How Worried Are You?

A friend asked me this week, given that you hold stocks how worried are you about a crash or major correction? Charlie Munger was asked a similar question during 2009, and his answer came to mind - "zero."

There is good evidence why that's the case. For investors who are heavy into cyclicals, biotechs, nanotech, tech tech, and all manner of flavor of the month (Michael Kors is hot, oh wait its not), there probably should be some concern. After all, there are plenty of risky stocks. Does that mean "the market" is risky? I do not think so, at least for some corners of the market where defense is prized over offense. So to the evidence, here is the ten year dividend returns for the WMD portfolio members.

Do I think the prices in the stock market are overdue to pull back by a double digit percentage? Sure. I thought it was overdue last year, too. But we just saw a massive pullback in 08-09, which was smack in the middle of the chart above. You know what? Its pretty hard to spot the impact looking at the dividend returns from wide moat companies.

The ability to pay dividends through a crisis like 08-09 is in itself a margin of safety, it shows the company's cash flows are stable, and the cash is useful to an investor who may be able to reinvest it at better prices. Its not to say that investors should be smug, the going in proposition with this type of investing is avoiding mistakes after all, its not swinging for the fences. Will the markets pull back? Sure, but like Buffett says - predicting rain doesn't count, building arks does.  Wide moat dividend payers are as close to an ark that can weather 08-09 storm  as an investor can reasonably expect to find. The quality companies not only manage through but come back even stronger, because they can reinvest through the crisis and take advantage of bargain prices.

The Detective and the Investor

One of the first books I read when I started learning about investing was Robert Hastrom's "The Warren Buffett Way." Hagstrom is a writer who excels at seeing connections and finding patterns.

As a fan of detective stories in general and Holmes in particular, I was happy to uncover a Hagstrom book from 2002, called "The Detective and The Investor." Its out of print now, but easy to find copies on Amazon. If you like investing and detective novels then you will enjoy it, because Hagstrom finds a lot of common thought processes from great detectives  and investors.

There is a chapter dedicated to the specific techniques of the three main subjects that Hagstrom covers: Poe/Dupin, Conan Doyle/Holmes, and Chesterton/Father Brown. Each chapter then links what the investor can learn from the methods of the detective.

Hagstrom draws out the Habits of Mind from the great detectives:

• Auguste Dupin
• Develop a skeptic's mindset; don't automatically accept conventional wisdom
• Conduct a thorough investigation
• Sherlock Holmes
• Begin an investigation with an objective and unemotional viewpoint
• Pay attention to the tiniest of details
• Remain open minded to new, even contrary information
• Apply a process of logical reasoning to all you learn
• Father Brown
• Become a student of psychology
• Have faith in your intuition
• Seek alternative explanations and re-descriptions

Hagstom skillfully traces the evolution of the detective novel, which he says begins with Poe's Dupin. The book shows how each of the three detectives refined the craft of the detective and brings new methods to the table. Each of these prove useful to investors as well.

Dupin shows the value of plodding detective thorough investigation (Hagstrom calls this the document state of mind) when combined with the tenacity to dig out as many facts as possible. This is done both by confirming and disconfirming observations. The most talented, productive people that I have worked with are the ones who work the hardest at beating up their own ideas.

Holmes has many qualities of successful investors. To cite one example, Holmes works at determining the underlying factors of what appears as self-evident. Holmes says "There is nothing more deceptive than obvious fact." That quote immediately brings to mind Charlie Munger's - "every time you see the word EBITDA, you should substitute the word ‘bullshit’ earnings.”

In the Father Brown chapter, Hagstrom shows how Buffett's famous Coca Cola purchase occurred at a time in 1988 when Coke was selling at five times book value, a below average dividend yield and an above average P/E. Where was the buy signal? Yet Buffett found it, put in $1 Billion and it led to one of the best investments of his career. Though the raw numbers did not show it, Buffett, like Father Brown, saw that things are not always as they seem.

Its a unique book on two of my favorite topics, so its hard to have too many quibbles. Some of the analogies and linkages are a bit of a stretch, but that is unavoidable in this type of writing, and the main points that connect the analytical toolboxes are expertly linked. Chesterton's work went well beyond detective novels and it may have been interesting to hear more about his other work as a logician. But these are minor points, like licorice this book is not for everyone, but the people who like it will like it a lot. If this is the kind of book that you will like, you already know it by now. I think its a hidden gem.

Dividends Give Management Discipline and You a Seat at the Table

A quote from Stephen Chazen the CEO of Wide Moat Dividend portfolio holding Occidental Petroleum underscores an important attribute for dividend investors.

“I think dividends—if there is a religious activity here, I think that’s it. It provides discipline to the management. Otherwise you print shares, do all sorts of wealth-destructive things. The dividends give you discipline.”

Investors always want to know not just that they are buying a piece of a business, but that they as an outside investor have a seat at the table, a voice in the overall direction. At the same time, the companies need a mission statement. For a company like Facebook its about identifying leading technology trends which can justify the massive purchases like Oculus and Whatsapp.

For companies that prioritize dividends its far simpler - maintain and increase the dividend. So any use of cash by management must be judged by that yardstick. That means in turn that when management evaluates the numerous options that any company has, it has to clear the hurdle that it would be able to continue to pay its dividend and increase chance for dividend growth down the road. So outside investors are present, not in person but virtually, in any major capital allocation debates.

I am sure that outside investors factor in on some level to most companies, whether they pay dividend or not, however its not always clear where shareholders fit versus management growth plans, incentive schemes, or corporate flavor of the month. In the case of dividends, we outside investors get our own line item on the Cash Flow statement- Cash Dividends Paid. We're first class citizens not an afterthought.

That's no guarantee that the right decisions will be made and there could be some cases where dividend growth should be put on the back burner for some period of time (in my view GE's current restructuring is an example here). Still the fact that dividends paid to outside investors represent a line item every quarter, year over year, that is expected to maintain and grow, this fact represents a distinctly different type of company-investor relationship.

In the case of Occidental this has proven to be profitable. Given the oil price crash, Shell and Chevron both had to borrow to pay their dividend, and they both had to hold the dividend steady because they do not have the cash flow for dividend growth. On the other hand, this week Oxy managed to increase its dividend by 4%. Shell and Chevron are both engaged in behemoth efforts with BG and Gorgon respectively, the much smaller Oxy is going the opposite direction, selling off its assets in Middle East and North Africa, and instead transforming into a pure play on its best asset the Permian. For investors, simplicity and focus often trump grand plans, especially when the company's management uses dividends as a filter for ideas.

The Surprising Link Between Jeff Bezos and Neil Woodford and What It Means to Dividend Investors

On the surface it appears that Amazon and Jeff Bezos are worlds away from anything a dividend investor would care about. After all, Amazon struggles to even show earnings, much less pay a dividend. But remember the first rule of investing, you are buying a part of a business, and Bezos has built a formidable business.

Here's the killer business insight from Bezos that should be a hallmark for long term and dividend investors (emphasis added):

"I very frequently get the question: 'What's going to change in the next 10 years?' And that is a very interesting question; it's a very common one. I almost never get the question: 'What's not going to change in the next 10 years?' And I submit to you that that second question is actually the more important of the two -- because you can build a business strategy around the things that are stable in time. ... [I]n our retail business, we know that customers want low prices, and I know that's going to be true 10 years from now. They want fast delivery; they want vast selection. It's impossible to imagine a future 10 years from now where a customer comes up and says, 'Jeff I love Amazon; I just wish the prices were a little higher,' [or] 'I love Amazon; I just wish you'd deliver a little more slowly.' Impossible. And so the effort we put into those things, spinning those things up, we know the energy we put into it today will still be paying off dividends for our customers 10 years from now. When you have something that you know is true, even over the long term, you can afford to put a lot of energy into it."

So here we have from the most unlikely source, a true blue, original dotcom, that even today struggles to show earnings, worlds apart from the staid world of dividend investing, yet Jeff Bezos has nailed one of the single most important things to dividend investors - staying power.

After all, the stock market prizes current yield, and it is hard to get excited about current yield at 2.5-3% range for blue chips like Clorox, Coke or Pepsi. But at the same time, the stock market misprices long run dividend growth and its easy to get excited to invest in a business that can compound and quadruple their dividends a decade out. 

For that to happen, then the operative question becomes Bezos' - what will not change ten years out? Will consumers still want beverages, candy, and salty snacks? Will they prize convenience (delivered by global supply chains)? Will there be more stuff to clean? Will they respond to ads?

These kind of questions should factor into any style of investing, but I would suggest that they are more relevant for a dividend investor than any other type. Long term focus is a hallmark of successful value and growth investing, but they can do quite well by defining long term as 3-5 years, meanwhile dividend investors see the best payoffs then plus years out.  A five year dividend investment could look something like this - 3% starting yield with low double digit growth rate (good luck finding one of these today, this is just for illustration purposes). So at five years your 3% may be yielding 6% on cost. Not bad, but its much more interesting to see where it can go next, and can you get it into a double digit yield on cost territory? 

Someone like Mohnish Pabrai can find great value investments that have a good shot at doubling inside of five years. Dividend investors can likely approximate that if we simply look at yield. However since the starting yield is so low, the yield must double twice say 2.5% x 4 before things get interesting. But once they do get there, a 10% yield on cost in a business that with a wide moat is a snowball rolling down hill. That's about as good as it gets for a dividend investor. 

The key ingredient in that is not yield or even dividend growth rate, its finding what won't change. Morningstar's Heather Brilliant says it well - ""The persistence of excess returns is much, much more important than the magnitude of excess returns"

Utilities, long the core engine in dividend investors portfolios are perhaps the ultimate example here - hard to be more basic and essential than electricity and heat. Looking at one of the all time great dividend investors portfolio, Neil Woodford, what do we see? We can learn from what he does and what he doesn't.

Woodford famously avoids banks (perhaps what he sees is that what wont change is bankers' ability to blow up at least once a decade?). The main sectors in Woodford's portfolio all have one thing in common - sustainable, long run demand - Pharma, Consumer defensive, Utilities, and Defense/Industrials. These all lack glamour, but have clear long run demographics and reasons to think that the healthcare, electricity, and defense will be as relevant a decade on as they are now.

Judging by the amount of ADD in the world, smartphoness Tweets et al, I'd say long term orientation, itself, is likely to be as rare ten years from now as it is today. So to sum up, think like Jeff Bezos, invest like Neil Woodford.

The Last Thing I Would Want to Do

Best case scenario is when you can find something you want to do. But you can learn a lot by simply ruling out things you do not want to do as well.

This week's WSJ reported on money managers who spend a tremendous amount of time worrying about the market hour by hour.

"Most mornings at 5:45, David Kotok hops on his exercise bike, straps a small miner’s lamp to his forehead to read in the twilight and begins scouring research reports for signs the stock market could crumble.

The Florida money manager, who is 72 years old, is bullish, but things can change suddenly. This month, he moved heavily to cash amid signs of trouble, but soon returned to stocks. So he pedals onward, reading reports and shifting two smartphones and a sheaf of papers to avoid drops of sweat.

In Minneapolis, Doug Ramsey ’s daily ritual involves tracking 130 indicators on subjects from corporate performance to investor mood. He isn’t as bullish and has reduced his stockholdings.

“I think about it hourly. It really keeps me up,” said Mr. Ramsey, chief investment officer at Leuthold Group, which oversees $1.6 billion."

Ok first off, I am sure that they are smart and have lots of money, but what a way to spend a life - predicting markets? Darting in and out based on 130 different indicators? 

I find Tom Gayner's "nobody knows nothing" and Howard Marks' "you can't predict but you can prepare" approaches both more successful and a far better quality of life.

As opposed to worrying about the hourly movements of 130 different indicators, instead of that what about Charlie Munger - "I succeeded because I have a long attention span." 

Beyond quality of life, I think it pays dividends towards long run returns to approach things that way. Investing skills can increase with age. Buffett's Heinz deal appears to have been one of his best, and that is saying something - Get paid 9% dividend for two years during which time you triple your money on a low risk investment.

Hard to top that. Not everyone is Buffett you say, not everyone can partner with 3G. All true. But even outside, individual Kraft investors have doubled their money, got paid a healthy 4ish% dividend, and now are part owners in a business that includes Heinz and is run by one of the best operators on the planet. 

By contrast of the 130 hourly indicators, here is the grand total of all time I spent worrying about Ketchup and Mac and Cheese consumption, wait I will round it down to the nearest whole number - zero!

On the plus side, the WSJ piece produced a modern day rarity - smart comments on an online  newspaper article.

Paul Wm Danielsen 2 days ago
Buy
Hold
Big Index Funds
Call me when I'm 70
Duh
( a miner's helmet light. Really ?!? )

Karen ThomasKaren Thomas 3 days ago
I've long believed one must view the circus from the outside and then make  decisions. In other words, watch the clowns to determine what to do.  There is much to learn from watching the show. It's insightful  to read the machinations of such managers.

Much in our culture (and others)  promotes short-term thinking. Perhaps our perceived enhanced degree of impatience and the promise for quick rewards is a by-product of technology and of course other things.  However, this mind-set has long been a part of societies. The media and it's advertisers (which is the media) pushes much of this. The cynic could say we are awash with snake oil sales people and their "idea of the day". These same people usually always have a vested interest in these ideas. Don't take them too seriously because they will have a new idea tomorrow along with another bottle of oil. There's a reason snake oil stands are in close proximity to a circus.

On Predictions

from Tom Gayner in the Markel annual report:

"A second example of how markets periodically become unhinged from long-term reality can be seen in the current action of the oil market. Arguably, oil is the most liquid, important and globally traded commodity on the face of the earth. Hundreds if not thousands of companies participate in the energy business. Hundreds of thousands if not millions of people work in, and study this field. The fact that oil could sell for over $100 per barrel, and for less than half that price within a few short months, should be about all of the evidence you need to dismiss those who believe in efficient markets, or forecasting just about anything.

Our investment record has not and will not be based on our ability to forecast the future of geopolitical changes, interest rates, currency moves, technological change or any other factor that occupies the minds and hours of countless investment professionals. We simply accept that all of those things will continue to fluctuate and change, and that our four part process does the best job we know of finding the people and financial circumstances who will make the best of whatever happens."

Here is my version. Four years ago, Kraft split apart into two companies. The high flying, international, big name brands went with the CEO and became a new company - Mondelez. The boring US-only, low/no growth businesses like Mac and Cheese, Oscar Mayer, and Planters became their own company still called Kraft. Naturally I liked the latter one, which had an excellent dividend policy. I liked it as a 10-20 year hold with a chance to slowly compound over a long time horizon. Needless to say I liked the company's long term prospects, but never thought it would go up 33% in a single day.

If I made a list of stocks that I would wake up and see a hockey stick on, Kraft would be very close to the end of the list. Which begs the question, if we cannot reliably predict the Mac and Cheese and Ketchup market, what chance do we have on oil and energy? As Howard Marks says, "we can't predict, but we can prepare."

Markel Annual Letter

The motto of this blog is Safety, Dividends, and Growth, but the overall goal is total return. Safety is a hard and fast rule, and generally dividends are excellent path to total return. But there are exceptions. One is Berkshire Hathaway which offers an excellent profile - about the safest company with exceptional long run returns. So while dividends are a main focus, there is no need to be dogmatic when it comes to a company like Berkshire.

One other exception to the dividends rule is Markel, sometimes called a "baby Berkshire." Like Berkshire, Markel is ostensibly an insurance company in Markel's case a specialty insurance company (see Tom Gayner's cocktail party summary of Markel's business model below(1)).

Like Berkshire, Markel has a three legged stool. Markel generates cash with its core insurance business.

Combined ratio

• 2010 97%
• 2011 102%
• 2012 97%
• 2013 97%
• 2014 95%

So Markel has been able to turn a profit on its insurance operations four of last five years.

Next, the second leg of the stool - equities. Like Berkshire Markel chooses to invest a lot more in equities than bonds as most insurers do. Markel CIO Tom Gayner turned in another solid year with 18.6% gains in equities in 2014.

Equities

• 2010 20.8%
• 2011 3.8%
• 2012 19.6%
• 2013 33.3%
• 2014 18.6%

That amounts to a weighted average 5 yr annual return: 20.4%. Markel completed the acquisition of Alterra, another insurance company whose portfolio is largely in bonds. Given that Markel's five average return from fixed maturities was 4.7%, there is a significant opportunity to convert bond holdings to equities and earn at least double what the bonds do.

The equity portfolio, like Berkshire's, is low turnover and high quality. Top holdings:

• CarMax - 8.7% of portfolio
• Berkshire Hathaway - 5.99%
• Brookfield Asset Management - 4.4%
• Walgreens - 4.3%
• Fairfax Financial - 3.9%
• Walt Disney - 3.8%
• Diageo - 3.7% 

These first two elements - profitable underwriting and investing - have propelled Markel throughout the last twenty years or so. But there is a third leg of the stool to Berkshire's model - wholly owned businesses. Berkshire now owns many more businesses than it has invested in equities.

Markel is not large enough today to buy up huge companies like Burlington Northern, but they have proven to be quick learners and fast followers in recognizing the efficiency of buying whole companies.

In 2005, Markel started Markel Ventures to buy up whole companies. Like Berkshire, they tend to be on the dowdy, but profitable side. Channel dredging, bakery, waffle maker manufacturers and the like. This third leg of the stool is the one I have been watching for to propel Markel to the next level, and it appears it is starting to:

"From the start in 2005 when we purchased 80% of AMF with its roughly $60 million in revenue, Markel Ventures ended 2014 with revenues of $838.1 million and Adjusted EBITDA of $95.1 million. Markel Ventures now stands as a real, and meaningful contributor to the wealth creation underway at Markel Corporation.

Markel Ventures does two things for Markel. One, it gives us another option for capital allocation decisions. Secondly, it makes a bunch of money. As one frame of reference for that statement, consider Markel Corporation 10 short years ago. In 2004, we earned underwriting premiums of just over $2 billion and underwriting profits of $72 million. While the language used to describe underwriting profits from insurance operations, and cash flows from non-financial businesses, are different, it’s not that hard to translate. Underwriting earnings are generally comparable to Earnings Before Interest Expense, Taxes, Depreciation, and Amortization. They equal the acronym EBITDA. In 2014, the Adjusted EBITDA of Markel Ventures, which also excludes a non-cash goodwill impairment charge of $13.7 million, totaled $95.1 million. This stuff is starting to add up."

Put it all together and Markel has established a good position in each of the Berkshire three legged stool. It has profitable insurance operations, a solid equity investment track record, and now a burgeoning wholly owned group of businesses. So Markel has all three legs of the stool in place and effective.

One question I have for Markel is that Tom Gayner is the face of the investment operation, but what is the bench? Is there a Munger, Simpson, Weschler, Combs at Markel?

Overall, the company has proven its ability to learn from a great example and implement as close as anyone else has - The Berkshire Operating system

***

1. Markel CIO Tom Gayner (circa 2011):
"Cocktail party definition of Markel if someone asks about Markel, its an insurance company that they've never heard of. Well an easy way to think about that is if you have an insurance policy that you can get easily and quickly, well we wouldn't do that. We do the sorts of insurance where people go 'Oh no. We've got a problem or we've got a situation' This isn't to disparage the other insurance companies, we all have a role in life. What GEICO says yes to is not going to be the same thing that Markel says yes to. What Markel says yes to isn't going to be the same thing that GEICO says yes to. Its a different organization and orientation.

We do 100 different forms of insurance - everything from children's summer camps that are out in the middle of nowhere, that have teenagers supervising teenagers and no fire departments nearby, kids jumping on trampolines and being out in canoes, all the sorts of exposures that go with that.

We would do oil rigs that are out in the Gulf of Mexico (one of the ways we lost some money this year), those sorts of things need insurance and Markel is a company that for decades has been in that business, and its a good business, but there are days when you wake up and read the headlines and go 'Oh no', but that is why people buy insurance.

We do things like bass boats with too big a motor on it, this has always been intriguing to me. Bass boats tend to be flat bottomed, and they come with a 10-15 hp motor or something like that, but if you are really into bass fishing you have to get to the spot in the corner of the lake faster than the other guy. So people put 250 hp engines on their bass boats. I can tell you that every accident or loss report reads the same way, and that is: 'Craft traveling at a high rate of speed, when it hit a submerged object. Occupants hurled from the craft.' When you are trying to buy insurance on your bass boat and you are a State Farm or  GEICO customer, they're going to ask you about how many horsepower you have on your boat and when you answer 250 they're gonna say 'thanks but you need to find somebody else to that.' 

Well, we're the Statue of Liberty, bring us your tired your poor, yearning to be free. Short line railroads, little spur lines with only one customers. We do bars and taverns that are sometimes on the wrong side of town. On and on and on.