Monday, May 30, 2011

Buffett: What See's Taught Us - Berkshire Shareholder Letter Highlights

In his 1991 shareholder letter, Warren Buffett noted that Berkshire Hathaway (BRKa) had just passed a milestone.

The milestone?

Twenty years earlier, on January 3, 1972, they had purchased control of See's Candy. Why is that a milestone worth noting?

Well, because that business happens to have played a role in the evolution of their thinking on what actually makes a quality business franchise.

How did the experience of owning what seems to be a simple candy business influence the thinking of two great investors?

From the 1991 letter:

Appreciating the Economic Value of a Franchise
"The nominal price that the sellers were asking [for See's] - calculated on the 100% ownership we ultimately attained - was $40 million. But the company had $10 million of excess cash, and therefore the true offering price was $30 million. Charlie [Munger] and I, not yet fully appreciative of the value of an economic franchise, looked at the company's mere $7 million of tangible net worth and said $25 million was as high as we would go (and we meant it). Fortunately, the sellers accepted our offer."

Profits Grew Substantially from 1972-91 (volume did not)
"...See's candy sales...increased from $29 million to $196 million. Moreover, profits at See's grew even faster than sales, from $4.2 million pre-tax in 1972 to $42.4 million last year."

Minimal Incremental Capital Required
"For an increase in profits to be evaluated properly, it must be compared with the incremental capital investment required to produce it. On this score, See's has been astounding: The company now operates comfortably with only $25 million of net worth, which means that our beginning base of $7 million has had to be supplemented by only $18 million of reinvested earnings. Meanwhile, See's remaining pre-tax profits of $410 million were distributed to Blue Chip/Berkshire during the 20 years for these companies to deploy (after payment of taxes) in whatever way made most sense."

Untapped Pricing Power
"In our See's purchase, Charlie and I had one important insight: We saw that the business had untapped pricing power. Otherwise, we were lucky twice over. First, the transaction was not derailed by our dumb insistence on a $25 million price. Second, we found Chuck Huggins, then See's executive vice-president, whom we instantly put in charge."

Weak Volume Does Not Translate into Weak Profits
"In 1991, See's sales volume, measured in dollars, matched that of 1990. In pounds, however, volume was down 4%. All of that slippage took place in the last two months of the year, a period that normally produces more than 80% of annual profits. Despite the weakness in sales, profits last year grew 7%, and our pre-tax profit margin was a record 21.6%."

Record Profits Despite Recession & New Sales Tax
"Almost 80% of See's sales come from California and our business clearly was hurt by the recession, which hit the state with particular force late in the year. Another negative, however, was the mid-year initiation in California of a sales tax of 7%-8% (depending on the county involved) on 'snack food' that was deemed applicable to our candy.

Shareholders who are students of epistemological shadings will enjoy California's classifications of 'snack' and 'non-snack' foods:

Taxable 'Snack' Foods
Ritz Crackers
Popped Popcorn
Granola Bars
Slice of Pie (Wrapped)
Milky Way Candy Bar

Non-Taxable 'Non-Snack' Foods
Soda Crackers
Unpopped Popcorn
Granola Cereal
Whole Pie
Milky Way Ice Cream Bar

What - you are sure to ask - is the tax status of a melted Milky Way ice cream bar? In that androgynous form, does it more resemble an ice cream bar or a candy bar that has been left in the sun? It's no wonder that Brad Sherman, Chairman of California's State Board of Equalization, who opposed the snack food bill but must now administer it, has said: 'I came to this job as a specialist in tax law. Now I find my constituents should have elected Julia Child.'"

Lessons Learned from See's
"Charlie and I have many reasons to be thankful for our association with Chuck and See's. The obvious ones are that we've earned exceptional returns and had a good time in the process. Equally important, ownership of See's has taught us much about the evaluation of franchises. We've made significant money in certain common stocks because of the lessons we learned at See's."

Buffett added this at the 2003 Berkshire meeting:

"Most of our businesses generate lots of money, but can't generate high returns on incremental capital -- for example, See's and Buffalo News."

More recently, in Buffett's 2007 Berkshire letter, he mentioned that sales volume growth since 1972 at See's has been relatively modest. In fact, it grew volumes only 2% annually over that time frame. Despite this meager growth See's earned nearly $82 million in 2007 compared to less than $ 5 million back in 1972.

Nearly all of those earnings were available to invest in high return opportunities of Buffett's choosing since See's has little need for incremental capital. From the 2007 letter:

"Just as Adam and Eve kick-started an activity that led to six billion humans, See's has given birth to multiple new streams of cash for us."

So a business with pricing power that doesn't need much capital to maintain competitiveness makes for a terrific franchise even if it has relatively modest physical growth prospects.

Adam

Long BRKb

Related previous posts:
Buffett on Coca-Cola, See's & Railroads
Buffett on "The Prototype Of A Dream Business"
Buffett on Economic Goodwill
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

Friday, May 27, 2011

Buffett on Earnings Precision: Berkshire Shareholder Letter Highlights

From Warren Buffett's 1990 Berkshire Hathaway (BRKa) shareholder letter:

"The term 'earnings' has a precise ring to it. And when an earnings figure is accompanied by an unqualified auditor's certificate, a naive reader might think it comparable in certitude to pi, calculated to dozens of decimal places.

In reality, however, earnings can be as pliable as putty when a charlatan heads the company reporting them. Eventually truth will surface, but in the meantime a lot of money can change hands. Indeed, some important American fortunes have been created by the monetization of accounting mirages."

It's pretty tough to identify where the bad accounting behavior is going to show up (events at certain companies in recent years have clearly demonstrated that).

Yet there are actually often more than a few red flags. At least enough of them to just decide to avoid something even if you can't figure out precisely what the heck is going on.

"The stock market is a no-called-strike game. You don't have to swing at everything--you can wait for your pitch." - Warren Buffett

The best defense is buying businesses run by managers with a strong reputation and track record of fostering a conservative accounting culture (again, not easy to identify or find).

In fact, all things being equal (they never are, of course) I wouldn't hesitate to buy a slightly inferior business if I thought the management was being conservative and that accounting chicanery had a lower probability of happening.

The problem is that earnings are not particularly precise even when management is doing its best to report the numbers honestly. Accounting has its inherent limitations.

That is one of many reasons why I find the obsession with quarterly results kind of humorous. Reported earnings are just not as meaningful on a quarterly basis as some would suggest (though reading quarterly earnings reports can be a very productive way to begin getting familiar with a company). Now, string ten or twenty quarterly earnings reports together and then you can begin to understand how a business performs in many different business environments.

For cyclical businesses, I'm more comfortable taking the average earnings and free cash flow over a full business cycle. I then decide what it's worth and what kind of margin of safety I want based upon that. If free cash flow is consistently lower than earnings over that time frame I avoid it. Occasionally free cash flow will consistently exceed earnings as a result of something like depreciation or amortization (or other non-cash expenses) being in excess of capex. Mohawk (MHK) is a cyclical business that has been an example of this in recent years.

That's an attractive situation only if management is not starving the business of the key investments that are necessary for it to remain competitive over the long haul.

For non-cyclical businesses like Pepsi (PEP) or Coca-Cola (KO), I'm much more comfortable using current year earnings and free cash flow. That's only the case because there are enough years (well, decades in fact) of evidence to suggest that the earnings power at those two businesses is extremely resilient.

Adam

Long all stocks mentioned
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

Thursday, May 26, 2011

If Buffett Were Paid Like a Hedge Fund Manager - Part II

Here is a follow up to this recent post:

If Buffett Were Paid Like a Hedge Fund Manager

That previous post explored the implications of Warren Buffett being paid like a hedge fund manager (over the past 40 plus years) instead of $ 100,000 per year (excluding security costs) that he's been paid.*

The bottom line was that the frictional costs of that additional pay over that time frame results in Berkshire ending up something like 1/10th its current value.

Seems a bit crazy but that is roughly what happens when frictional costs of that magnitude is compounded over many years. So Berkshire would, in fact, be a shadow of its current self under that arrangement.

The first scenario was a look in the rear-view mirror.

Here's a forward look.

In this hypothetical scenario, the Berkshire Hathaway (BRKa) as we know it exists (260,000 employees, $ 150 billion portfolio, $ 12 billion plus in earning power) with one difference. The difference? Buffett decides that, starting this year, he will finally get in on the action and be compensated like a typical hedge fund manager. The hedge fund industry standard "2 and 20" (2% of assets and 20% of profits above a certain level) compensation structure will be used.

This compensation arrangement will apply only to the investment portfolio (the $ 150 billion portfolio of stocks, bonds, and cash that Berkshire owns).

Now, we know that Buffett's actual job goes beyond deciding whether to buy or sell shares in things like Wells Fargo (WFC) or Johnson & Johnson (JNJ). In addition to managing the $ 150 billion portfolio, Buffett, as CEO also oversees Berkshire's operating businesses (the businesses that employ those ~260,000 people and earn the bulk of that $ 12 billion or so per year). Under this new hypothetical arrangement he continues to have those responsibilities.

So we start with the Berkshire Hathaway we know of today but what's interesting is, as a result of Buffett's new pay structure, a likely very different future.

Here's why.

Assume that $ 150 billion portfolio that Buffett manages increases in value by 14% this year.

Under a typical "2 and 20" pay structure Buffett would earn $ 6 billion in pay.**

The first implication of this is that the intrinsic value of Berkshire drops substantially since that $ 6 billion in pay cuts into nearly half of Berkshire's earning power.

That's not the worst part since $ 6 billion just happens to be the amount that Berkshire Hathaway's operating companies combined invest in capital expenditures (capex) per year. From the 2010 Berkshire Hathaway shareholder letter:

"Last year – in the face of widespread pessimism about our economy – we demonstrated our enthusiasm for capital investment at Berkshire by spending $6 billion on property and equipment. Of this amount, $5.4 billion – or 90% of the total – was spent in the United States. Certainly our businesses will expand abroad in the future, but an overwhelming part of their future investments will be at home. In 2011, we will set a new record for capital spending – $8 billion – and spend all of the $2 billion increase in the United States."

These days, much of that capex is for investments that enhance and expand the capabilities of the gas pipelines (Berkshire's pipelines transport 8% of U.S. natural gas), railroads, and other utility infrastructure that Berkshire owns.

Kind of useful stuff.

These investments certainly should produce nice returns but the benefits clearly go beyond what it earns for the shareholders. Think of the accumulated benefits of those investments over 20 years? We are talking about easily $ 150 billion (actually considering likely growth...much more) of improvements to and the expansion of very useful and productive capital intensive assets over that time horizon.

The type of investments that have meaningful long-term economic benefits and maybe even improvements to living standards.

The point of all this being that it is certain those investments would have to be reduced substantially to accommodate Buffett's new hedge fund like pay structure. The company obviously simply cannot afford as much investment in the form of capex (or otherwise) if roughly half the earning power of a company is going to the top guy in the form of compensation.

As I noted above, the current intrinsic value will be reduced by the explicit cost of the higher pay but the real big hit is to the future growth in intrinsic value. That growth in value is throttled by an expensive compensation system draining capital away from potentially useful and value-creating investments.
(There might just be a few benefits to society as a whole in the form of improvement and expansion of infrastructure and the jobs that they create but that is beyond the scope of this post.)

I'm using this example to illustrate the problem. Some may believe that the large amounts of capital currently invested in hedge funds is somehow different than the situation at Berkshire Hathaway because they do not have an operating business. It's not. The money drained away in the form of compensation subtracts from the capital in the system as a whole along with the potential for that capital to help those with bright ideas create and build important things.
(By definition, even though individual hedge funds may perform just fine, substantial capital is drained from the system in the form of compensation. Naturally, some of that compensation eventually ends up being reinvested.)

Back in early 2010, Jeremy Grantham made the point that these frictional costs actually "raid the balance sheet" of investors.

In his example, Grantham talks about how raising fees from .5 percent to 1 percent is a raid of the balance sheet of investors. Well, the hedge fund industry's current typical fees are much higher than that. They make the .5 percent to 1 percent seem like, by comparison, a quaint amount.

The thinking that the prevailing compensation systems used in asset management somehow doesn't directly or indirectly cut into -- or, at least, delay and diffuse -- the amount of investing dollars available to build, improve, and expand productive assets it would seem is some form of denial or delusion.***

There is clearly a real cost.

To put this in perspective, it's worth keeping the following comments by Buffett in mind (also from the most recent shareholder letter):

"The prophets of doom have overlooked the all-important factor that is certain: Human potential is far from exhausted, and the American system for unleashing that potential – a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War – remains alive and effective." - Warren Buffett

Fortunately, we have an incredibly effective overall system that works despite some of the current weaknesses (hedge fund compensation represents one important flaw among many...it's certainly not the only problem) that have emerged in how we go about capital formation and allocation.

That doesn't mean we won't unleash somewhat less of the potential Buffett refers to if we don't put in place some kind of an intelligent overhaul. It's just not smart to ignore systemic weaknesses once they emerge.

In the U.S., a financial system that effectively forms and allocates capital has historically been a source of economic strength.

It just happens to have become -- for a number of reasons and in important ways -- less effective in recent decades.

It also happens to be fixable.

From the letter, Overcoming Short-termism signed by Buffett, Bogle and 25 others back in 2009:

"...market incentives to encourage patient capital...is likely to be the most effective mechanism to encourage long-term focus by investors. Capitalism is a powerful economic and societal force which, if properly directed, can have a hugely beneficial impact on society at all levels."

Capital Misallocation

Among other things, the letter recommends changes to the tax-code to reward long-term holders over short-term holders and reforms to compensation systems to focus on long-term value creation.

That letter did not have much impact but I can't say that's surprising. In the real world meaningful improvements will be pretty tough to come by considering the interests (and the amount of money) involved. So I don't expect much to happen anytime soon. It's possible future financial challenges could eventually create the pressure that will be needed to force improvements upon the system.

In a perfect world we would not wait for that.

"Somebody ought to spend a little time thinking, and this gets back to the classics, about the role of business in society. It should add value. But the financial business does not add value. By definition the financial business subtracts value. In round numbers, it takes something like $600 billion out of the pockets of investors every year. That's $6 trillion dollars in 10 years." - John Bogle

Bogle: History and the Classics

I just don't think there is much doubt that a few well thought out changes could go a long way toward the objectives of reducing frictional costs and encouraging real investment over casino capitalism.

Adam

Long position in stocks mentioned

Related posts:
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again

* Buffett was paid $ 100,000 last year but did not get any stock grants, stock options, or bonuses. An apples-to-apples comparison to hedge fund frictional costs should also include all the operating costs of Berkshire's corporate office (though much of those costs are presumably related to the operating businesses Berkshire owns outright) and related (that now also would include the costs related to Todd Combs, the new investment manager). Buffett does have personal and home security paid for by Berkshire. Consider how small these costs are in the context of Berkshire's assets overall. The difference in frictional costs is still measured in orders of magnitude compared to a typical hedge fund. So let's not split hairs. This difference, I think, speaks for itself. Precision not required. Berkshire is built to minimize frictional costs for investors like few other investment vehicles. Of course, during Buffett's partnership era, the fee structure was lucrative for him on the upside but also gave him exposure to losses on the downside. In fact, he could lose more money than he invested into the partnership by covering a quarter of all losses from his partners. From Alice Schroeder's book, The Snowball"I got half the upside above a four percent threshold, and I took a quarter of the downside myself. So if I broke even, I lost money. And my obligation to pay back losses was not limited to my capital. It was unlimited." (pp. 201-202)
** The first part of the "2 and 20" calculation would go something like this: 2% of $ 150 billion equals $ 3 billion in pay. The second part: assume that the performance benchmark is something like 4%. Subtract that 4% from the 14% return achieved and multiply by the $ 150 billion equals $ 15 billion in profit above the benchmark. That $ 15 billion in profit is multiplied by 20% for another $ 3 billion in pay. Total pay would = $ 6 billion (a bit more than the $ 4.9 billion hedge fund manager John Paulson made last year).
*** I realize that Buffett is likely to take his fees and invest it wisely elsewhere. So, in his case, the money will almost certainly still get put to use as patient capital. Still, another money manager could just as easily pull a Citizen Kane so to speak and use the money to purchase expensive works of art or some kind of trophy property. (There is certainly nothing wrong with that by the way. The freedom to buy or sell whatever one wants is crucial. My focus here is systemic not individual.) The person who sells the art will then, of course, buy something else and eventually the dollars may even someday end up back in the hands of another talented capital allocator (one who puts those dollars to the kind of use Berkshire in its current size and form is capable of doing). So the money, of course, does not disappear but it may take some tangential journeys before it again ends up in the hands of a smart allocator with some scale. There is, if nothing else, a delay. Well, since there's a time value of money, that alone is a real cost. So the delay is, in itself, expensive on a compounded basis over the longer haul. The specific cost may not be easy to measure but, ultimately, this dynamic seems likely to at least slow the rate of increase to living standards and wealth creationMy point is, in part, that some of the most impactful long-term investments need patient capital to be allocated with big scale to succeed. We are better off with a system designed to encourage funds to stay inside the Berkshire's of the world (i.e. places that intelligently allocate capital at some scale and with low frictional costs) while obviously maintaining the freedom for individual wealth to be spent whatever way one wants. In the current system's form, an awful lot of capital ends up as diffuse consumption or trophy-oriented spending/investment. Excessive frictional costs in finance, as Grantham points out, literally does "raid the balance sheet".
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Wednesday, May 25, 2011

Will Fairholme Become A Mini-Berkshire?

Fairholme (FAIRX) now has roughly 75% of its assets in financials.

Previous post: Fairholme's 1Q 2011 Portfolio: Still Dominated by Financials

So far that concentration in financials has performed poorly but Fairholme certainly has made a lot of money for its investors over the years.

Time will tell how that all works out but below is an article on Fairholme that is well worth reading. The article is from Institutional Investor Magazine and explores how Fairholme may use its control of St. Joe (JOE) as a way to buy assets that a regulated mutual fund normally cannot.

If so, Fairholme just might become an investment vehicle that is more similar to Berkshire Hathaway (BRKa) over time.

A Mini-Berkshire?
...they saw St. Joe as a way to buy assets that a regulated mutual fund would be prohibited from owning directly. In essence, if successful, they could transform their flagship Fairholme Fund into something akin to a hedge fund or an investment vehicle like Warren Buffett's Berkshire Hathaway.

"We're trying to go in a direction we think most mutual funds will be going — where we have the flexibility to do private transactions and public transactions, and the ability to do what makes sense for our shareholders," Berkowitz says.

Buying Banks
"There are plenty of people out there who think we're crazy for being in banks and brokers and AIG," Berkowitz says.

Then later in the article...

"We're only in the third inning," he says. "The last time I was heavily involved with the banks, it was a five-to-ten-year period. And I'm always early, which in a way is a good thing because if you were right on day one, you'd have a much smaller position."

The last comment is something that's been covered several times in the past on this blog (most recently here).

Value investing sometimes requires living with an asset in the red for an extended period of time to make sure a large enough position is accumulated. In other words, you sometimes need to be temporarily willing to be in the red to avoid the quantity of "an eyedropper" when a full glass is wanted problem.

Something cheap generally ends up getting even cheaper and it's impossible to pick the bottom. So, inevitably, being in the red while accumulating shares is going to happen. I know of no perfect solution to this.

The fact is many cannot stomach to see the temporary paper losses that are usually part of this process.

Being "too early" is a situation that goes with the territory but it only works if an investor can consistently get the approximate value a business right and buys it with the appropriate margin of safety. Some assets, like most tech stocks need the gap of price versus value to be large enough to drive a truck through while the Coca-Cola's (KO) and Pepsi's (PEP) of the world need much less.

An entirely different situation is when you judge the value of an asset wrong then hold on while losses mount in an attempt to get back to even.

The impact to a portfolio for this kind of behavior can be hugely negative.

Comparing the two:

1) An investor misjudges what an asset is worth yet holds on. The end result will frequently be, other than pure chance working in the investor's favor, an unnecessarily large permanent loss of capital.

2) An investor buys "too early" at a discount having correctly assessed intrinsic value and the potential for growth in that value. In contrast, returns are likely to work out just fine with enough patience and discipline over the long haul (even if it looks ugly on paper for a while).

"The first principle is that you must not fool yourself -- and you are the easiest person to fool." - Richard Feynman

To be successful, making a candid assessment whether the situation is more 1) than 2) is crucial.

In any case, what happens with Fairholme and St. Joe will be interesting to watch.

Adam

Long BRKb, KO, and PEP

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Tuesday, May 24, 2011

James Grant: Wry Observations About Investor Self-Delusion

"Progress is cumulative in science and engineering, but cyclical in finance." - James Grant in Money of the Mind

That quote by Grant back reminds me, to some extent, of this one by John Kenneth Galbraith from his bookA Short History of Financial Euphoria:

"The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version." - John Kenneth Galbraith

A variation of Grant's quote was also cited by Seth Klarman in an interview last year with Jason Zweig.

That interview with Klarman can be found here.

Grant's stuff is frequently thoughtful and useful for historical perspective (and yes...entertaining at times) even if you happen disagree on some things. Here are some excerpts from a recent interview with Grant:

On asset prices
"When you're not getting anything on your savings, you are inclined to go out and buy something, anything, to generate either income or the expectation of capital gains. So the things that we take as prices freely determined are in fact manipulated."

On stock valuations
"Some big multinationals left behind in the past ten years (like) Wal-Mart (WMT), Cisco Systems (CSCO), Johnson & Johnson (JNJ) appear to be attractively priced. But generally speaking, things are rich."

On what, if in Bernanke's shoes during the crisis, he'd have done
"Resign. I don't know. I have great faith in the price mechanism, in the mechanics of markets. I think there should have been much less intervention and we should have let some chips fall, many chips fall."

On gold
"Gold is a very difficult investment because its value is indeterminate. It is the reciprocal of the world's confidence in the likes of Ben Bernanke. I think the price will go higher."

Jim Grant is certainly one of the better financial historians out there (though not necessarily known for picking specific stocks).

He's often full of insights and always worth a listen.

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, May 23, 2011

Buffett on "Look-Through" Earnings: Berkshire Shareholder Letter Highlights

Warren Buffett wrote the following in the 1989 Berkshire Hathaway (BRKashareholder letter:

In addition to our reported earnings, we also benefit from significant earnings of investees that standard accounting rules do not permit us to report...we list five major investees from which we received dividends in 1989 of about $45 million, after taxes. However, our share of the retained earnings of these investees totaled about $212 million last year, not counting large capital gains realized by GEICO and Coca-Cola. If this $212 million had been distributed to us, our own operating earnings, after the payment of additional taxes, would have been close to $500 million rather than the $300 million shown in the table.

The question you must decide is whether these undistributed earnings are as valuable to us as those we report. We believe they are - and even think they may be more valuable. The reason for this a-bird-in-the-bush-may-be-worth-two-in-the-hand conclusion is that earnings retained by these investees will be deployed by talented, owner-oriented managers who sometimes have better uses for these funds in their own businesses than we would have in ours. I would not make such a generous assessment of most managements, but it is appropriate in these cases.

In our view, Berkshire's fundamental earning power is best measured by a "look-through" approach, in which we append our share of the operating earnings retained by our investees to our own reported operating earnings, excluding capital gains in both instances.

So forty percent of Berkshire's economic earnings came from "look-through" earnings back in 1989.

This year it will be a much lower percent yet still certainly material.

Partial ownership via shares held in companies like Coca-Cola (KO), Wells Fargo (WFC), American Express (AXP), Procter & Gamble (PG), Kraft (KFT), Johnson & Johnson (JNJ) are now the main drivers of "look-through" earnings for Berkshire Hathaway.

From the Berkshire Hathaway owners manual:

Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable. This is precisely the choice that often faces us since entire businesses (whose earnings will be fully reportable) frequently sell for double the pro-rata price of small portions (whose earnings will be largely unreportable). In aggregate and over time, we expect the unreported earnings to be fully reflected in our intrinsic business value through capital gains.

We have found over time that the undistributed earnings of our investees, in aggregate, have been fully as beneficial to Berkshire as if they had been distributed to us (and therefore had been included in the earnings we officially report). This pleasant result has occurred because most of our investees are engaged in truly outstanding businesses that can often employ incremental capital to great advantage, either by putting it to work in their businesses or by repurchasing their shares. Obviously, every capital decision that our investees have made has not benefitted us as shareholders, but overall we have garnered far more than a dollar of value for each dollar they have retained. We consequently regard look-through earnings as realistically portraying our yearly gain from operations.

These days, excluding "look-through" earnings, Berkshire's after tax earning power is in the $12-13 billion range compared to the $ 300 million back in 1989.

That $12-13 billion of earnings, while fluctuating quite a bit from year to year, will continue to grow at a nice clip though not nearly as fast as it has in the past 20 years. Yet it still materially understates Berkshire's economic earnings (though the understatement is a lower percentage than in 1989).

For quite some time now Berkshire's growth in earnings has been driven by an emphasis on buying whole businesses instead of partial ownership via common stocks. So naturally Berkshire's operating businesses now play a more substantial role in the earnings picture (and, of course, intrinsic business value) compared to 1989.

Having said that Berkshire's current ~$ 60 billion equity portfolio, the driver of "look-through" earnings these days, still easily add another 15-20% to the $ $ 12-13 billion in annual earnings.

As Buffett explains above, the extra 15-20% will not show up in the reported GAAP results but economically they are just as significant.

The fact that they are treated differently is more a reflection of the inherent limitations of accounting. Those limitations in the accounting discipline do not make them any less real to an investor in an economic sense.

Adam

Long all stocks mentioned
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

Friday, May 20, 2011

Chancellor & Chanos on China

Excerpts from Edward Chancellor's white paper on China's Red Flags:

Three years ago, Premier Wen described China's economy as "unstable, unbalanced, uncoordinated and unsustainable."

End Game
Forecasting the end game is no easy task since speculative bubbles can run to extremes. It's made more difficult in this case by the fact that China is not a pure market economy. State-owned enterprises can be called upon to prop up markets. Losses may be concealed or shuffled around like a shell game, as has happened in the past. Such measures, however, won't cure China's problems. They only delay the dénouement.

Field of Dreams
China’s real estate market, and indeed its economy and financial system, have been shaped by a belief that past rates of economic growth will continue into the future. This assumption justifies more investment, which spurs the growth, leading to more investment. ...China has become a field of dreams; a build-and-they-will-come economy.

One commentator compares China to the Hollywood thriller, Speed, in which a bus has been planted with a bomb set to detonate if the vehicle slows to below 50 miles per hour. This seems apt. Were China's economy to slow below Beijing's 8% growth target, bad things are liable to happen. 

A recent Barron's article added that fixed-asset investment is a huge part of China's GDP.

He [Chancellor] shakes his head at "this idea that the Chinese authorities are competent to allocate capital at an 8% to 10% rate of growth."

Jim Chanos explained his thinking on China in a recent interview with Charlie Rose. Sixty percent of China's GDP depends on construction. From this Bloomberg article.

Treadmill to Hell
China is "on a treadmill to hell," said Chanos, who said in January the nation is Dubai times a thousand. "They can't afford to get off this heroin of property development. It is the only thing keeping the economic growth numbers growing."

My understanding is that fixed-asset investment is now nearly 70% of China's GDP. That's not a sustainable mix for any economy and it's not like we are talking about a small one.

Bubbles don't usually end without substantial short-to-intermediate term economic disruption. I know of no instance where a bubble this size has not.

The problem is just when it will happen and how severe it will be is impossible to know but the hangover will probably be proportional to the duration of the party.

For investors, the ripple effects of all this will almost certainly be significant even if not directly investing in China.

Be ready to buy more of your favorite businesses if they temporarily go on discount as a result.

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Thursday, May 19, 2011

Stocks to Watch

Here's an update to the list of common stocks that I like* for my own portfolio at the right price. I've noted below the maximum price I'd be willing to pay for each stock.

From my point of view, the shares listed are attractive buys as long-term investments only if they can be bought cheaper than the max price (preferably well below, of course) indicated. Unfortunately, in contrast to when I first published this list, all have become too expensive to buy or, at least, are borderline.

Naturally, the objective is to buy these significantly below the maximum prices I've indicated when the opportunity presents itself.

Since creating the initial Stocks to Watch list, none of the 20+ stocks on the list is selling at a lower price. 

I don't view this as great news. It'd be safer and easier to invest right now if at least some of these stocks were selling at much lower prices. As I've mentioned many times in the past, not only does it allow the investor time to accumulate more shares below intrinsic value, the company itself can use excess free cash flow to do the same.

"When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases." - Warren Buffett in the 1984 Berkshire Hathaway (BRKb) Shareholder Letter

The stocks on this list are fine businesses (some better than others, of course) and, in my view, if held for a long enough period are likely to create solid returns for shareholders even when bought slightly higher than the maximum price I would pay. I just happen to prefer a higher margin of safety than what is being offered by Mr. Market right now.

As always, the stocks in bold have two things in common. They are:

1) currently owned by Berkshire Hathaway (as of 3/31/11) and,
2) selling below the price that Warren Buffett paid in recent years.

There are several other Berkshire Hathaway holdings on this list but they don't have the 2nd thing going for them.

Some things to consider:
- This Stocks to Watch list is intended to remain very stable over time with few additions or deletions. I think of it differently than the Six Stock Portfolio. Unlike that portfolio, I use Stocks to Watch as a list of quality businesses to monitor and, over a long period of time, build into a concentrated portfolio of 5 to 10 stocks based upon what becomes available at the biggest discount to intrinsic value in the market. After that, the intent is to hold these indefinitely as long-term investments.

- In contrast, I established the Six Stock Portfolio in April 2009 as an example of some quality stocks that could be bought relatively quickly (at prevailing market prices back then) and held long-term yet still outperform. No trading required. A sale will only become necessary if the core long-term economics of one of these businesses have become impaired/were misjudged in some material way or maybe due to rather extreme overvaluation. Otherwise, this concentrated portfolio exists to reject the idea that trading rapidly in and out of different securities is necessary to create above average returns. Basically, that the ownership in shares of quality businesses at the right price trumps trading.
(As of yesterday, the Six Stock Portfolio is up 85% versus the 59% for the S&P 500 since first mentioning these on 04/09/09. Dividends are included in that total return calculation for the six stocks and for the S&P 500 so it is an apples-to-apples comparison.)

- A term used frequently by analysts is a "price target". I never have one. Shares of businesses are not like trading cards. Returns for an investor should be driven by the core economics of the businesses they own compounding in value, ideally over a very long time, not some unique talent to jump in and out of the stock at the right moment. The ownership period of shares in a sound business can be indefinite when bought at a fair price. Again, buy/sell behavior should be influenced by material changes to the long-term economics (i.e. permanent damage to the economic moat) or when the market takes prices to extremes.

The bottom line is that these are all intended to be long-term investments. A ten year horizon or longer. No trades here.

All of the stocks on this current list were part of the original Stocks to Watch unless otherwise noted.

Stock   |Max Price I'd Pay |Recent Price|Total Return Since 1st Mention**
JNJ   |    65.00          |  66.50      |18%
WFC|    28.00         |  28.92    | 58% - 1st mention 04/09/09 @ $ 19.61/share
USB |    24.00          | 25.74     | 44%
MHK |    45.00          |   67.17    | 74%
KFT  |    30.00           |  34.88     | 34%
NSC  |     54.00          | 72.11       | 42% - 1st mention 12/17/09 @ $ 52.06/share
MCD |    63.00           | 81.50      | 36% - 1st mention 12/17/09 @ $ 61.92/share
KO    |    55.00           |  68.30     | 42%
COP  |    50.00          |  72.81      |  78%
PM    |    45.00          |  69.28      |  94% - 1st mention 04/09/09 @ $ 37.71/share
PG     |    60.00          |  67.38     |  32%
PEP   |    65.00          |  71.27     |  43% - 1st mention 04/09/09 @ $ 52.10/share
LOW |    19.00          |  25.05      |  29% - 1st mention 04/09/09 @ $ 20.32/share
AXP  |    35.00          |  51.06      |198% - 1st mention 04/09/09 @ $ 18.83/share
ADP  |    37.00          |  54.24      | 59%
DEO  |    60.00          |  82.98      | 90% - 1st mention 04/09/09 @ $ 45.54/share
BRKb|    68.00          | 79.62      | 34%
MO     |    16.00          | 27.87     | 75%
HANS|   30.00          |  68.47     | 134%
PKX   |   80.00           | 106.4      | 18%
RMCF|    6.00            |  10.58     | 37%
(Splits, spinoffs, and similar actions inevitably will occur going forward. Will adjust as necessary to make meaningful comparisons.)

Removed from the list:
  • BNI - I liked purchasing BNI up to $ 80/share. It was bought out by Berkshire Hathaway for $ 100/share in late 2009. Deal closed in early 2010.
The max price I'd pay takes into account an acceptable margin of safety***. That margin of safety differs for each company.

In other words, I believe these are intrinsically worth quite a bit more than the max price I've indicated in this post and in prior Stocks to Watch posts. I also believe most of these companies generally have favorable long-term economics (i.e. the best of them have high and durable return on capital) and, as a result, intrinsic values will increase over the long haul. Of course, I may be misjudging the core economics and that margin of safety could provide insufficient protection against a loss. Still, a year or so from now I would expect to be willing to pay more for many of these based upon each company's intrinsic value growth over that time frame.

Though I could easily be wrong, at the right price I consider these stocks appropriate for my own portfolio (i.e. not for someone else's) given my understanding of the downside risks and potential rewards.

So these don't make sense for others unless they do their own research and reach their own similar conclusions.

Even if not wildly overvalued, these stocks are mostly too expensive to buy right now. The margin of safety is too narrow for my money. There has been no shortage of chances to buy these at a discount to value in the not too distant past. That was the time to act. The risk of missing the chance to own a well understood investment when a fair price is available (error of omission) can be more costly than suffering a short-term paper loss (though, due to loss aversion, many focus much more on the latter). Hopefully, at least some of them will get cheap again.

Here are some thoughts on errors of omission by Buffett from an article in The Motley Fool.

Also, from the 2008 Berkshire Hathaway shareholder letter:

"During 2008 I did some dumb things in investments. I made at least one major mistake of commission and several lesser ones that also hurt... Furthermore, I made some errors of omission, sucking my thumb when new facts came in." - Warren Buffett

In other words, not buying what's attractively valued to avoid short-term paper losses is far from a perfect solution with your best long-term investment ideas.

To me, if an investment is initially bought at a fair price, and is likely to increase substantially in value over 20 years, it makes no sense to be bothered by a temporary paper loss. Of course, make a misjudgment on the quality of a business and that paper loss becomes a real one (error of commission).

There is no perfect answer to this problem. When highly confident that a great business is available at a fair price it's important to accumulate enough while the window of opportunity exists.

Sometimes accepting the risk of short-term losses is necessary to make sure a meaningful stake is acquired.

Finally, above average long-term returns at lower risk is the objective. Performance over the complete market cycle without needing to trade.

For me, performance during a down market and tough economy matters more. Truly good businesses should become stronger in a tough economic environment.

Having said that, I am not tempted to trade from "defensive" to "cyclical" stocks (or anything similar to that approach) depending on the market environment. Too much trading leads to unnecessary mistakes. This is about part ownership of businesses.

I'll let others play the trading game.

I believe this approach will do just fine in the long run even if it offers a little less excitement.

Adam

* This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to remain long the above stocks (at least those that at some point became cheap enough to buy) unless market prices become significantly higher than intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
** Calculated using the May 18, 2011 closing price compared to the average selling price from the date each stock was first mentioned as being attractively priced on this blog. The total return includes dividends. 1st mention was 07/21/09 unless otherwise noted.
*** The required margin of safety is naturally larger for a bank than for something like KO. When I make a mistake and substantially misjudge a company's economics, the margin of safety may still not be sufficient. Judging the durability of the economics correctly matters most. If the economics remain in tact but the stock goes down that is a very good thing in the long run.

Technology Stocks

So why aren't some of the tech stocks with low P/Es that have been mentioned recently on the Stocks to Watch list?

The reason is simple: everything on that Stocks to Watch list is intended to be stocks I like -- for my own portfolio -- as very long-term investments if they can be bought cheap enough. Well, there's just no technology stock that I'm comfortable with as a long-term investment.

Most tech businesses operate in an environment that's exciting, dynamic, and highly competitive.

That's precisely what too often makes their common stock unattractive as a long-term investment.*

No matter how good business looks today, it's just not that easy to predict their economic prospects many years from now.

With the best businesses that's not the case.

"At Berkshire we will stick with businesses whose profit picture for decades to come seems reasonably predictable. Even then, we will make plenty of mistakes." - Warren Buffett in the 2009 Berkshire Hathaway (BRKa) Shareholder Letter

Here are a couple other posts related to this:


For me, it's just too difficult to judge what the economic moat of most tech stocks will look like in the long run. Occasionally, certain tech stocks have sold at a big enough discount to my own (conservative) estimate of intrinsic value that I was willing to own some shares. In other words, their price was cheap enough relative to likely future per share cash generation (and, in some cases, there's been a meaningful chunk of net cash on the balance sheet for an added cushion) that it provided a substantial margin of safety. 

So nothing great had to happen to get a satisfactory investment result.

Even then I've only been willing to slowly accumulate very limited amounts. 

They will remain, at most, very small positions and are generally not long-term investments.

That doesn't mean there aren't some spectacular investment opportunities in technology. There surely have been -- and will continue to be -- some rather exceptional winners among technology businesses. 

A winner, in this case, being those businesses that actually build and maintain a durable competitive advantage along with attractive economics. In other words, it's NOT those businesses that capture the speculative imagination and, as a result, have a common stock that temporarily -- in fact, maybe more than temporarily -- reflects the excitement. 

A big new opportunity usually means lots of well-capitalized and capable players; it usually means one, maybe two, get the big economic "prize" while many others fail. Never mind that today's winner (s) often lose what appears to be, at least for a time, an insurmountable advantage. Consistently judging beforehand who will succeed long-term, while also mostly avoiding the current or eventual losers, is rather tough to do reliably well.

At least it is for me.

Sometimes, the businesses with the most exciting prospects actually deliver on the promise. Those same businesses also often tend to sell for premium prices. Well, mostly due to a high price paid upfront, the investment result ends up being no where near as impressive as the business outcome. A similar or better result could have been accomplished with reduced risk and a narrower range of outcomes.

As always, price matters a great deal because it's an effective way to regulate the balance of risk and reward. Investment is mostly about the returns that can be achieved considering the specific risks and against alternatives (opportunity costs). It's not about whether per share intrinsic business value will someday end up justifying the current market price. That kind of approach to investing is a great way to end up correctly judging future prospects without commensurate compensation, or being wrong in such a way that permanent capital loss is the result.

So it's not just about being correct about the future prospects of a business. It's about being compensated well for being correct. That mostly comes down to judging value well, avoiding what's not understandable, and paying a price -- considering the specific risks -- that represents an appropriate margin of safety. The reality is that much of what happens in the future is beyond the control of an investor. Well, the price that gets paid is definitely one thing that an investor does have direct control over. Paying a premium price -- with the idea the asset will grow into its valuation -- is a great way to achieve subpar investment results (or worse) and take on unnecessary risks.**

I am not suggesting it never makes sense to pay what on the surface appears to be an expensive price. I am suggesting, instead, for those investments with seemingly the most potential upside, it becomes even more important that confirmation bias is held in check. Overconfidence in the "story" can lead to excessive focus on what might go right at the expense of what might go wrong. The investment process should allow for careful consideration of both. It's essential to recognize what's simply not knowable. Big mistakes can get made when the range of outcomes is very wide. Much of the investment process should be focused on the elimination of mistakes.

I am also not suggesting no one can effectively invest in the shares of technology businesses.***

Far from it. 

Some are, no doubt, actually capable of reliably picking the big winners in technology, have discipline when it comes to price, while also keeping the large and costly misjudgments to a minimum. It's just that some will overestimate their own ability to do this effectively. The result? More risk for less reward.

A sound investment approach doesn't necessarily depend upon brilliant foresight or insight; it does depend upon staying within realistically assessed limits.

Adam

* I'm speaking only in the context of investment results. Naturally, many innovative companies produce great benefits for civilization. It's just important to consider that societal benefits need not necessarily translate into attractive investment results. A correlation between the two can exist but, too often, it does not. Sometimes, the winner is only easy to identify after the fact. Other times, the clear winner is priced accordingly. Many fail in the process. So separating the winners from the losers beforehand, without making big mistakes, becomes easy only in theory. No doubt some reliably judge this sort of thing very well. Others mistakenly think they can. In the final nine or so paragraphs of this 1999 Fortune article, Warren Buffett offers some useful thoughts on this subject.
** Must be rather particularly annoying when what looked like promising future prospects mostly becomes reality yet, because of the price paid, the compensation turns out to be insufficient considering risks and alternatives. In this case, I'm referring to an investment result not a speculative result. Those who pay a speculative price then try to sell at an even higher speculative price are playing an entirely different game. Nothing wrong with it, of course, but it mostly has little in common with investment. Speculation is mostly about profiting from market price action; investment is mostly about what an asset can produce -- in terms of excess cash -- over time.
*** Charlie Munger once talked about technology investing and the important of knowing your "circle of competence":

"...Warren and I don't feel like we have any great advantage in the high-tech sector. In fact, we feel like we're at a big disadvantage in trying to understand the nature of technical developments in software, computer chips or what have you. So we tend to avoid that stuff, based on our personal inadequacies.

Again, that is a very, very powerful idea. Every person is going to have a circle of competence. And it's going to be very hard to advance that circle. If I had to make my living as a musician.... I can't even think of a level low enough to describe where I would be sorted out to if music were the measuring standard of the civilization.


So you have to figure out what your own aptitudes are. If you play games where other people have the aptitudes and you don't, you're going to lose. And that's as close to certain as any prediction that you can make. You have to figure out where you've got an edge. And you've got to play within your own circle of competence."

---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.
 
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