MONEY Warren Buffett

The Guy Who Made a $1 Million Bet Against Warren Buffett

knife cutting dollar bill
David Franklin Hedge fund managers take a big cut of returns

Even if hedge funds were winning—which they aren't—you still should be in indexes.

Warren Buffett bet a prominent U.S. hedge fund manager in 2008 that an S&P 500 index fund would beat a portfolio of hedge funds over the next ten years. How’s it going?

“We’re doing quite poorly, as it turns out,” president of Protege Partners Ted Seides, who made the bet with Buffett, told Marketplace Morning Report today. In fact, an S&P 500 fund run by Vanguard rose more than 63%, while the other side of the wager, a portfolio of funds that only invest in hedge funds, has only returned 20% after fees.

The fees are the important component. When the two sides made their respective cases for why they would win, Buffett noted that active investors incur much higher expenses than index funds in their quest to outperform the market. These costs only increase with hedge funds, or a fund of hedge funds, thus stacking the deck even more in his favor.

“Funds of hedge funds accentuate this cost problem because their fees are superimposed on the large fees charged by the hedge funds in which the funds of funds are invested,” Buffett argued at the time. “A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors.”

Before fees, Seides’s picks would be up 44%—still almost twenty percentage points behind Buffett, but way ahead of where they are.

Seides, to his credit, has been transparent. “Standing seven years into a 10-year wager with Warren Buffett, we sure look wrong,” he wrote in a recent blog post for CFA Institute. He went on to cite the Federal Reserve, both for its decision to keep interest rates at basically zero and undertake an unconventional bond-buying program to jumpstart the economy in the wake of the Great Recession, as one reason why his portfolio has been so roundly beaten by the S&P 500. Of course, investors inability to consistently foresee and time major market events is one reason why index funds are so powerful. (He also points out that a broad stock market index fund is a poor measuring stick for hedge fund performance.)

There’s still three years left in the bet, but barring a prolonged stock market crash, Girls Incorporated of Omaha—Buffett’s charity of choice—seems well placed to win. (The size of that donation stands right now at more than $1.5 million, for reasons having to do with zero-coupon bonds.) Those who are inclined to support passive investing, like MONEY, can be satisfied that once again indexes trumped active traders.

Now here’s the thing: Seven years ago, Seides’ chances of winning this bet actually weren’t so terrible. Cheap index funds have a strong statistical edge over active managers, but that doesn’t mean every stock picker loses. Last December, S&P Dow Jones Indices published “The Persistence Scorecard,” which measures whether outperforming fund managers in one year can continue to outperform the market going forward. “Out of 681 funds that were in the top quartile as of September 2012, only 9.8% managed to stay in the top quartile at the end of September 2014,” according to the report. While that’s not a terribly good record, about 10% of portfolio managers (and their shareholders) think that they are clever investors.

The trouble is, they probably won’t be in the top 10% of investors over the next ten years. There will always be market beaters, even if just by random (and unfortunately unpredictable) chance. That fact goes a long way towards keeping money managers in business.

So when you hear a hot-shot alpha investor type say that he’s beaten the market over the last couple of years, just remember: Stuff happens.

MONEY Ask the Expert

When Investment Growth, Income, and Safety Are All Priorities

Investing illustration
Robert A. Di Ieso, Jr.

Q: I’m 64 and retired. My wife is 54 and still working, but I’m asking her to join me in retirement. We have about $1 million in savings, with about half in an IRA and the rest in CDs. How can try I try to preserve the principal, generate about $2,000 in monthly income until I collect Social Security at age 70, and somehow double my investment? — Rajen in Iowa

A: The first thing you need to ask yourself is what’s really more important: Growth, income, or safety? You say you want to preserve your principal – and your large cash position suggests that you are risk averse – but you also say you want to double your investment.

“Why do you need to double your investment?” asks Larry Rosenthal, a certified financial planner and president of Rosenthal Wealth Management Group in Manassas, VA. “Everybody likes the idea of doubling their investment, but there’s a high cost if it doesn’t work out.”

Given that you’re already retired, doubling your investment is a tall order. You probably don’t have that kind of time. At a 5% annual return, it would take you more than 14 years, and that’s without tapping your funds for income along the way. Nor can you afford to take on too much additional risk.

Either way, you do need to rethink how you have your assets allocated.

A 50% cash position is likely far too much, especially with interest rates as low as they are. “You’re effectively earning a negative return,” factoring in inflation, says Rosenthal.

And while cash is a great buffer for down markets, the value is lost in the extreme: The portion of your portfolio that is invested in longer-term assets such as stocks and bonds needs to do double duty to earn the same overall return.

If generating growth and income are both priorities, “look at shifting some of that cash into dividend paying stocks, a bond ladder, an annuity, or possibly a combination of the three,” says Rosenthal, who gives the critical caveat that the decision of how to invest some of this cash will depend on how your IRA money is invested.

Meanwhile, you should take a closer look at the pros and cons of claiming Social Security at full retirement age, which is 66 in your case, or waiting until you’re 70 years old.

The current conventional wisdom is to hold off taking Social Security as long as possible in order to maximize the monthly benefit. While that advice still holds true for many people, you need to look at the specifics of your situation – as well as that of your wife. The best way to know is to run the numbers, which you can do at Social Security Timing or AARP.

The tradeoff of waiting to claim your benefit, says Rosenthal, is spending down more of your savings for six years. You may in fact do better by keeping that money invested.

What’s more, “if you die, you can pass along your savings,” adds Rosenthal. But you don’t have that type of flexibility with Social Security benefits.

MONEY Customer Service

The Insulting Names That Businesses Call You Behind Your Back

150225_EM_WhatBusinessesCallYou
Lasse Kristensen—Shutterstock

Ever wonder how casinos, car dealerships, restaurants, pay TV providers, and online marketers refer to customers in private? The answers aren't pretty.

You may think you are a living, breathing, thinking, three-dimensional human being. To online marketers, however, you might just be classified as “waste.” That’s one of the revelations in a new report from the Annenberg School for Communication at the University of Pennsylvania.

“Many online marketers use algorithmic tools which automatically cluster people into groups with names like ‘target’ and ‘waste,'” the researchers explain. Those viewed as “targets” based on their personal data and online history are deemed worthy of retailer discounts and deals. On the other hand, because the majority of bankruptcies come as a result of medical expenses, “it is possible anyone visiting medical websites may be grouped into the ‘waste’ category and denied favorable offers.”

It’s insulting enough that your worthiness as a person and potential customer is being judged by some computer algorithm. And yet the words chosen for these groups we’re lumped into make this sifting process more impersonal and insulting still.

The study got us thinking about all the other disdainful, mocking, or otherwise insulting ways that companies have been known to refer to the paying customers and clients that, you know, keep these businesses in business. Even as you essentially pay the bills for these operations, you might be thought of as little more than …

Muppets
In 2012, the very public resignation of Greg Smith from Goldman Sachs revealed that the firm’s executives sometimes referred to clients as “muppets.” Apparently, in the U.K. the slang term is applied to someone who is ignorant or clueless and easily manipulated. In certain circles, an investor might also be dubbed an ostrich, pig, or sheep depending on if he, respectively, buries his head in the sand no matter what’s happening in the market, is overly greedy, or has no strategy and does whatever someone else tells him.

Bunnies, Grapes, Squirrels
Behind the scene at car dealerships, customers who are bad negotiators and easy for salespeople to push around and talk into deals are sometimes known as “bunnies” or “grapes,” presumably because they’re just waiting to be pounced on or squeezed, respectively. A “squirrel,” on the other hand, is a hated species of customer who hops from salesperson to salesperson with no sense of loyalty or thought to who should get the commission.

Dogs, Fish, Bait, Whales
These are all terms used in the world of gambling and casinos, and they generally refer to players who are losing or are likely to lose—to the house, but also to the shark sitting across the table. A “whale,” of course, is a high roller who bets big, and who therefore will probably lose big money at one time or another. For that matter, in the restaurant industry, “whales” are super-wealthy customers with so much money they don’t blink when running up bills into the tens of thousands at overpriced eateries where, for example, a Bud Light costs $11.

Campers, Rednecks
Also in the sphere of restaurants, these are two kinds of customers that seriously annoy the employees and owners. A group of “campers” camps out at their table for hours, eliminating the opportunity for a new party to run up a tab, while a “redneck” is another term for a cheapstake or stiff who doesn’t tip—perhaps because they’re not city folk and aren’t familiar with tipping etiquette.

The N Word
Some waitstaff not only refer to their customers using racial epithets, but they’re also dumb enough to put these derogatory terms in print on diners’ receipts. Examples have popped up in Pennsylvania, Texas, and Virginia, among other places. And yes, the incidents have resulted in lawsuits and people getting fired. On the flip side, some horrible restaurant customers have been known to leave insults (including the N word) instead of tips for their waiters.

Fat
Among the other popular, not particularly creative insults left on receipts is some variation of “fat”—“Fat Girls” and “Pink Fat Lady,” to name a couple specific examples.

The C Word
Yes, some angry Time Warner Cable customer service agent apparently went there, recently renaming a customer as “C*** Martinez” in a letter after she reported a problem with her service.

Assorted Expletives and Insults
The C word episode followed on the heels of multiple reports of agents at Comcast—Time Warner Cable’s equally hated pay TV competitor and would-be partner if the much-discussed merger ever takes place—renaming subscribers things like “A**hole,” “Whore,” “Dummy,” “Super B*tch,” and such. (Only whoever did the renaming at Comcast always used letters instead of asterisks.) There’s a good argument to be made that the absurd pricing and policies installed by pay TV providers are at the heart of why “customer service” agents so often hate subscribers, and why the feeling is mutual.

A Sad Person, a Hateful Mess
You’d think that New York Knicks owner James Dolan—a no-brainer to appear on a wide variety of Worst or Most Hated Owners in Sports in Sports roundups—would have developed a thick skin after years of criticism for astounding ineptness and mismanagement at the helm of one of sport’s most valuable franchises. But Dolan’s response to the recent criticism of one New Yorker who has been a fan of the team since 1952 shows otherwise.

“I am utterly embarrassed by your dealings with the Knicks,” the fan, Irving Bierman, wrote to Dolan, pleading with him to sell the team so that “fans can at least look forward to growing them in a positive direction.” Instead of taking the criticism constructively and thanking Bierman for watching the Knicks for 60+ years, Dolan responded via email by calling him “a sad person,” “a hateful mess,” “alcoholic maybe,” and likely “a negative force in everyone who comes in contact with you.” Dolan finished up the screed by telling Bierman to “start rooting for the Nets because the Knicks dont [sic] want you.”

While certainly extreme, Dolan’s message speaks to the disdain with which some sports owners and certain league executives seem to regard fans—who are supposed to root loyally and pay up for the product as a matter of blind faith, and never to question or criticize. For Dolan’s sake, let’s hope he never listens to sports talk radio. He probably wouldn’t like the ways that people refer to him.

MONEY Warren Buffett

Warren Buffett’s Secret to Staying Young: 5 Cokes a Day

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Daniel Acker—Bloomberg via Getty Images Warren Buffett, chief executive officer of Berkshire Hathaway, drinks a Cherry Coca-Cola.

The world’s most successful investor stays youthful by eating "like a 6-year-old." Turns out, the Berkshire Hathaway CEO’s bizarre diet is highly strategic.

How does the world’s top investor, at 84 years old, wake up every day and face the world with boundless energy?

“I’m one quarter Coca-Cola,” Warren Buffett says.

When he told me this in a phone call yesterday (we were talking about the death of his friend, former Coca-Cola president Don Keough), I assumed he was talking about his stock portfolio.

No, Buffett explained, “If I eat 2700 calories a day, a quarter of that is Coca-Cola. I drink at least five 12-ounce servings. I do it everyday.”

Perhaps only a man who owns $16 billion in Coca-Cola KO 0.71% stock—9% of Coke, through his company, Berkshire Hathaway BRK.A -0.23% —would maintain such an odd daily diet. One 12-ounce can of Coke contains 140 calories. Typically, Buffett says, “I have three Cokes during the day and two at night.”

When he’s at his desk at Berkshire Hathaway headquarters in Omaha, he drinks regular Coke; at home, he treats himself to Cherry Coke.

“I’ll have one at breakfast,” he explains, noting that he loves to drink Coke with potato sticks. What brand of potato sticks? “I have a can right here,” he says. “U-T-Z” Utz is a Hanover, Pennsylvania-based snack maker. Buffett says that he’s talked to Utz management about potentially buying the company.

Investors in Berkshire Hathaway may feel relieved that the CEO isn’t addicted to Utz Potato Stix at every breakfast. “This morning, I had a bowl of chocolate chip ice cream,” Buffett says.

Asked to explain the high-sugar, high-salt diet that has somehow enabled him to remain seemingly healthy, Buffett replies: “I checked the actuarial tables, and the lowest death rate is among six-year-olds. So I decided to eat like a six-year-old.” The octogenarian adds, “It’s the safest course I can take.”

This article originally appeared on Fortune.com.

MONEY investing strategy

The Track Records of Wall Street’s Top Strategists Are Worse Than You Think

fever graph on screen
Richard Drew—AP

Listening to Wall Street's top strategists is no better than random guessing.

This is embarrassing.

There are 22 “chief market strategists” at Wall Street’s biggest banks and investment firms. They work at storied firms such as Goldman Sachs and Morgan Stanley. They have access to the best information, the smartest economists, and teams of brilliant analysts. They talk to the largest investors in the world. They work hard. They are paid lots of money.

One of their most important — and certainly highest-profile — jobs is forecasting what the stock market will do over the next year. Strategists do this every January by predicting where the S&P 500 will close on Dec. 31.

You won’t be shocked to learn their track record isn’t perfect. But you might be surprised at how disastrously bad it is. I certainly was.

On average, chief market strategists’ forecasts are worse than those made by a guy I call the Blind Forecaster. He’s a brainless idiot who assumes the market goes up 9% — its long-term historic average — every year, regardless of circumstances.

Here’s the average strategist’s forecast versus actual S&P 500 performance since 2000:

Some quick math shows the strategists’ forecasts were off by an average of 14.7 percentage points per year.

How about the Blind Forecaster? Assuming the market would rise 9% every year since 2000 provided a forecast that was off by an average of 14.1 percentage points per year.

Underperforming the Blind Forecaster isn’t due to 2008, which forecasters like to write off as an unforeseeable “black swan.” Excluding 2008, the strategists’ error rate is 12 percentage points per year, versus 11.6 percentage points per year for the Blind Forecaster. Our idiot still wins.

The Blind Forecaster wasn’t a good forecaster, mind you. He was terrible. He missed bear markets and underestimated bull markets. In only one of the last 14 years was his annual forecast reasonably close to being accurate. But he was still better than the combined effort of 22 of Wall Street’s brightest analysts.

And the Blind Forecaster required no million-dollar salary. He worked no late nights. He attended no conference calls, meetings, or luncheons. He made no PowerPoint presentations, and never appeared on CNBC. He has no beach house, and was granted no bonuses. He works free of charge, offering his services to anyone who will listen.

Amazingly, these stories aren’t rare. In 2007, economists Ron Alquist and Lutz Kilian looked atcrude futures, a market used to predict oil prices. These markets were actually less accurate at predicting oil prices than a naïve “no-change” forecast, which assumes the future price of oil is whatever the current price is now. The no-change forecast was terrible at predicting oil prices, of course. But it was better than the collective effort of the futures market.

This raises two questions: Why do people listen to strategists? And why are they so bad?

The first question is easy. I think there’s a burning desire to think of finance as a science like physics or engineering.

We want to think it can be measured cleanly, with precision, in ways that make sense. If you think finance is like physics, you assume there are smart people out there who can read the data, crunch the numbers, and tell us exactly where the S&P 500 will be on Dec. 31, just as a physicist can tell us exactly how bright the moon will be on the last day of the year.

But finance isn’t like physics. Or, to borrow an analogy from investor Dean Williams, it’s not like classical physics, which analyzes the world in clean, predictable, measurable ways. It’s more like quantum physics, which tells us that — at the particle level — the world works in messy, disorderly ways, and you can’t measure anything precisely because the act of measuring something will affect the thing you’re trying to measure (Heisenberg’s uncertainty principle). The belief that finance is something precise and measurable is why we listen to strategists. And I don’t think that will ever go away.

Finance is much closer to something like sociology. It’s barely a science, and driven by irrational, uninformed, emotional, vengeful, gullible, and hormonal human brains.

If you think of finance as being akin to physics when it’s actually closer to sociology, forecasting becomes a nightmare.The most important thing to know to accurately forecast future stock prices is what mood investors will be in in the future. Will people be optimistic, and willing to pay a high price for stocks? Or will they be bummed out, panicked about some crisis, pissed off at politicians, and not willing to pay much for stocks? You have to know that. It’s the most important variable when predicating future stock returns. And it’s unknowable. There is no way to predict what mood I’ll be in 12 months from now, because no matter what you measure today, I can ignore it a year from now. That’s why strategists have such a bad record.

Worse than a Blind Forecaster.

Check back every Tuesday and Friday for Morgan Housel’s columns.

The more you know about the most common mistakes that investors make, the better your likelihood of building lasting wealth. Click here for more commentary on how I think about investing and money.

Contact Morgan Housel at mhousel@fool.com. The Motley Fool has a disclosure policy.

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MONEY Autos

Why Apple Can’t Sell Cars Like iPhones

Apple employees prepare the newly released iPhone 6 for sale
Hannibal Hanschke—Reuters

Apple makes its money selling affordable luxury, but an Apple car would likely be luxury—period.

The Apple car! It’s Cupertino’s latest nonexistent product to drive the tech world into a frenzy. Ever since the Wall Street Journal reported that Apple has “several hundred employees” working on the production of a Tesla competitor (by 2020, no less, according to Bloomberg), pundits have been fighting over the viability of an Apple-branded automobile.

On Monday, Vox’s Matt Yglesias jumped into the fray, taking on what he saw as the prevailing argument against the Apple car: namely, that the car industry is a low margin business, and Apple needs high margins to keep making its usual hefty profits. Here’s Yglesias:

The misperception here is that Apple earns high margins because Apple operates in high margin industries. The truth is precisely the opposite. Apple earns high margins because it is efficient at manufacturing and firmly committed to a business strategy of sacrificing market share to maintain pricing power.

If Apple makes a car, it will be a high margin car because Apple only makes high margin products. If it succeeds it will succeed for the same reason iPhones and iPads and Macs succeed — people like them and are willing to buy them, even though you could get similar specs for less.

That’s sort of true, but it’s not the whole picture. To understand Apple’s business model, we need to take a step back. Apple earns high profits because it goes into high-volume industries dominated by low-margin players who sell relatively affordable products. Apple then makes a premium product, one where you can’t get similar specs for less—there is no other computer or smartphone with the software or build quality of an iPhone 6 or Macbook Air—and prices its offering a few hundred dollars more than the competition. Then it earns billions off this relatively small price increase by selling high quantities of units.

In other words, Apple makes premium versions of things everybody needs at prices most people can still afford. To quote a 2010 review of the iPad, by Daring Fireball’s John Gruber, ” ‘Affordable luxury’ is the sweet spot for mass market success today, and Apple keeps shooting bulls eyes.” A similar strategy for an Apple car then, would be to sell a premium-quality car with higher margins (Apple’s gross margin in 2014 was close to 40%) at a still-affordable price.

The problem for Apple is that it’s a lot easier to increase margins in a low-cost industry than a high-cost one. Even if an iPhone 6 costs 100% more than a cheap LG smartphone, it’s only $200. Same thing with the Macbook Air, which is twice the price of a low-end Windows laptop but still affordable at $1,000.

But trying to get similar margins in the automobile market means a price increase of thousands of dollars, not hundreds. Double the price of a $22,970 Toyota Camry, or ask for even a 50% premium, and you’re in BMW territory. (That company’s cheapest sedan costs $32,000.)

The typical Apple customer has enough disposable income to double their phone budget and buy an iPhone 6. Buy one fewer latte a week, and you’re pretty much there. Asking someone to double their car budget is a very different story. That’s not affordable luxury, that’s luxury—period.

This isn’t to say Apple won’t make an expensive high-margin car, just like BMW. The premium car market isn’t nearly as profitable as the cell phone market, but it’s not nothing. It’s also possible Apple will make a low-margin car while charging a slight premium over the likes of GM and Ford. The entire global automobile market in 2014 was about half the size of the iPhone market alone, meaning such an endeavor would be a lot of work for not much growth, but anything is possible.

But for Apple to do either of these things would be to abandon the affordable luxury strategy that has made it the most valuable company in the world. That’s worth thinking about when considering an Apple car’s chances.

MONEY financial advice

Even a “Fiduciary” Financial Adviser Can Rip You Off If You Don’t Know These 3 Things

man in suit with briefcase stuffed with bills
Roy Hsu—Getty Images

After years of fits and starts, the move to require brokers and other financial advisers to act as fiduciaries—essentially making them put their clients’ interests first—seems to be gaining traction again. Witness President Obama’s recent speech at AARP on the topic. Whether a fiduciary mandate eventually comes to pass or not, here are three things you should know if you’re working with—or thinking of hiring—an adviser bound by the fiduciary standard.

1. Fiduciary status doesn’t guarantee honesty, or competence. The idea behind compelling financial advisers to act in their client’s best interest is that doing so will help eliminate a variety of dubious practices and outright abuses, such as pushing high-cost or otherwise inappropriate investments that do more to boost the adviser’s income than the size of an investor’s nest egg. And perhaps a rule or law requiring advisers to act as fiduciaries when dispensing advice or counseling consumers about investments will achieve that noble aim.

But you would be foolish to count on it. Fact is, no rule or standard can prevent an adviser from taking advantage of clients or, for that matter, prevent an unscrupulous one from using the mantle of fiduciary status to lull clients into a false sense of security. As a registered investment adviser with the Securities and Exchange Commission, Ponzi scheme perpetrator Bernie Madoff had a fiduciary duty to his clients. Clearly, that didn’t stop him from ripping them off.

Fiduciary or no, you should thoroughly vet any adviser before signing on. You should also assure that any money the adviser is investing or overseeing is held by an independent trustee, and stipulate that the adviser himself should not have unrestricted access to your funds.

2. Your interests and an adviser’s never completely align. There’s no way to eliminate all conflicts of interest between you and a financial adviser, even if he’s a fiduciary. If an adviser is compensated through sales commissions, for example, he may be tempted to recommend investments that pay him the most or frequently move your money to generate more commissions. An adviser who eschews commissions in favor of an annual fee—say, 1% or 1.5% of assets under management—might be prone to avoid investments that can reduce the value of assets under his charge, such as immediate annuities. Or, the adviser might charge the same 1% a year as assets increase even if his workload doesn’t.

My advice: Ask the adviser outright how your interests and his may deviate, as well as how he intends to handle conflicts so you’ll be treated fairly. If the adviser says he has no conflicts, move on to one with a more discerning mind.

3. Even with fiduciaries high fees can be an issue. Much of the rationale over the fiduciary mandate centers around protecting investors from bloated investments costs. But don’t assume that just because an adviser is a fiduciary that his fees are a bargain, or that you can’t do better. Advisers can and do charge a wide range of fees for very similar services, and fiduciaries are no exception. So ask for the details—in writing—of the services you’ll receive and exactly what you’ll pay for them. And don’t be shy about negotiating for a lower rate, or taking a proposal to another adviser to see if you can save on fees and expenses.

A fiduciary may have a duty to put your interests first. But that duty doesn’t extend to helping you find a competitor who may offer a better deal. That’s on you.

Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at walter@realdealretirement.com.

More from RealDealRetirement.com:

Should You Claim Social Security Early and Invest It—Or Claim Later For A Higher Benefit?

How To Protect Your Nest Egg From Shifting Government Policies

Your 3 Most Pressing Social Security Questions Answered

 

MONEY Walmart

Here’s Walmart’s Long-term Bet

Walmart Neighborhood Market, Camarillo, California
John Crowe—Alamy

Walmart's willingness to spend a little more today to reinvigorate sales growth won't necessarily hurt its long-term cost structure.

In the past few years, retail giant Walmart WAL-MART STORES INC. WMT 0.16% has discovered that sticking to the same old script isn’t working anymore. Prior to the Great Recession, Walmart was clearly a growth company despite its massive size, with a high single-digit annual growth rate. More recently, it has struggled to eke out low-single digit revenue growth.

WMT Revenue (TTM) Chart

Under the leadership of previous CEO Mike Duke, Walmart began to experiment with changes to its business model, such as adding more small-format stores. However, these efforts were still too little to turn the tide.

New CEO Doug McMillon has shown that he will be more aggressive about making investments to restart Walmart’s growth. He is doubling down on existing initiatives to add small-format stores and grow Walmart’s e-commerce presence. Most notably, he is raising pay for half a million employees in a bold bid to improve Walmart’s lagging customer service.

Another weak year

Walmart’s profit growth has stagnated lately. In the recently ended 2015 fiscal year, Walmart’s “underlying” EPS — which excludes unusual gains and losses — was $5.07. That represented a slight decline from Walmart’s fiscal year 2014 underlying EPS of $5.11 and fell short of the company’s original guidance for EPS of $5.10-$5.45.

Fiscal year 2015 was the second straight year of earnings stagnation. In fiscal year 2014, underlying EPS rose 2%, and even that was just a function of share buybacks.

Revenue growth has also been weak in this period, increasing 1.6% in fiscal year 2014 and 2% in fiscal year 2015. Currency fluctuations negatively affected revenue growth by about $5 billion (a little more than 1% of sales) in each year, but the underlying trend is still low single-digit revenue growth.

Going small for growth

Since McMillon took the reins last year, Walmart has accelerated its small-format store strategy. In his first month as CEO, Walmart announced that it planned to open 270-300 small-format stores during fiscal year 2015, up from the original plan of 120-150 small-format store openings that it had presented just a few months earlier.

Walmart ended up opening 233 small-format Neighborhood Markets last year — below its target but still more than 50% ahead of its original goal. In fiscal year 2016, Walmart plans to open another 180-200 Neighborhood Markets.

This initiative looks promising — the relatively small existing base of Neighborhood Markets generated 7.7% comparable store sales growth last quarter. Since the vast majority of the new Neighborhood Markets last year were opened in Q4, they will have a bigger impact on sales growth in the new fiscal year.

Boosting wages

While the Neighborhood Markets represent an important new growth outlet for Walmart, the company still gets the vast majority of its revenue from supercenters, and that will continue to be the case for the foreseeable future.

Poor customer service in these supercenters has contributed to Walmart’s sluggish sales growth. (Walmart ranked at the bottom of the American Customer Satisfaction Index in 2014.) Walmart’s efforts to juice profit growth by cutting costs to the bone in previous years caused it to have fewer and less-motivated employees in stores. This backfired as the company lost sales to dollar stores and other discounters.

Walmart began to reverse its stingy attitude last year by keeping more registers open during the holiday season in order to keep lines short. Walmart announced on its earnings call that it has continued this “Checkout Promise” policy during Q1.

In an even bigger break from the status quo, Walmart announced that it will raise wages for about half a million hourly employees in the U.S. In April, Walmart will raise its entry wage to $9/hour, and by next February all current employees will make at least $10/hour. (New hires may still start at $9, but after completing six months of training, they will move up to $10/hour.)

Department managers and other employees who are making more than $10/hour today will also be eligible for raises under this program. Walmart is also changing its scheduling practices to help employees to get more consistent hours and it is making it easier to use paid sick days.

Lastly, Walmart is creating a training program to help employees move to jobs with more responsibility. It wants to create clear career paths so that entry-level workers understand how they can move up the ranks over time.

How higher pay could help

Raising employee pay could be transformative by re-energizing the Walmart workforce. More engaged employees are likely to provide better customer service, which should draw more customers to Walmart in the long run. Furthermore, if workers feel more “invested” in Walmart, they will be more likely to suggest process improvements that could improve profitability.

Paying higher wages should also allow Walmart to be more selective in its hiring, improving the quality and productivity of its workforce over time. Improving long-term career mobility could also encourage Walmart employees to stick around. Lower employee turnover reduces training costs.

As a side benefit, by paying its employees higher wages, Walmart could also put upward pressure on wages at comparable employers. That would put more money in the hands of Walmart’s core customer demographic.

Even with its planned wage increases, Walmart will still be paying significantly less than one key rival: Costco Wholesale. Whereas Walmart is touting the ability of entry-level workers to eventually move up to positions paying $15/hour or more, the average hourly wage at Costco is more than $20/hour.

This is both a positive and a negative. On the one hand, it means that Walmart probably needs to keep raising wages to attract and retain high-quality employees. (Otherwise, it might lose its best workers to Costco.) On the other hand, Costco’s experience shows that paying good wages is compatible with maintaining a low-cost model.

This will take time

In the long run, Walmart’s strategic initiatives could help it return to faster growth. By opening more Neighborhood Markets, it will be able to tap into a huge market of customers who don’t want to navigate a gigantic Walmart supercenter to pick up a few groceries.

By paying its employees more, Walmart may be able to improve its customer service while also contributing to higher working class incomes more broadly. Both trends could drive better sales growth.

Nevertheless, Walmart investors will have to be very patient. Walmart is projecting another EPS decline for this year, primarily due to the $1 billion cost of raising employee compensation. Since there will be another step-up in wages next February, EPS will probably remain depressed in fiscal year 2017.

Still, if paying more can drive a return to sustainable comparable sales growth, Walmart should be able to gradually leverage the additional costs. (To some extent, the cost headwinds could also be offset by higher employee retention and improving productivity over the next few years.)

As a result, Walmart’s willingness to spend a little more today to reinvigorate sales growth won’t necessarily hurt its long-term cost structure. There can be no assurance of success, but this seems like a much more promising strategy than Walmart’s previous fixation on cost-cutting.

MONEY Tech

Why Apple Won’t Buy Tesla

Tesla Model S
Tesla Tesla Model S

It doesn't make any sense.

According to Jason Calacanis, who bills himself as an “angel investor, entrepreneur, conference host, and podcaster,” Apple APPLE INC. AAPL -1.5% will spend $75 billion to acquire Tesla Motors TESLA MOTORS INC. TSLA -1.86% within the next year-and-a-half. While he listed a number of reasons for such a deal, his primary argument is that “once the [Tesla] Model 3 hits the road, Tesla’s market cap would make a deal with Apple a merger — not an acquisition.”

In other words, Calacanis expects such a sharp upturn in Tesla financials once it launches the more affordable Model 3 car that its market capitalization could be well north of what even Apple could afford — assuming, of course, Apple even wants to buy Tesla.

But this seems highly implausible to me.

Tesla is already quite richly valued

The first fundamental flaw with this claim is the idea that Tesla financials and market capitalization will skyrocket once the company is delivering relatively affordable electric vehicles in significant volumes. I would argue the current $25 billion market capitalization already bakes in some pretty high investor expectations.

To put this into perspective, current analyst consensus for Ford 2015 revenue — keep in mind that Ford is already in the high-volume, mainstream automobile game — sits at $143.7 billion, and its market capitalization is just shy of $64 billion as of this writing. Tesla trades at approximately 39% of Ford’s market capitalization even though the upstart carmaker is projected to generate just 4% of its 2015 revenue.

Of course, Tesla is a much higher-growth company, and it is far “sexier” than Ford, so I do not take issue with Tesla getting a richer valuation. The problem, though, is that the stock price today — at least, from what I can tell — already bakes in a lot of future success.

That means when or if Tesla succeeds in driving more volume and growing its revenue significantly, the financials might improve, but I am not convinced this could lead to the huge growth in the stock price that Calacanis predicts.

Apple would be better off buying its own stock

If Apple were to drop $75 billion on Tesla today (a three times premium to the current market capitalization), it is highly questionable as to when the company could see a return on that investment. Tesla has outright stated it does not expect to be profitable on a GAAP basis until 2020.

In this scenario, not only would Apple have to wait five years before a single cent of profit showed up on the income statement, but Tesla operations could actually drag on Apple. If the company owns Tesla, and Tesla is losing money, then that comes straight out of Apple financials.

Additionally, since Apple would need to buy Tesla with U.S.-based cash or with stock, the deal would either force the tech giant to issue shares, undoing the benefits of previous stock repurchases, or to issue a hefty amount of debt, which means paying interest on that debt. Alternatively, Apple could repatriate its foreign-held cash and get hit with a huge tax bill, but that would probably be the least likely option.

If Apple is really itching to spend $75 billion on something, it would be far better for the company to simply buy back stock. At least in this case, Apple would shrink the number of shares outstanding, immediately providing a meaningful boost to earnings per share. In my humble view, that would certainly be a quicker and easier way to juice the bottom line than to spend an exorbitant amount of money on Tesla.

MONEY stocks

Can You Really Beat the Market?

Campbell Harvey, Professor of Finance at Duke's Fuqua School of Business
Jeff Brown Don't assume everything you read in financial journals is true, says Duke University finance professor Campbell Harvey.

Turns out the smart money isn't always so.

We put the question to Duke University finance professor Campbell Harvey, 56, former editor of the Journal of Finance and president-elect of the American Finance Association. Harvey is known for taking unorthodox positions when it comes to academic research, portfolio rebalancing, and Bitcoin.

MONEY writer Taylor Tepper interviewed Campbell for the March 2015 issue of the magazine, where this edited interview originally appeared.

Q: Can you really beat the market?

A: There’s all this academic research out there that attempts to explain why stocks do well or poorly by focusing on investment factors, such as momentum or low price/earnings ratios. In all, 316 different factors were identified in the papers I studied, including things like the amount of media attention a company gets or how much it spends on advertising. My research found that of all the published papers in finance, over half are likely false. The problem is the researchers were applying the tools of statistics as if there was only one test going on when there are multiple variables. Some factors are going to look statistically significant just by chance.

Q: Can you help us understand?

A: There’s a cartoon that explains this well. Let’s say somebody has a hypothesis that jelly beans cause acne. So researchers conduct a controlled experiment where some people get jelly beans and some don’t. It turns out that there’s no significant difference. Then somebody says, “Well, maybe we’re looking at this incorrectly. We should look at this by the color of the jelly bean. So then 20 new experiments are undertaken. Again, some people get jelly beans and others don’t. But the jelly beans are just red. A separate experiment uses just yellow beans. Then all purple. Each time there’s no effect. On the 20th try, which happens to test green jelly beans, they find there’s a difference that is statistically significant by the usual rules. And then in the newspaper the next day, there’s this headline: GREEN JELLY BEANS CAUSE ACNE.

Q: What should the standard be?

A: Usually you’re looking for 95% confidence, which means there’s a 5% chance the result was a fluke. But that’s true only if you’re conducting a single test. As soon as you go to multiple tests, it’s like the jelly bean problem. You do 20 experiments and you’re likely to get a hit by chance.

Q: To be fair, you’ve made this mistake yourself.

A: Some of the papers we analyzed are my own. This actually gives me a bit of a pass when I’m talking to my colleagues and saying, “Half of what you guys published is false.” And they kind of push back: “How could you say that?” And I say, “Well, it also holds for me, okay?”

Q: What does this mean for the average investor?

A: For individual investors the best thing to do is to just go with an index fund. Don’t believe these claims of using this or that “factor” to beat the market. Invest in the broad market, and go with the lowest possible fee.

Q: But so-called smart beta index funds claim to capitalize on these “factors.”

A: Imagine there are 316 of these “smart” beta index funds, each chasing one of the factors that I detail. It is likely that more than 50% of them are destined to disappoint.

Suppose there’s an ETF investing only in stocks beginning with the letter “H.” The managers claim historical outperformance for H stocks based on simulations going back to 1926. They claim their results are “significant.” They’re likely using the wrong statistical method to declare their strategy “true.” They might have tried 26 letters and “H” worked by chance.

“Don’t believe these claims of using this or that ‘factor’ to beat the market. Invest in the broad market, and go with the lowest possible fee.”The insight is the same for 316 factors. If you try enough strategies, some will work by luck. In many cases it’s not about being “smart.”

Q: Speaking of smart, rebalancing has been recommended as a prudent approach. You’ve done research on this topic, right?

A: Rebalancing is like mom-and-apple-pie sort of finance, in that we just assume it’s a good idea. We don’t think through what it involves. In my research I detail the risk that is induced by a rebalancing strategy.

Q: Don’t you rebalance to reduce risk?

A: Let’s say you’ve got a portfolio of 60% stocks and 40% bonds. Now, imagine stocks drop and you’re in a prolonged bear market. If you’re rebalancing, you have to buy equities to get that proportion back up to 60%. So as stocks are falling, you’re buying more and more. Your portfolio is going to have a bigger drawdown than another portfolio where you didn’t rebalance.

It works in bull markets too. If equities are going up and up and you’re rebalancing, you’re dumping stocks. The market goes up. You dump more. All of a sudden your portfolio has done worse than if you had just let it run.

Q: So how should investors think about rebalancing then?

A: It is not smart to rebalance the last day of the year or the last day of the quarter by rote. It means you’re ignoring all of the information in the market. There’s lots of information out there, so use that
information. Use your judgment.

Q: If you don’t have time to figure this out, isn’t rote rebalancing worth the risk to keep from being overly exposed to stocks before a bear market?

A: If you have a very long time horizon, you may be able to bear the extra risk by rote rebalancing. You will still have bigger drawdowns in the value of your retirement portfolio, but you don’t need the money in the short term and you can ride out the risk. My point is all investors need to understand that rote rebalancing is an active investment decision that increases risk.

Q: You’ve also done research on Bitcoin. The smart money is pretty sure it’s a worthless currency. What don’t people get?

A: Almost everything. For instance, part of the misunderstanding is the focus on the price of the Bitcoin. You see that it was at $1,000, then it’s down to $200. People say, “Well, the bubble has burst,” and stuff like that.

They are looking at just one aspect of Bitcoin. These critics don’t start by asking themselves, “What problem does Bitcoin solve?”

Q: What problem does it solve?

A: I am tired of constantly getting phone calls from my credit card companies, having to go online to fix the 20 things I’ve got auto-debits for, and dealing with charges that are not mine on my card. These are problems that many people encounter.

Q: Bitcoin is safer?

A: Bitcoin is much safer. When you go to buy something, the retailer actually is able to check a common ledger of all transactions to make sure you actually have the money to spend. The public ledger, which is almost impossible to hack, solves the problem of double spending—using the same Bitcoin to buy two things. Merchants, such as restaurants, which are paying 3% to the credit card companies, love this.

For me, though, I look at Bitcoin not just as a currency, but what it could do in the future in other applications. Think of the Bitcoin technology as a way to exchange and verify ownership. It’s like getting into your car with your smartphone. You present cryptographic proof of ownership. You’re the owner, and it’s verified through this common ledger. The car is able to identify that it is your car, and so the car starts. You’re done.

Now suppose you borrow money from the bank for the car and you’re three months behind in your payments. You present your key, the car doesn’t start. The bank has the key that starts the car. So this is a very cool idea, right?

Q: There’s still a problem with the roller-coaster ride in Bitcoin prices, right?

A: There is, and Bitcoin currently is not a reliable store of value because of it. But the price swings could be solved with more liquidity—more money in the market. The recently launched Bitcoin exchange, which is fully regulated, insured, and backed by the New York Stock Exchange, should help with this. Bitcoin price fluctuations are a factor of it being so young.

The best way to judge Bitcoin is not to look at the price progression, but to look at the vast amount of money that’s being invested by venture capitalists into Bitcoin-related companies. That’s what I look at.

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