Munger's Daily Journal: Decisive Shift into Stocks

Daily Journal Corporation (DJCO) has had, to say the very least, substantial success with its investments in recent years.

Daily Journal is a publisher based in Los Angeles that has been shifting its excess cash into stocks picked by Charlie Munger and J.P. Guerin.

Charlie Munger is the non-executive chairman of Daily Journal and, of course, the vice chairman of Berkshire Hathaway. While better known for serving as Warren Buffett's business partner, he's also been more quietly serving as the chairman and a director at Daily Journal since 1977.

J.P. Guerin is the vice-chairman of Daily Journal.

Well, they've had so much success in recent years that, back in February of 2013, the SEC formally asked why Daily Journal shouldn't be considered an investment company (as defined in theInvestment Company Act of 1940).

Here's the Daily Journal's rather lengthy response.

Among other things, the SEC noted the high percentage of Daily Journal's total assets that are now marketable securities. This is important for the following reason as explained in Daily Journal's response: "...the Investment Company Act (the 'Act') defines an investment company as an issuer (i) 'engaged … in the business of investing, reinvesting, owning, holding, or trading in securities' and (ii) whose assets are at least 40% investment securities."

They go on to further explain that "the Act exempts from this definition any issuer 'primarily engaged, directly or through a wholly-owned subsidiary or subsidiaries, in a business or businesses other than that of investing, reinvesting, owning, holding, or trading in securities.'" 

I found this part of their response, where they explain why in their view the above noted exemption applies, of particular interest:

"...Daily Journal is not just 'primarily' engaged in businesses other than investing - it is entirely engaged in other businesses. The Company and its two wholly-owned subsidiaries have nearly 275 employees and contractors, all of whom are engaged either in the publication of newspapers and magazines or the development and licensing of case management software. 

There is no question that Daily Journal's marketable securities currently exceed 40% of its total assets. This is due to the wise decision of the Board of Directors in 2009 to begin shifting the Company's cash and cash equivalents into marketable securities that have appreciated significantly. The Board recognized that this decision would be contrary to the conventional (but questionable) notion that the least risky way to preserve corporate capital for the long-term benefit of stockholders is to invest it in government bonds at interest rates approximating zero, notwithstanding rising inflation. 

That the Company even had excess cash to invest is due primarily to the confluence of a unique aspect of its publishing business and the country's largest financial crisis in more than 70 years. The Company's newspapers are 'adjudicated', which means they are eligible to publish legal notices, including notices of residential foreclosure sales that are required by California and Arizona law to be published by the foreclosure trustee in an adjudicated newspaper. The Company aggressively competes for the opportunity to publish trustee foreclosure notices, and there were lots and lots of them to be published in California and Arizona beginning in 2006. 

So, while the 'Great Recession' ironically benefitted Daily Journal, the Board knew that it needed to plan for the Company's post-recession operations. To do that, the Company needed to (1) hedge a very difficult environment for newspapers generally, (2) provide for an asset base from which to pursue attractive acquisition opportunities, and (3) establish a minimum net worth that would enable it to bid on significant government software contracts that the Company had been too small to qualify for in the past. Accordingly, the Board decided to purchase three securities selected by Charles Munger, the Company's non-executive chairman, and J.P. Guerin, the Company's vice-chairman. Those investments were quite successful, and the Company now holds positions in six securities." 

In July of 2013, the SEC said they had completed their review while making it clear future actions could still be taken.

Consider that, at the end of 2004, Daily Journal had net cash and investments (at that time primarily U.S. Treasury Bills) of $ 11.26 million. After subtracting notes payable of $ 4.55 million, net cash and investments was ~ $ 6.71 million.*

As of the most recent quarter -- nearly but not quite 10 years later -- Daily Journal had cash and investments (now, primarily made up of the six stocks) of $ 134.7 million. After subtracting $ 14.0 million in margin borrowing net cash and investments was ~$ 120.7 million.**

So I'd say they've put their capital (including free cash flow over that time) to rather wise use over the past decade or so.

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What are the long-term prospects for Tesco Plc (LON: TSCO)?

I'm always searching for shares that can help ordinary investors like you make money from the stock market.

Right now I am trawling through the FTSE 100 and giving my verdict on every member of the blue-chip index.

I hope to pinpoint the very best buying opportunities in today's uncertain market, as well as highlight those shares I feel you should hold... and those I feel you should sell!

I'm assessing every share on five different measures. Here's what I'm looking for in each company:

1. Financial strength: low levels of debt and other liabilities;

2. Profitability: consistent earnings and high profit margins; 

3. Management: competent executives creating shareholder value;

4. Long-term prospects: a solid competitive position and respectable growth prospects, and;

5. Valuation: an under-rated share price.

A LOOK AT TESCO

Today I'm evaluating Tesco (LSE: TSCO) (NASDAQOTH: TSCDY.US)], a British multinational retailer, which currently trades at 363p. Here are my thoughts:

1. Financial strength: Tesco is in solid financial position.  Net debt/operating cash flow is less than 2 times; net gearing is 50%; interest cover is an adequate 7.5 times; and free cash flow has averaged nearly £2bn per year over the last 3 years.

2. Profitability: Tesco has delivered outstanding growth for nearly two decades. However, with the continuing weakness in Europe and facing stiff competition at home, the company has struggled of late. In the last fiscal year, underlying profit before tax declined by 15% while underlying earnings per share fell by 14%. Forced to compete in price, the company's margins have contracted from to 3.4% from 5.6% the previous year.

Also, international trading profit declined by 22%, due to the impact of regulatory changes in South Korea and impairment of businesses in Turkey, Poland and the Czech Republic.

3. Management: I believe the company's new direction under Philip Clarke, which focuses on developing its "multichannel" footprint, strengthening its core UK business, and adopting a more prudent international growth strategy,  places the company in a better position moving forward.    

4. Long-term prospects: Tesco has fallen out of favour with investors recently after a rough 18 months where it was rocked by the horsemeat scandal, several quarters of declining market share and like-for-like sales, and write-offs of its Fresh and Easy US business and several UK properties of more than £1bn  and £804m, respectively.

However, despite the grim outlook, I believe Tesco's competitive position remains solid. It is still the largest UK grocer with a market share of 30% --almost doubling that of its closest rival Wal-Mart's ASDA. It also owns the UK's widest store network with around 3,000 stores and the world's largest and most profitable online supermarket, which reached a record-high revenue of over £3bn last year. In addition, it is the number one or two retailer for general merchandise in 8 out of 9 of its international markets.

Furthermore, to adapt to the rapidly changing retail environment, the company has announced new strategic objectives which include: a shift from traditional large-store formats to building its "multichannel" retail capabilities such as convenience and online retailing; focusing on its core UK operations to maintain its leading position -- the company has invested around £1bn to overhaul its superstores; and adopting a more disciplined approach to international expansion, concentrating only on markets that could deliver strong investment returns. 

5. Valuation: With a market cap of £30bn, Tesco trades at a forward price-to-earnings (P/E) ratio of 11 -slightly below its 10-year median P/E of 13 and the industry average of 12-- and a prospective dividend yield of 4%, twice covered.

My verdict on Tesco

Although recent results have been disappointing and with competition in the UK likely to remain competitive, I think the company still owns a distinct advantage with its scale and size. Also, its profitable international business --29% of the company's profits come from outside the UK--  and established online presence could be a source of future growth opportunities.

Moreover, the company intends to tighten capital spending during the next few years --around 3.5% to 4% of revenue-- which will add to its already strong cash flow. What's more, shares are trading at an undemanding P/E of 12, a discount compared to its peers Wal-Mart andCarreouflour.        

So overall, I believe Tesco at 363p looks like a buy.

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Munger:"Cognitive Failure" in Economics

"Alan Greenspan at the Federal Reserve overdosed on Ayn Rand. Basically he kind of thought anything that happened in the free market, even if it was an axe murder, had to be ok. He's a smart man and [a] good man, but he got it wrong. Generally, an over-belief in any one ideology is going to do you in if you extrapolate it too hard, and that's what happened in economics."

So, according to Munger, what caused this "cognitive failure" in economics?

"They reasoned correctly that a free market would be way more predictive than anything else, and they reasoned correctly that once you had a fairly advanced capitalist system – if the people that were putting up the capital could sell their pieces of ownership in the company to other people, they'd be more inclined to invest because it gave them an option to get out if they wanted to leave. It's not like buying a restaurant in the wrong place. Then they reasoned that if that was true, if you had a really free, liquid, wonderful market in securities, that would be wonderful, and the bigger and more wonderful it was, the better it was for the wider civilization."

Having a million shares trade in a day was a rare occurrence when Munger attended Harvard Law School. Now billions of shares trade each day. He guesses that those who think along these lines are probably looking forward to when trillions of shares will trade in a day. Munger then adds...

"Our civilization is not going to work better if we have trillions of shares traded everyday. It's the most asinine idea you could ever have to extrapolate so vigorously, and of course three or four billion shares is way too many. We have computer programs that are trading with other computer programs. We have many of the bright people who ought to be doing our engineering going to work at hedge funds and investment banks and algorithmic trading places and so on and so on."

Munger goes on to say "at any rate, these people got the idea [that] unlimited trading is a big plus for civilization."

Well, John Maynard Keynes certainly thought otherwise as Munger further explains: 

"[Keynes] said a liquid market of securities is one of the most attractive gambling devices ever created. It has all the joy of gambling, plus it's respectable. Furthermore, instead of being a zero-sum game, where you are bound to lose the frictional cost, it's a game where you can pay the frictional cost and actually make a profit. This is one of the most seductive gambling devices ever invented by man, and some nut who took economics thinks that the bigger and better it gets, the better it is for wider civilization."

Now, consider that speaking to Forbes back in 1974, Warren Buffett described the business of investing in the following manner:

"I call investing the greatest business in the world...because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! And nobody calls a strike on you. There's no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it."

Investing can certainly be a great business but all this hyperactivity is directly at odds with the reasons why.

Compared to all this rapid trading of price action, waiting patiently for something you understand to get cheap enough, then owning it for a very long time, is a completely different game.

Modern capital markets are an incredibly convenient way to buy part of a good business that's priced attractively with minimal frictional costs. 

To me, it seems quite the shame to see something so incredibly useful and powerful converted into a casino; see it turned into something less than it otherwise might be.*

So more of something doesn't automatically make it better. There's often optimal amount -- at least within some range -- and, of course, diminishing returns or worse. Some short-term oriented speculative activity is necessary and even desirable. That doesn't logically mean that unlimited amounts of it is a good thing. 

The amount of speculation relative to investment matters and the former is currently swamping the latter. What John Bogle describes as The Triumph of Speculation over Investment.

There may not be a precisely knowable correct ratio of speculation to investment, but I think it's safe to say we are far from what makes sense. I've used the petrol engine as a simple -- even if a limited and imperfect one -- example of this. 

The petrol engine just doesn't function all that well if the air-fuel ratio strays too far from what's optimal (and, eventually, it won't function at all if there's too much of either substance).

As with most any system, even what is a comparably simple one, the proportion matters rather a lot.

If efficiently and effectively allocating capital and strong long-term business performance are the primary goals then, in their current hyperactive form, the equity markets seem likely to have far from the optimal ratio of speculation relative to investment.

Check out the entire conversation with Charlie Munger at Harvard-Westlake. 

Lots of useful thoughts and insights.

That 1974 Forbes article is a pretty worthwhile read too even if not exactly breaking news.

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