dividend income  and that they will still be at a stage of their business where dividend growth can continue for an extended period.
To be sure, mid cap and small cap dividend investment is a 'riskier' play than looking at the larger more established dividend payers.

Starting early

Building up a dividend income stream takes time. The sooner you start putting money to work the quicker your get there.
I’ve heard it said that Einstein referred to compounding as the 8th wonder of the world. If so, its with good reason. The ability for individuals to grow their investments at progressively faster rates as each dollar gets reinvested is truly pretty amazing.
It also helps explain why the best time to start investing is as soon as you reasonably can. Compounding investment dollars at an early age can leave you with a significant amount of wealth later on in life.
An investor in The Coca-Cola Company  who invested $10,000 about 50 years ago would have had a stock value of almost $500,000 today. If you think that’s impressive, consider the scenario where those dividend were reinvested. That same investor would have almost $1.75M in an investment in the Coca-Cola company!. Talk about an acceleration in wealth from compounding returns!
Similarly, if your are targeting a certain level of dividend income starting the pursuit of this early will give you many more years of dividend increases to get to that level of income. Going after a similar goal later in life will likely require a much larger capital investment to attain the same dividend goal, given that market yields will likely be much the same in future years as they are now.

Tuesday, 29 November 2016

Some tips for investing in volatile markets

With the recent volatility I tought it would be a good idea to write a few tips for people that are investing their hard earned cash right now.
1. Think about your tolerance for risk
Investing offers a way to develop long-term wealth. But investors need to choose from a range of investment alternatives by considering their risk and return prospects including cash, bonds, alternatives such as commercial property and commodities, and stocks.
Most people will understand the importance of making financial provisions for the future and will also have a savings goal in mind - perhaps for retirement, a holiday or just for future emergencies. Then, they may also know how long they have to save - a year, ten years, perhaps longer. There is also the investors temperament to consider - how well they could cope with the possibility of their investment falling in value. With these factors in mind, therefore, an individual should be able to judge how much risk they are willing to take.
Investment risk is like the volume dial on an amplifier – you can turn it up and down as you wish. In theory, the more risk you are able or willing to take, the greater your potential reward. Of course, more risk also means greater potential for loss.

2. Remember the value of dividends
When things are going well and the stock market is rising strongly, the extra return from dividends may be considered as little more than a token gesture. However, in weaker markets the extra return from dividends becomes a valuable part of the total return, especially over time as reinvested dividends are compounded.

For example, £100 invested in the FTSE All Share in January 1988 would have grown to £304 by now. But if the dividends had been reinvested it would now be worth £726, more than double. Dividends can also be more reliable than both corporate earnings and stock prices during a bear market because many companies usually strive to maintain their dividend even if their profits are temporarily falling. I did use the FTSE as an example since I'm busy investigating some UK stocks

3. Recognise the benefits of diversification
Diversification has always been considered the first line of defence in reducing investment risk. This is because spreading your funds across different investments reduces the impact of an unexpected fall in one of them. In effect, it reduces the importance of each single investment decision.
 The main asset classes perform differently at different times in the economic cycle.
Trevor Greetham, Fidelity’s asset allocation director, did say in a interview: “Recently there have been no safe havens in the equity world. However, stocks and bonds often move in opposite directions. Commodities dance to their own tune, sometimes moving with stocks, sometimes against. Each time a bull-run in one asset class comes to a halt, leadership passes to another.
“When equities peaked in 2007, commodities surged. When the commodities ran out of steam in mid 2008, government bonds started their charge. When the world economy recovers from its current difficulties, stocks will take up the running once more. A well-diversified portfolio of stocks, bonds, commodities and cash would have performed well over the past 30 years with a low level of volatility.”

4. Be aware of the dangers of trying to time the market 

Perfectly timing your investments to coincide with the top and bottom of market cycles is generally not possible. Experts advise long-term investors to remain calm through periods of volatility. For new investors, the challenge is also a question of timing. Many investors experience a nervous wait for what they consider to be the ‘right moment’. Unfortunately, that moment is only clear once it has passed.
The real danger of missing that crucial bottom is that the early part of the recovery is often the strongest. After the crash, it took 56 months for the US market to fully recover, but half of the total gains were made in the first 16 months.

5. If you are nervous, drip feed your investments
Investors who are nervous about timing their investment can make regular contributions to their asset growth in smaller tranches over a period of time. Regular savers, including those investing into managed funds with regular contributions are set to reap long-term rewards. This can be especially effective when markets are at a turning point.
“Buying the U” describes the process of feeding money slowly into the market while it is still falling, through the bottom and up the other side as the market recovers. Monthly investments offer a way to benefit no matter how the markets are performing: If stock prices go up, the stocks you already own will increase in value. If stock prices go down, your next payment will buy more stocks.
Such an approach can go a little way to eliminate the anxiety of timing large investments, can smooth the highs and lows of the market and even improve an investor’s eventual outcome. The regular investor finishes the period with an investment that is worth more than if the entire amount was invested at the outset, even though the units are the same price at the end of the period as they were at the beginning.

6. Start sooner rather than later
Conventional wisdom suggests it is ‘time in the market’ rather than ‘timing the market’ that is the key to developing long-term wealth. Therefore, starting to invest early is important.
The impact of compounding, which describes the exponential growth that can be achieved by earning interest on previously earned interest - is profound. The earlier you start investing, the longer your assets have to work in the market for you. Starting that strategy today or tomorrow is not too late but failing to act may result in falling short on assets when they’re needed most.