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This is quite random and posted for my educational purposes'

Berkshire has a problem. Albeit a high class problem. If it does not get the opportunity to allocate capital, it will eventually have too much cash.

Take Apple for example. It's arguably fairly valued (it's a great business) or perhaps expensive. Certainly few would expect market beating returns from here. But what can Berkshire do?

It can't just unload that much stock without depressing the price.

If it did sell up, what would it buy that would be a better business in the very long term?

If it sold it, capital gains tax would be payable. If there was nothing better to buy would it return capital to shareholders in dividends and pay yet more tax. It's not easy being big and successful.

2023 has been a challenging year on the deploying capital front so far. Buybacks have dried up due to valuation. The equity bubble has re-inflated and Berkshire is a net seller. Large private businesses are not finding a home at Berkshire, or a least not enough of them.

The world has changed dramatically in the last year. Suddenly bonds and cash are providing a return that keeps up with inflation. But that friends, is not enough of a return to justify Berkshire holding excessive cash. After all we can all put money on deposit or buy low risk treasuries. We don't need to be paying Mr Buffett that $100,000 p.a to manage our capital, if he doesn't perform capital allocation master strokes for us.

Yes it seems clear that the reason we hold Berkshire, at this juncture, is for a steady return with an option to allocate capital again, if things get cheap at some point in the future.

I can't see Mr Buffett or his successor letting cash as percentage of assets or compared to insurance float going significantly higher. Something has to give.

"I can't see Mr Buffett or his successor letting cash as percentage of assets or compared to insurance float going significantly higher. Something has to give."

Large acquisition would help with this high class problem.

And maybe higher interest rates will dampen the enthusiasm of the leveraged buyout crowd, or Private Equity as they prefer to be called'we live in hope

The cash pile is somewhat of a problem, but it's not exactly an unusual one for Berkshire.

The cash pile is big in absolute terms, but Berkshire is a lot bigger than it once was.
Cash was 27% of investments per share at June 30.
10-year and 20 year averages are both about 29%, so the cash allocation is lower than usual.
It was 33-36% at year ends 2016-2028, and in the range 33-39% at year ends 2003-2006.

I think that cash is often best seen as merely the shortest end of the fixed income spectrum, not a magical thing by itself.
Cash + fixed income at June 30 made up 31% of investments at June 30.
That figure was as low as 35% at only one year end in recent memory, 2013. And two other years in the 38-39% zone.
Other than that it was 41% or more for every year end in the 20 years to 2018.
So again, the [cash+fixed] allocation is lower than usual.

The world has changed dramatically in the last year. Suddenly bonds and cash are providing a return that keeps up with inflation.
I don't think that the world has changed dramatically.
Interest rates are higher, but real interest rates aren't really. A little at the very short end, which won't last long.

I do agree that there is a problem for future capital allocation.
What's new is that the absolute number for the cash pile also matters now: there aren't a lot of elephants in the world.
It's extremely unlikely that Berkshire will ever have another single stock position like Apple which adds meaningfully to the company's value in so short a time.
For both of those reasons, new allocations of capital which are very large will almost certainly have moderate, not great, returns.

Jim

It can't just unload that much stock without depressing the price.

Can BH sell APPL stock directly to Apple as part of their buyback program? Is that a solution for this problem?

Berkshire has a problem. Albeit a high class problem. If it does not get the opportunity to allocate capital, it will eventually have too much cash.

Less than a month ago, Berkshire paid $3.3 billion for a 50% stake in a liquefied natural gas facility. The sub that bought it, Berkshire Hathaway Energy, began as a $2 billion acquisition in 1999. Today it is valued at around $90 billion.

The energy infrastructure space is full of midstream players that wade waist-deep into debt to build pipelines, storage facilities, export terminals, transmission networks and such. With the recent rapid rise in interest rates, some of them are now feeling stress around all that debt. This was the reported reason for Dominion's sale of the 50% interest in Cove Point, an asset arguably more valuable than the valuation at which Berkshire bought control as one of only seven LNG export terminals in the U.S.

If not now, might Berkshire get more ambitious in this space once Greg Abel, longtime CEO of BH Energy and architect of its rapid growth, is in charge? At a certain dollar level, the private equity houses generally are not a factor. You don't see them writing checks for $50 billion.

Take TC Energy, for example, a Canadian midstream player with a vast network of irreplaceable gas and liquid pipelines and multi-billion-dollar annual capital spending projects to build more. Like a lot of energy companies, it has not participated in the recent re-inflation of the equity markets. It's trading near its 52-week low at a market cap of about $36 billion. Under the current management, recent projects have been plagued by construction delays and cost overruns. Shareholders are not thrilled.

Is it possible that Berkshire under Abel would not confine itself to friendly acquisitions but make plays for parts or all of similar companies?

It's an area with a lot of healthy regulated returns on the operations side and it could absorb a lot of capital. Does anyone else think that Greg Abel's expertise in this space and growing influence in the Berkshire C-suite might make it even more aggressive allocating capital there?

It can't just unload that much stock without depressing the price.
...
Can BH sell APPL stock directly to Apple as part of their buyback program? Is that a solution for this problem?

I think it's probably more apt to say "you can't unload that much stock without depressing the price during the time period you're unloading".
But given the liquidity of Apple, that might be down in the rounding error. It's a deep book.
Berkshire's position is about 16 days of average trading volume, but even that can be done.

It's possible to do a block trade to Apple or to an investment bank at a very small discount, though even those buyers have pockets of finite depth.

The main thing is that Berkshire presumably has no intent to sell, so it's all a bit moot.

I'd rather they dumped Coke.
Ignoring the occasional high valuation for a great company is one thing, but ignoring a high price for Coke is quite another.

Jim

<The sub that bought it, Berkshire Hathaway Energy, began as a $2 billion acquisition in 1999. Today it is valued at around $90 billion.>

90/2 = 1.17^24, that's annual appreciation of 17% over 24 years. Nice!

90/2 = 1.17^24, that's annual appreciation of 17% over 24 years. Nice!

The returns have been good, but not like that. The cost basis is a whole lot more than the purchase price.
I don't know how much capital has been deployed into BHE but it's a lot.

It's amazing how well they do from tax incentives.

Jim

<I don't know how much capital has been deployed into BHE but it's a lot.>

That's the reinvested capital earned by BHE, not from the parent BRK. Right?

That's the reinvested capital earned by BHE, not from the parent BRK. Right?

Both, I think. But I've never tried to track it.
I guess BHE has its own filings, so one could figure it out.

[we pause briefly while Jim has a peek for the first time]

I had assumed some of the larger acquisitions would not have been done with just debt and retained earnings, especially the earlier ones: money from Omaha would have been needed.

But maybe you're right...the filings show only $6bn of paid in capital, versus $42bn in retained earnings, comprising effectively the whole of shareholders' equity.
Maybe the funding from Berkshire that I had imagined was (if it existed) limited to loans, perhaps only bridge financing since Berkshire is clear on the fact that the debt is non-recourse.
I couldn't find any mention of notes payable up the chain, but the filing is 569 pages.

Jim

Deja Vu all over again. But well summarized by EVBigMacMeal.

I recall discussing this with a close friend and fellow BRK shareholder some years ago. We met because of a shared background - same birth state, university, and former employer. He is a retired senior tax attorney with a huge corporation. Not much has changed since our discussions.

The issue is basically what to do with BRk's cash flow.

There are still several private US companies that can each soak up a year of cash generation. But you've got to land one every year. Otherwise there are only two private US companies that can move the needle for BRK. These are Cargill and Mars.

And D&A apparently offset capex needs for most of our companies. BNSF may need more since real annual maintenance is larger than D&A - maybe $1 billion? BHE is largely self funding, and - being regulated - favors debt over being funded by BRK. Maybe in major acquisitions? Small bolt-ons for others? NetJets may be an exception, but I don't know how profitable they are. Wish this was disclosed.

So that leaves the stock market and buybacks. Dividends still are a tax problem for Buffett and many long term shareholders.

Buffett has fairly recently moved into the Japanese stock market. But, again, only soaking up part of annual cash flows. And our success in buying foreign private companies is limited. Only Iscar comes to mind, and they sought out Buffett, not vice-versa. Seems to be some combination of tax and inheritance problems, maybe government influences? I don't really understand this. Just know that little has happened. And Buffett has been trying for several years. The Iscar guy tried to help - but not much has happened.

Maybe the future is some mix of the following. Buybacks when below IV. Index funds - maybe even sectors - when attractive. Otherwise hold cash and play the cycle? Hope for another Apple opportunity, and being flexible enough to react? I recall Buffett talking about Google some years ago in terms of low capex, high profits, and growth. But apparently wasn't predicable enough.

I do think that self-imposed limitations on competing for acquisitions need to be relaxed. I'm still upset that we lost a $9 billion Oncor acquisition in Texas over $300 million. Will the board go along with this after Buffett?

OBviously I don't know what the future will bring. But I think BRK will have to be more flexible in finding homes for its cash flow. It is our major future issue - more so than succession - in my opinion.

"We don't need to be paying Mr Buffett that $100,000 p.a to manage our capital, if he doesn't perform capital allocation master strokes for us." Au contraire mon frere. It's not the capital allocation we're paying him for, it's the ones he decides to take a pass on!

There's great value in those behemoths which are Alibaba and Tencent, He should be listening to Mr Munger. $25bn in each. Terrific values, great businesses, Alphabet was another op for 25bn.

I predict that Buffett's successors will put share repurchases into an automatic program, like Apple and most US companies do. Set a target for cash to be used for repurchases, agnostic of IV, and implement. They may suspend it when they need to build up cash reserves after a major acquisition or catastrophe.

BRK investor profile will also gradually change as long-term estates liquidate A shares. Will they even get rid of A shares?

As I first suggested in 2008, brk should have acquired the , right of first refusal , on all brkb sales by the foundations. At the very least, brk should have been buying at least half of the Gates Foundation sales of brk. The truth is, Buffett was never interested in brk buying back shares until he got tired of selling his life's work near 1.1 xs book. Finally, splitting the stock increased liquidity, which got brk added to indexes, made the stock and options more liquid, which resulted in brkb trading up toward 1.4 ish xs BV.

I submitted my previous post prematurely. Here is the full, corrected version.

I predict that Buffett's successors will put share repurchases into an automatic program, like Apple and most US companies do. Set a target for cash to be used for repurchases, agnostic of IV, and implement. They may suspend it when they need to build up cash reserves after a major acquisition or catastrophe. They may have a couple of years grace after succeeding Buffett, but investors/activists, will not show them the deference they have shown Buffett, if cash pile and cash flow remain high. Be patient and do nothing won't be an option.

Most of the time BRK seems to trade south of its IV, at least as calculated by most on this board and many respected analysts/investors. The short periods when it does trade above IV, it trades at only a modest premium and not at nose bleed levels. So an automatic repurchase program will not lead to a bad result. Alternatives like a dividend, or getting into auctions for acquisitions would be much worse.

Another interesting thought is the future of the A share. BRK investor profile will also gradually change as long-term holders' estates liquidate A shares. A decade after Buffet's passing his estate would have converted all the A shares. Will the bulk of the then outstanding A shares reside with activists hedge funds, institutions and their Wall St cohorts, pursuing short term returns, big fees, and ESG agendas? It may be better to buy back A shares even at a premium or get rid of them altogether.

Most of the time BRK seems to trade south of its IV, at least as calculated by most on this board and many respected analysts/investors. The short periods when it does trade above IV, it trades at only a modest premium and not at nose bleed levels. So an automatic repurchase program will not lead to a bad result. Alternatives like a dividend, or getting into auctions for acquisitions would be much worse.



If Berkshire usually trades below its value (a proposition which I agree has been true for most of the past 20 years), then repurchasing shares will usually be the right way to go. And in retrospect, a policy of automatic repurchase would have been fine, up to now. Suspending the repurchases and either accumulating cash or paying a dividend would be the right policy if the Berkshire shares rose beyond intrinsic value. Suspending repurchases also makes sense if a major acquisition is anticipated, and this is something Buffett has also done recently.

But I can't really see why Berkshire's policy should ever be like Apple's, where shares are repurchased with the same enthusiasm at 30 times earnings as they were at 8 times earnings, with no consideration of their value or of other alternative uses of capital. If Berkshire's new management were to ever adopt a policy of paying dividends and repurchasing shares all the time in the same proportions, I would seriously question whether Buffett had succeeded in arranging for a succession where his value orientation was maintained.

DTB

But I can't really see why Berkshire's policy should ever be like Apple's, where shares are repurchased with the same enthusiasm at 30 times earnings as they were at 8 times earnings, with no consideration of their value or of other alternative uses of capital. If Berkshire's new management were to ever adopt a policy of paying dividends and repurchasing shares all the time in the same proportions, I would seriously question whether Buffett had succeeded in arranging for a succession where his value orientation was maintained.

It's a perfect example of the circularity of the problem.
Buybacks make sense because Berkshire's prospects for value growth per year are more certain and slightly better than average.
But if they were silly enough to keep buying their own shares at stupidly high valuation levels, that would show they had lost the plot on capital allocation, and the shares weren't worth as much, so almost any buybacks would be unlikely to be a great use of capital.

At the scale of Berkshire these days, the opportunities for big wins from a few smart big investments are over, or nearly so.
Measured by impact on Berkshire's share value, maybe BNSF was the last-ever big win on the whole-company acquisition front, and maybe Apple will end up being the last big win on the public stock front.
Instead, the continuation of increasing value at an above average rate will likely rely more and more on simply avoiding the dumb things: prudent, rather than genius, capital allocation.
It's amazing how much better one can do by simply eliminating a few big losers from the barrel.
It's not actually that hard, with some discipline: Most big losers lose because of a risk that might have been unlikely, but whose possibility was pretty foreseeable well in advance.
Common categories of dumb moves: being impatient to deploy capital (even if it's a below-usual fraction of the assets), investing in businesses that won't last long enough to earn back their prices, and buying stories that are plain overvalued.

Berkshire's style, in short: Don't speculate, don't buy something just because it's growing rapidly, just buy streams of earnings.
Aim for the most future earnings for your dollar, with the highest certainty, and the longest probable time horizon.
Reinvest those earnings the same way.
If it isn't making 7% of the purchase price now, it has to make more than 7% of the purchase price next year. (paraphrased quote from Mr Buffett)

Jim

BRK could invest as much as they'd like in a factor-mimicking fund.

https://blogs.cfainstitute.org/investor/2019/04/15....

Berkshire's style, in short: Don't speculate, don't buy something just because it's growing rapidly, just buy streams of earnings.
Aim for the most future earnings for your dollar, with the highest certainty, and the longest probable time horizon.
Reinvest those earnings the same way.
If it isn't making 7% of the purchase price now, it has to make more than 7% of the purchase price next year. (paraphrased quote from Mr Buffett)

Combs said the test Buffett uses is this:

1. How many names in the S&P are going to be 15x earnings in the next 12 months?
2. How many are going to earn more in five years (90% confidence)?
3. How many will compound at 7% (50% confidence)?

This test was used to find Apple.

1. How many names in the S&P are going to be 15x earnings in the next 12 months?


Is that

How many names in the S&P are going to be trading at 15x (earnings in the next 12 months)?

or

How many names in the S&P are going to be (trading at 15x earnings) in the next 12 months?

?

Jim

BRK could invest as much as they'd like in a factor-mimicking fund.

They wouldn't even have to get that fancy if they were willing (and able) to use the cash.

In 2012 Berkshire held $42 billion in cash, plus $31bn fixed and $87bn equities.

It's still in cash, and with interest it's now about $50 billion.

In SPY it would be over $150 billion.

I've long thought Berkshire could create their own value-weighted quant fund and soak up any amount of cash.

They wouldn't even have to get that fancy if they were willing (and able) to use the cash.

Sure. If 90% S&P500 is good enough for his wife once he passes, why not for BRK?

Sure. If 90% S&P500 is good enough for his wife once he passes, why not for BRK?

And by extension if it's good enough for BRK, it's good enough for us. Who needs Berkshire to exist?

Jim

"...if it's good enough for BRK, it's good enough for us. Who needs Berkshire to exist?"

We all do.

Without a Berkshire, there would be no Buffett to admire, no Annual Report to anticipate, no unique one-of-a-kind business to own a piece of from afar or to gather around in Omaha annually, no Discussion Board to share our thoughts about a common financial interest (thanks, Manlobbi), and no Mungofitch to conduct a free financial master-class for all who will listen. I am thankful that Berkshire exists for all of these reasons and more, and would happily cede a small edge to the S&P500 for the benefits I've received.

Phil

Aside from the things Phil mentioned, for me, a big advantage of Berkshire in the last 18 years has been that the S&P 500 has been overvalued for the bulk of this period. This meant that most of my funds went towards buying Berkshire and none towards the index.

If the S&P 500 index was more undervalued than Berkshire, I may have invested more funds in an index fund representing it than in Berkshire. Hence, by having both, one gets the flexibility to choose where to invest, depending on valuation levels.

As Mr. Buffett has said, in the long term (say. next 20 years), the returns from both are likely to be very similar. But I still prefer whichever is more undervalued.

"If 90% S&P500 is good enough for his wife once he passes, why not for BRK?"

And by extension if it's good enough for BRK, it's good enough for us. Who needs Berkshire to exist?




I think this is in the category of "What to tell the surviving spouse who has no knowledge of-- or interest in -- investing how to handle their inherited investments after you are gone."


William Bernstein: "If money management is not enjoyable, then a lousy job inevitably results, and, unfortunately, most people enjoy finance about as much as they do root canal work."

These are Cargill and Mars.

You have no idea how much I would love it if Warren bought Mars.

I see BRK as an index---an index of companies that have a good steady cash flow. I rest better with an index of companies I know will make money, than a collection of companies I hope will make money. The results may be quite similar, though I have faith the BRK is a bit more resilient in a downturn, particularly when the downturn is reflects stock market sentiment as much as fundamentals. I want the weighing machine, not the voting machine. If I miss various bumps from .com, AI euphoria so be it. I need BRK because it fills that niche in what I want in investments.

You have no idea how much I would love it if Warren bought Mars.

Does anyone know how profitable is Mars?
Who here buys Mars products regularly?
Candy and petfood, right?
Petfood seems to be a growing market. Not sure about candy.

Who here buys Mars products regularly?

There is a Snickers bar on my desk as I type. I always have one in my pocket on a bike ride or skiing. We buy in bulk boxes at Costco. Cheaper and better than all those fancy sports bars. You asked.

Snickers... I always have one in my pocket on a bike ride or skiing. We buy in bulk boxes at Costco.
Mhm, if you really move to France with all those slim Frenchmen ......

And by extension if it's good enough for BRK, it's good enough for us. Who needs Berkshire to exist?

For any who might of missed it, my comment above was sarcasm. And "reductio ad absurdum".

Berkshire is better at capital allocation than I am, and probably a lot better than most of us are.
They exist, and earn their existence, thereby.

In general we can't do what they do, and it's probably not going to work out well if we try to tell them what to do.
Like giving up on cash and holding an index fund which (yes) would have higher long run returns, but also remove the ability to write very big cheques reliably on short notice in case of elephant opportunities or nuclear explosion claims.

We don't need, and don't want, Berkshire to be an index fund.

Jim

I see BRK as an index---an index of companies that have a good steady cash flow.

It's an index of cats and dogs.
Apple - Can buy that directly. One tech company among many, in a sector where the road is paved with the carcasses of former stalwarts.
Insurance - picking up pennies ahead of a steamroller. Highly regulated (irrational regulators in California are refusing to raise rates enough, so many insurance companies won't write new policies at all. For fire (i.e. home) or auto.) Can't make money on premia because loss ratios are above 100%. "Wonderful management in a poor business" (paraphrasing).
Utilities - Nuff said. Also highly regulated.
Rail - continuously heavy CapEx. Common carrier regulations.
Kittens and puppies - consumer cyclicals like paints and Clayton (subject to homebuilding cycle), Forest River (economic cycle), Netjets (!) No-moat businesses.

What is so great about this index? Has no significant exposure to health care or tech beyond cell phones or consumer staples. Those are proven winners among sectors for the last 20 years (at least). OK, maybe S&P 500 is overvalued. But still more promising for growth than Berkshire.

The basic assumption of value investors - that people will one day wake up and start assigning prices based on deterministic future cash flows - is flawed. It has never been true in the history of stock market. Prices have always been decided by half hype and half reason.

How has BRK stock portfolio done compared to S&P?

In 1998 Buffett recalled the incredible story of how LTCM went bust. He found it truly fascinating, given how a group of extremely high IQ + life long experience and expertise in their field + using their own money: could go bust.

In telling the story, Buffett referred to a book that was not a great book but had a great title.

###You only have to get rich once###

Despite Berkshire's growing 'cash problems', currently minor but with the potential to escalate: it's worth reminding myself why I really own Berkshire.

###Defensive qualities and superior capitalisation skills and discipline.###

* Defensive qualities and superior capital allocation skills and discipline.

Apologies, when I previously said: superior capitalisation skills. I must have been thinking about Tesla. (Sorry a poor accounting fraud joke there')

Like giving up on cash and holding an index fund which (yes) would have higher long run returns, but also remove the ability to write very big cheques reliably on short notice in case of elephant opportunities or nuclear explosion claims.

If you're holding a reserve in case of nuclear explosion claims and such, you can't use that same money for elephant opportunities, obviously.

Berkshire..... What is so great about this index?

A) That I trust it more than others like the S&P, sleep better at night with the majority of my money in that one. Which partly is a function of B:

B) It's extremely consistent and because of that predictable. See the narrow and highly consistent Price/BV range

C) Because of B it allows relatively risk-free additional return/entertainment by buying calls when it's low in that range, selling covered calls when it's high.

D) Once a listening to 2 amazing people.

None of this advantages I see with other indexes. While advantage D won't last forever Ihhope the other 3 may outlast me.

Like giving up on cash and holding an index fund which (yes) would have higher long run returns, but also remove the ability to write very big cheques reliably on short notice in case of elephant opportunities or nuclear explosion claims.
...
If you're holding a reserve in case of nuclear explosion claims and such, you can't use that same money for elephant opportunities, obviously.

There is currently a lot of cash for both.
If they invest that money, there won't be money for either.
It's the same problem.

Consider the post suggesting we'd be better off if the lion's share of the cash pile had been put into the S&P ten years ago.
True, but that's a comment with hindsight.
The valuation level of the S&P 500 ten years ago was about the same as the valuation level in, say, late 1968 (based on smoothed trend real earning power).
The next roughly ten years had a return of -4.2%/year below inflation that time. Holders of the S&P were luckier this time.

Invested money is invested. It isn't available for immediate use, especially not at the scale that Berkshire operates.
Heck, if they wanted to sell $40bn in T-bills in one day it would probably move the market.

Jim

The basic assumption of value investors - that people will one day wake up and start assigning prices based on deterministic future cash flows - is flawed.
It has never been true in the history of stock market. Prices have always been decided by half hype and half reason.

I guess it depends on your definition of value investing.
I certainly wouldn't use that one, which seems rather odd to me, so I wouldn't come to the same conclusion.

The value of any purely financial instrument is the present value of all future distributions, nothing more and nothing less.
It's a specific number rather than any opinion, though it's not known with precision in advance.
Value investing is just paying less than that number. If you hold for a long time, you are guaranteed a profit.
(If you pay more than that number, the only way you can make a profit is being able to sell to a future greater optimist--in which case future market prices do matter a lot)

A value investor, thus defined, doesn't need anyone ever to agree with them. You don't need future stock prices to reflect your opinion about the value.
You get ownership of the future earnings and distributions, so you can just sit and wait.
Mr Market might make you a great offer for your equity from time to time in future, which is pretty likely, but there is no strict need for it: you can just sit on your duff and get the future distributions.

Berkshire's style of investing is just buying as many large streams of future earnings as they can, at the lowest purchase price, with the highest reliability and longevity they can foresee.
That's what all the investments have in common. It's enough.

Sometimes the expectations of the future earnings will be too high (or too low), but the average should be OK if that's what you're aiming for.
Does Berkshire own some duds? Sure, nobody's perfect. But the reasoning was the same for all of the purchases.

How has BRK stock portfolio done compared to S&P?

Lately? Trounced it, by being overweight Apple.
A long time ago? Trounced it.
In between? Not so much.

Jim

There is currently a lot of cash for both [insurance claims and investment opportunities].
If they invest that money, there won't be money for either.
It's the same problem.

Sure. Buffett at the AM this year:

'What we'd really like to do is buy great businesses. If we could buy a company for $50bn or $75bn, $100bn, we could do it'.
but...
"It isn't killing us to hold $130bn of bills at 5%+".

https://www.cnbc.com/video/2023/05/06/warren-buffe...

1. It was implied that value investors try to pay less than NPV of DCFs, leaving a MOS. Point is, their returns as measured by actual stock prices have shown that they are making an unrealistic assumption that Mr Market WILL eventually make it "right". Future is yet to be written, so DCF calculations even with a MOS are mostly a joke. BRK could project them well for their own businesses like utilities and rails and other slow, ponderous, highly regulated , CapEx heavy businesses where their profit margins depend on spending on assets. But not their stocks.
2. You cannot sit on your duff forever. People get older and need to cash out. Even if you own through a corporation like BRK. Irrational (as defined by value investors) > solvent.
3. BRK stocks - Apple = low quality. I too bought Eli Lilly in 2009 and 2017 and did spectacularly well with it. One stock proves nothing. Long-ago outperformance is irrelevant for the future. See Michael Burry, John Paulsen et al one hot wonders.
4. BRK operating businesses = low quality.
5. Denying reality has kept BRK out of high growth stocks, S&P 500 or any broad index does not have that problem.

Jim:

The basic assumption of value investors - that people will one day wake up and start assigning prices based on deterministic future cash flows - is flawed.
It has never been true in the history of stock market. Prices have always been decided by half hype and half reason.

I guess it depends on your definition of value investing.
I certainly wouldn't use that one, which seems rather odd to me, so I wouldn't come to the same conclusion.

The value of any purely financial instrument is the present value of all future distributions, nothing more and nothing less.
It's a specific number rather than any opinion, though it's not known with precision in advance.
Value investing is just paying less than that number. If you hold for a long time, you are guaranteed a profit.
(If you pay more than that number, the only way you can make a profit is being able to sell to a future greater optimist--in which case future market prices do matter a lot)

A value investor, thus defined, doesn't need anyone ever to agree with them. You don't need future stock prices to reflect your opinion about the value.
You get ownership of the future earnings and distributions, so you can just sit and wait.
Mr Market might make you a great offer for your equity from time to time in future, which is pretty likely, but there is no strict need for it: you can just sit on your duff and get the future distributions.

Berkshire's style of investing is just buying as many large streams of future earnings as they can, at the lowest purchase price, with the highest reliability and longevity they can foresee.
That's what all the investments have in common. It's enough.

Sometimes the expectations of the future earnings will be too high (or too low), but the average should be OK if that's what you're aiming for.
Does Berkshire own some duds? Sure, nobody's perfect. But the reasoning was the same for all of the purchases.

How has BRK stock portfolio done compared to S&P?

Lately? Trounced it, by being overweight Apple.
A long time ago? Trounced it.
In between? Not so much.

Jim

"It isn't killing us to hold $130bn of bills at 5%+".

Not killing, but still a slow loss of blood.
T-bills have averaged 5.16%/year rate in the last 6 months.
A half year of that would be pretax interest of 2.58%.
After 21% corporate tax, that's 2.04%.
Inflation has been 3.00% in the same six months (not annualized).
Real after tax return on T-bills in six months -0.96%
Annual real after-tax rate of return -1.91%/year
Agreed, that is certainly way better than substantial inflation and no interest.
But it's not better than no inflation and no interest.

As an aside, it's good to remember that elephants can also be funded in part with debt, not just cash.
One of the things that Berkshire has quietly done with the annoyingly large cash flow in recent years is to reduce consolidated leverage.
Debt is lower these days than historically normal levels. For example, head office would have to borrow over 30% of book value to get the leverage to where it averaged around 2016-2017.
[Total assets : Shareholders equity] ratio averaged 2.23 from early 2016 to late 2017, and was never under 2.15 in the prior 3 years. It was 1.929 at end of Q2.
That "unused borrowing power" amounts to over $110bn (one AT&T or Mondelez), without touching the cash pile, and bringing leverage only up to the old normal.
Counting spare cash, there are only about 25 US-domiciled firms that could be ruled out as prey purely on size.

Jim

2. You cannot sit on your duff forever. People get older and need to cash out. Even if you own through a corporation like BRK. Irrational (as defined by value investors) > solvent.

True, I can't sit on my duff forever.
But Berkshire can. This is a discussion of what makes sense for Berkshire's portfolio, not mine.
As a big profitable firm with a robust balance sheet, it is very likely to outlive us all.
Therefore Berkshire doesn't need the market ever to change its mind about the value of any of its holdings: the true intrinsic value is all that really matters. Wait for the coupons.
Mr Market might offer up opportunities for great sales or great purchases at some point, but those opportunities are not needed. No "rerating" is needed.


What about us mortals? Sure, personally I do rely on the ability to sell at some point.
The defence I use is simple: I never rely on the existence of a future optimist.
I never assume than any investment can be sold in future at a high valuation level, or even what these days would be considered average. Luck is not a strategy.
If I'm getting a ton of future earnings for each dollar put at risk today, I don't need any particular optimism or exuberance in the person I'm eventually going to sell to.
I rely on my guesses of future earnings being roughly right, which is certainly not always the case, but I can do quite well with a very modest exit multiple.


Denying reality has kept BRK out of high growth stocks, S&P 500 or any broad index does not have that problem.

I'm sure you're aware that value investing has nothing whatsoever to do with avoiding high growth stocks.
The value of any firm is the future profits, most of them in the quite distant future.
Value investing is nothing other than trying to buy that stream of future earnings for a low price.
A broad index does not have that goal, and so on any given day a lot of the money is invested in overvalued stuff, dragging on long run returns.
Some people are fine with that, others aren't. Berkshire doesn't ever consciously suffer from that disease, which is the reason the value grows more quickly.

Jim

T-bills have averaged 5.16%/year rate in the last 6 months.
A half year of that would be pretax interest of 2.58%.
After 21% corporate tax, that's 2.04%.
Inflation has been 3.00% in the same six months (not annualized).


Are you talking about US inflation? CPI in recent 6 months (December 2022 to June 2023) is actually only 0.2%; for the most recent 12 months, it's 3.2%. Media outlets always quote the year over year increase which is still above the target, but there's actually been less inflation in the last 6 months.
https://www.bls.gov/news.release/cpi.t01.htm

The current (July) CPI number is 305.691, and the January number was 300.536 (seasonally adjusted); July 2022's number was 294.628. https://fred.stlouisfed.org/series/CPIAUCSL

305.691/300.536 = 1.0172, so 1.7% (3.5% annualized), and 305.691/294.628 = 1.03755, so 3.8% for the whole year.

https://www.bls.gov/news.release/cpi.t01.htm

Your point still holds, inflation eats into taxable bond returns, but maybe not as much as your numbers indicate; it would be slightly (although almost insignificantly) positive now.

DTB

CPI in recent 6 months (December 2022 to June 2023) is actually only 0.2%

Sorry for that confusing typo; CPI inflation (seasonally adjusted) in that period was not 0.2% (that was the June to July inflation.) As I said further along, 6-month inflation (not annualized) was 1.7%, and 12-month inflation was 3.8%. My point was just that non-annualized inflation from January to July was considerably less than 3%.

dtb

CPI in recent 6 months (December 2022 to June 2023) is actually only 0.2%
...As I said further along, 6-month inflation (not annualized) was 1.7%,

You're right that my figure was misleading, though the correct figure certainly isn't 0.2%, nor 1.7%.

As with Berkshire's book value, my habit is to use my "point in time" data set, being the figure that was known on a given day, not the figure which was named after a given day.
A quirk of the BLS release date schedule meant the figure I quoted was for the rise during seven data releases rather than six.

The most recent data release now is the "July" figure, released and known as of August 10, CUR0000SA0=305.691
Six months earlier on Feb 10, the most recently known and released figure was still the "December" figure, CUR0000SA0=296.797, as the "January" figure was not released till Feb 14.

So, comparing the "last known number" to "last known number six months earlier", the rise between the two is the 3.0% that I quoted.
The underlying data collection dates were, however, seven months apart, which I didn't notice, sorry.

Had it been only a couple of days earlier or later, the "most recently known and released" figures would have been for underlying data collection months six months apart.
Had I posted a couple of days earlier I'd have said 2.80% (the rise from the release named "December" till the release named "June"),
and a couple of days from now I'd have said 2.18% (the rise from the release named "January" till the release named "July").
Right on the release date cusp I guess the most "correct" figure would be the average of those two, around 2.50%.

It's always surprised me that they make it so extremely difficult to find the actual CPI. They quote the year-on-year rise everywhere, but the actual index level is hard to find.
This is the link https://download.bls.gov/pub/time.series/cu/cu.dat...
For the usual all-urban figure you have to search for CUUR0000SA0 and remember that M13 means the average for a calendar year, not a real month.
That's the "All items in U.S. city average, all urban consumers, not seasonally adjusted"
Seasonal adjustment isn't appropriate in this context, especially not this year with its wild swings due to things other than the time of year.

(reminder that all rates being discussed are six-month rise not annualized rates)

Jim

Berkshire..... What is so great about this index?

I have to add an important point to my previous answer which I think some might share:

E) If Berkshire wouldn't exist I wouldn't know what to do with my money.

I am not kidding. Surprising for myself the last 2 years I made quite some money with mostly options, but that was
- either sheer luck (TUP calls when it was (still is) close to bankruptcy, which became 10-15x baggers, without really knowing anything about TUP = Gambling)
- or based on Jim (DLTR calls)
- or based on Jim again (BRK calls at 1.25x or so Price/PeakBV)
- or sheer luck again (a few days ago selling covered BRK calls and buying them back completely unexpected the very next day with 24% profit)

And when I, Warren's "know nothing" investor, dare to invest based on valuation, the outcome is completely unpredictable. End of last year I diversified away a bit from Berkshire with a very simple (too simple) and lazy valuation method and bought decent amounts of especially BABA, META, KMX, VZ, GOOGL, PYPL, WRB, MKL and LHA.DE).

The result up to now:
- The tech stuff is up.
- Most non-tech stuff are down, especially VZ, PYPL, WRB.
That all together I am up big is not caused by my "valuation" of those companies but simply by this year's tech hype. Even by nearly one stock only, META, which was my biggest position and which tripled or so. Without that ...

Seriously. Without Berkshire I wouldn't know what to do. I'd probably put most of my money in "Jim's Latest" (which he calls "LargeCapCash"). And without Berkshire AND Jim? Omg!

'Seriously. Without Berkshire I wouldn't know what to do. I'd probably put most of my money in "Jim's Latest" (which he calls "LargeCapCash"). And without Berkshire AND Jim? Omg!'

Where's the shame in owning a fund? There's some interesting quality and/or value factor ETFs out there. Pay 15-25 basis points and let someone else do the work. It's a reasonable option.

Where's the shame in owning a fund? There's some interesting quality and/or value factor ETFs out there. Pay 15-25 basis points and let someone else do the work. It's a reasonable option.

Make sense. For the average fellow over a decent time horizon there is no need to beat the market, and little chance to do so even if you wanted to, so there is no need to put in the work to try.

Since it doesn't increase the work, I'd tend to pick a fund that isn't cap weighted.
And perhaps a tiny skew towards better firms, if you could find one that wasn't cap weighted?

My only concern:
If there are companies you would not invest in for ethical reasons, index investing is out. And most funds.

Of course it's pretty easy these days to simply do it yourself.
Find a list of tickers you like, S&P 500 or whatever.
Delete the few you won't touch. (e.g., the ticker which matches your evil step-sister's initials)
Upload the list to your broker's site, assign a list of weights, enable fractional shares if you want precision, use "one click" rebalancing if desired.
Other than the hour to figure it all out the first time, it's not appreciably harder than putting your money in an index fund.


The only pitfall with doing the "index except odious" yourself is probably the temptation to start doing individual picks that you're not qualified to make.
A very slippery slope indeed.

An equally weighted portfolio of the 200 highest ROE firms in the S&P 1500, rebalanced quarterly, beat the S&P 500 by 4.0%/year in the last 30 years after trading costs, with vastly lower single-company risk.
(actually I tested the 1500 biggest by market cap in the Value Line database, which is almost but not quite the same thing)
One step in that direction of stock selection may actually be sensible, but five steps in that direction leads to madness.

Jim

There's some interesting quality and/or value factor ETFs out there. Pay 15-25 basis points and let someone else do the work. It's a reasonable option.

Do you have a list of funds that are managed by a Jim somebody who lives in Monaco?

At the scale of Berkshire these days, the opportunities for big wins from a few smart big investments are over, or nearly so.
Measured by impact on Berkshire's share value, maybe BNSF was the last-ever big win on the whole-company acquisition front, and maybe Apple will end up being the last big win on the public stock front.

Maybe the future portfolio managers will have to focus on which market sectors, or which markets to invest in? Just pump money into ETFs or investments like the sogo shosha?

I'm in the UK, and currently the FTSE 100 and FTSE 250 indexes look like candidates, for slightly different reasons. For both, sterling is relatively cheap on a medium / long term timeframe. The 100 is the huge stodgy companies at low/average valuations, a bond equivalent type investment, but with a little more growth. The FTSE 250 is not much different in valuation, a little more expensive, but provides a lot more diversification, a different sector blend and much better historical growth. Buy some of each?

SA

Do you have a list of funds that are managed by a Jim somebody who lives in Monaco?

Ha! There used to be one.
Alas, it started just before the credit crunch. Not the greatest time to build a good early record to attract capital : )
We shut it down in 2012...too much paperwork.

Jim

Aside from the things Phil mentioned, for me, a big advantage of Berkshire in the last 18 years has been that the S&P 500 has been overvalued for the bulk of this period. This meant that most of my funds went towards buying Berkshire and none towards the index.

If the S&P 500 index was more undervalued than Berkshire, I may have invested more funds in an index fund representing it than in Berkshire. Hence, by having both, one gets the flexibility to choose where to invest, depending on valuation levels.

As Mr. Buffett has said, in the long term (say. next 20 years), the returns from both are likely to be very similar. But I still prefer whichever is more undervalued.

This.

I'm in the UK and I've had investments in, and invested more, in the FTSE 100 and FTSE 250 in the past decade or more. These investments have done worse than some things, and better than others. But the reason I'm content with them is that they seemed undervalued when I bought them, so hopefully fairly valued even if I was mistaken. The reasonable valuation makes it easier to expect an ok outcome even in "bad" circumstances, and perhaps a good outcome if things turn out well ... ;-)

I'm in the UK and I've had investments in, and invested more, in the FTSE 100 and FTSE 250 in the past decade or more. These investments have done worse than some things, and better than others. But the reason I'm content with them is that they seemed undervalued when I bought them, so hopefully fairly valued even if I was mistaken. The reasonable valuation makes it easier to expect an ok outcome even in "bad" circumstances, and perhaps a good outcome if things turn out well ... ;-)

The FTSE 100 suffers a bit from the same malaise as the Canadian market: heavily concentrated in a couple of sectors. As those go, so go your returns.
The FTSE 250 is much more diversified, for sure, so among other things it's easy to value.
It's a shame it's over 23% financials and under 1.2% technology. I guess you can always add more "zippy" tech stuff yourself.

FWIW, here is a six month old glance at valuation for the FTSE 250.
https://www.ukdividendstocks.com/blog/ftse-250-cap...
CAPE is a poor valuation metric for small or unbalanced markets, but the FTSE 250 doesn't really suffer from those.
The write-up is half a year old, but the index has gone roughly nowhere this year, so the numbers are just a pinch more attractive now.
Bottom line: if the economy experiences some decent mean reversion, it's probably a pretty good buy for an index.

The main reason I don't invest in the UK market that much is, well, capitalists in the US just seem to do better on average over time.
If you're hunting for diamonds, it's better to be searching near diamond mines.
And of course the UK economy is suffering from rather more than the usual number of bumps in the road lately. Like much of the world's investors, "wait and see" is about the most bullish stance you'll find on the UK market these days.

Speaking of UK headwinds:
Oddly enough, the thing about the big one-time drop in the pound since the Brexit vote is so overdone that it rather annoys me.
The writers never seem to notice that the pound had just had a big run-up prior to that in 2014 and 2015.
On a trade weighted basis, it's about the same remarkably steady level it was before that.
The average level since the Brexit drop is a whopping 2.7% below the average 2009-2013 inclusive, before the run up. This is newsworthy?
The latest figure is actually up 1% from the average in that stretch.
The big one-time lasting step drop was actually in 2008 due to the credit crunch, about -19% comparing average in the years before to the years after.

Jim

An equally weighted portfolio of the 200 highest ROE firms in the S&P 1500, rebalanced quarterly, beat the S&P 500 by 4.0%/year in the last 30 years after trading costs, with vastly lower single-company risk.

Thanks, Jim.

What about valuation of these high ROE firms?
Does the current set have the same over-valuation issue as the S&P500, perhaps even more so?

What about valuation of these high ROE firms?
Does the current set have the same over-valuation issue as the S&P500, perhaps even more so?

Well, I'm sure you'll do better if you started such a scheme when things were cheap compared to when things were expensive.
And this would probably not be one of the cheap days.

But the general idea is very Buffettish, combining two of his unrelated ideas in a pretty minimal way:
Over the long run you're simply better off owning the better-quality businesses, and over the long run the broad US market will do well for you.

Think of it the way you would think of someone investing in SPY, just (one hopes/expects) a little bit better long run average return.
The people who buy SPY are not generally the people who worry about starting that purchase on the best possible date.

Jim

An equally weighted portfolio of the 200 highest ROE firms in the S&P 1500, rebalanced quarterly, beat the S&P 500 by 4.0%/year in the last 30 years after trading costs, with vastly lower single-company risk.

You have pisted an enormous number of such back-tested screens. Do you have any data for, say, how the screens you posted 8 years ago (or any such longish period of time) have done since posting them?

Since there is no economic reason why high RoE firms should do better than low RoE firms (*) in these days of differing buyback policies, I would like to know why I should repose any faith that this screen will continue working.

(*) Meaning the low RoE firms are not reducing their equity - the denominator - as fast as the high ones, but their actual business and earnings and earnings growth (the numerator) could be better than the high RoE firms.

Since there is no economic reason why high ROE firms should do better than low ROE firms (*) in these days of differing buyback policies, I would like to know why I should repose any faith that this screen will continue working.
(*) Meaning the low RoE firms are not reducing their equity - the denominator - as fast as the high ones, but their actual business and earnings and earnings growth (the numerator) could be better than the high ROE firms.

In fact there *is* a very good reason that high ROE companies should be above-average long run performers.

ROE is hard to measure reliably...there are lots of things that can give you a somewhat misleading result. The effect of buybacks is one of them, but that effect is so tiny that it can be ignored.
(if a firm buys back 20% of all of its shares, paying an average of 2 tiles book, both big numbers, it drops book per share "artificially" by only 11%--we have bigger flaws to worry about).

The reason ROE works, though, is that on book value per share is on average a "good enough" proxy for the replacement value of the firm's assets.
Not good enough to be entirely reliable in any specific case, but good enough to be a statistically useful predictor on average.

Imagine a widget factory with a $10m factory making $2m/year in net profit, 20% ROE. Assume $10m is both book value and the cost of duplicating the factory.
A competitor will be highly motivated to raise money at less than 20% cost of capital, build a duplicate factory, and undercut the first factory: they'll still make an above-average return.
This keeps going until it is no longer profitable for a new competitor to enter the fray, which is the point that the return on capital for the next would-be competitor is equal to the cost of capital for them all.
(axiomatically, the global average return on capital is equal to the global average cost of capital)

Let us continue to assume that the book value of our firm is a reasonable proxy for the cost to duplicate its assets.
But let's say the firm is making 20% ROE year in and year out for a long time.
What does that tell us? That, for whatever reason, competitors can't (or won't) set up in competition with them successfully: the company has an economic moat of some type.
This is, as we know, a very good business to be in. Sustainably high profitability that isn't being eaten away by competitors.
Some subset of those firms will also have the ability to deploy new capital into their business at the same high rate of return on assets, the very best of the best in terms of business economics.
If you're not buying equal amounts of all the companies out there, you at least want to make sure you are owning these great ones.

So, though ROE is not 100% reliable in the case of any specific firm, mainly because of quirks in the way assets are booked, it is almost always true that a great long term business (a business with moat giving them lasting high profitability) is going to have a high ROE.

So, why does the screen work? The businesses it picks are higher than average quality.
It will pick some duds that have undeservedly high numerical ROE, and presumably does badly on those. Most obviously, companies that are over-leveraged.
But it catches a very large fraction of the very best companies (it's hard to be one of the best without a high ROE), and eliminates almost all the firms with the ho-hum poor business economics: poor returns on capital employed.
In short, not all firms with high ostensible ROE numbers are good investments by a long shot, but almost all good long run investments have good ROE figures over time.
This filtering, though certainly flawed in any single instance, gives a statistical edge that seems to be big enough to be worth exploiting.

The temptation is to make the screen more and more sophisticated--skip those that are overleveraged, allow those that have negative book value, adjust for dud goodwill, and so on.
But that way lies the slippery slope. As the saying goes, if you torture a data set long enough, it will confess to anything.
But if you can buy 50 or 100 companies that will beat a dartboard on average over time by a percent or two, that's probably good enough, and you aren't in danger of fooling yourself too much.
The real world results will still be worse than the backtest--that's the nature of things. But it should still give you a good chance of outperformance, and if it's all just statistical noise you shouldn't do meaningfully *worse* than average over the long run.

You have posted an enormous number of such back-tested screens. Do you have any data for, say, how the screens you posted 8 years ago (or any such longish period of time) have done since posting them?

Good question.
I'll discuss only the prominent failures, since those may have the most useful insights to offer. They're certainly the ones prominent in my mind : )

The most interesting failure is a screen called YLDEARNYEAR, invented in 2003. (not by me)
It outperformed the market through thick and thin for a dozen years after it was published, the sort of thing that gives a lot of confidence that there is something "real" going on.
Then it promptly turned around and started underperforming the market for the next 5-6 years.
So, what's going on?
That screen seeks firms with both high earnings yields and high dividend yields.
That population of stocks itself seems to go in and out of fashion, not necessarily on a cycle matching bull and bear markets.
With hindsight, it appears that the screen magnifies (very successfully) the degree to which that dividend population is in vogue.
Some numbers:
In the first 11 years after the screen was published, the set of all moderately profitable firms with dividends outperformed the broad market by about 4.4%/year.
(for that I looked at all stocks in the Value Line 1700 database with P/E < 33 and any dividend yield, equally weighted)
Consequently, that was a very fertile hunting ground for any stock screen:
The YLDEARNYEAR screen outperformed the market by about 14.1%/year in this stretch. (5 fresh stocks bought each month, each held two months, for a 10 stock portfolio).
But in the next 6.1 years, the set of all profitable dividend earners underperformed the S&P by -5.6%/year, and the screen underperformed by -17.1%/year.
Dividend payers have come back into fashion again, outperforming the S&P by +5.4%/year in the last 3.25 years.
And, as you might now expect, the screen has come back into its own: it has outperformed the S&P by 17.7%/year in that same period.
During the stretch that dividend payers were out of fashion, almost all humans using this screen would have thrown in the towel.
Yet, had one stuck with it, it has still outperformed overall since its invention 20 years ago.
S&P returned 10.1%/year, the set of passably profitable dividend payers returned 11.5%/year, and the screen returned 14.3%/year.
One could potentially check to see if dividend earners are in or out of fashion lately, and use the screen only when the omens are good--tie situation doesn't change often. But it's hard to know in advance how that attempt would do long term.

The biggest total failure screen was one I created and suggested that simply looked at very large firms with great balance sheets and low P/E ratios, nicknamed "BlueCheaps".
This is one that I would definitely sweep under the carpet if I were still in the money management business : )
The original post that suggested it http://www.datahelper.com/mi/search.phtml?nofool=y...
In the backtest 1986-2009 inclusive it indicated performance 9.4%/year better than the S&P 500, with 5 stocks each month after trading costs.
But then, alas, among the large and financially sound firms, the ones without many profits became the ones that were the better performers. Much, much better.
The same screen 2010 to date underperformed the S&P 500 by -6.9%/year.
You were still holding big profitable stable firms making a lot of money, so individual picks didn't tank, and the returns of ~6%/year were relatively steady...you just didn't do nearly as well as a monkey with a dartboard would have. A portfolio of genteel mediocrity.
Lessons? One very big flaw of this and many other screens is that its results were based on a portfolio of only 5 stocks, sometimes 10.
There is so much randomness in having such a concentrated portfolio that the odds of a good backtest being good merely by chance become very high.
These days, I'm much more interested in a screen that indicates outperformance of (say) 2-4%/year with 30-60 stocks than one that teases you with seeming outperformance of 10%/year on only 4-10 stocks then falls flat.

Jim

A simple "thank you" is grossly inadequate for this gem of a reply to my somewhat impudent question, but thank you!


Since there is no economic reason why high ROE firms should do better than low ROE firms (*) in these days of differing buyback policies, I would like to know why I should repose any faith that this screen will continue working.
(*) Meaning the low RoE firms are not reducing their equity - the denominator - as fast as the high ones, but their actual business and earnings and earnings growth (the numerator) could be better than the high ROE firms.

In fact there *is* a very good reason that high ROE companies should be above-average long run performers.

ROE is hard to measure reliably...there are lots of things that can give you a somewhat misleading result. The effect of buybacks is one of them, but that effect is so tiny that it can be ignored.
(if a firm buys back 20% of all of its shares, paying an average of 2 tiles book, both big numbers, it drops book per share "artificially" by only 11%--we have bigger flaws to worry about).

The reason ROE works, though, is that on book value per share is on average a "good enough" proxy for the replacement value of the firm's assets.
Not good enough to be entirely reliable in any specific case, but good enough to be a statistically useful predictor on average.

Imagine a widget factory with a $10m factory making $2m/year in net profit, 20% ROE. Assume $10m is both book value and the cost of duplicating the factory.
A competitor will be highly motivated to raise money at less than 20% cost of capital, build a duplicate factory, and undercut the first factory: they'll still make an above-average return.
This keeps going until it is no longer profitable for a new competitor to enter the fray, which is the point that the return on capital for the next would-be competitor is equal to the cost of capital for them all.
(axiomatically, the global average return on capital is equal to the global average cost of capital)

Let us continue to assume that the book value of our firm is a reasonable proxy for the cost to duplicate its assets.
But let's say the firm is making 20% ROE year in and year out for a long time.
What does that tell us? That, for whatever reason, competitors can't (or won't) set up in competition with them successfully: the company has an economic moat of some type.
This is, as we know, a very good business to be in. Sustainably high profitability that isn't being eaten away by competitors.
Some subset of those firms will also have the ability to deploy new capital into their business at the same high rate of return on assets, the very best of the best in terms of business economics.
If you're not buying equal amounts of all the companies out there, you at least want to make sure you are owning these great ones.

So, though ROE is not 100% reliable in the case of any specific firm, mainly because of quirks in the way assets are booked, it is almost always true that a great long term business (a business with moat giving them lasting high profitability) is going to have a high ROE.

So, why does the screen work? The businesses it picks are higher than average quality.
It will pick some duds that have undeservedly high numerical ROE, and presumably does badly on those. Most obviously, companies that are over-leveraged.
But it catches a very large fraction of the very best companies (it's hard to be one of the best without a high ROE), and eliminates almost all the firms with the ho-hum poor business economics: poor returns on capital employed.
In short, not all firms with high ostensible ROE numbers are good investments by a long shot, but almost all good long run investments have good ROE figures over time.
This filtering, though certainly flawed in any single instance, gives a statistical edge that seems to be big enough to be worth exploiting.

The temptation is to make the screen more and more sophisticated--skip those that are overleveraged, allow those that have negative book value, adjust for dud goodwill, and so on.
But that way lies the slippery slope. As the saying goes, if you torture a data set long enough, it will confess to anything.
But if you can buy 50 or 100 companies that will beat a dartboard on average over time by a percent or two, that's probably good enough, and you aren't in danger of fooling yourself too much.
The real world results will still be worse than the backtest--that's the nature of things. But it should still give you a good chance of outperformance, and if it's all just statistical noise you shouldn't do meaningfully *worse* than average over the long run.

You have posted an enormous number of such back-tested screens. Do you have any data for, say, how the screens you posted 8 years ago (or any such longish period of time) have done since posting them?

Good question.
I'll discuss only the prominent failures, since those may have the most useful insights to offer. They're certainly the ones prominent in my mind : )

The most interesting failure is a screen called YLDEARNYEAR, invented in 2003. (not by me)
It outperformed the market through thick and thin for a dozen years after it was published, the sort of thing that gives a lot of confidence that there is something "real" going on.
Then it promptly turned around and started underperforming the market for the next 5-6 years.
So, what's going on?
That screen seeks firms with both high earnings yields and high dividend yields.
That population of stocks itself seems to go in and out of fashion, not necessarily on a cycle matching bull and bear markets.
With hindsight, it appears that the screen magnifies (very successfully) the degree to which that dividend population is in vogue.
Some numbers:
In the first 11 years after the screen was published, the set of all moderately profitable firms with dividends outperformed the broad market by about 4.4%/year.
(for that I looked at all stocks in the Value Line 1700 database with P/E < 33 and any dividend yield, equally weighted)
Consequently, that was a very fertile hunting ground for any stock screen:
The YLDEARNYEAR screen outperformed the market by about 14.1%/year in this stretch. (5 fresh stocks bought each month, each held two months, for a 10 stock portfolio).
But in the next 6.1 years, the set of all profitable dividend earners underperformed the S&P by -5.6%/year, and the screen underperformed by -17.1%/year.
Dividend payers have come back into fashion again, outperforming the S&P by +5.4%/year in the last 3.25 years.
And, as you might now expect, the screen has come back into its own: it has outperformed the S&P by 17.7%/year in that same period.
During the stretch that dividend payers were out of fashion, almost all humans using this screen would have thrown in the towel.
Yet, had one stuck with it, it has still outperformed overall since its invention 20 years ago.
S&P returned 10.1%/year, the set of passably profitable dividend payers returned 11.5%/year, and the screen returned 14.3%/year.
One could potentially check to see if dividend earners are in or out of fashion lately, and use the screen only when the omens are good--tie situation doesn't change often. But it's hard to know in advance how that attempt would do long term.

The biggest total failure screen was one I created and suggested that simply looked at very large firms with great balance sheets and low P/E ratios, nicknamed "BlueCheaps".
This is one that I would definitely sweep under the carpet if I were still in the money management business : )
The original post that suggested it http://www.datahelper.com/mi/search.phtml?nofool=y...
In the backtest 1986-2009 inclusive it indicated performance 9.4%/year better than the S&P 500, with 5 stocks each month after trading costs.
But then, alas, among the large and financially sound firms, the ones without many profits became the ones that were the better performers. Much, much better.
The same screen 2010 to date underperformed the S&P 500 by -6.9%/year.
You were still holding big profitable stable firms making a lot of money, so individual picks didn't tank, and the returns of ~6%/year were relatively steady...you just didn't do nearly as well as a monkey with a dartboard would have. A portfolio of genteel mediocrity.
Lessons? One very big flaw of this and many other screens is that its results were based on a portfolio of only 5 stocks, sometimes 10.
There is so much randomness in having such a concentrated portfolio that the odds of a good backtest being good merely by chance become very high.
These days, I'm much more interested in a screen that indicates outperformance of (say) 2-4%/year with 30-60 stocks than one that teases you with seeming outperformance of 10%/year on only 4-10 stocks then falls flat.

Jim

"These days, I'm much more interested in a screen that indicates outperformance of (say) 2-4%/year with 30-60 stocks than one that teases you with seeming outperformance of 10%/year on only 4-10 stocks then falls flat."

Mungofitch


"But to make money they didn't have and didn't need, they risked what they did have and did need. That is foolish. That is just plain foolish."

Buffett


I'm not suggesting that Jim ever loaded up leverage like the LTCM folks, but to me there is some thematic echo.
It's very difficult to shift gears in the midst of market success and dial back risk. Exogenous events don't post departure times like the Eurostar. Go out and celebrate the wins periodically, but get back home unassisted.

My working life is coming to an end - gratefully. I won't have 10 years of wages to repair investing mistakes.
If you have a reasonable capital base, you've got runners in scoring position, a base hit or a walk usually scores a run. I have no business swinging for the fences or signaling for the hit & run.

- Cmore

A competitor will be highly motivated to raise money at less than 20% cost of capital, build a duplicate factory, and undercut the first factory: they'll still make an above-average return.
This keeps going until it is no longer profitable for a new competitor to enter the fray, which is the point that the return on capital for the next would-be competitor is equal to the cost of capital for them all.
(axiomatically, the global average return on capital is equal to the global average cost of capital)'


Mungo,

This will appear to be nitpicking, but it really is just that I want to make sure I am understanding the important point that you are making - do you really mean axiomatically? Or could it be that you mean 'as a result of this process (i.e., the pursuit by competitors of returns on new capital in this industry, as long as they are higher than the cost of capital.)'

TIA, DTB

This will appear to be nitpicking, but it really is just that I want to make sure I am understanding the important point that you are making - do you really
mean axiomatically? Or could it be that you mean 'as a result of this process (i.e., the pursuit by competitors of returns on new capital in this industry, as
long as they are higher than the cost of capital.)'

No, I meant it.
"Axiomatically" isn't quite the mot juste...probably "by definition" would be better.
It's an economic identity: the total amount paid by everybody to get the use of money has to equal the total amount received by everybody to provide the use of money.
Divide that aggregate cost by the total amount of money provided, and you get the global weighted average cost of capital AND the global weighted average return on capital.

It's a very simple identity in the case of interest, and true in every sub period.
But it's also a separate broader identity for the total cost of capital including debt and equity--it's just much harder to measure it.

Jim

You were still holding big profitable stable firms making a lot of money, so individual picks didn't tank, and the returns of ~6%/year were relatively steady...you just didn't do nearly as well as a monkey with a dartboard would have. A portfolio of genteel mediocrity.

Hmmm. I could imagine quite a few people liking those kind of results. Ok, some of the time and good / very good at other times. And holding relatively conservative / orthodox, large-cap shares. Thanks for the reminder.

I used to like the sound of YEY a lot but I guess returns of zero or less for years on end would be v hard to take.

SA

I used to like the sound of YEY a lot but I guess returns of zero or less for years on end would be v hard to take.

If you can guess whether dividend payers are currently in fashion, even with a very dodgy level of reliability, it's still a great screen.
When you're wrong you don't go bust, you just don't outperform the market.
To every thing there is a season.

Jim

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