Category Archives: Investing Ideas

Does Google deserve a high multiple? (part 2)

This is the second part of an article entitled “Does Google deserve a high multiple?”.

The article is based on a blog post by venture capitalist Bill Gurley entitled “All Revenue Is Not Created Equal: The Keys To The 10X Revenue Club”. The blog post discusses ten business characteristics that drive the multiple at which a company trades.

My argument is that Google stacks up pretty well based on Gurley’s characteristics.

5. “Gross Margin Levels”

According to Gurley, “Lower gross margin companies will trade at highly discounted price/revenue multiples.”

Google enjoys high gross margins. As Google states in its annual report, its cost of revenues consists primarily of traffic acquisition costs. Google pays members of its AdSense program for displaying targeted ads on the members’ web sites. Google’s cost of revenues also includes the expense of operating its data centers.

Revenue: $21,796
Cost of revenue: $8,622
Margin: 60%

Revenue: $23,651
Cost of revenue: $8,844
Margin: 63%

Revenue: $29,321
Cost of revenue: $10,417
Margin: 64%

6. “Marginal Profitability Calculation”

In his blog post, Gurley actually uses Google as his example in explaining the idea of marginal profitability.

If a business is scaling nicely, you will see a gradual increase in marginal profitability as its fixed costs are spread out over a growing revenue base. Investors love this because it portends higher future cash flows.

Gurley points out that, in Google’s case, the recent data is not positive. Google’s marginal profitability for Q1, 2011 was lower than both Q1, 2010 and Q4, 2010. On its conference call, Google attributed the uptick in spending to an expansion in hiring to drive future growth.

On a longer-term basis, the picture is positive. According to Value LIne, Google had a net profit margin of 29% in 2010. In 2005, it was 24.7% and in 2002, the earliest year for which Value Line has data, it was 22.7%.

Google marginal profitability is something to watch. Google is fighting on numerous fronts – search, mobile, browser, local, enterprise, etc. These efforts require large numbers of engineers. An investment in Google is, in part, a bet that some of these efforts, particularly those outside of its core search business, will generate a good return.

7. “Customer Concentration”

A company has a problem if a large percentage of its revenue is controlled by a small number of powerful customers.

In 2007, the New York Times reported that Google had 1 million advertisers based on a regulatory filing with the SEC. That number is likely materially higher today.

Google’s business has no risk from customer concentration.

8. “Major Partner Dependencies”

Just as a business is at a disadvantage if it is dependent on a small numbers of powerful customers, a business is at a disadvantage if it depends on a major partner.

For example, Nokia’s recent decision to use Microsoft’s Windows Phone 7 on most future Nokia smart phones has certain built in risks because it creates a dependency on Microsoft. Going forward, although it will surely have input, Nokia will be dependent on what Microsoft decides to do with its OS and how it evolves.

Also, Microsoft’s OS will be available on smart phones from other phone manufacturers which will tend to commoditize Nokia’s offering.

Google has no such dependencies. Google goes out of its way to be self-reliant. For example, its data centers run on Google’s own software which give it cost and performance advantages.

9. “Organic Demand vs. Heavy Marketing Spend”

Some companies requires heavy marketing spending to grow and compete and some businesses grow because there is strong organic demand for their products or services. All else being equal, the latter are the better businesses because 1) they don’t need to spend a lot on marketing which leaves more free cash for shareholders and 2) it tells you something important about a business if the demand for what its does is so strong that it can grow virally through word of mouth.

Google has enjoyed organic growth and it did not require marketing to achieve its dominant position. Only now are we beginning to see some limited marketing spend to accelerate the adoption of Chrome, which Google is using to protect its advertising castle. (For more on this see “The Freight Train That Is Android”; more on Google’s moat…)

10. “Growth”

According to Gurley:

“Nothing contributes to a higher valuation multiple like good ole’ growth. Obviously, the faster you are growing, the larger, and larger future revenues and cash flows will be, which has direct implications for a DCF. High growth also implies that a company has tapped into a powerful new market opportunity, where customer demand is seemingly insatiable. As a result, there is typically a very strong correlation between growth and valuation multiples, including the price/revenue multiple.”

Google’s revenues and earnings have grown at an annual rate of 50% over the past five years. This rate of growth will not continue given Google’s size. Going forward, it’s simply starting from a too large a base.

As Buffett stated, “The investor of today does not profit from yesterday’s growth.” In Google’s case there is reason to believe that strong growth lies ahead. Google is benefiting from four huge secular waves.

  1. This first is the continued increase in Internet usage around the globe.
  2. The second is the ongoing increase in online advertiser spending.
  3. The third is the rise of mobile Internet usage. Cisco projects that global mobile data traffic will increase 26-fold between 2010 and 2015.
  4. The forth is the massive amount of new data that will continue to be placed on the Web. This will only accelerate as more and more devices are connected to the Internet.  This will benefit Google because it will make Google’s core search engine more valuable.

In conclusion, Google seems well positioned with regard to Gurley’s criteria. Investors will need to decide if these factors are already priced into the stock or if the current price undervalues Google’s future cash flows.


Does Google deserve a high multiple?

A few week’s ago, I wrote an article about venture capitalist Bill Gurley’s business traits which determine whether a company deserves a high-multiple valuation. As I wrote in the article, “The multiple at which a stock trades is nothing more than a shorthand proxy for its DCF.”

Here’s my take on how Internet juggernaut Google stacks up against Gurley’s criteria.

1. “Sustainable Competitive Advantage (Warren Buffett’s Moat)”

I just finished reading Steven Levey’s excellent book In The Plex: How Google Thinks, Works and Shapes Our Lives. The book is must reading if you are interested in Google. It was also recommended by Charlie Munger who thinks highly of Google’s moat.  I’ve written before on the strength of Google’s moat.

Google is the leader in search, and they work hard at keeping it that way.

Googlers continually measure the effectiveness of their search algorithm by analyzing whether it achieves a good outcome. Basically, they judge a search to be successful if a person quickly selects a link and “goes away”.  Multiple successive clicks indicate dissatisfaction.

Based on these observations, Google is constantly tweaking its algorithm and running hundreds of simultaneous tests on small but meaningful subsets of their users. If a tweak improves the outcome, it is rolled out and another baby alligator is added to the moat.

This Darwinian process makes it tough for someone to catch up and pass them.  In The Plex sheds light on the large number of significant search problems that Google has already solved. Cumulatively these comprise a strong moat.

That being said, a technology centric company like Google will always be more susceptible to disruption than an entrenched consumer product company such as Coke or Wrigley’s.

Google’s data centers are another source of competitive advantage. Google is in a unique position to deliver globally-synchronized data in real time at a cost that is materially lower than it’s competitors.

According to In The Plex, “By perfecting its software, owning its own fiber, and innovating in conservation techniques, Google was able to run its computers spending only a third of what its competitors paid.” (Levy, Steven (2011). In The Plex, p. 198) [emphasis added]

Is also worth mentioning that the Internet seems to favor companies that establish an entrenched position. Amazon, eBay, Google, and Facebook have all proven difficult to disrupt by their rivals.

2. “The Presence of Network Effects”

When a product or service enjoys a network effect, the utility of the product or service increases as the number of people using it increases.

Google benefits from a network effect.

The more people who use Google, the more data it has to improve its search results and related products such as Google Translate. This leads to happier users who are more likely to continue to use Google because they are increasingly likely to find what they’re looking for.

Advertisers benefit from this because the more people who use Google, the more likely it is that users will click through and purchase something. The more advertisers there are on the system, the more likely it is that Google can deliver a relevant add to a user when he or she does a search.

A Darwinian ranking system of multiple variables continuously ranks ads and rewards better ads with better placement, further reinforcing this virtuous circle.

3. “Visibility/Predictability Are Highly Valued”

In business there is a continuum between highly predictive sources of revenue – such as a subscription based service – and one-off, non-recurring lumpy revenue – such as a business that sells major construction projects and which can only expect to sell a few per year.

Obviously the former types of business will sell at higher multiples – all else being equal – because their revenue is more predicable.

Google enjoys highly predictable revenue because it operates as a kind of toll-booth on Internet advertising, and its revenue is derived from millions of individual advertising clients – none of which controls more than a tiny fraction of Google’s overall revenue.

Moreover, just like there is a hard limit on prime real estate such as beachfront property in Los Angeles county, there is a large, but limited number of key words that drive Internet commerce. Google controls the lions share of this “real estate” for these invaluable search words.

It should be noted that advertising revenue is tied to the general economy and as such is cyclical. Google did experience softening revenues in the latest recession although this was mitigated by the strong secular growth in both Internet usage and advertising.

4. “Customer Lock-in / High Switching Costs”

There is nothing that locks users and advertisers into using Google in the classic sense of switching costs. This may slowly change as more users adopt Google applications such as Docs and Gmail. Google’s + initiative, if successful, may also make Google’s offerings more sticky.

The real issue is that, if an advertiser leaves Google, where do they go?  Leaving Google means conceding visibility to your competitors for the 65% of Internet users who use Google in the U.S. and a much higher percentage in numerous other countries.

(to be continued in a second part)

Value Investors Club write-up values Berkshire Hathaway B shares at $125

A member of the Value Investors Club named Den1200 has valued Berkshire Hathaway B shares at $125.05 per share in his March 28, 2011 write-up of the company. I think his approach and logic are sound. (You can sign up for guest access to the Value Investors Club to see the actual write-up.)

The $125 valuation is over 60% higher than Berkshire’s current trading price of about $77.

Let’s walk through Den1200’s logic.

He starts with the fact that in Warren Buffett’s 2010 letter to shareholders, Buffett estimates Berskhire’s normalized pre-tax earnings power to be $17 billion. This figure does not include insurance cat losses as Berkshire has shown the ability to operate at a combined ratio of less than 100%. (In my judgment, there is reason to believe that Berkshire’s insurance operations will be net profitable over the long-term which would further add to Berkshire’s value.)

Den1200 then proceeds to use a two-track approach to value Berskhire which values the business as the sum of its investments – which includes equities, fixed income, cash, and cash equivalents – and capitalized non-insurance operating earnings. This is the general approach used by Buffett in multiple shareholder letters.

Non-Insurance Operating Earnings

After subtracting all Berkshire’s investment income, Den1200 calculates that the non-insurance operating businesses earn normalized earnings of $12.07 billion pre-tax. If you include Lubrizol’s earnings, Berkshire pre-tax operating earnings grow to $13.04 billion. That equates to $9.13 billion after tax, given Berkshire’s 30% tax rate. Lubrizol is being acquired by Berkshire and its earnings were not included in Buffett’s normalized earnings estimate.

Den1200 then assumes that Berkshire’s earning can conservatively grow at 5% and will be $9.88 billion by December 31, 2012. That equates to $4.00 per B share or $60 of intrinsic value if valued at 15 times earnings.

Buffett has traditionally hinted at a higher multiple when valuing Berkshire. Given the high-quality nature of Berkshire’s operating businesses, a market multiple seams reasonable.

Investment per Share

In addition to the non-insurance operating businesses, Berkshire has $155.86 billion in investments. Den1200 makes several adjustments to this figure. He first subtracts $5.56 billion to account for deferred taxes on the equity holdings. He then subtracts $9.7 billion to account for the cash used in the Lubrizol purchase and adds $1.06 billion for pre-payment penalties from Goldman Sachs, GE and Swiss Re related to redemptions.

These adjustments yield $141.65 billion in investments or $57.40 per B share.

Finally, he notes that this figure probably understates the intrinsic value of Berkshire’s large equity holdings as several may be undervalued, namely AXP, JNJ, KFT, Munich Re, POSCO, WMT, USB and notably WFC.

Berkshire’s Intrinsic Value

Den1200 then estimates that Berkshire will earn $18.90 billion or $7.65 per B share between the time of the write-up (March 28, 2011) and December 31, 2012.

Adding it all together, Deb1200 calculates that the intrinsic value of Berskhire will be $125.05 in December, 2012 ($60.00 for its capitalized operating earnings + $57.40 for its investments + $7.65 future earnings through Dec 2012). That figure is 60% higher than Berkshire’s current price.

Closing Thoughts

Berskhire’s derivative book has been a source of concern for several years now as investors have seen several companies blow up as a result of poor derivative bets. Den1200 argues that this level of risk is not likely present in Berkshire’s portfolio and calculates that even a major hit on those contracts would only equate to a relatively modest reduction in Berkshire’s intrinsic value.

Regarding Buffett’s eventual departure, Den1200 suggests that the negative case may already be baked into the stock; it’s hardly a secret that Buffett is 80. At the current price, if Buffett lives several more years – or even longer – his capital allocation decisions are available now as a free option.

Finally, Berkshire operates in a highly decentralized manner with highly skilled division CEO’s. Couple that with Berkshire’s strong culture and a talented board with plenty of skin in the game and it is not a stretch to conclude that Buffett’s departure will have little effect on day-to-day operations.

Long-term it is unreasonable to expect to find a capital allocator as good as Buffett. There was only one Michael Jordon. That doesn’t mean there are not very capable, talented players in the NBA today.

Charlie Munger on Google’s moat – it’s huge … probably widest he’s ever seen

Buffett has famously said that one useful way to think about a business’s moat – its durable competitive advantage – is to imagine that you had unlimited resources to attack it.  If you still could not topple it, you would have found a business with a solid moat.

In Google’s case, this isn’t a hypothetical.  Microsoft has spent billions of dollars in a determined effort to put a dent in Google’s moat.  So far, all they have to show for it is heavy losses and only modest market share.  It is believed that a large part of Bing’s market share has come at the expense of search engines other than Google. Microsoft was recently embarrassed when Google discovered that it was copying Google’s search results.

Charlie Munger had this to say about Google’s moat. “Google has a huge new moat. In fact I’ve probably never seen such a wide moat.”


It’s useful to think about Google’s moat the way you would think about the moat of a dominant city newspaper in the pre-Internet era.


For readers, the newspaper was the only game in town for keeping up with local news and an essential tool for buying a car, getting a job, learning about retail sales events, and an almost limitless number of niche activities.  Reading the paper was also quintessentially habit forming: pleasurable, repeated daily and low cost.

If you use the Internet, Google is a basic essential tool.  Its value lies in letting you navigate the Internet in a rational fashion, whether you’re looking to buy a new camera or need to know the capital of Uzbekistan.  This value grows as more information is placed on line – something that is happening at a dizzying pace – and as Google’s search algorithm improves.  Google is maniacally focused on improving its search engine and it benefits from having by far the largest number of searches to analyze and learn from.

It tells you something about a company when the company’s name becomes a verb that is synonymous with the underlying function it performs. Could you “xerox” that for me?  Google has this kind of mind share.

If you’re Bing, you can’t attack by lowering the price to customers. Google is free. At one point, Bing even tried paying people to search. There is no easy lever to disrupt the habit of going to Google each day to navigate the web.


If you were an advertiser – auto dealer, employer, department store, furniture store, pretty much any local business – you needed to advertise in the newspaper because you had to be in front of your customers and that was the only cost effective way to do it.  The newspaper set the rate and you paid it.  Period.

Google is a must-have outlet for advertisers given its 65% share of U.S. search.  Its share is much higher in many international markets.  Advertisers not only pay for advertising but also work hard to optimize their sites so they show up at the top of searches on important key words.  A recent tweak in Google’s search algorithm showed the lengths that companies will go to rise in the search rankings.  A company can see it’s sales materially reduced if it falls in the rankings.

Google’s advertising is superior to that of traditional media because it is targeted and the results can be quantified.  More value means happier advertisers.  That rates are set by auction helps mitigate accusations of monopolistic price gauging which were frequently heard in the “old days” from newspaper advertisers.

A dominant daily newspaper’s growth was constrained by the development of the local economy.  Google is not constrained by local geography and is riding two huge secular waves: the transfer of advertising dollars to the Internet and the ever increasing adoption and usage of the Internet.

Regulatory risks swirl around Google but the threat to its core search business seems remote. Because Google’s business is based on technology, there is a some risk of disruption from creative destruction.  However, Google is determined to stay ahead in search and it has plenty of cash to purchase start-ups with a better idea.

Recent price: 524.20

Cash per share: 113.00

Cash adjusted price: 411.20

2012 consensus EPS estimate: 39.91

2012 cash adjusted earnings yield: 9.7%


P&C insurance companies can build wealth for the patient

Property and casualty insurance companies which combine disciplined underwriting with solid investing can generate wealth. The good ones produce what has been called “structural alpha” because their float gives them low-cost – or no-cost – leverage. The best ones actually generate a profit on their float. Returns are typically lumpy because the insurance industry is inherently subject to episodic events which generate large numbers of claims.

A good point to get greedy is when they trade at or below book value. Another metric to track is the ratio of investments per share to the share price. For example, consider a case where you could buy a good P&C company at $100 per share that holds $300 per share in investments. If the company has a history of generating long-term investing results of 6% it implies an 18% return on your initial carrying cost.

Here are a few names to track taken from Fairfax Financial’s 2010 Annual Slide Presentation. These results include a very difficult time in the stock market. I have also included three additional slides which show Fairfax Financial’s long-term performance. Although much less known than Warren Buffett, Prem Watsa of Fairfax Financial – sometimes called “the Warren Buffett of Canada” – and Tom Gayner of Markel are worth studying. By way of disclosure, I am long Fairfax, Berskhire and Markel.

The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures. The data and information presented in this blog entry is believed to be accurate but should not be relied upon by the user for any purpose. Any and all liability for the content or any omissions, including any inaccuracies, errors or misstatements in such data is expressly disclaimed.

Citigroup Offers Attractive Risk-Reward Opportunity

I recently took a position in Citigroup (NYSE:C). I think the stock has the potential to double or triple over the next three to five years with relatively little risk of permanent loss of capital from current levels. The stock was hammered by bad judgment and poor risk management. Prior shareholders were massively diluted. The bank now appears to be moving past the crisis and is well-financed. Its new management is focused on capitalizing on Citi’s unique strengths.

The Business

Citi is well positioned to capitalize on globalization with its unique global franchise and assets in approximately 140 countries. Under Vikram Pandit’s leadership, the bank is focused on a core strategy of serving affluent, globally-oriented retail customers and multinational corporations. Citi already has a leading position in serving these markets and this strategy exploits Citi’s competitive advantages. This strategy gives Citi large exposure to faster growing markets in Latin America and Asia.


Vikram Pandit is a very smart, high-integrity CEO, who is driven to “right the ship” and put his mark on Citigroup. He was hand-picked by Robert Rubin, who, notwithstanding criticism for his prior role at Citi, has been around a lot of very talented people. Pandit had no part in Citi’s prior leadership regime that led to Citi’s near collapse. In addition, he has been characterized as being prudent with regard to risk, which is obviously an important trait in someone running a large bank. Finally, I like his strategy of focusing the bank on areas where Citi has competitive advantages and shedding non-strategic assets. Pandit is also on record as wanting to begin returning capital to shareholders in 2012.

What is the downside?

The first question to focus on with Citigroup is, “What is the downside?” How do you get comfortable with the Citigroup’s bad loans and what they mean to its intrinsic value?

In my judgment, although the company is still dealing with its credit problems, they have turned the corner, and over the next few years they will work through the bad loans and return to normalized earnings. I look at this as similar to Buffett’s investment in Well Fargo in 1989 and 1990 after the California real estate crisis.

To get comfortable with Wells Fargo, Buffett assumed a worse-case scenario where 10% of its loans would become problematic leading to eventual losses averaging 30% of principal. Buffett concluded that Wells Fargo’s annual pre-tax earnings power was sufficient to “roughly break even” in such a scenario. Buffett wrote that he was happy to invest in a company with Wells Fargo’s economics and valuation, even if he had to face the possibility that the company would generate no earnings for a single year.

Consider the mathematics of Citi’s situation. Citi currently has gross loans of $608 billion. If 15% of those loans were to go bad and all the principal were to be lost – a scenario far more draconian than that envisioned by Buffett (and arguably deservedly so) – it would be a loss of $97 billion. Citi has loan loss reserves of $41 billion, so the net loss would be $56 billion. Citi generated $38 billion of pre-provision, pre-tax income in 2010 so such a meltdown would amount to far less than two years of earnings. Citi’s actual loan loss reserves are less than 7% and it has slowly begun to release reserves as conditions improve.

Here is what Bruce Berkowitz said about getting comfortable with Citigroup in an interview with Morningstar.

In the U.S., this was not a bankruptcy, but it’s gone through a scrubbing process, very similar to a bankruptcy, by the U.S. Treasury. Citigroup has spent a good amount of time with the U.S. government and many of its financial regulators, going through every liability and asset in the books.

After such a period of time, you normally are able to count the cockroaches. That is, the liabilities have been under a microscope for quite a period of time. There’s been huge capital injections by the government. There’s been a massive amount of dilution to old shareholders. And you’re starting to see some stability, the beginnings.

It’s very much what I call now the pig in the python. You have to look at their liabilities. So you have to look at their bad debt, and you have to continue to watch how the company is digesting its bad debt.

At the same time, you have to see the new debt that’s coming in, the new loans that they’re giving out. It’s fascinating. It amazes me, with financial institutions, the extent, the amount of new loans that are being created in relation to the total loan portfolio.

So it’s just now, in my opinion, a question of time, an ingestion period, where how many more quarters is it going to take before the new loans start to outweigh the old, existing loans?


Like Buffett, I focus on earnings power when valuing a bank, as opposed to book value. The key driver in a bank’s earnings is normalized return on assets (ROA). Citigroup has a long history of strong returns on assets with normalized ROA. Moreover, Citigroup has reorganized and is now focused on growing its core, higher return franchises, and it is shedding its non-core assets. Pandit’s guidance is for a normalized ROA of 1.25% to 1.5% on Citigroup’s assets, not including the assets that are marked for eventual divestiture or run-off.

I think these levels represent Citi’s normalized earnings power.

In my base case, I assume Citigroup will grow assets at a CAGR of 3% over the next three years and reach a normalized ROA of 1.4%. This puts normalized EPS three years out at about $.80 a share. (This may prove conservative given Citi’s new asset mix and exposure to emerging markets.) At its current price of about $4.90 that is about six times normalized 2014 earnings. In addition, I estimate that the assets in Citi Holdings and Citi’s $21 billion operating deferred tax asset could be worth another two dollars a share, which would drop the multiple to less than four times earnings.

If ROA only reaches 1.2% and the other assets are only worth $1 per share, the current price is still only about 5 1/2 times 2014 earnings.

I believe the current price, strong reserves and liquidity, and the quality of the global franchise provide a margin of safety and that investors are being compensated for the risk involved.


Price moving above $5 per share (economically meaningless, but possibly important to some institutional buyers).  Citi’s institutional ownership is less than 50%, whereas Wells Fargo and US Bancorp’s are 76% and 67%, respectively.

Return of capital to shareholders in 2012

Continued improvement in operating results

Other Positives

Large positions held by high quality value-oriented funds: Pershing Square (Ackman), Fairholme (Berkowitz), Paulson, Appaloosa Management (Tepper), Viking Global Investors (Halvorsen), MFP Investors (Price), and Kingdom Holdings (Alwaleed).

The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures. The data and information presented in this blog entry is believed to be accurate but should not be relied upon by the user for any purpose. Any and all liability for the content or any omissions, including any inaccuracies, errors or misstatements in such data is expressly disclaimed.

Niall Ferguson: Where He Recommends Investing Given a Possible U.S. Debt Crisis

On Friday, August 20, 2010, I posted a link to a lecture given by Niall Ferguson, a Harvard historian who also teaches at the Harvard Business School, entitled “Fiscal Crises and Imperial Collapses: Historical Perspectives on Current Predicaments”. I chose to write about the lecture because during the Q&A, a questioner asked Ferguson what, “History tells us about how one invests their money in this kind of situation?” Before I get to Ferguson’s answer, I want to offer some brief perspective.

Those who follow value investing know that value investors are famous for not spending a lot of time on macroeconomics. The general view among value investors – at least going into the current crisis – is that the performance of the economy cannot be predicted with a useful level of certainty. Ample evidence exists to bolster this claim.

Investing is, after all, about predicting what will happen in the future. It makes sense to limit oneself to those few areas where it can actually be done.

One such area, which is generally focused on by Buffett in the Berkshire era, is to only invest in companies with clear durable competitive advantages, which lend themselves to long-range forecasting. The most obvious example of this approach is Buffett’s investment in Coke.

Another strategy is to invest in situations where predicting the future is unnecessary because the assets in which you invest are so compellingly valued that you are (nearly) assured of making money regardless of what happens in the future.

What is striking about Ferguson’s analysis about the current macroeconomic predicament is his conclusion about the seeming inevitability of the outcome. Picking up the argument, based on historical precedence, Ferguson argues that there are six ways out of the debt crisis facing the United States.

  1. Grow your way out.
  2. Lower interest rates on your borrowing.
  3. Get bailed out.
  4. Fiscal pain: Increase taxes and cut spending
  5. Print money (inflate your way out)
  6. Default

Ferguson quickly rules out the first three options. He is skeptical the U.S. can grow fast enough given its current burdens. Rates are already low and borrowing costs could spike if the market begins to focus on the growing risks of U.S. debt. No one is in a position to bail out the U.S.

Then, based on the lessons of history, he concludes that option 4 is highly unlikely (he could find only one example where it was successfully done) which leaves printing money and default. I recommend reading the lecture in its entirety to better follow Ferguson’s argument.

Now back to the investing question. As I previously indicated, Ferguson was asked how he would invest given his assessment.

He likes countries that are fiscally sound as evidenced by moderate debt-to-GDP ratios. He cited Canada and Norway as specific examples of countries where he would be long.

He is bullish on the future growth of both China and India, but he favors India given its rule of law, representative government and free speech. He is concerned about the sustainability of innovation and entrepreneurship in a controlled economy.

He is also concerned about the rising risks of holding paper currencies and said he should perhaps be valuing his portfolio in terms of barrels of oil or ounces of gold. He did not offer any specific recommendations for going long oil or gold.

Many hedge funds have been taking material positions in gold over the past year. See the blog for excellent coverage of these investments. Interestingly, the FPA Capital Fund, whose investment officer Bob Rodriguez is a highly regarded value investor with one of the best records over the past decade, has over a third of its capital in oil-related investments as of June 30, 2010 (24.38% Oil Field Services and 11.7% Oil & Gas Exploration).

Value investor Chuck Akre, whose 2nd Quarter 2010 letter I also posted on Friday and whose take on Ferguson’s analysis is worth reading, recommends investing in businesses with superior economics in light of possible U.S. debt crisis.

We do positively conclude therefore that the “best” safe place for the preservation and future enhancement of our accumulated capital is in operating businesses which have ‘pricing power.’ So we continue down that very path which we have been on for several decades, searching for the outstanding businesses that demonstrate high returns on capital, managed by folks with equal parts of skill and integrity, where the ‘reinvestment’ thinking and execution are way above average. It turns out that in 1975, and again in 2009, that those businesses which have these attributes continued to build real economic value throughout the market collapse, and recovered much of their “lost” value in a reasonable time frame. We continue to purchase such businesses while being disciplined about price. We’re also mindful that in the midst of a massive debt crisis, having some cash on hand for a rainy day really isn’t awful. If we’ve explained it properly, our hope is that this defensive approach will appeal to you, although it most certainly will cause our results to vary from the indices.

Johnson & Johnson Valuation Part 2: Predicting its 2020 Value Line Sheet

In part 1 of my valuation of Johnson & Johnson (JNJ), I looked at four different discounted cash flow scenarios. All four showed JNJ to be undervalued, one by as little as 15% and one by as much as 64%.

This is a wide range and skeptics of this approach may argue that this approach is entirely too imprecise. On the other hand, it may be useful to learn that JNJ is cheaper than even a conservative estimate of its discounted future free cash flows. After all, the most conservative model assumes no growth after year 8; this seems unlikely, even if we are talking about real growth after inflation.

Today, I’m going to look at how JNJ’s Value Line sheet might look in 2020 in order to ball park what an investors total return might be if he or she invested in the stock at around $60 per share, roughly where it is trading today. I was inspired to do this exercise because some years ago Buffett said that that’s what he tries to do when analyzing a business in Value Line. Both Buffett and Munger (and Li Lu, the seeming heir-apparent to at least part of Berkshire’s CIO position) are on record as singing the praises of Value Line as an analytical tool.

For most stocks/businesses, such a projection would be an exercise in self-delusion as their economic fundamentals are subject to too many unknown factors such as creative destruction, lack of growth and reinvestment opportunities, heavy debt loads that are subject to unknown future conditions in the credit markets, no current profits – the list could go on. Others argue that, more than ever, current macroeconomic uncertainties make such a long-range forecast impossible.

The contention here is that JNJ’s exceptional track record, current economics and future prospects make such an exercise both possible and useful. If nothing else, it is an exercise in inversion in that it allows you to test your assumptions and see what type of economic performance and action by management is required to achieve a given total-return hurdle rate.

The primary variable in the three Value Line scenarios is the Return on Equity (ROE). In the base case, I assume it will be 23.5%, which was its actual ROE in 2009. In this case, I also assume that the stock will trade at 15x earnings in 2020, which is an average historical multiple for the S&P 500. The argument here is that JNJ warrants at least an average market multiple.

In the pessimistic case, I assume an ROE of 20%, which is 2-3% lower than anything JNJ has produced in the past decade, and a 2020 P/E ratio of 10. Finally, in the optimistic case, I assume an ROE of 27%, which was approximately the average ROE over the past ten years and a 2020 P/E ratio of 18.

In all cases, I used Value Line’s actual numbers for 2010 to provide a common baseline.

The spreadsheets’ formats will be roughly familiar to those who follow Vale Line. I left out a lot of rows and data which are not material to the exercise. I also added some rows that do not appear in Value Line (the rows in gray shade at the bottom).

The first added row is “Profits Reinvested in Equity”. Although Value Line shows the percentage of net profit which is “retained to common equity”, it does not break out how the retained cash is used, i.e. dividends, share repurchases, maintenance cap-ex. In the case of JNJ, I assume that earnings are free cash flow because, historically, JNJ’s depreciation and cap-ex have been roughly equivalent. I further assume – somewhat over simplistically – that profits retained to common equity will be used for only one of two things: equity reinvestment in the business or share repurchases.

The “Profits for Share Repurchases” and “Avg. Price per share of Repurchases” allow me to calculate how many shares are repurchased annually. Obviously, this won’t happen in a linear fashion, if at all, although it is broadly consistent with JNJ’s use of cash over the prior five years.

Share Repurchases

2005 – $1.7 billion

2006 – $6.7 billion

2007 – $5.6 billion

2008 – $6.7 billion

2009 – $2.1 billion

Cash could also be used to do something else such as make an acquisition. The long-term outcome should be roughly the same if we assume that JNJ will do intelligent things with their capital and get a return commensurate with the company’s long-term returns.

I assume that future share repurchases will be done at 3.5x book value per share. This assumption cuts both ways. Historically, JNJ has traded at a higher multiple to book, so you could argue that shares will not be available at this price going forward. This would reduce the number of shares repurchased and lower future earnings per share. On the other hand, it would mean a higher multiple for the stock and potentially a higher total return, depending on when and if the stock was sold.

The Base Case

The base case results in the stock growing at a CAGR of 11.7%. Add in average dividends of 3% and the total return is close to 15%.

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The Pessimistic Case

The pessimistic case results in the stock growing at a CAGR of 7%. Add in average dividends of 3% and the total return is still about 10%.

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The Optimistic Case

The optimistic case results in the stock growing at a CAGR of 14%. Add in average dividends of 3% and the total return is approximately 17%.

(click image to enlarge)

As always, I invite and welcome your comments.

The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures. The data and information presented in this blog entry is believed to be accurate but should not be relied upon by the user for any purpose. Any and all liability for the content or any omissions, including any inaccuracies, errors or misstatements in such data is expressly disclaimed.

Johnson & Johnson Looks Undervalued (Part 1)

Johnson & Johnson (JNJ) was formed in 1886. Over the past one-hundred and twenty-five years, it has produced an enviable record of growth and profitability and has grown into a diversified global giant with three main operating segments: consumer products, pharmaceuticals, and medical devices and diagnostics. 2009 sales were $61.9 billion with operating profits of $16.6 billion. JNJ is one of only four companies that have an AAA credit rating – the others are ADP, Exxon and Microsoft.

Operating profits have tripled over the past decade but the stock price has made relatively little progress given its high multiple at the beginning of the decade. This has caught the attention of numerous value investors who have taken large positions in the stock. Major holders include Warren Buffett, Prem Watsa, Donald Yacktman and Tweedy Browne. As a frame of reference, Buffett’s basis in the stock is just over $60.00 per share.

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JNJ has grown operating earnings at a CAGR of 5.5%, 8.5% and 9.6% over the past 5, 10 and 15 year periods, respectively. Although growth has slowed in the United States and Europe over the past five years owing to the recession, sales in the Asia-Pacific, Africa region have grown at 11.2% and sales in the Western Hemisphere, excluding the U.S., have grown at an accelerating 14.8%. This growth in developing regions bodes well for JNJ and should provide a long-term growth platform. JNJ should also benefit from an aging population and above-GDP levels of growth in the healthcare sector, although increased regulation may have a dampening effect in the U.S.

Here is the basic historical data and growth rates over the past 5, 10, and 15-year periods.

Leading pharmaceuticals companies have also experienced margin compression because of investor concerns over patent expirations. These concerns may prove to be overblown in the long-term as, according to Morningstar analyst Damien Conover, CFA, JNJ has, “Nine potential blockbusters in late-stage development or recently approved.” Of course, handicapping pharmaceutical blockbusters is a tricky business, even if you have considerable industry expertise. Nevertheless, JNJ has a superlative track record of innovation and spends approximately $7 billion annually on research & development.

Unlike other leading pharmaceutical companies, JNJ is well diversified with over $10 billion in operating profits coming from its two non-pharmaceutical divisions, consumer products and medical devices & diagnostics. There is evidence that JNJ operates with a strong durable competitive advantage: per Value Line, return on equity over the past ten years has ranged between 24.3% and 30.1%, with almost no leverage.

Since 2000 through 2009, JNJ added $31.8 billion in equity while growing after-tax profits by $8.1 billion for a strong 25.5% return. This is even more noteworthy because the acquisition of Pfizer’s Consumer Healthcare business in 2006 resulted in $6.6 billion in goodwill and $8.9 billion in intangible assets.


The next step is to attempt to value JNJ. Following Seth Klarman, I’m going to look at JNJ in a couple different ways and subject these valuations to sensitivity analyses. Today, I’ll be doing a simple discounted cash flow. In the next installment, I’m going to do an exercise suggested by Warren Buffett. Buffett, who is a big fan of Value Line, has said that what he is trying to do when he values a business is determine what Value Line will look like in ten years. In my judgment, Buffett would only perform this exercise with businesses where he has a high level of certainty about their future earnings.

Discounted Cash Flow Analysis (DCF)

This approach is the theoretical framework followed by Buffett who derived it from the economist John Burr Williams. The discounted cash flow of a business comprises its intrinsic value. Here’s what Buffett says about it in the Berkshire Hathaway Owner’s Manual.

“Let’s start with intrinsic value, an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.

The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover – and this would apply even to Charlie and me – will almost inevitably come up with at least slightly different intrinsic value figures. That is one reason we never give you our estimates of intrinsic value. What our annual reports do supply, though, are the facts that we ourselves use to calculate this value.”

To the best of my knowledge, it is not known precisely how Buffett performs this calculation. Charlie Munger has said that he has never seen Buffett perform a discounted cash flow computation.

Some prominent value investors, such as Bruce Greenwald of Columbia University, object to the use of discounted cash flow analyses because of the large portion of total earnings that is contained in the terminal portion of the calculation, which attempts to capture earnings in the very long term. They argue that this simply cannot be done with sufficient precision to make it useful.

At least two approaches are used to deal with this objection. First, only use very conservative assumptions and second only perform this calculation with companies that have superior earnings visibility into the distant future. An example of this type of company is Coca-Cola: a hundred-year plus track record, evident durable competitive advantages, and growth prospects far into the future (Coca-Cola accounts for less than 3% of worldwide beverage consumption). I believe JNJ’s track record, economics and future prospects put it in this category.

How Longleaf Partners Does It

In the first DCF, I’m going to follow the general approach used by Mason Hawkin’s partner Staley Cates at Longleaf Partners as disclosed in an email exchange between Cates and an investor.

According to Cates, Longleaf projects 8 years worth of free cash flows, which I understand to equate to Buffett’s “owner earnings”: reported earnings plus depreciation and other non-cash charges less capital expenditures. For JNJ, I’ll use reported earnings as, historically, depreciation and cap-ex have been roughly equal.

To be conservative, Cates also uses a terminal multiple that assumes no growth after year 8. The no-growth terminal multiple is tied to the discount rate used. For example, if you use a 10% discount rate, a no-growth terminal value is 10x. (Value = Earnings / Discount Rate.) If you use a 7% discount rate, the no-growth terminal value jumps to 14x.

In the example, I assume book value per share of $21.60 (Value Line’s estimate for 2010) and a 23.5% ROE which produces year 1 earnings of $5.08 (consensus estimates for 2011 per Marketwatch are $5.07).

Following its historical practice, I assume that JNJ will payout 70% of its earnings in the form of dividends and share repurchases, which will produce a growth in equity and earnings of approximately 7% (ROE of 23.5% x 30% of earnings reinvested = 7%). (Since 2000 through 2009, JNJ added $31.8 billion in equity and produced $89.7 billion in net profits. From this you can see that approximately 30% of profits were reinvested in the business in the form of equity.)

Also, for the record and to be conservative, 23.5% is the lowest ROE earned in the past decade.

Using a 7% discount rate produces an intrinsic value of $105 per share which would imply a 43% discount at a share price of $60. Using a 10% discount rate produces an intrinsic value of $71 per share, which would imply a 15% discount at a share price of $60. The 7% discount rate is lower than many analysts would use but is closer to Buffett’s approach.

Here’s the data.

Buffett favors using the interest rate on long-term government bonds as his discount rate, and he has said that he will use a slightly higher rate when these rates are particularly low. He believes it is mistaken to compensate for risk by using a higher discount rate. Instead he limits himself to only investing in situations where he is highly certain and has a margin of safety.

In the second two examples, I use the same two discount rates, but, instead of using a no-growth terminal multiple, I project earnings out 10 years and assume that, after year 10, earnings will grow in perpetuity at 3%. In this case, using a 7% discount rate produces an intrinsic value of $167 per share which would imply a 64% discount at a share price of $60. Using a 10% discount rate produces an intrinsic value of $91 per share, which would imply a 34% discount at a share price of $60.

Here’s the data (use the second tab “7% Growth 3% Terminal Growth” at the top of the page)

Of interest is that all four models produce an intrinsic value for JNJ that is higher than its current share price – in some cases, materially so.

In addition to being undervalued, JNJ looks to be in a position to grow intrinsic value in the mid to high single digit range, while simultaneously paying a generous dividend (currently over 3%) and buying back shares. The result should be a satisfactory total return.

In the next installment, following Buffett, I’ll attempt to project what JNJ’s Value Line sheet will look like in ten years.

The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures. The data and information presented in this blog entry is believed to be accurate but should not be relied upon by the user for any purpose. Any and all liability for the content or any omissions, including any inaccuracies, errors or misstatements in such data is expressly disclaimed.