Sunday, November 30, 2008
The main difference between Berkshire's permanent equity holdings and marketable equity holdings is on the sell condition. With the permanent holdings, Buffett has indicated that Berkshire will not sell those holdings. The reason why Warren wouldn't sell the permanent holdings is believed to be due to the personal relationships he has with those company's managements. However, the buy criteria for both permanent holdings and equity marketable holdings is the same. Buffett looks for a companies with strong underlying business economics available at attractive prices in the marketplace.
Once Buffett buys an equity marketable security, he is content to hold onto it indefinitely, provided the return on capital is sufficient, management is competent honest and shareholder friendly, and the market does not overvalue the business.
Nardelli took the reigns at Home Depot (HD) in the year 2000 after losing a power struggle for the top job at GE to Jeffrey Immelt. A great boom in housing would ensue in the next several years, but Home Depot's stock had essentially remained flat for his entire tenure all the way to 2007! When confronted by angry shareholders at the 2006 annual shareholder meeting, Nardelli limited each shareholder to one minute, and refused to answer many of their questions. Meanwhile, competitor Lowe's (LOW) saw its stock triple during Nardelli's seven years at HD. Nardelli, however, received a $210 million parachute when he left.
A few months later, Nardelli accepted the top job at Chrysler. A year and a half later, he's back in the spotlight! Here he is asking Congress for taxpayer funds to help his company out:
Is Nardelli a bad manager that runns companies into the ground, or simply a victim of circumstance? It's impossible for us to tell from the outside. Operationally, Home Depot has looked great (as we've discussed here) but its stock never really responded. However, his stock results in both of these companies certainly haven't made him look good at all.
Saturday, November 29, 2008
Arbitrage is the practice of taking advantage of a price differentials. Buffett has typically practiced risk arbitrage. With risk arbitrage, a stock price trades in the market at a discount to some future value. In particular, he has looked to invest in large merger transactions where the merger has been publicly announced and is considered to be a friendly event.
Buffett counsels that investors should answer four questions in order to evaluate a risk arbitrage situation:
1) How likely is it that the announced event will take place?
2) How long will your money be tied up?
3) What is the chance that something better will transpire (e.g. a competing bid)
4) What will happen if the event does not take place?
Buffett has practiced arbitrage for decades and estimates that Berkshire has earned on average a 25% pre-tax return on arbitrage operations. He sees risk arbitrage as an alternative to investing in short term treasuries.
Around 1989, Buffett started to withdraw from arbitrage transactions. He noticed that with the increasing popularity of leveraged buyouts came an environment of "unbridled enthusiasm" caused by financial excesses. Buffett has always acted fearful when others were greedy and this may be why he has increasingly looked to make deals with convertible preferred deals rather than arbitrage.
In order to best reflect a company's operating reality in a company's financial statements, revenue is recognized not when cash changes hands, but rather when the revenue has been earned. In most cases, this means the good has been transferred to the buyer (and the buyer now assumes its risk) or the service has been performed. In some cases, it's not so easy to determine when this has occurred.
As a software company, i2 Technologies was showing revenue from customers that the SEC deemed were not actually earned. An excerpt from the SEC press release reveals why the SEC drew this conclusion:
Historically, i2 favored up-front recognition of software license revenue, purportedly in accordance with generally accepted accounting principals (GAAP). However, as i2 knew or was reckless in not knowing, immediate recognition of revenue was inappropriate for some of i2's software licenses because they required lengthy and intense implementation and customization efforts to meet customer needs. In some cases, i2 shipped certain products and product lines that lacked functionality essential to commercial use by a broad range of users. In other cases, the company licensed certain software that required additional functionality to be usable by particular customers.
In essence, i2 had not yet completed the work, but was recognizing the revenue. i2 was not dishonest in any disclosure, however. Its policy of revenue recognition was clearly identified in the notes to its financial statements. As we've discussed before, by reading the notes to the financial statements, you will have a much better picture of a company's position than by relying on the financial statements alone.
Friday, November 28, 2008
On Aug 1, 1991, Berkshire purchased $300 million worth of convertible preferred shares of American Express (AMEX). This was not a typical convertible preferred share deal for Berkshire, because there was an upside cap on their ability to profit from a potential conversion into common shares.
In this deal, the convertible preferred shares paid a fixed dividend of 8.85% and must be converted in three years into AMEX common stock, with the possibility of a one year extension. At the time of issuance, the AMEX common shares were trading in the market at $25 per share. The value of a conversion into AMEX common shares was capped for Berkshire at $414 million, regardless if the market priced the conversion to be worth more.
With regards to this deal, Buffett commented that "for me, it's what's available at the time". The alternative for Berkshire at the time included treasury bills that paid 6% or treasury bonds paying 7.5%. As it turned out, within two years of making this deal, the value of AMEX common shares had risen to $31 per share.
Many believe the best way to play the market is to behave like it. Buy when things are hot, sell when they're cold. After all, in the "long-term" we're all dead. They point to "lost decades" in stock investing, such as the 1929 crash where the S&P did not recover its pre-crash price for 25 years.
Unfortunately, this is far too simplistic a viewpoint. While certain stocks undoubtedly matched the market, others did poorly and other blossomed. Those who can pick the stocks trading at discounts to their intrinsic values, and who do so recognizing that companies with low debt (including required payments such as operating leases) have the ability to survive, will do well.
Furthermore, looking only at S&P price points ignores the all-important dividend factor. When including dividends, the S&P index in 1952 was 4.5 times its price in 1928! Unfortunately, this stat never makes it into the headlines thanks to an inherent media bias towards sensationalism. (You can't blame them though...that's how they pay the bills!)
For more on this subject, Professor Dan Richards of the Rotman School of Business has written a terrific article here.
Thursday, November 27, 2008
Champion was in the forestry business and among other assets, they owned paper mills and valuable timber holdings. Warren recognized that he wasn't confident about the future economics of the forestry business, so if a deal would be made, it wouldn't be for Champion's common stock. Warren also noticed that Champion was sitting on timber holdings which were on the balance sheet at $1.5 billion but based on transactions of similar assets, those timber holdings could be worth up to $2.5billion. If Champion sold some of its timber holdings, the value of those holdings would become recognized in the marketplace and the common shares should benefit as a result.
In Dec 1989, Berkshire Hathaway bought 300,000 shares of Champion's convertible preferred stock which represented an 8% stake in the company. From 1989 to 1993, Champion's progress was lackluster. Particularly in the 90's, there was weak demand for paper products and the industry was plagued with overcapacity.
Berkshire bought Champions convertible preferred stock with the hope of being able to convert the investment into common shares at a favorable price. Investing in Champions convertible preferred shares provided the downside protection that Berkshire needed (as it turned out), while still offering some hope of upside possibilities.
Professor George Athanassakos, whom we've described here, is the chair of the Ben Graham Centre for Value Investing. Every year, he offers a one-week seminar to educate investors on value investing methodologies. Attendees learn how to identify stocks that are potentially undervalued, how to determine the intrinsic value of a stock, and how to construct a portfolio that controls for risk without limiting potential returns. In essence, you'll learn how to apply valuation techniques that most value investors keep under wraps! You can read more about the seminar here.
The class sizes are deliberately kept small so that each individual gets ample opportunity to ask questions and get the most out of the experience. Let us know if you ended up registering or if you have any questions, as Reyer and I have attended a couple of these sessions.
Wednesday, November 26, 2008
Well maybe not. You might be hesitating to invest because you are unsure how much further the markets will decline. It would be ideal to have a precognitive or clairvoyant ability that would allow us to predict the lowest possible price for a stock, buy it, and then watch the price soar upwards soon after making the investment. The problem is, to my knowledge, no one has demonstrated such an ability. So, what should one do?
Well, if you are certain that you have recognized a good solid investment but are hestitating to do so, why not consider making a partial investment now? One strategy is to predetermine a maximum dollar amount you would like to invest in the opportunity and then split up the buy purchases by price levels. With this strategy, if the market suddenly rallies, at least you will own some shares as opposed to none.
For example, you might like a stock at $10/sh, and have decided it makes sense to buy at most $10,000 worth of the stock. You could decide that you will commit $5,000 now, at $10/sh, and then another $5,000 should the price decline to say $8/sh (the example is arbitrary, you decide what makes sense). With this method, you would at least own some of the undervalued stock now, in case the price starts to move upwards and out of your buy range. On the flip side, if the stock does decline further, you still have reserve funds to lower your average purchase price, which is a better alternative to having committed the full amount at a higher price. As well, you might want to use several buy tranches, depedending on the situation.
There are some drawbacks with this method. First, you will be paying more commission fees. Second, if the stock price does decline further, you might have wished you had waited.
I think the extra commission fees can make sense provided you are deploying enough capital into the purchase and the percentage of fees to investment capital is small enough. If you are low on capital, joining an investment club might be one solution to make the strategy practical.
If the stock price declines further, yes, we will wish we had waited. However, if you truly believe that no one can accurately predict market bottoms on a consistent basis, why torture yourself about making the decision to buy at least some shares of an undervalued company now? As value investors, we should recognize that our strategies are designed to work typically over a business cycle.
Sure, as described here, we can follow the mandatory Berkshire filings which detail its ownership in various securities (and many copy-cat investors do so diligently), but Buffett is not the only portfolio manager at Berkshire. But don't take my word for it, as this statement comes from Buffett himself:
"The media continue to report that "Buffett buys" this or that stock. Statements like these are almost always based on filings Berkshire makes with the SEC and are therefore wrong. As I’ve said before, the stories should say "Berkshire buys."...Even then, it is typically not I who make the buying decisions. Lou Simpson manages about $2½ billion of equities that are held by GEICO, and it is his transactions that Berkshire is usually reporting."
As an example, shares in CarMax rose 7.5% on the day a filing from Berkshire indicated it had taken a position. Presumably investors assumed Buffett had seen something in the valuation that the market hadn't. However, Alex Taylor refutes the fact that KMX was a Buffett purchase in a well-written article here.
So even though you know how to access Berkshire's filings, you may not know the buyer behind the buys. Your best defense is to do your own homework and to know yourself what you're buying.
Tuesday, November 25, 2008
Many of the advantages available through an investment club stem from the various economies of scale that are obtained by bringing people together. For example, with multiple persons working on analysis, your club can research and present more opportunities than if you were working on your own. Hopefully by considering more opportunities, your club can invest in the very best ideas and benefit from the extra choices brought forth.
Another economy of scale made available by an investment club is the increased size of funds under management and the opportunity for diversification. Many smaller investors with limited funds may not be able to adequately diversify their holdings into individual stocks and so they consider other investment vehicles like ETFs and mutual funds, which charge recurring fees.
Administrative work is also made less onerous through the participation of an investment club. Tasks such as club accounting, reporting and transaction execution could be delegated on a rotational basis over a wider basis of individuals than if you were working independently.
It shouldn't be surprising that operating in an investment club does come with some drawbacks. One problem might be the difficulty in obtaining approval for an investment idea that you really believe in. However, I think this drawback has a silver lining attached. Defending an investment thesis and valuation can be a valuable exercise, both to widen your own perspective and to teach others about the merits of an investment thesis. The investment decision process is more difficult through a club (than on your own), but the hope is that the decisions are more sound because of the additional scrutiny.
I believe the largest drawback about joining an investment club is if your club allows untrustworthy people in as members. Someone will need to act as club treasurer and you will want to make sure your money is safe and only gets used to invest in ideas that the club has authorized. For this reason, its important to be comfortable with the members of a club and to be reassured that there are adequate checks in place to protect the integrity of the club.
All in all, I think the advantages of an investment club make it well worth looking into.
TATTF has cash of $44 million, accounts receivable of $21 million, and inventory of $38 million. All of its liabilities add up to $62 million, with debt representing only $5 million of this figure. Therefore, these three liquid asset items minus all liabilities actually add up to more than the company trades for! (44+21+38-62=41 > 32).
With a valuation like this, one would expect the company to be in dire straights, losing money hand over fist. However, the company has been profitable throughout the last several years, and was so even in its last quarter ending September 30th. In fact, in its latest quarter it grew year-over-year revenue across all three of its segments. In the first 9 months of this year, it has made $3.5 million dollars!
However, TATTF is dependent on activity in the aircraft sector. The airline industry will undoubtedly suffer in the short-term despite lower fuel prices, as the economy has taken a turn for the worse. However, TATTF also has exposure to military customers, which aren't subject to the same patterns as the private sector. Also, more than half of TATTF's revenue comes from repair services largely based on long-term contracts. TATTF further added to its list of contracts in the 2nd quarter, thus lowering the risk of unexpected shortfalls in demand.
While no one can predict the length of this downturn, those with a long-term view should look for companies with the financial strength to survive for several years until things improve. TATTF is well positioned to survive thanks to its low debt position, high liquid assets, and long-term contracts, and should thus eventually emerge with a stock price far greater than where it currently stands.
Monday, November 24, 2008
The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.
In this article, Graham gives four examples of scenarios that represent the extremes that can occur on Wall Street.
Penn Central (Railroad) Co - An extreme example of a failure to recognize the warning signals of financial weakness.
Investors failed to recognize that the interest coverage ratio (1.9x) failed to meet the bottom threshold of 5x that Graham sets out. Investors ignored the fact that earnings per share were being published BEFORE special charges associated with an ill-conceived merger, and that AFTER these charges, the EPS was negative (the investors pushed the price upward anyways). Further, even after considering all the quantitative problems with the company, investors ignored the fact that use of railroads was going down and Penn Central was losing a greater share than its competitors.
Present-Day Comparison: Lucent Technologies vastly overpaying for Chromatis Networks
Moral: Always conduct a proper analysis! Failure to recognize warning signs will lead to inconsistent returns at best, major losses at worst.
Ling-Temco-Vought Inc - An extreme example of empire building.
James Ling started a company that began acquiring dozens of unrelated companies. These acquisitions were funded by LTV stock. The more acquisitions LTV made, the higher its stock went, which meant that LTV could afford more acquisitions. This was a house of cards that inevitably came crashing down.
Present-Day Comparison: Tyco International (Acquired 200 companies in 2000 alone!)
Moral: Unrelated acquisitions are often ill-conceived and lead to poor returns. Watch out for companies that appear to be empire building.
NVF Corp - An extreme example of a corporate acquisition of a company seven times its size, which led to huge debt. In doing so, the company employed accounting gimmicks with a series of undecipherable entries to make the company seem far more attractive than it is.
Present-Day Comparison: AOL-TimeWarner (AOL shareholders getting 55% of the newly merged firm, despite TimeWarner being 5x the size!)
Moral: Be careful about companies that have taken on enormous amounts of debt to purchase larger companies. This may make the new entity unsustainable. Be extra careful when the subsequent financial statements are shady, as this is a good sign that management bit off more than it can chew and is now trying to hide its mistake.
AAA Enterprises - An extreme example of public stock financing of a small company.
The owner had begun franchising his business which only earned $61,000 before tax. He went public, selling at 115x earnings due to the franchising concept. Ultimately, it crashed.
Present-Day Comparison: eToys (went public, becoming valued at $7.8 billion on the first day, when it only had losses to show for itself. It was spending $2 for every $1 in sales!)
Moral: Don’t fall for ambitious plans for the future or other “hot issues.” Buy based on historical performance of the underlying company.
According to the Energy Information Administration, the US imports approximately 12 million barrels/day. With oil at $95/barrel last November versus $55 for November 2008, this represents a positive effect on US GDP of $175 billion at an annual rate, or 1.3% of GDP. Considering annual GDP growth is approximately 3% per year, this is not insignificant.
However, there are complications which threaten the accuracy of this rough calculation. First of all, when Americans send money abroad to import oil, some of that money flows back to the US in the form of equipment purchases, technical expertise or any other goods and services that Americans provide, which dampens the subtractions to GDP.
Furthermore, if Americans are not spending that money on oil, they might spend some of it on another imported product. Therefore, the savings from the drop in oil might still flow out of the country for the purchase of another good or service, which would serve to further lower our estimate for how much GDP would benefit from lower oil prices.
However, for the money no longer spent on oil that is spent on domestic goods and services, there is a multiplier effect, as the domestic providers of these goods and services will then spend a portion of their receipts on more goods and services (a portion of which will be domestic), which has the effect of increasing GDP to a level higher than our rough calculation.
Economists disagree on exactly what the final effects of such secondary and tertiary effects might be. But finally, it's important to recognize that oil is not the only major factor that will contribute to upcoming GDP growth numbers. If people are effectively storing their money in mattresses due to low consumer confidence, as we saw here, this will have a far more profound impact on GDP than changes in oil prices.
Sunday, November 23, 2008
At the other end of the "cyclicality" spectrum is Archer Daniels Midland (ADM), which procures, transports, stores, processes, and distributes agricultural products including corn, wheat, cocoa, soybeans, flour, ethanol and biodiesels. Whether in a recession or not, the demand for many of these staple items doesn't change by much if at all.
ADM has a P/B just over 1.2, along with a P/E of 7, suggesting there could be some value here. However, it's important to note that many of the items sold by ADM are commodity products. As we discussed here, value investors are not big fans of companies heavily reliant on commodities as future revenues and earnings are very difficult to predict.
In the case of ADM, recent spikes in food prices have made recent results higher than normal. As such, investors must be cognizant of this fact when evaluating metrics like P/E ratios which are based on the most recent numbers. As discussed here, value investors tend to prefer using earnings averages rather than the most recent earnings. A failure to do so would make you think ADM is far cheaper than it actually is...
Saturday, November 22, 2008
In my last post, I referred to an article which Buffett wrote where he stated that he is putting his money where his mouth is and is investing his personal cash into primarily U.S. equities. He feels the time is right to start investing. One question you may be asking is how can we make Buffett-like investments? I believe one of the best solutions to that question is to consider investing in the Berkshire Hathaway class A shares or the more affordable class B shares. There are several reasons why you may want to invest in Berkshire Hathaway shares at this time.
The first reason is that Buffett is a very disciplined and patient investor who knows how to invest wisely in fearful markets. He has a long-term investment performance track record that is widely recognized as the being the best ever. Who would be a better choice to invest your money in these markets?
Second, Buffett can get access to deals that the average investor cannot participate in. In the Warren Buffett way, we have written about special convertible preferred shares that Warren has been able to invest in over the years, primarily because of his reputation as a wise and patient investor with deep pockets. In these markets, there are many companies that desperately require patient capital, and we have already observed special Berkshire-only deals made with General Electric and Goldman Sachs.
Third, by buying shares in Berkshire Hathaway, you get to own interests in some of the finest, cash-generating companies on the planet. Buffett, together with Munger, have purchased incredibly profitable companies over the years that have met their strict standards for quality. In fact, many of these companies are now owned outright by Berkshire Hathaway. So when you buy Berkshire Hathaway today, your investment is comprised of the same diversified companies that Berkshire owns.
My last point is that Berkshire Hathaway may be currently trading at a good price for investors. First, the share price of Berkshire Hathaway class B shares, has fallen from a 52-week high of $5,059/sh to a current price of $2,914/sh. Also the fact that Buffett is now bullish on buying equities is a strong endorsement that share prices in general have fallen below what he considers to be rational. Also, Barron's published an interesting article here, which supports the notion that Berkshire Hathaway may be available at historically cheap prices in today's market.
Disclosure: The Author is a shareholder of Berkshire Hathaway
SVT has a market cap of just $13 million, so it most certainly flies well under the radar of institutional buyers. As such, this is where one can find the most inefficienly priced securities, and so small investors who do their homework can profit over the long term by buying the ones that trade at large discounts to their instrinsic values.
SVT's cash, accounts receivables, and inventory cover all of its liabilities, with some $8 million to spare. This means you're paying only $5 million ($13 million - $8 million) for its cash generating assets, with little to no risk of liquidity concerns. So how much are these cash generating assets worth? Well in the last four years, the company's net income has averaged just over $2.5 million per year!
From this perspective, the company looks very cheap. However, there is one caveat. Digging into the company's financials reveals that around 50% of the company's revenue comes from the US government, specifically overseas military. Having one customer as such a large percentage of sales represents a very real risk, particularly when there is much uncertainty surrounding the future status of US military operations overseas.
While this may turn out to be a very good stock over the long haul, there are plenty of other opportunities out there in this fearful environment where such risks are not present.
Friday, November 21, 2008
Last year, while attending Prof. George Athanassakos' value investor speaker series at the Richard Ivey School of Business, I had the privilege to listen to the wisdom of Bob Tattersal, a very experienced and successful value investor. I was excited to learn that Bob was actually going to reveal his technique for finding "deep value" in securities. Then Bob said something which revealed his tremendous insight of human behaviour. Bob said, "I don't mind showing you these techniques because quite frankly, most if not all of you are not going to be able to follow my advice". Wow, that really hit me!
Bob knew that many people would go to other careers and would not have the time to diligently apply his methods if it wasn't their main job. He also knew that many others would obtain jobs in companies that would not have a value mandate. For those of us who would go on to work in a value shop, Bob also realized that many of those firms might eventually cave to client pressures when times got rough and eventually veer away from value investing. Even of the remaining few students that were deeply devoted to value investing and willing and able to follow its principles, he knew that even those people would likely not have the internal fortitude and discipline to stay the course. Basically, Bob knew that there were not many people in that classroom that would be able to stick it out as value investors and apply his methods.
Is it easy being a value investor? I think not. Its especially difficult to be a true value investor in a rapidly declining market like the one we are currently experiencing. In this kind of a market, value investors and their clients, have to be prepared to look silly in the short term. Buffett has said that in the short term, he has no idea what the stock markets will do, but in the long term, a company's share price will track remarkably well to the underlying economics of a business.
Warren Buffett also recognizes the difficulty in acquiring the requisite discipline to be a value investor. While Buffett was working for Graham, he learned the hard way the value of being selective and disciplined. In the book "The Warren Buffet Way", Buffett is quoted as saying he became frustrated when Graham shot down idea after idea that Warren presented to him. However, Warren acknowledges that he has benefited tremendously from his acquired discipline to buy only the best ideas. Buffet commented that Graham would only buy when he had all the factors working in his favor. That was an important lesson for Buffett to learn.
What does the most successful investor of all time advise us to do today? Warren Buffett advises us to invest in equities. He counsels that we can't just invest when we feel comfortable doing so and still hope to be successful investors. In this article, released last month, Buffett reveals that he feels now is the time to be buying equities.
As value investors we have to capitalize on the opportunities that Mr. Market offers us and often that means doing something different than the crowd is doing.
Conrad Black owned a controlling stake and was Chairman and CEO of Hollinger International (now known as Sun-Times Media Group (SUTM)), which owns several newspapers throughout the United States including the Chicago Sun-Times. Last year, he was convicted of fraud and sentenced to 6.5 years in prison.
In a recent twist, he's decided to apply for a Presidential Pardon. The US President can pardon or commute the sentence of anyone convicted of a federal crime. (Outside of death penalty cases, does the country really benefit from the existence of this executive pardon privilege accorded to the President?) The incredible part in this story, however, is that the company Black stole from has to foot his legal bills, including those for this pardon attempt! Here's a line from the annual report of Sun-Times Media:
"In connection with future legal bills, the Company agreed to advance 75% of the legal fees of attorneys representing Black."
Needless to say, this company does not appear to be worth investing in.
Have you been convicted of a federal crime? Perhaps you'd like to fill out the Presidential Pardon application forms. Feel free to forward all legal bills to your employer...see what happens!
Thursday, November 20, 2008
In Aug 1989, Berkshire Hathaway invested $358 million in convertible preferred shares of USAir Group. These shares paid a yield of 9.25% and could be converted into USAir Group's common shares at a price of $60 per share. When Berkshire made the investment, the USAir common shares were trading at $50 per share. If Berkshire did not convert into common shares, USAir Group would have to redeem the convertible preferred shares within ten years.
USAir Group was earning 14% return on equity from 1981 to 1988 and seemed to have good business economics working in its favor during this time period. Warren was optimistic but not certain about the future economics of USAir and so he structured the investment in convertible preferred shares to give added downside protection to Berkshire's investment but also provide the opportunity to participate in upside of the company if things went well. Buffet wrote that because of his lack of a strong conviction about the airline business, he structured the investment differently compared to when he buys into a company where he is convinced it will continue to enjoy great economics.
As it turned out, the airline business is one of the worst businesses to invest in. The airline companies started to compete viciously on price in order to boost market share. Bankrupt airlines were selling tickets at less than cost. Airlines were hampered by large fixed costs and overcapacity and this led to one of the worst years on record for the industry in 1991.
Buffett commented that "the problem in a commodity business like the airlines, is that you are only as smart as your dumbest competitor". Healthy airlines were suffering from the unprofitable practices of airlines that were going out of business. Buffett commented that he was very surprised to observe just how cutthroat airline executives were behaving at that time and how that exacerbated the industry's problems.
Overall, Buffett acknowledges that the investment in USAir was not a good one. He structures deals as preferred convertible shares to provide added capital protection when he feels it is necessary. However, even with the downside protection, Buffett is making the investment for the upside, and so if Berkshire doesn't get the chance to convert convertible preferred shares into common shares, the overall investment will be considered poor. The yield on a preferred convertible share like USAir group was 9.25%, which was far below the average return on investment for Berkshire Hathaway at that time.
The only good news right now in the chart above is that by definition the confidence level cannot go below zero. But is consumer confidence even important? Maybe people say one thing about their purchase intentions, but change their minds soon after and end up doing another? After all, unlike unemployment statistics or GDP numbers, no money is changing or has changed hands at the time of measurement.
However, we do see strong correlations between consumer confidence and purchases. For example, last week we discussed LCA-Vision (LCAV) as a possible investment. We saw that its stock price had been crushed, but that it had negative debt and could therefore outlast the downturn. But we wondered if it had a secular problem as historical demand in its industry was as follows:
After all, 2001 numbers are higher than those from each of 2005 - 2007. From a different perspective, however, this may not be a secular issue, but rather a strong correlation between demand for this product and consumer confidence. If you compare this chart with the one above, there appears to be a strong correlation.
Consumer confidence levels can sometimes be useful in gauging whether demand for a company's products is down for reasons it can't control. Finding those with low debt that can outlast the low confidence levels offer the opportunity for great returns off of current stock prices.
Wednesday, November 19, 2008
The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.
Convertible issues are those which allow the investor to convert the share/bond into something else. For example, a convertible bond that allows you to convert to common shares gives you the benefit of consistent bond coupon payments, with the upside potential derived from common stocks if the share price takes off. The downside is that you pay for the option to convert, through a lower yield or subordinate position to non-convertible issues.
Graham looks at the historical performance of convertible preferred shares to show that they tend to perform worse than the general market except during upsurges. Graham warns that the addition of a conversion privilege often shows an absence of genuine investment quality. Thus, conversion privileges may be added as sweeteners.
An additional problem with conversion rights is the decision of when to convert. It is difficult for an investor to convert and then watch as the price continues upward, and may lead to less prudent behaviour in the future.
The key point here is that convertible securities should be considered with greater scrutiny than regular securities. In doing so, you are looking for something with strong security, exchangeable for common stock which is attractive in its own right and convertible for a price only slightly higher than it currently trades at.
Convertible securities are also important to the intelligent investor in the analysis stage - it is important to consider the effect of these securities when calculating earnings per share, by “diluting” the figure as if all the convertible securities would indeed by converted. This dilutes the earnings available for the common shareholder, and so it affects the value the intelligent investor places on that common share.
LoJack sells tracking units that help its customers locate stolen or lost mobile assets. It has integrated its systems with law enforcement agencies, has several regional networks in place (to detect stolen assets once a unit has been reported stolen), and uses its FCC licensed radio frequency and proprietary technology that can find assets that are hidden from view (unlike GPS systems), all of which make it difficult for competitors to replicate their business.
But how does it match up to the criteria we laid out for long-term investments in this area? First of all, it's financing structure should allow it to last through this downturn. Its cash balance of $66 million is much higher than its total debt of $27 million. Furthermore, it has remained cash flow positive through even the last quarter (though it does show negative earnings due to a writedown of Goodwill).
Second, it is not dependent on any one car manufacturer. LoJack unit purchase decisions are made by individuals purchasing vehicles regardless of maker, and by insurance companies looking to reduce losses due to theft.
Finally, could LoJack be in a secular downturn rather than just a cyclical one? This would seem unlikely. International sales were up 40% last quarter as LoJack enters new markets, which made up for the drop in domestic demand which occurred due to the slower pace of new vehicle sales. LoJack is also diversifying from its reliance on vehicles, as it recently obtained approval to use its technology for use on construction equipment (for which it has already begun to produce revenue) as well as for persons with cognitive disabilities (for which it expects to have a product out in 2009/2010). It also currently has a "LoJack for Laptops" program and has also recently made its product available for motorcycles.
But is the stock cheap? LoJack's EPS has averaged just under $1 for the last four years, while its current stock price sits at just under $5. For a company with more cash than debt, good revenue growth prospects, and a few factors which make it difficult for competitors to copy, its stock price would seem to be trading at a large discount to its intrinsic value.
Tuesday, November 18, 2008
In 1987, prior to the stock market crash, Buffett had purchased $700 million worth of Salomon convertible preferred shares. The deal was requested by the CEO of Salomon, to help prevent a takeover of the company. Buffett knew the CEO of Salomon, John Gutfreund (from GEICO) and respected him as a person with integrity who put clients interests first. Buffett and Gutfreund were able to quickly craft the deal for Berkshire to buy the newly issued Salomon convertible preferred shares.
The reason Buffett purchased convertible preferred shares rather than common shares was that he wasn't confident what the the future cash flows of the business would be. However, he was still reasonably sure that Salomon would earn a good return on equity over time.
The Salomon convertible preferred shares paid a yield of 9%, were convertible to common shares at a price of $38 per share within 3 years, were redeemable by the company within 5 years starting in 1995 and were issued at a premium of 15% to the price of the common shares.
In the stock market crash of 1987, the common shares of Salomon sank in half. The common shares eventually recovered but in Aug 1991, the company announced that they had violated U.S. Treasury rules. After the announcement of this violation, the common shares fell to a price of $16 per share. Buffett stepped in as the interim chairman of Salomon to help the company through the crisis. After putting in place controls and a new management team, the company's share price rose to $47 per share by Dec 1993.
In 1994, Buffett purchased 5.5 million common shares of Salomon and Berkshire still held the preferred shares at that time. It is surmised that Buffett made the common share purchase because he was much more confident about the company's prospects after being the interim chairman and was able to put in cost controls and a new management team.
Buffett acknowledges that the value of the preferred convertible shares that Berkshire purchased came mostly from the fixed income aspect of those securities as opposed to the convertibility aspect.
Disney has strong, well-recognized brands, has great margins, and has a P/E under 10. Its stock has dropped from about $35 just a few months ago to its current price under $20! As a result, it has undoubtedly popped up on the radar screen for a few value investors with long-term outlooks.
A quick look at its balance sheet reveals equity of $32 billion and debt of $15 billion. Since nobody knows how long this (or any) downturn will last, a conservative capital structure is essential. In the near-term, people will cut down on their trips to Disneyland, and businesses will cut their advertising budgets for Disney's television stations. As such, it's of utmost importance that a company have manageable debt loads if it is to qualify as a long-term investment.
Digging a little deeper, however, reveals that Disney has agreed to purchase various non-cancelable broadcasting rights in order to bring its viewers action from the NFL, NBA, NASCAR and other sporting events. Capitalizing these obligations results in more than doubling the debt of $15 billion on the balance sheet to $37 billion! The D/E ratio changes from 46% to 115%!
But is this really how we should be treating these broadcast agreements, the same as how we treat debt? Absolutely. If Disney had "bought" these rights upfront, they would qualify as assets, and whatever they borrowed to pay for these would qualify as debt on the balance sheet. Just because the various sports leagues have agreed to effectively fully finance these rights does not change economic reality.
Furthermore, the debt we've just added on represents very real risk. If viewership goes down, or advertisers cut their spend, Disney would not make as much off of those games, but they would still owe every part of that debt. This is akin to a company buying a hard asset financed with debt, and not being able to generate the returns off that asset to cover the debts.
That's not to say Disney should be discarded. So far this year it has shown an ability to weather the storm. Furthermore, last recession it also managed to stay profitable. It is diversified across many segments and has strong margins which shows it owns differentiated products. However, investors must recognize that for all companies they consider, it is essential that they recognize all of a company's debts before proceeding with an investment.
Monday, November 17, 2008
Since convertible preferred shares can be redeemed into common shares, if the common shares price rises, then the convertible preferred shares price will also rise. If the common shares price falls, the higher yields on the convertible preferred shares will reduce the extent of preferred shares price decline. A theoretical price floor for the convertible preferred shares, would be the price at which its yield would approach that of a similar nonconvertible bond.
Buffett has invested in quite a few convertible preferred shares of various companies. In the next few posts we will examine Buffett's investments in the convertible preferred shares of Salomon, Champion International, USAir and American Express.
Every quarter, Berkshire is required to file a form (titled 13F) detailing its holdings. Three days ago, Berkshire filed its 13F for the quarter ended September 30th. You can access this form as follows:
1) Go the Edgar page for Berkshire Hathaway filings
2) In the "Form Type" search box, type "13F" (without the quotes)
3) Open the 13F-HR filings and scroll to the holdings section
This process isn't unique to Berkshire; you can use it to track any "institutional money managers" of US public companies that invest at least $100 million in securities. There are also sites out there (like gurufocus.com) that aggregate this data for several managers, and provide it in easy to read formats.
Keep in mind, however, that there is a time lag. Since the filing covers up to September 30th, we have no idea what Berkshire bought in October, even though this filing took place in November.
Sunday, November 16, 2008
In 1983, WPPSS was in default of $2.25 billion of municipal bonds. The state had made a ruling that the local power authorities did not have to pay WPPSS for power they had previously committed to purchase. The money raised from these in-default bonds was supposed to be used to complete the construction of two nuclear power plants. The construction of the power plants was in jeopardy due to the state ruling. At the time, this was the largest municipal bond default in US history.
WPPSS had other issued other municipal bonds which were used to fund entirely different projects. However, the value of all WPPSS bonds were marked down pessimistically in the marketpalce, even those bonds that were not directly tied to the financing of the construction of the nuclear power stations. Buffett evaluated the risks of other WPPSS municipal bonds, specifically those for projects 1, 2 and 3, which were tied to existing operational projects and were direct obligations of the government agency, Bonneville Power Administration. When the WPPSS bonds for the nuclear project defaulted, WPPSS project 1,2 and 3 bonds declined significantly and were yielding a tax-free return of 15-17 percent.
Through Berkshire Hathaway, Buffett purchased $139 million of WPPSS projects 1, 2 and 3 bonds, when their face value was $205 million. From a business point of view, the $139 investment would produce an after tax cash payment of $22.7 million. Buffett explained, that there were very few investments available at that time that were selling at a discount to book value and able to produce such a high, unleveraged, after-tax rate of earnings. These bonds ended up doubling in value while paying Berkshire a tax-free high rate of return on capital.
This is an example of a "fallen angel" Buffett bond purchase.
If your fund charges an upfront commission or sales charge, keep in mind that the managers will spend a lot of marketing resources trying to sell the fund to new and old investors, since this is how they get paid. In addition, or instead, funds may also charge you a commission when you redeem your investment. This suggests that your fund has a longer-term focus, as they don't want to be subject to high churn rates.
While those two fees are not charged by all funds, all funds will charge annual expenses, usually as a percentage of the money you have invested. You can see a breakdown of this fee in your fund's prospectus. Some of this will be a distribution fee (again, this rewards the salespeople who sold it to you), a management fee (to attract and retain professional managers), and other expenses.
It's difficult to judge mutual funds on their performances alone, since past performances are not necessarily predictive of the future. By understanding a fund's fee structure, you can get a better idea of where your fund focuses its resources.
Saturday, November 15, 2008
High-yield bonds were introduced as a financial product innovation in the 1980's. Buffett makes an important distinction between "fallen angel" bonds and high-yield "junk" bonds. According to Buffett, "fallen angel bonds are investment grade bonds that have fallen on bad times whereas the new high-yield bonds, were junk before they were issued".
Wall Street salespeople were able to sell the new high-yield bonds based on historical research that showed that higher bond yields compensated investors for the accepting the higher investment risk. Buffett warned investors that the yield history that salespersons were quoting was for fallen angel bonds and is an entirely different situation than what is being inferred for the junk bonds.
There was a lot of junk bonds being sold in the 1980's. Buffett observed that "mountains of junk bonds were being sold by those who didn't care to those who didn't think". Problems started cropping up in the later 1980's with firms that were financed using junk bonds. Companies started defaulting on their bonds and by 1989, junk bonds were largely out of favor in the market.
As the junk bond market unravelled, Buffett noticed that RJR Nabisco's bonds were declining with others in the market. Unlike many other companies that had issued high yield bonds at the time, RJR Nabisco was meeting its financial obligations. Buffett thought that RJR's bonds were being overly punished in the markets. RJR was selling parts of its business and was successfully lowering its debt-to-capital ratio, thereby reducing its financial risk.
Berkshire bought $440 million worth of discounted RJR bonds in 1989 to 1990. In early 1991, RJR Nabisco announced it was retiring its high-yield bonds and Berkshire turned a profit of $150 million on the investment.
However, this is not to suggest any purchase in this sector will do. There are a few criteria to consider which will determine whether a stock qualifies as a low-risk, long-term investment.
First of all, one needs to make sure the company being considered is not overly reliant on debt financing. A cyclical downturn such as this will wipe out companies with high debt loads, as these companies will be unable make payments when demand is at abnormally low levels. For example, when we looked at a 2004 chart of GM and Ford's debt levels, we saw clear signs of their now widely accepted solvency issues.
Another important requirement for a worthy long term investment in this sector is that it should not be reliant on a few concentrated customers. A company's risk is much higher if it is too dependent on just a few companies. For example, while Linamar (LNR) is a well run parts manufacturer, its four largest customers account for almost 50% of its sales, which makes it susceptible to its top customers' problems, not just its own. The companies with the least risk are those that will make sales no matter who the market share leader is, whether it's Toyota or Tata.
Finally, it's important to consider whether the company's product is undergoing a secular downturn that is masked as a cyclical one. For example, companies manufacturing engines without hybrid technologies may never recover from this downturn, as the world becomes more sensitive to energy prices and environmental issues.
Know any companies in this industry that get a passing grade in all of the above criteria? Let us know, and we'll try to discuss them in our next rendition of The Mailbag.
Friday, November 14, 2008
In general, Buffett considers bonds to be mediocre investments. Buffett understands that in an inflationary scenario, the purchasing power of money declines. With confidence on the stability of a currency, Buffett would become more interested in bonds. Buffett also views bonds from a "business-persons perspective". Most fixed-income returns are set below the returns that Buffett expects as a businessperson.
Buffett knows that the long-term average return on equity for American businesses is 12 percent. If an investment was made in a business that reliably earned 12 percent on equity and the company retained all of its earnings, an initial $10 million investment would be worth $300 million in 30 years. Therefore, in order to earn a businesslike return from a yield paying bond, the bond would have to pay a 12% yield and all coupons paid out would also need to be reinvested at 12%. Comparing the expected returns on investments between bonds and businesses is prudent in making a choice on where to invest.
Its noteworthy that Berkshire has historically held a much smaller percentage of fixed-income securities compared to other insurance companies. In 1993, Berkshire held only 17% of their investment portfolio in fixed-income securities compared to the 60%-80% that most of their insurance peers held in fixed-income securities.
But as we know, Wall Street is far too concerned with current earnings. As such, cyclical drops in demand allow those with long-term horizons to pick up companies at a bargain. But while the economy will pick up eventually, it's impossible to know when. As such, one of the most important things to look for with a company like this is its ability to survive a recession. In LCAV's case, it has a quick ratio of 2.2 (meaning payments coming due in the next year should not be a problem) and it has more cash than all of its debt (including short-term debt, long-term debt, and capitalized operating leases).
Its chief public competitor, TLC Vision (TLCV), is currently selling assets and reducing exposure to the volatile (from a demand point of view) laser eye surgery (40% of its business comes from other medical services) as it wrestles with a quick ratio well below 1, and a debt/capital ratio of 80%. Over the years, LCAV has handsomely outperformed TLCV in pretty much every profitability category.
For those who look at buying stocks for the long-term and like to buy when others are fearful, LCAV looks undervalued, and is in a financial position to wait out this downturn. While 2008 net income will likely be close to zero, for the previous four years net income has averaged $29 million a year, while the current market cap for the stock is just $67 million.
Thursday, November 13, 2008
The Government Employees Insurance Company Corporation (Geico Corp.), is engaged through its affiliates, in the multiple line property and casualty insurance business. The company was founded in 1936 by Leo Goodwin, an insurance accountant. Leo had the idea to market insurance directly to customers. By doing so, Geico could save between 15% to 25% per collected insurance premium dollar by eliminating the need for a conventional insurance sales force. Geico could then pass on the savings to its customers and become the low cost provider of insurance policies. Leo also had the idea to insure only government employees, since statistically speaking, they were less risky policy holders to insure.
Geico was quite successful for a number of years, but they lost their way starting in the late 1960s. During that time, Geico had pushed ahead to expand their business and started writing money losing insurance policies to higher claim risk customers. There problems seemed to start as they moved away from their successful business model.
Buffett started buying shares in Geico in 1976, when the company was close to bankruptcy. At that time, a new manager, John Byrne took over at Geico. His plan to rescue the company included focusing on their previously successful business model, raising capital and cutting costs. He named the rescue plan, "Operation Bootstrap".
Its curious that Buffett invested in Geico in 1976, since he is not a strong in corporate turnarounds and typically does not invest in commodity businesses. However, Buffett commented that even in 1976, "the Geico franchise was still intact". Buffett said that the company was still the low cost provider of insurance and that even a commodity business can make a lot of money, provided they are the low cost producer. Buffett felt that since the business model was still direct to customers, Geico could improve their profitability by increasing premiums, cutting costs and only insuring low claim risk customers. That is precisely what happened under the leadership of John Byrne.
John Byrne led Geico to a dramatic recovery, largely due to his cost cutting discipline and willingness to forgo growth for profitability. As Geico adjusted the pricing on policies, they lost 1.3 million policy holders (almost half their total number of policy holders at the time). However, within one year, Byrne's actions led to restored profitability at Geico.
Starting in 1976, Berkshire Hathaway purchased a 33% stake in Geico for an average price of $6.67 per share. Buffett had purchased both common stock and preferred convertibles that were later converted into common shares. In 1980, just 4 years later, Berskhire's $47 million investment in Geico was worth $105 million.
Since 1982, Geico's return on equity has averaged 21.2%, which is roughly twice the industry's average. From 1980 to 1992, every dollar retained by Geico resulted in $3.12 of market value. From 1980 to 1992, not including the impact of dividends, Geico's share price has risen at a compounded annual rate of 29.2%.
Disclosure of the salary, bonuses and compensation structure of the five top executives are an SEC requirement for all public companies in each company's annual proxy statement. As an investor, you can find this info for any US stock you own as follows:
1) Go to the EDGAR Company Search page
2) Enter the ticker symbol of your company and hit 'Find Companies'
3) Search for the latest filing called "DEF 14A"(this is the annual proxy statement)
4) Open that file, for all sorts of goodies about executive compensation
In there, you'll also find a discussion about how the pay/bonus and compensation structure was determined, including some company peer groups that were used as comparisons by the Compensation Committee.
Wednesday, November 12, 2008
(note: subsequent to Hagstrom's publishing of this book, Cap cities merged with Disney).
Starting in the 1960's (and for the next 30 years), Tom Murphy and Dan Burke were responsible for running Capital Cities. They were widely considered the best managers in the media business at the time. In particular, Murphy was known as a hands-off manager who hired the best and brightest people and generally let them run things the way they saw fit. However, Murphy would not hesitate to get involved if he saw costs rise. Murphy's ability to increase the cash flows of acquired businesses by cutting costs was well known in the industry.
Warren bought Berkshire's stake in the company while he was helping Tom Murphy do a merger deal between Capital Cities and ABC. To prevent from getting acquired post merger, Tom Murphy was looking for the right type of investor to help capitalize the deal to acquire ABC. Tom already had a good relationship with Warren Buffett and asked him to participate in the deal. Interestingly, Tom had asked Warren to be a director of Capital Cities some 15 years earlier, but Warren had declined. However, when Warren was asked again by Tom Murphy to become a director at Capital Cities during the ABC deal, Warren finally agreed.
Warren agreed to purchase three million newly issued shares (before the merger announcement) at a price of $172.50/share. In 1985, at the time of the deal, Capital Cities was averaging around 19 percent return on equity and had a 20 percent debt to capital ratio. In order to have had a margin of safety on the purchase price of $172.5/sh of Capital Cities, Warren likely had to believe that Tom Murphy would once again be able to increase cash flows by reducing expenses. Buffett is quoted as having said "I doubt if Ben's up there applauding me on this one".
Two important factors in Buffett's decision to purchase Capital Cities included 1) the competence and shareholder conscious attitude of Tom Murphy and Dan Burke, and 2) the healthy operating profits and ability to grow cash flows without a need for capital investment in excess of normal depreciation rates.
During 1985 to 1992, one dollar of retained earnings at Cap Cities/ABC resulted in the creation of $2.01 of market share. The market value of the company rose from $2.9 billion in 1985 to $8.4 billion in 1992.
Although it's rare, sometimes management will even comment directly on the company's stock price. For example, here's an assertion from Office Depot CEO Steve Odland on the quarterly conference call which took place about two weeks ago:
“The stock price doesn’t make any sense. We could monetize any part of our business. We could sell the North American Retail business. We could sell the North American Business Solutions. We could sell country by country. We could package the whole thing. All of these things clearly have been discussed at least on our level and have not gone unnoticed. What we are setting out to try to do is to assure and inform everybody of our liquidity situation. You would have to believe that in order to justify the stock price that we have today, you would have to believe that we were at the end of our liquidity, which is simply untrue.” Office Depot (ODP) has been profitable throughout the last several years (including through the last recession), but is having a tough year this year (although still positive so far). As a result, it's stock has dropped from over $30 to $2 in the last year. To put some perspective on that stock price, Office Depot's EPS over the last four years has averaged over $1.35 per year!
Of course, listening to management's thoughts cannot replace your own analysis. Many managements simply discuss the glass half full scenario without publicizing the risks. As an example, here's what management of Lehman Brothers had to say on their last conference call:
"We believe that the Lehman of early 2009 will be a significantly de-risked financial institution. I will now provide an update on our liquidity position, which remains very strong. We maintained our cash capital surplus at $15 billion at the end of the third quarter. Our liquidity pool also remains strong at $42 billion, versus a record $45 billion at May 31st."
We all know how that turned out!
Tuesday, November 11, 2008
The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.
Graham begins with a caveat: It is easy to achieve average returns (just invest in an index fund), and extremely difficult to beat the average with any consistency. Just look at the history of different funds and you will see that most funds, even those with the best security analysts and research departments, failed to beat the market as a whole with any consistency.
“random portfolios of NYSE stocks with equal investment in each stock performed on average better than mutual funds in the same risk class”
So, you’ve been warned.
Graham’s starts by making a list of stocks that, on their face, appear to be cheap based on their P/E (remember to use average historical earnings) and Price to Net (Tangible) Asset Value. This list is easily generated today using a stock screener, like the Google Finance Stock Screener.
Then, apply additional criteria from the list in previous chapters:
- Financial Condition (Current ratio of at least 1.5 and debt not more than 110% of net current assets),
- Earnings Stability (No deficit in past 10 years),
- Dividend Record,
- Earnings Growth,
- Price <>
Once you apply these additional criteria, your list of potential candidates will be severely reduced. At this point, you should research the remaining candidates further by reviewing their annual statements and proxy disclosures.
Graham warns against secondary issues - that is, smaller companies in any given industry. Without significant size, these companies lack momentum when the market turns sour and are the first to suffer large price declines. Graham suggests you avoid these in making up your portfolio unless they are bargains sufficient to create wide margins of safety.
Remember: being a bargain issue that satisfies all of the tests is not sufficient to make a good investment. You NEED a portfolio that diversifies away most of your risk.
Zweig suggests enterprising investors start by practicing with hypothetical portfolios of all of their trades, for one year, before investing money. This has clear advantages over jumping in (head-first?) without proving yourself to be a competent stock picker. If, after one year, you enjoyed yourself and earned good returns, then gradually add a small portion of your total portfolio comprised solely of individual stocks you have picked. Over time, increase this portion according to your own success.
Two things successful investing professionals share in common: They are disciplined and consistent, even when their approach falls out of favour with Wall Street; and they focus on what they do, rather than what the market is doing.
At times like these, the current consensus amongst many investors is to find safety in large, predictable cash churning businesses. It also helps that prices have come way down, enough for the small investors to take the opportunity to solidify and anchor their portfolios with these blue chips and make it their permanent holdings. I admit, this is an excellent, fantastic, brilliant, stunning strategy. But... I haven't been following it and don't intend to. Stupid huh?
The point I would like to bring up is this: it feels like there is too much of an emphasis on this of late and people are forgetting about the disciplines and strategies of investing in other smaller opportunities and deep value plays.
Looking around, I see companies that are being sold for less than their assets or even their cash. An example is Perini Corporation (PCR) which had a market cap, until recently, of less than it's pure cash holdings. Obviously, some digging should be done, but this could be just one of the many potential gems once Wall Street overcomes its fear. A blog that looks for such opportunities is Stock Pursuit and is recommended for people like me who go around the SEC with a metal detector.
With the recent course of events, the playing field has certainly changed. It's even trickier to decipher a company's future. Many companies big and small have and will fail but there are also many that will survive. It's also even more important to make sure you know the company, check it has a strong balance sheet and management that is capable and experienced even in downturns, such as K-Tron (KTII).
You've heard it before, an investor creates wealth by seeing and thinking about things others don't. While everyone is clamoring to get on board the Wal-Mart express, don't throw away that SCHN ticket just yet.
Disclosure: The author owns KTII at the time of this post.
Monday, November 10, 2008
Coca-Cola's business is easily understood. The company takes in raw materials such as water and sugar (among other ingredients) and produces drink concentrate, soft drink syrups and carbonated beverages. The company has a long track record of dominant market presence as well as profitability. The Coca-Cola company sold their first soft drink product in the United States in 1886. The company has an incredibly strong brand name with an impressive worldwide distribution network.
Leadership of Coca-Cola was generally considered to be of poor quality during the 1970's. During this period, management made several questionable investments using shareholders' retained earnings. The questionable investments were made in projects with slim profit margins and included ventures such as investing in a shrimp farm. Despite the lack of effective management, the company was still profitable.
However, in the 1980's, there was a change of leadership with Roberto Goizueta and Donald Keough, both of whom brought in dramatic positive change at the company. They focused on improving the company's operating performance (cost-cutting was one aspect) and on improving shareholder returns. The effectiveness of this management team did not go unnoticed by Warren Buffett.
Under the new leadership, there was a renewed focus on investing in the core business, optimizing returns on equity and empowering management to be proactive rather than reactionary. In 1980, the return on equity of the company was around 20%. In 1988, under the new leadership, Coca-Cola's return on equity had increased dramatically to 31.8%. From 1980 to 1988, $1 of retained earnings resulted in the creation of $4.66 of market share.
The renewed core operating focus at Coca-Cola resulted in significant growth of net cash flow. The cash flow was put to use by initiating the first ever stock buyback program in 1984, increasing shareholder dividends and reinvesting in the business. Since 1984, the company has bought back 25% of their shares.
In 1988, the time when Buffett made his investment in Coca-Cola, the company had a price to earning ratio of 15 times and a price to book ratio of 5 times. On the surface, this didn't seem to be a value play, but as Buffett has said, the value of a company has nothing to do with price and everything to do with what the expected future discounted cash flows will be during the life of the business.
In 1988, Coca-Cola produced owner earnings of $828 million at a time when the long term U.S treasury rate yield was around 9%. Coca-Cola grew owner earnings at a annual rate of 17.8% between 1981 to 1988.
Using the Coca-Cola's 1988 owner earnings, the 9% treasury yield as a cash flow discount and a growth assumption for owner earnings of 10% for 10 years followed by 5% thereafter, results in a value for the company of $32.5 billion. At the time Buffett purchased Coca-Cola in 1988, the market cap of the company was just $14.8 billion.
According to Buffett, "the best business to own, is one that over time can employ large amounts of capital at very high rates of return". This fits the description of the Coca-Cola Company.
For example, it took many years before officials finally caved and made stock option expensing mandatory. Managements, fearing that they would have to lower the number of options they receive or face huge drops in their reported profits, lobbied hard against the move. This quote is attributed to Harvey Golub, former Chairman and CEO of American Express:
"…while stock options have value to the executives, …, they cost the corporation nothing. They are never a cost to the company and, therefore, should never be recorded as a cost on the income statement."
If they are not a cost to the company, then a company that pays out no cash but instead pays suppliers, bills, and employees in options has operating profit margins of 100%! Obviously, this is a distortion of the company's true economic picture.
Though option expensing is now mandatory, I would argue that option accounting requirements have not gone far enough. Currently, balance sheets omit any indication of the value of outstanding options, but the outstanding options are very real obligations that should be subtracted from the shareholder's equity. Fortunately, within the notes to the financial statements, investors have what they need to make the adjustments themselves.
This was but one example of adjustments that need to be made to accounting statements in order for investors to make a more accurate determination of a company's intrinsic value. Many other examples exist, some of which are discussed on this page.
Sunday, November 9, 2008
The Washington Post is a media company owning television stations and interests in several other newspapers at the time Buffett made his first purchase in the company in 1973. Buffett felt that the Washington Post had favorable long term prospects. In 1984, he wrote that the economics of a dominant newspaper business are among the very best in the world.
Buffett had four years of hands-on-experience with the Omaha Sun newspaper, prior to owning any Washington Post shares. This experience taught him about the business dynamics of a newspaper company. Therefore, investing in the Washington Post fell within Warren's circle of competence.
The Washington Post had been reporting great operating performance numbers for years before Bufett made any purchase in the company. In 1973, the market value of the Washington Post was $80 million. Buffet wrote that most security analysts would have estimated the intrinsic worth of the company to be around $400 million to $500 million dollars. Buffett purchased around $10 million worth of the Washington Post's stock in 1973.
Buffett believed that the capital expenditures of a newspaper would equal the depreciation and amortization charges over time. Therefore, the Washington Post's owner earnings would simply be the sustainable net income for the company. Net income for the Washington Post was $13.3 million in 1973. Dividing this by the long-term U.S. government bond rate of 6.81% would result in a valuation or around $196 million for the company, more than double the market cap at the time. Further adjustments to reflect an improvement in operating margins back to the business cycle average and a 3% growth rate reflecting the ability raise real prices into the future, would result in an intrinsic value of the company closer to $485 million. Therefore, there was a suitable margin of safety when Warren made his first purchase in the Washington Post company.
The management at the Washington Post acted in a very shareholder friendly way. Warren was a company director and schooled key management on the value of acting in the shareholders best interests. Management bought back large quantities of the company's stock at low prices, reduced expenses and effectively confronted the relevant labour unions. In essence, management took the necessary actions to increase the value of the business.
At the time Buffett made the purchase in the Washington post, the return on equity for the company was around 15.7%. Within 5 years, the return on equity had more than doubled while company debt had been reduced. When Buffett made the purchase, the market value of the company was $80 million, in 1992, this figure had risen to $2.7 billion. For every dollar in retained earnings, $1.81 was created in market value over this period.
The Washington Post earned the status of a permanent holding of Berkshire Hathaway.
When you buy a mutual fund, the mutual fund manager issues you shares of the mutual fund and takes your cash investment. But now he has to keep the cash around, which drags the whole fund's return, or he has to incur transaction costs buying shares of the underlying index. The same thing happens when you redeem your shares; the manager has to keep cash around to return your money (which drags on returns) or he has to incur transaction costs by selling stock to provide you with cash.
The first ETF was a financial product innovation that started in Canada and has now spread through the world like wild fire due to its advantages. ETFs don't have to incur transaction costs or keep pools of cash around for when individuals buy and sell shares, because these shares are issued in large blocks and are traded in the secondary market (meaning when you buy/sell a share, you're buying/selling an existing share, which doesn't require the issuing/redemption of a new one).
Shares in large blocks can be issued or redeemed from time to time as needed, but most of the time they are in the hands of dealers who make money off the bid/ask spread of the ETF (like a regular stock). The dealers compete with each other for volume, however, so the bid/ask spreads are kept competitive for liquid ETFs (just like regular stocks). Unlike closed-end funds, however, which can trade at huge discounts or premiums to their underlying assets as we saw here, ETF shares can indeed be redeemed if there are arbitrage opportunities. For example, if the ETF trades at a discount to the underlying assets, traders can buy the ETF and redeem it for a profit, which results in ETFs trading fairly close to their Net Asset Values.
If you're an index investor who owns mutual funds, consider checking if an ETF exists that invests in the same index...you will likely increase your returns by almost 1% per year due to the management fee cost savings.
Saturday, November 8, 2008
Fisher taught Buffett that an investment is either better to hold than cash or it is not. It is instructive to note that Buffett is willing to hold onto investments provided that 1) the return on capital is sufficient 2) management is competent and 3) the stock market does not significantly overvalue the business.
Interestingly, Buffet has indicated that Berkshire does have four holdings that will never be sold. These permanent Berkshire holdings are the Washington Post, Geico, Capital Cities/ABC and Coca Cola. Buffett only indicated that these were permanent holdings many years after the initial investments were made.
(This chapter review will include four more sections. Each section will be devoted to reviewing the conditions that led to one of the initial Buffett investments in the Washington Post, Geico, Capital Cities/ABC and Coca Cola)
After all, value investors prefer to buy businesses that have proven themselves over the course of many businesses cycles. In such cases, one can more accurately predict a company's earnings power. If one can accurately predict the earnings power, one can be confident that after applying a margin of safety, one is getting a good deal.
For example, if Coca-Cola had been invented 10 years ago, perhaps value investors would be hesitant to buy stock...could it be a fad? might it have long-term health effects? But after many successful years, Coke qualifies for consideration, and value investors look for opportunities to buy it at a discount, as we saw when we looked at a graph of its historical P/E over time.
In the same way, we don't know the long-term implications for laser-corrected vision. The market for this surgery is also unknown. The surgeries have been accessible since the 1990s, but only really gained acceptance in the last decade. Here, a look at the total number of annual surgeries may be of assistance:
A few things stand out on this chart. First, we see it's a relatively new industry, with tremendous growth in the late 1990s. Second, we see how cyclical demand is (see the recession of 2002), and how its tied to economic growth. (Note that the 2008 number is an estimate from November 2007; the current 2008 estimate is likely much lower considering the state of the economy.) But we already knew these first two points.
Perhaps the most important thing we can see from this chart is the secular slowdown that appears to be occurring. Despite all the credit excesses, the run-up in housing prices, and higher confidence in this surgical procedure, at no point in the decade was the surgery more demanded than in the year 2000. Furthermore, surgeries actually dropped from 2005 onward, despite a strong economy.
This raises some questions. What is the market going forward? Did all the likely adopters already have the surgery, meaning the sustainable annual rate of surgeries going forward is much lower than the past cycle would indicate? What is the sustainable number of annual surgeries going forward?
These are tough questions to answer, but they do clarify why value investors prefer industries that are tried and tested, as there is far less uncertainty involved.