Reaching Financial Independence

When can you give up the security of a regular paycheck?

This is a fundamental question that everyone must eventually answer in the context of their own “retirement”.  I put “retirement” in quotes because what we are really talking about is not necessarily retirement in the conventional sense. Instead, the goal might be better stated as attaining the level of financial independence that is needed to make a regular paycheck optional.  You might like your job and have great relations with your boss today, but that could always change tomorrow or next month.  A recession could result in layoffs and you might find yourself involuntarily out of work.  Illness has been the cause of many premature exits from the workforce.

At what point are you immune from having to worry about drawing a paycheck?

Nassim Nicholas Taleb should be credited with the concept of “F*** You Money” that he developed in The Black Swan and has elaborated on numerous times since the book was published.  To state the obvious, not everyone works for a pointy-headed boss and hates their job as much as Dilbert and Wally, and plenty of people actually love their job and enjoy the people they work with.  Whether or not you like the language used by Scott Adams, Nassim Taleb, or John Goodman, the point is obvious:  When can you declare independence from paid employment if you choose to do so?

At the risk of stating the obvious, there are two major factors that we need to look at:

  1. How much money is needed to fund your lifestyle every year?  The answer is not as simple as looking at what you are currently spending every year.  There will almost certainly be expenses related to work that will entirely disappear from your budget if you choose to leave paid employment.  You will no longer have to commute to work so the cost of driving or public transit will disappear.  Maybe you can even give up your car entirely.  It will be unnecessary to purchase clothing specifically for work.  If you aren’t packing a lunch for work almost every day, you are probably spending a lot of money on eating out and that could be eliminated as well.  This list isn’t exhaustive.  On the other side of the equation, you will incur new expenses in “retirement” such as the cost of health insurance, which is likely to be the largest new big ticket item.  Also, you will have more time to travel and pursue recreational activities.  You could very well end up spending more money in “retirement”!
  2. How much money have you saved?  This is obviously simpler to answer but I don’t think that it can be distilled into a single number.  Most importantly, it is critical to differentiate between assets that are accessible and assets that are locked up for an extended period of time.  If you are 40 years old and contemplating giving up your paycheck, what matters for the foreseeable future is the amount of liquid assets that you have in non-retirement accounts.  You do not want to even contemplate touching retirement funds in a 401(k) or IRA because early withdrawal penalties are significant for anyone who is younger than 59 1/2 years of age.  You also do not want to consider any form of home equity as a source of liquidity unless you are planning to downsize to a smaller home in retirement.

If you read enough personal finance articles, you probably have already come across discussions of “safe withdrawal levels”.  The idea of a safe withdrawal level is to calculate the amount of money that can be withdrawn from an investment portfolio on an inflation adjusted basis over a specific period of time without running a significant risk of depleting all of your assets.  There are usually a number of embedded assumptions that are made in studies of safe withdrawal levels, such as the percentage of assets invested in stocks versus bonds and whether the stocks are invested in an index fund.  Typically, safe withdrawal levels are contingent upon a certain stock/bond mix and broad diversification of a portfolio.

The Four Percent Rule

Over the past two decades, the idea of the “Four Percent Rule” has spread quite widely.  The idea is that one can withdraw four percent of an investment portfolio in the first year of retirement and subsequently withdraw the same amount adjusted for inflation every year.  The inverse of the four percent rule is that one needs to have savings equivalent to 25 times annual spending requirements in order to safely retire.  So, if you have calculated that you need to have $50,000 available for spending in the first year of retirement, you would need to have an investment portfolio of $1,250,000 to support that level of withdrawal in a “safe” manner.

When I first started thinking about the concept of early “retirement”, I spent quite a bit of time researching the topic of safe withdrawal rates and came upon a study that went quite a bit deeper than the four percent rule.  I am not going to link to the study because it has not been updated since 2001 and generated some subsequent controversy regarding the methodology that was used.  However, at the time it was the most comprehensive look at safe withdrawal levels that I had come across.  The study looked at financial market returns from 1871 to 2000 and projected the safe withdrawal level for various payout periods based on past history.  A reader could pick their projected payout period and find the optimal mix of stocks versus bonds that would generate a “100% safe” withdrawal level.

The payout periods ranged from ten years, which would only be appropriate for someone who is either already very old or in poor health, to sixty years which was more appropriate in my situation since I was in my thirties at the time.  I found that the safe withdrawal rate for a sixty year payout was 3.24 percent with a 85%/15% split between stocks and bonds.

The study examined 70 periods from 1871 to 2000 in order to come to the conclusion that a 3.24 percent withdrawal level could be safely sustained for sixty years, with withdrawals rising each year with inflation.  In the vast majority of cases, there would be a very substantial portfolio left at the end of the sixty years. In fact, the median result was that every $1,000 of value in the initial portfolio would end up being worth nearly $43,000 after 60 years assuming a yearly withdrawal of 3.24 percent of the initial portfolio rising each year with inflation.  The worst possible result was that the portfolio would be effectively depleted.

But the main problem with safe withdrawal level studies is that they are backward looking.

It is a major logical fallacy to assume that the next sixty years will look like the period that spanned 1871 to 2000, or anything like it at all!  This is obvious, but it is tempting to look at an overly precise number like “3.24 percent” and assign it with more certainty than it deserves.

No one has any idea what the future will bring or what investment returns will look like, but if we want to make any kind of estimate regarding financial independence, we have no choice but to at least try.  This exercise calls for a great deal of conservatism.  I am not comfortable with the four percent rule, and not really comfortable with the 3.24 percent figure that came out of the study.  Part of this is because of the fact that interest rates have been at an unusually depressed level in recent years.  In addition, the level of the stock market implies an “earnings yield” that is below average.  In a world of savings deposits earning next to nothing, a ten year treasury note yielding just 2.7 percent, and stocks trading at high valuations relative to the past, is it really conservative to look at a four percent withdrawal rate as a sure thing?  Would you bet your financial future on it?

The Three Percent Rule

I am not going to propose any specific rule for readers to follow, but I will say that I am comfortable with a three percent withdrawal rate and that is the rate that I initially used when considering my own financial independence, although my present withdrawal rate is far lower.  This rule implies that you would need to save a little bit over 33 years of annual expenses in order to consider yourself financially independent.  That’s obviously more than the 25 years that is implied by the four percent rule, but it is much more conservative.

Many people would criticize this approach as far too conservative, but is that such a bad thing?  Sure, you might have to save for a longer period of time to achieve independence, but once you do, the level of stress over withdrawal rates will be much lower.  Also, I’ve read criticism of low withdrawal rates along the lines of ending up with “too much” savings at the end of the withdrawal period.  This line of criticism is based on the idea that something big is being given up by under-spending for many years and that ending up with a large account balance in old age is a negative.  I think this is somewhat absurd for a number of reasons.  First, old age involves facing vicissitudes that younger people might not think of, especially when it comes to nursing care.  Having a pile of cash available to make life comfortable would hardly be unwelcome.  Second, most people want to leave some kind of legacy to family members and providing financial security to others in old age is hardly a negative.  Finally, you can always give away money.  There’s value in generosity and the knowledge that one’s savings can generate benefits beyond personal consumption.

The Bottom Line

The subject of safe withdrawal levels has not been a personal concern for quite some time as the level of my annual spending has declined well below any plausible “danger zone” as a percentage of my available investment assets.  I would suggest that using a three percent initial withdrawal level is far more reasonable than the much more commonly advocated four percent level and this would imply setting a target of about 33 times annual expenses as a goal for financial independence.

The other factor that should be noted here is that the lower your annual spending requirements, the sooner you can reach financial independence.  Perhaps that is obvious, but it might not be widely understood.  Too many people think about financial independence in terms of replicating their current income in retirement.  This is the wrong way to look at it.  For example, let’s say that you earn $150,000 per year but are only consuming $40,000 per year, which you expect to remain relatively constant in retirement.  You do not need to replicate a $150,000 income in retirement.  You only need to ensure that you can safely withdraw $40,000 per year from your portfolio, and that you can increase this figure each year at the rate of inflation.  Using a three percent rule, this would imply a required portfolio of a little over $1.3 million, which is less than nine times your current $150,000 annual income.

Obviously, no one want to live some horribly restrictive lifestyle either while employed or in retirement, but what is “horribly restrictive” for one person might represent luxurious living for another. Even for those who enjoy their paid employment and plan to continue working for others for decades could benefit greatly from financial independence and the peace of mind that makes work optional.

Note to readers: A version of this article originally appeared on The Spartan Spendthrift which I created a few years ago. I am planning to merge some of the existing content of The Spartan Spendthrift into The Rational Walk and to post future articles on personal finance here. It is easier to maintain only one website for all of my writing. 

Jack Bogle: Crusader for Investment Professionalism

“If you want to be trusted, be trustworthy. If you demand hard work, work hard. If you want your colleagues to level with you, level with them. It’s not very complicated!”

— John C. Bogle, Enough: True Measures of Money, Business, and Life

John C. Bogle (1929-2019)

John C. Bogle, who died on January 16, 2019 at the age of 89, was hardly universally well liked within the investment community. Visionary leaders who disrupt comfortable industries rarely escape the ire of those who have been displaced. On the other hand, Mr. Bogle was a hero to millions of investors at The Vanguard Group, the investment company he founded in 1975, as well as to the broader community of cost-conscious individual investors known as “Bogleheads“. Through Mr. Bogle’s tireless efforts to lower the cost of investing, investors have saved billions of dollars that would have otherwise gone to various “helpers” in the investment community.

Warren Buffett had the following to say about Mr. Bogle two years ago:

If a statue is ever erected to honor the person who has done the most for American investors, the hands- down choice should be Jack Bogle. For decades, Jack has urged investors to invest in ultra-low-cost index funds. In his crusade, he amassed only a tiny percentage of the wealth that has typically flowed to managers who have promised their investors large rewards while delivering them nothing – or, as in our bet, less than nothing – of added value.

In his early years, Jack was frequently mocked by the investment-management industry. Today, however, he has the satisfaction of knowing that he helped millions of investors realize far better returns on their savings than they otherwise would have earned. He is a hero to them and to me.

Berkshire Hathaway Annual Letter, 2016

Mr. Bogle’s crowning achievement was the invention and proliferation of low cost index funds that are designed to simply match the investment results of unmanaged indexes such as the S&P 500. These funds do not attempt to beat the market through selection of securities or timing the movement of funds based on macroeconomic factors.

In exchange for giving up the prospect of beating the market, investors gain the certainty of knowing that they will at least match the market prior to investment costs. And due to the lack of a need to hire active managers and to Vanguard’s investor-owned fund structure, costs are vanishingly small. Today, the expense ratio of the Vanguard S&P 500 Index Fund (Admiral Shares) is a mere four basis points, or 0.04%, meaning that one only pays $4 annually for every $10,000 invested in the fund. In contrast, the famous Fidelity Magellan Fund, which is actively managed, has an expense ratio of 0.69%, or $69 annually for every $10,000 invested in the fund.

Over the decades, the expense ratio of Vanguard’s funds have dropped due to increasing scale and this has pressured the expense ratios prevailing throughout the mutual fund industry. Mr. Bogle also did away with fund loads, or sales charges, early in Vanguard’s history. These sales loads, which were often up to 7 percent of assets invested in a fund, have become much less common in the mutual fund industry. Between lower expense ratios and the decline of sales loads, no wonder Mr. Bogle’s popularity within the investment community wasn’t universal!

Much has been written regarding Mr. Bogle’s legacy with a focus on the massive sums he has saved for individual investors. However, anyone who has read Mr. Bogle’s book, Enough:  True Measures of Money, Business, and Life, realizes that cost savings were only one part of his overall philosophy toward business and life. One chapter of the book is entitled “Too Much Business Conduct, Not Enough Professional Conduct“. The distinction between professional conduct and business conduct may seem confusing to many people, at a surface level. After all, in our free enterprise system, isn’t a profession simply one of many means to the end when it comes to achieving business success?

Take a step back from thinking about finance, narrowly defined, and consider the field of medicine. A doctor goes through many years of education and residency prior to achieving meaningful income potential. This seems like a classic investment calculation: The prospective medical student compares the cost of his or her education (and the opportunity cost of many years of foregone wages in some other field) to the lucrative riches that can be expected once established as a fully trained physician. If the present value of the expected income earned as a doctor exceeds the costs of the education, then become a doctor. If not, enter some other more lucrative field.

But does anyone really believe that this is how a prospective medical student thinks about his or her decision to become a doctor? Of course not. The decision to enter medicine has an economic component, but it also has many completely non-economic factors. Although encounters with jaded doctors who have been in practice for many years may obscure this truth, the reality is that the vast majority of doctors almost certainly enter the field in order to help patients and save lives! They are entering a profession and a calling, not merely seeking to maximize their economic outcome.

Mr. Bogle believed that the same fundamental professionalism should exist in the field of investment management. But should it? After all, those of us who are in the investment industry aren’t here to save lives, are we? We are here to make money. So we should maximize our economic outcomes at all costs, right?

Mr. Bogle would have completely disagreed with that all-too-common sentiment, as his book makes crystal clear. Investment professionals are agents acting on behalf of owners of capital. Looking at the numbers, one can easily forget that these owners include millions of ordinary individuals who are saving for various life goals such as sending their children to college, purchasing a home, and funding retirement. Looking after the financial health of individuals should be viewed as a calling, as a profession, and not merely as a business.

In our consumer driven culture, wealth is often thought of as the ability to purchase goods and services, and this is obviously one use of money. However, what money really represents is financial freedom and independence. Money can buy control over the one thing we all have a limited supply of: Time. Poor returns, whether driven by bad investment choices or high costs, shows up as a lower balance on account statements, but the real effect is that financial freedom is deferred for those who are affected. There are very real consequences for those who have to defer retirement or find that their activities in retirement are highly constrained.

Mr. Bogle was a capitalist and acknowledged that the primary requirement for any business is to earn a profit. However, he insisted that business should operate within a context of ethical and professional conduct, and was particularly critical of the investment industry. He argues that business principles have been compromised in recent decades:

It wasn’t so many decades ago that the standards in the conduct of business were close to absolute:

There are some things that one simply doesn’t do.

But today we place our reliance on relative standards:

Everyone else is doing it, so I can do it, too.

Our society cannot and should not tolerate the substitution of moral relativism for a certain form of moral absolutism, and its debasement in the ethical standards of commerce.

Enough: True Measures of Money, Business, and Life, p. 139

Mr. Bogle was a wealthy man but he left billions of dollars on the table compared to other founders of large financial institutions. It does not seem like this bothered him very much, although he does acknowledge that he did not have any premonition regarding the massive wealth he was giving up by creating Vanguard’s structure. He comes across as a man who had more than enough in terms of financial wealth and was highly satisfied with the fulfillment of his professional calling.

The Quarterly Guidance Trap Bites Apple

“In all of our communications, we try to make sure that no single shareholder gets an edge: We do not follow the usual practice of giving earnings guidance or other information of value to analysts or large shareholders. Our goal is to have all of our owners updated at the same time.”

Warren Buffett, Berkshire Hathaway Owner’s Manual

When Warren Buffett first wrote the Berkshire Hathaway Owner’s Manual in 1983, investors had far fewer options to access corporate information in a timely manner. During the 1980s and well into the early 1990s, it was still common to research investments in a library setting. Readers over forty might even recall reviewing old magazine and newspaper articles using microfiche machines, a practice that would seem ridiculously archaic to the millennial generation. By the mid 1990s, the “information superhighway” was born and investors increasingly had access to all sorts of information online. The past two decades has seen tremendous progress in terms of the volume and velocity of data, but this progress has not necessarily been accompanied by greater understanding; in fact, it seems like market participants are as bewildered as they ever have been and increasingly value “guidance” from experts and insiders.

Apple “Misses” Guidance

The most reported financial story of the first week of 2019 involved coverage of Apple’s “missed” revenue forecast for its fiscal first quarter period which ended on December 29, 2018. Apple CEO Tim Cook kicked off the year on January 2 with a letter to investors describing various difficulties the company experienced during the holiday quarter. The number analysts immediately focused on was the revised revenue guidance which was lowered to $84 billion from a range of $89 to $93 billion given during the last earnings call on November 1. The company also lowered the gross margin estimate to 38 percent from a range of 38 to 38.5 percent.

The reaction of the market on January 3 was swift and severe with the stock price falling nearly 10 percent, although some of that decline has been reversed over the past few days. Interestingly, Berkshire Hathaway’s Class A shares declined 5.6 percent on January 3 which far exceeded the decline in the value of Berkshire’s Apple holdings and appeared to reflect Mr. Market’s skepticism regarding Warren Buffett’s ventures into technology investing.

Apple is probably the most scrutinized company in the United States, or at least in the top five, and I have little of value to add when it comes to judging the intrinsic value of the company or expressing an opinion on its future business prospects. While Tim Cook tried to frame the reduced guidance in the most benign way possible, including blaming much of the situation on macroeconomic factors in China, market participants clearly see more serious trouble ahead, particularly related to Apple’s premium pricing strategy and reports of weak demand for the iPhone XR. The fact that Apple will stop presenting unit sales data for its product lines has only added to investor angst.

The Guidance Addiction

Companies that provide quarterly guidance to the investment community are doing so because the market appears to demand it. Earnings calls typically take place a month into the subsequent quarter so analysts expect executives to not only talk about the prior period but to give a sense of how things are going during the current quarter. Typically, management will furnish either a range or a point estimate for various measures and analysts will plug these numbers into their models and then herd around a “consensus” expectation for the coming quarter.

While this might seem harmless, let’s take a step back and think about exactly what the investment community is asking for. A month into a quarter, analysts are asking management to look at the first third of the quarter and to make projections for the next sixty days. Because investors pay so much attention to guidance, managers spend significant time thinking about these estimates and deciding how aggressive or conservative they should be. Since time is finite, this means that managers are not using this time to run the actual business.

When a large company like Apple makes a prediction on November 1 and then drastically revises the prediction on January 2, a period of only 62 days, this leads investors to believe that management does not have a handle on the business or that events are spiraling out of control. After all, two months is a very short period of time.

When managers provide guidance, this effectively causes analysts to crowd around the mid-point of the range in their own models and the variation of estimates is narrower than would be the case if analysts had to do their own work. This reduces the overall quality of analyst estimates and encourages analysts to do less work and to be more reluctant to make estimates that fall far outside the consensus. When guidance later must be adjusted dramatically, the effect on the stock price is likely to be much greater than would be the case if management provided no guidance whatsoever. The irony is that managers typically give guidance in an effort to reduce volatility in the stock.

Buffett Calls for Ending Guidance

A few months ago, Warren Buffett and Jamie Dimon co-wrote an article in the Wall Street Journal calling for an end to quarterly earnings estimates. The main point of the article is that the act of providing guidance shifts management from thinking about the long term to thinking about the next quarter.

The intrinsic value of a company like Apple will depend on the quality of the decisions Tim Cook makes over the next several years. Shareholders should want Mr. Cook and other executives at Apple to focus on matters such as the optimal price points at which to offer phones for various geographic markets along with R&D that will allow the company to retain its technical and aesthetic edge over time. The last thing shareholders should want is for Mr. Cook to focus his time and energy on providing analysts with estimates of Apple’s revenue and margin over the next ninety days.

If Apple or any closely followed company stops providing all guidance, the market’s reaction is likely to be negative in the short run because it could be perceived as an attempt to hide bad news. However, over time, analysts will come up with their own estimates and a market driven consensus will emerge, probably centered around a wider range of estimates. In time, the market will get used to the lack of spoon-feeding and the actual results delivered over time will drive the value of the stock. This is as it should be and the example of Berkshire Hathaway shows that guidance is unnecessary.

Guidance vs. Disclosure

An important distinction needs to be made between guidance, or forecasts, from management and the actual disclosures that are made regarding past periods in 10-Q and 10-K reports. Apple recently announced that the company will no longer report unit sales data for its product lines starting in the current fiscal year. Changes in disclosure, as opposed to changes in guidance policy, could very well send an important message to investors. In the case of Apple, investors have reason to view the lack of unit sales disclosure with some skepticism given that it is coinciding with weak sales. A reduction in disclosure at a time of weakness does not send the most bullish signal to investors.

Berkshire Hathaway shareholders have been paying a great deal of attention to Apple in recent quarters. At the end of the third quarter of 2018, Apple represented Berkshire’s largest equity holding and Warren Buffett’s bullishness on Apple’s prospects has been a tailwind for the stock until recently. Apple’s weakness during the fourth quarter could have enticed Mr. Buffett to further increase Berkshire’s Apple holdings. On the other hand, Berkshire’s new repurchase policy opened up the ability for Mr. Buffett to make potentially large buybacks.

We will have to wait until mid-February to learn whether Berkshire’s Apple stake increased during the fourth quarter, and news of any Berkshire repurchases will have to wait until the end of February when the 2018 annual report is released. After all, Berkshire doesn’t provide guidance.

Disclosure: Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway, and by virtue of such ownership, also own shares of Apple on a “look through” basis.

Ten Books Recommendations For The Holidays

Great books represent a terrific value proposition.  For a modest amount of money, or even free of charge at the local library, a reader can gain access to some of the greatest minds in human history.  We take it for granted today that most people can afford to read whatever they want, but this has not always been the case.  Books used to be indulgences available mostly to the wealthy.  Thomas Jefferson, who spent a fortune on his books, would be amazed by the selection and pricing on Amazon.com!

The ten books listed below, in no particular order, include some old classics as well as newer releases.  Most of them are not related to investing.  They are simply books that I have read over the past year and could be interesting selections to read over the holidays or to purchase as gifts.  A previous post provides a list of book recommendations specifically for investors.  All books ever reviewed on this site can be found in the book review archive.

All Quiet on the Western Front

World War I officially ended just over a century ago on November 11, 1918.  Veterans Day this year marked the occasion, although the last American veteran of WWI unfortunately did not live to see it.  The horrors of this war are described in this novel from the perspective of a young German soldier.  The Great War was thought to be “the war to end all wars” due to the extreme misery brought about by modern warfare and the determination of leaders in the post-war period to spare future generations of the same fate.  A century later, we know that these hopes were anything but fulfilled. War remains a constant presence and is more deadly than ever, with the added danger of global annihilation if nuclear war is ever allowed to break out.  This novel, originally published in 1928, tells the story from the perspective of an author not yet aware of the horrors that the coming years would bring.

The Idea Factory

The nature of research and development is that some ideas that seem initially promising may never lead to commercially viable opportunities.  Short term thinking and faulty incentives can lead executives to view R&D as a cost center rather than as a potential driver of future growth.  This book provides a history of Bell Labs, a remarkable institution that spanned six decades during the middle years of the last century and was responsible for numerous important innovations.  The angst over American business “no longer investing” is somewhat overstated given the tremendous success of American technology companies in recent years.  Shareholders with longer term horizons should encourage intelligent long term R&D investments and avoid setting up incentive systems for managers that are excessively short term oriented.

Leonardo da Vinci

If you have ever wandered through an art gallery in awe of what you are looking at but lacking any real understanding, Walter Isaacson’s wonderful biography of Leonardo da Vinci should be required reading.  Even those who normally read books on Kindle should purchase the physical hardbound copy because the book itself and the illustrations are very aesthetically pleasing.  Although the book is quite long, it is structured in such a way that most readers with intellectual curiosity will not be bored.  I read this book prior to a trip to Chicago in late 2017 and I think that it led to a greater appreciation of the art located in the Art Institute of Chicago and the Driehaus Museum.  Leonardo was a remarkable character with diverse interests and a true multidisciplinary mindset and a study of his life is well worth the time spent.

Jefferson and His Time: Volume 1

There are obviously many biographies of Thomas Jefferson but none provide the level of detail in Dumas Malone’s epic six volume biography written over the course of several decades starting with the publication of Jefferson The Virginian in 1948.  Each book covers a specific chronological period in Jefferson’s life and provides much more detail than would be possible in a single volume biography.  Many readers might not desire this level of detail and would be better served with a modern biography.  But those fascinated by the man or a specific period in his life might want to pick up one of Malone’s volumes.  I have read the first three volumes and found all of them to be worthwhile.  However, some readers may find Malone’s treatment to be overly deferential to Jefferson on the slavery issue and the books pre-date the DNA evidence related to Jefferson’s relationship with Sally Hemmings.

Skin in the Game

Nassim Nicholas Taleb despises “book reviews” and heaven help the reviewer who attracts his ire on Twitter. Taleb makes a good point that a book that can be reviewed, or synthesized into some set of basic points, is not one that is worth reading.  A book must stand on its own and not be subject to summarization.  Skin in the Game is the latest volume in Taleb’s Incerto series, described as “a landmark five-book investigation of uncertainty, chance, volatility, risk, and decision-making in a world we don’t understand”.  To get a flavor of the book, read The Intellectual Yet Idiot, a critique of the policy makers who would tell us “what to do, what to eat, how to speak, how to think, and who to vote for”.  Taleb’s style will rub some people the wrong way, but anyone with intellectual curiosity (who is not an IYI) will benefit from a serious consideration of his arguments.

Bad Blood

If you are looking for a book that will get your blood boiling, pick up a copy of John Carreyrou’s epic reporting on Theranos, the fraudulent blood testing company founded by Elizabeth Holmes.  With the aid of her accomplice, Ramesh “Sunny” Balwani, Holmes managed to deceive a cast of characters operating at the highest levels of venture capital and politics.  Theranos released products that flat out didn’t work or produced unreliable or invalid results for important medical tests that doctors and patients relied on.  This went on for much longer than it should have, in part due to the fact that Holmes managed to assemble a board of directors that knew little about medicine but was well connected in the political and business worlds. It is important for investors to be skeptical about young leaders with new ideas, but not to be unreasonably cynical.  The Theranos saga makes it difficult not to tilt too far toward cynicism.

Reminiscences of a Stock Operator

The more things change, the more they stay the same.  Anyone who has observed the cryptocurrency bubble over the past year might think that we’ve never seen anything that crazy in the past, but that is incorrect.  Originally published in 1923, Edwin Lefèvre presents a fictionalized account of the early life of “Larry Livingstone”, but Livingstone is really a pseudonym for Jesse Livermore. Livermore’s career began as a teenager in the “bucket shops” of the 1890s where he learned to speculate on securities.  What he engaged in was what we could call “day trading” today.  His career spanned several decades and he made and lost fortunes several times.  Livermore was a speculator, not an investor, but his observations and anecdotes are valuable for anyone interested in the mentality behind market madness.  Again and again, the reader comes across statements in the book that would ring as true today as they did a century ago.

Fahrenheit 451

This book might be best paired with 1984, George Orwell’s classic dystopian novel. Both novels deal with societies that have become totalitarian tyrannies barely recognizable to anyone living in a free society today.  In the case of Fahrenheit 451, books are banned and “firemen” are employed to immolate books and any homes in which they are found.  Like in 1984, the protagonist of this novel is just a cog in the totalitarian machine, yet a part of him remains that values freedom and rebels against tyranny.  Americans often take for granted our constitutionally protected rights, but they are under various assaults constantly.  It is worth reading novels dealing with the polar opposite of a free society just to remember that the state of affairs we enjoy is not inevitable and must be vigilantly defended whenever it is threatened.

The Complete Works of Montaigne

Any list of the “great books” of western civilization will inevitably include the essays of Michel de Montaigne.  Montaigne was born in 1533 in the Bordeaux region of France.  As a member of a wealthy Catholic family, Montaigne received a classical education.  Interestingly, his native language was Latin since French was prohibited in his household until the age of six. After a brief career in public service, Montaigne retired to the family estate at the age of 38 to devote himself to various intellectual pursuits.  Despite Montaigne’s elite standing in his society, his essays come across as down-to-earth and are surprisingly accessible to the modern reader, at least in Donald Frame’s translation.  Although lengthy, this book can be read over time since the content is comprised of relatively brief essays on various subjects that stand on their own.  So far, I have completed Book 1 of the essays and look forward to reading Books 2 and 3 along with the included travel journals and letters.

The History of Jazz

Ted Gioia’s book is a comprehensive account of the evolution of jazz.  The story is primarily about the individuals who defined this musical genre over many decades but it is also inextricably linked to the evolution of American cities such as New Orleans, Chicago, Kansas City, and New York.  Gioia spends considerable time providing insight into the social context of the music, especially within the African-American community.  Although at certain points the book delves into more detail than the casual jazz fan might prefer, it is still engaging especially if you listen to YouTube recordings of the various artists he covers.  In fact, it is probably impossible to enjoy this book without pairing it with the actual music.  One sad aspect of this book involves the early deaths of many of the musicians which is an unfortunate trend that extends to the history of rock and roll as well.

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Berkshire’s Repurchase Policy: Too Little, Too Late?

Berkshire Hathaway acquired $928 million of its own stock during the third quarter of 2018 through a series of purchases of Class A and Class B shares from August 7 to 24.  A repurchase of this size, relative to the company’s cash flow and market capitalization, would normally attract relatively little attention.  However, Berkshire has maintained an unusual policy with respect to return of shareholder capital in general and stock repurchases in particular.

Rational capital allocation is a problem that many companies never adequately resolve because the skill set of management is often more attuned to solving operational problems rather than allocating free cash flow.  However, Berkshire shareholders have benefitted from Warren Buffett’s superior operational and capital allocation skills for decades.  For almost all of Berkshire’s history, there was never any question regarding whether capital should be retained within the company.  Few shareholders would have been better off receiving dividends or selling their shares back to the company and reinvesting the after-tax proceeds elsewhere.  Mr. Buffett’s investment prowess fully justified full retention of all free cash flow generated by the business.

In 2015, Berkshire marked its 50th anniversary of Mr. Buffett taking full control of the company.  This was a natural time to look back on the history of Berkshire and, more importantly, to take a look at where the company might be a decade in the future:

The implications of Berkshire continuing to retain all earnings over the next decade while growing book value per share at a compound rate of approximately 10 percent are staggering.  If we take Berkshire’s 2015 net earnings of $24 billion as a baseline, reinvestment of all earnings would need to result in enough incremental earnings power to generate approximately $62 billion of net income for Berkshire by 2025.  We would expect retained earnings to increase by about $420 billion over the next decade.  Berkshire’s shareholders’ equity would approximate $675 billion by the end of 2025 based on these assumptions.  With this kind of track record, the market would most likely value Berkshire in excess of $1 trillion.

The idea of a trillion dollar company is no longer as novel today as it was a few years ago, but the numbers are still staggering.  We also pointed out in the article that Berkshire’s repurchase policy may well need to be changed in order to allocate a portion of the massive free cash flow likely to accrue over the coming decade and noted that the novel repurchase policy adopted by Berkshire could make it difficult to deploy cash via repurchases.  Berkshire had, for several years, limited repurchases to times when shares could be repurchased under a fixed price-to-book ratio which had been set at 120% since late 2012 after being established at 110% in 2011.

For critics of Berkshire’s repurchase policy, Berkshire’s updated repurchase policy announced on July 17, 2018 was welcome news.  A fixed price-to-book ratio limit was eliminated in favor of allowing repurchases anytime both Warren Buffett and Charlie Munger believe that the stock is trading “below Berkshire’s intrinsic value, conservatively determined” and when doing so would not reduce Berkshire’s holdings of cash and equivalents below $20 billion.  The news was very surprising to the market with shares closing up over 5 percent on July 18.  One caveat was that repurchases under the new policy would not be permitted until after Berkshire released second quarter earnings.  As a result, the first day that repurchases were permitted under the new policy was August 6.

Let’s take a look at Berkshire’s repurchase activity under the new policy.  Here is an excerpt from the recently released 10-Q report showing repurchase activity during the quarter:

It helps to put these repurchases into proper context by looking at Berkshire’s trading activity during that time.  The charts below, presented separately for Class A and Class B shares, were derived using data from Yahoo Finance:


We can see from the charts that there were two significant bumps in Berkshire’s trading price following the revision to the repurchase policy on July 17.  On July 18, the stock price rose significantly due to market expectations that repurchases were more likely to occur and, on August 6, the stock rose again in response to the release of second quarter earnings.  These price increases did not deter Mr. Buffett from repurchasing close to 9 percent of the company’s trading volume, in aggregate, over the period from August 7 to 24.  This is not to say that he regularly purchased some fixed percentage of volume, although perhaps he did, and repurchases could have been concentrated on specific days.  However, the average price paid of $312,807/A and $207.09/B is pretty typical for that range of dates.

After August 24, the stock price rose to a level where Mr. Buffett decided to halt repurchase activity.  We know that no further shares were repurchased between August 25 and September 30.  However, we can infer that additional shares were repurchased between October 1 and October 25.  We know this because Berkshire is required to release a recent share count along with its 10-Q report.  On the first page of the recently released 10-Q, we see the following:

Given the conversion ratio of 1,500 Class B shares per Class A share, the Class A equivalent share count on October 25 was 1,641,681 shares whereas the Class A equivalent share count was 1,642,269 shares on September 30.  Berkshire typically issues a very small number of shares every year so we cannot simply subtract the October 25 share count from the September 30 share count.  However, we can infer that at least the difference of 588 A equivalents were repurchased between October 1 and October 25.  This is a relatively small deployment of capital – probably around $185 million.  Obviously shares were available during this timeframe well under the levels paid during the August repurchases.

What can we infer from these repurchases regarding what Mr. Buffett and Mr. Munger think of Berkshire’s intrinsic value, “conservatively calculated”?  Since Berkshire’s repurchase policy was based on book value for several years, it is logical to start by considering what price-to-book ratio was paid for the August repurchases.  Mr. Buffett made a point to wait until after second quarter results were released prior to initiating any repurchases.  June 30, 2018 book value per share was $217,677/A and $145.12/B.  The average price paid for the August repurchases was 1.437x book value for the A shares and 1.427x book value for the B shares.  This is substantially higher than the prior 1.2x book value limit and quite surprising.

We do not know the price or timing of the repurchases that took place from October 1 to 25, and there are sometimes “quiet periods” that limit companies from freely repurchasing stock prior to releasing earnings.  However, we know that Berkshire traded below the average level of the August repurchases from October 11 to 25.  Additionally, we know that Berkshire’s book value rose to $228,712/A and $152.47/B as of September 30.  Berkshire’s A class stock price on Friday, November 2 closed at $308,411 which is slightly under 1.35x book value.  With the caveat that the recent stock market correction has put pressure on Berkshire’s book value due to its large holding of marketable securities, it seems like we can still infer that Mr. Buffett and Mr. Munger view Berkshire’s stock to be trading below conservatively calculated intrinsic value.

Although we are still awaiting the release of Berkshire’s 13-F report which will reveal the company’s U.S. equity portfolio as of September 30, astute observers have already inferred from the 10-Q that Berkshire was a heavy buyer of common stocks during the second quarter.  Although an analysis of what Berkshire may have been doing in its equity portfolio during the quarter is beyond the immediate scope of this article, it is worth pointing out that the scale of Berkshire’s repurchases are quite small compared to its overall free cash flow and its allocation of capital into the stock of other companies.  This could be due to a variety of factors.  Mr. Buffett and Mr. Munger could believe that Berkshire is undervalued but not as undervalued as other opportunities in public markets.  It could also be due to the relative lack of trading volume in Berkshire’s stock which could put a cap on how much Berkshire can repurchase without pushing up the price dramatically.

Shareholders who were hoping for very large repurchases relative to Berkshire’s market capitalization or free cash flow will probably be disappointed with the magnitude of actual repurchase activity in the third quarter.  It could be that the peculiarities of Berkshire’s shareholder base and trading volume will make it difficult to execute large repurchases and that activity will be more modest.  However, over long periods of time, a significant reduction of the share count is still a possibility.

One cannot help but wonder how much lower Berkshire’s share count might be today had the present repurchase policy been adopted in 2011 rather than the policy that imposed the 110 percent of book value limit.  We now know that Mr. Buffett and Mr. Munger view a price below 140 percent of book value as a definite bargain.  Although we must note that the ratio between intrinsic value and book value can change over time, we can see that the price-to-book has been below 140 percent for substantial periods since 2011:


Would Berkshire shareholders have been better off with aggressive repurchase activity at various times since 2011 given that the stock price has traded below management’s view of intrinsic value for much of this time?  This is a complicated question to answer because obviously Berkshire has utilized its resources for other purposes during the past several years.  However, the presence of a large amount of undeployed cash on the balance sheet for a long period of time has signaled a dearth of opportunities and, for much of this time, management was unable to capitalize on an undervalued bargain in the form of the company’s own stock due to the constraints imposed by the 2011 and 2012 repurchase authorizations.

The updated repurchase policy is well overdue and hopefully will not be “too little, too late” when it comes to Berkshire’s overall capital allocation over the next decade.  We should, however, note that this new repurchase policy places no more of a “floor” on the stock price than the old policy.  Markets can and will do crazy things and Berkshire’s stock will certainly trade at depressed levels at times in the future.  Now, management has full flexibility to take advantage of such times.  Despite occasional criticism by the uniformed and/or politically motivated, repurchases can be a very intelligent way to deploy capital under the right circumstances.  The key issue is to avoid overpaying and there seems to be little risk of that happening at Berkshire.

It is also worth noting that for many longtime shareholders with a low cost basis, Berkshire represents a particularly tax advantaged way of compounding wealth.  Allocating capital to repurchases rather than dividends, as long as repurchases are below intrinsic value, will have the effect of increasing unrealized capital gains and continue tax efficient compounding for continuing shareholders.  The alternative of receiving dividends would result in immediate tax consequences and interrupt the snowballing tax deferred compounding machine known as Berkshire Hathaway.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.

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