Legendary Investors

This post will profile three legendary investors, John Burr Williams, John Bogle and Warren Buffett. I will examine their respective approaches to investing.

John Burr Williams

John Burr Williams (1899-1989) was one of the first economists to change the traditional “casino” view of market pricing, instead he argued that markets determine stock prices from their “intrinsic value”. In his 1938 paper, The Theory of Investment Value, he wrote:

“The investment value of a stock is the present worth of all future dividends to be paid upon it . . . discounted at the pure [riskless] interest rate demanded by the investor.” (Donaldson, 2007)

Essentially Williams proposed that the present value of a stock is equivalent to the long-term worth of future net cash flows. Alternatively, one could say that the present value of a stock is the discounted value of future earnings. Whilst it is generally agreed that Williams did not pioneer present value, he was, however the first to develop a method to calculate it with the dividend discount model (or DDM).

The use of present worth in conjunction with portfolio theory is the most widely used stock valuation method used today.

John Burr Williams believed that the volatility of the stock market is not due to variations of intrinsic value but speculation. Whilst Williams was opposed to speculations he did caution against it as a long term investment strategy as stated below.

“To gain by speculation, a speculator must be able to foresee price changes. Since price changes coincide with changes of marginal opinion, he must, in the last analysis, be able to foresee changes in opinion. Successful speculation consists in just this. It requires no knowledge of intrinsic value as such, but only what people are going to believe intrinsic value to be” (Donaldson, 2007)

As a footnote, William’s anticipated the Modigliani Miller theorem by stating that a company’s capitalization does not influence the present value of a stock since it is derived solely from future dividends.

John Bogle

John Bogle (1929-) is the retired CEO of The Vanguard Group, a company he founded in 1974. The Vanguard Group is the second largest mutual fund company in the world and it was the first company to offer an indexed mutual fund.

Bogle is a staunch believer in indexed mutual funds over actively managed mutual funds and believes that indexed funds offer superior returns over the long term.

Bogle believes in a simple and common sense investment approach that includes the following eight tenants.

• Select low-cost funds
• Consider carefully the added costs of advice
• Do not overrate past fund performance
• Use past performance to determine consistency and risk
• Beware of stars (as in, star mutual fund managers)
• Beware of asset size
• Don’t own too many funds
• Buy your fund portfolio – and hold it
  (Bogle, 2009)

During Bogle’s undergraduate studies at Princeton he found that three quarters of mutual funds underperformed a hypothetical market portfolio. Essentially the premium earned from an actively managed fund was insufficient to cover the cost of the fund management.

Bogle retired as chairman of Vanguard in 1999. Today the group manages approximately $1,300,000,000,000 in assets.

Warren Buffett

Warren Buffett (1930-) is an American icon. Buffet is a businessman, philanthropist and most important, a very successful investor.

With the recent economic downturn, Buffett relinquished his position as the world’s richest person to his good friend Bill Gates. Buffett’s personal wealth is currently a staggering $37 billion.

Buffett is known for his frugal lifestyle and also his vehement adherence to value investment philosophy. His investment approach is influenced by his mentor, former teacher and employer, Ben Graham. Graham advocated a cautious approach to investing, preferring stocks that are priced significantly below their intrinsic values.

In 1956, when Graham retired, Buffett moved back to his home town of Omaha Nebraska and started Buffett Partnership Ltd, an investment partnership. By 1962, Buffett was a millionaire and began purchasing stock of a textile company called Berkshire Hathaway. He bought shares worth between $8 and $15 even though the working capital of Berkshire Hathaway exceeded $20 per share. In 1969, Buffett liquidated the partnership but continued as chairman of Berkshire Hathaway.

Shares of Berkshire Hathaway began trading in 1979 for $775. These shares have increases quite significantly even considering their recent drop as reported by the New York Times.

“Mr. Buffett’s company, Berkshire Hathaway, reported a 62 percent drop in net income for 2008 and posted a decline in book value per share for only the second time since he took control in 1965. Shares of the company, which peaked in late 2007 at more than $148,000 apiece, closed Friday at $78,600.” (Segal, 2009)

Contributing to this loss was Berkshire Hathaway investment in preferred stock of Goldman Sachs and General Electric. Both stocks have experienced consider declines in stock value. This and other losses forced the SEC recently to demand increased disclosure of the valuation of contracts.

It has been suggested that Berkshire Hathaway intentionally perpetuates a “Warren Buffett myth”. The myth, it is suggested, is a self-fulfilling prophesy as other investors mirror Buffets investments.

Berkshire Hathaway shares currently sell for $84,574 (as of 3/20/2009) making them the highest priced shares on the New York Stock Exchange. The exorbitant price is due to Buffet’s refusal to split the stock as a deterrent for short-term investors. Despite the sky-high price, Berkshire Hathaway’s stock has yet to be included in the S&P500.

Ben Graham pioneered the value investing approach of purchasing stock below their intrinsic value. Graham called this discount from a stocks market price to its intrinsic value, “margin of safety”. Warren Buffett…

“…has taken the value investing concept even further as his thinking has evolved to where for the last 25 years or so his focus has been on "finding an outstanding company at a sensible price" rather than generic companies at a bargain price.” (Value Investing, 2009)

Comparing legends

John Burr Williams is essentially a value investor. Not only did Williams pioneer the theory of value investing but he formally expressed the theory of discounted cash flow in his 1928 text, The Theory of Investment Value. Williams also recognized the effect of speculation and cautioned against its unpredictability.

John Bogle was no less of a pioneer. Bogle was able to prove that an investor was better off investing his/her funds in a market index portfolio than most mutual funds. Bogle consequently established no-load market index mutual fund that out performed most of his competitors.

Warren Buffett is the current undisputed king of investors. Being the second richest person in the world is testament to this fact. Like Williams, Buffet is a value investor. However unlike Williams, Buffet was able to benefit from a rewarding mentorship and research in the field of investment theory. Research in the 1960’s included the capital asset pricing model (or CAPM). CAPM can be used to calculate the expected return on an individual asset in a portfolio which in turn can be used to calculate the discounted or “intrinsic” value. Warren Buffet is unquestionably the master of calculating the intrinsic value of assets.

Conclusions

Both Williams and Buffett can be considered value investors. Essentially they believe the market to be inefficient and are banking on the fact that the market has not fully realized the future cash flow of a particular stock. It is undeniable that value investing is a successful investment approach.

Numerous academics have published studies investigating the effects of buying value stocks. These studies have consistently found that value stocks outperform growth stocks and the market as a whole. (Value Investing, 2009)

Having said that consider the following quote from Warren Buffet.

“Growth and Value Investing are joined at the hip” (Growth Investing, 2009).

This statement suggests that Buffet believes that the differences between growth and value stock are trivial.

References

• Donaldson G, 2007, Donaldson Capital: Rising Dividend Investing: John Burr Williams and the Theory of Investment Value
  http://risingdividendinvesting.blogspot.com/2007/03/john-burr-williams-and-theory-of_09.html
• Donaldson G, 2007, Donaldson Capital: Rising Dividend Investing: John Burr Williams: Investing Versus Speculating
  http://risingdividendinvesting.blogspot.com/2007/03/john-burr-williams-investing-versus.html
• Segal D. 2/28/2009, In Letter, Warren Buffett Concedes a Tough Year, New York Times,
  http://www.nytimes.com/2009/03/01/business/01buffett.html?_r=1&scp=7&sq=warren%20buffet&st=cse

International Sweatshops – Are they ethical?

[Originally published 6/9/2008]

INTRODUCTION

Wikipedia defines a sweatshop to be:

A sweatshop is a working environment with very difficult or dangerous conditions, usually where the workers have few rights or ways to address their situation. This can include exposure to harmful materials, hazardous situations, extreme temperatures, or abuse from employers.
(Wikipedia 2008)

However, two incidents in 1995 brought sweatshops to the public’s attention. The first was the discovery of a concentration camp style clothing factory in El Monte that employed 80 Thai immigrants. Workers were paid two dollars an hour to make branded garments for major stores like Mervyns.

The second incident involved a factory in Honduras that manufactured clothing for Kathie Lee Gifford’s apparel line that sold at Wal-Mart. The women employed at the factor were aged as young as 13 and were until to attend school due to the long working hours.

More recently, organizations like the Walt Disney Company, The Gap and Nike have been criticized for using sweatshops in third world countries.

The last decade has seen an explosion of offshoring as organizations take advantage of international trade agreement as administered by the World Trade Organization (WTO). The WTO regulates and enforces agreements between nations that include the reduction (or elimination) of tariffs and subsidies.

In Ian Maitland’s The Great Non-Debate over International Sweatshops, an ethical justification is made for the existence of sweatshops and their relatively poor working conditions. The essay will examine Maitland’s arguments and present an opinion on each.

Are wages too low?

Maitland states that critics of sweatshops often complain about the wages and working conditions of workers. However he shows evidence that many factory workers get paid much better that their compatriots that work outside the factory.

Additionally, factory jobs in underdeveloped countries are in high demand. Applicants for factory jobs are plentiful and are willing to accept “low wages” with full knowledge of the working conditions. That is, it is ethical to offer a job with low wages if a reasonable person freely accepts it.

Even though the wages in foreign factory may seem extremely low compared to wages in the United States, I agree with Maitland that it is ethical provided the wages are accepted freely.

Are underdeveloped countries exploited?

Critics of offshore factories claim that large multinational companies are exploiting poor nations. Maitland contends that offshore factories (or “sweatshops”) and the foreign investment associated with the factories actually leads to economic prosperity. He cites Taiwan, Korea, Singapore and Hong Kong as examples of nations that have emerged from a labor-intensive manufacturing economy.

Countries are self-ruling and hence can choose not to accept foreign investment. So, I would disagree that corporations actively “exploit” weaker nations. In fact, some countries actually seek out foreign corporations by offering tax incentives.

In summary, I believe that there is nothing unethical associated with countries establishing factories in foreign nations. A country that accepts foreign investment and manufacturing factories can potentially transform itself into a developed nation. When nations progress, so too do its citizens.

Do companies profit from repression?

It is not surprising that many countries that host sweatshops have repressive governments. This could be because nations that are economically and politically unstable require a repressive government to maintain stability.

As mentioned above, Maitland believes that factories in underdeveloped countries build wealth. That wealth can translate into political freedom.

I concur with Maitland’s theory that foreign investment in countries with repressive regimes is ethical provided the multinational corporations do not use repressive practices inside their factories. For example, it would be unethical if a factory used coercion to force workers to work without pay or for extended hours against their will.

Is a minimum wage bad?

Maitland asserts that a mandated minimum wage is unethical. He contends that most factory workers get paid well above other workers outside the factories. He states that enforcing a minimum wage will reduce the profitability of the factory. A country that implements (and enforces) a minimum wage will become less desirable to multinational companies.

I agree with this finding that the market should decide how much a worker should get paid and that wages should not be imposed by a third party.

However I strongly disagree with his second assertion that companies should be permitted to skimp on worker safety. He argues that it is ethical for companies to refrain from unnecessary expenditure to improve worker safety. Improving safety is costly and will either force wages up or force factories to employ less people.

In my opinion, to advocate reduced worker safety is unethical and inhuman. Whether working in a factory in India or the United States, an employer should guaranteed the same standard of safety. Granted, that a worker in India will have a much cheaper cost of living than a worker in the United States, but both workers value life equally. Both workers need to provide for their families and need some assurance from their employers that there is a low probably of getting injured on the job.

Conclusion

Maitland concludes that the actions of critics to increase wages and improve working conditions in sweatshops in counterproductive. These actions are ultimately detrimental to factory workers and the nation hosting the factories. The sole purpose of offshore factories is to reduce the cost of products. Attempts to change this may result in a country losing factories and the foreign investment associated with them.

Not surprisingly, Maitland states that there should be more sweatshops not less. I am sure that this comment is partially tongue-in-check. But I do agree wholeheartedly that manufacturing factories in underdeveloped countries can lead to economic growth and political stability.

What surprised me is Maitland’s assertion that below subsistence wages is ethically permissible provided that a worker freely and knowingly accepts the position. Again, I agree with this statement provided that workers are not coerced into accepting a job or are mislead as to the work conditions. The justification of permitting subsistence wages is to allow countries to be competitive for foreign investment.

Throughout this essay I have interchanged the term “sweatshop” and “factory”. This was done for aesthetics rather than a distinction of meaning. However the term “sweatshop” does infer a working environment that is unduly harsh. In agreeing with Maitland, my opinion is that “sweatshops” are ethical as they benefit factory workers and the nation that hosts them.

References

• Maitland I. (1997). The Great Non-Debate Over International Sweatshops. In British Academy of Management Annual Conference Proceedings. (pp 240-265).
• Modern day sweatshops. In Sweatshop Watch. Retrieved June 22, 2008 from
  http://www.sweatshopwatch.org/index.php?s=67

The Economic Revolution

Adam Smith from Wikipedia

First published 10/6/2008

Heilbroner (1999) called the emergence of capitalism in the 17th century an “economic revolution”. This essay will examine what brought on this revolution and what it meant for individuals and society at the time. The author will examine capitalism today and suggest an alternative.

The market system is a system where buyers and sellers are motivated by financial gain rather than tradition or authoritarian rule. The market system grew gradually in the 18th century and was influenced by a number factors including European exploration (and expansion), the renaissance, scientific discoveries and the decline of the guilds.

Civilizations have long relied on human interdependence for survival. Today we would not survive long without our human compatriots providing (and maintaining) essential services like power, water and cable television.

Early civilizations maintained cohesion by restricting human independence with tradition (or customs) and authoritarian rule. For example, an individual iron monger were often iron mongers for life and would train heirs to be future iron mongers.  The selection of gymnasts during cold war Russia is an example of authoritative rule.

The introduction of the market economy had a significant effect on society. Individuals were no longer bound to a profession by virtue of his or her family association or class. Individuals began to seek work with the greatest gain. Similarly landowners used their lands to generate wealth by pursuing ventures that had the greatest promise of reward.

A planned economy is a system in which the government manages the economy through regulation and ownership of businesses. Countries with planned economies today include Cuba, Libya, Saudi Arabia, Iran, North Korea and Burma (Planned economy, 2008).

Most countries today have mixed economies, that is, an economy that contains elements of capitalism and socialism. People are encouraged to pursue their entrepreneurial ambitions but the government retains some control on the economy through regulation.

The economy of the United States and that of many other counties is currently undergoing a severe correction. Share markets are declining and credit markets failing as investors lose confidence. But the root of this problem is the US subprime mortgage crisis that was permitted to flourish with little oversight.

Lending institutions repackaged risky loans as Mortgages Backed Securities (MBS) and appended Credit Default Swaps (CDS) as a quasi-insurance policy (CBS News, 2008).

In a brief moment of clarify, Alan Greenspan admitted that the securitization of subprime loans was the cause of the financial problems that started in October of 2007.

Former Federal Reserve chairman Alan Greenspan defended the U.S. subprime mortgage market, arguing that the securitization of home loans for people with poor credit — not the loans themselves — were to blame for the current global credit crisis.
(MSNBC, 2007)

It may be difficult to assign exclusive fault for the current financial woes to the government. But is it the government’s responsibility to prevent financial crises or clean up the mess following one? It would seem that the former is more logical.

Perhaps it is time to re-invent capitalism (Baldwin, 2008). One solution would be for the US to consider a more left-wing approach to government, that is, to permit greater government influence in the economy to ensure that excesses in business are tempered.

REFERENCES

• Baldwin Bob (2008, October 6). University of Redlands.
• Heilbroner Robert (1999), The Worldly Philosophers, 7th ed., Simon and Schuster.