Category Archives: Investing Ideas

Buffett’s Missed Pharma Investment: Is it Available Today?

In 1999, Warren Buffett was asked by a shareholder if he made a mistake by not buying the stocks of leading pharmaceutical companies when they were selling at depressed prices in 1993 under the specter of increased government regulation. Buffett’s response was that he had “blown it” by not doing so and that he would “do it in a second” if given a chance to buy a basket of pharmaceuticals at a “below-market” multiple. (1)

His reasoning was simple. Leading pharmaceutical companies are good businesses and as such they don’t deserve to trade at a depressed multiple. He also said that rather than trying to pick an individual pharmaceutical company in which to invest, he would buy a basket of leading pharmaceutical stocks because of the difficulty in picking winners in that industry.

Currently many leading pharmaceutical stocks are once again selling at depressed multiples, and some highly regarded investors have taken notice and made substantial purchases. According to the latest data at Gurufocus.com, a site that tracks the investments of prominent value investors and hedge funds, twenty-nine of the “gurus” they track have an investment in Pfizer, with three of the investors – David Einhorn, Irving Kahn and Donald Yacktman – having more than 5% of their long equity investments in the stock.

Several prominent investors have recently taken positions in other leading pharmaceutical companies including Astrazeneca (AZN), Bristol-Meters Squibb (BMY), GlaxoSmithKline (GSK), Johnson & Johnson (JNJ), Eli Lill (LLY), Merck (MRK), Novartis (NVS), and Sanofi-Aventis (SNY).

Regarding Pfizer, David Einhorn made the case in his second quarter 2010 letter that investors were overreacting to a difficult macro-economic outlook in Europe and concerns about Pfizer’s pipeline. He thought that investors would eventually pay more than the sub 7x earnings at which it was then trading.

Here is David Yacktman’s take on Pfizer from his just-released 2Q, 2010 letter to shareholders.

“Pfizer is the largest pharmaceutical company in the world. Pharmaceuticals are a cost effective way to treat an aging population. However, Pfizer is the least predictable business of the five in this list (PepsiCo, News Corporation, Coca-Cola, Clorox) because it is fighting patent expirations, pricing controls, and greater competition than consumer or subscriber based businesses.

To compensate for the less predictable future, the stock trades at less than 7 times free cash flow. We believe the company should generate more than $10 per share in free cash flow over the next 5 years. Given the significant residual value of the business at that point, we see lots of safety in the current price of slightly more than $14 per share. There can be material upside if the company has even modest success with drugs in its pipeline, finds accretive acquisitions, successfully expands its generic business, or grows its biologic drug presence.”

Value investor Vitaly Katsenelson, CFA argues that Pfizer is worth $19-20 per shares even if sales of Lipitor drop 90% from $12 billion to $1.2 billion and its massive R&D effort of $11 billion does not produce a single new drug.

Similar concerns about patent expirations and pipelines weigh on the other leading pharmaceutical companies as well.

The difference between now and 1993 is that currently the market is concerned about the large numbers of blockbuster drugs coming off patent, whereas in 1993 it was the political risk of increased regulation. Investors will have to decide if Buffett’s central argument – that a basket of leading pharmaceutical companies does not deserve to sell at a depressed multiple – still holds in today’s environment.

Here’s the current earnings multiples on a number of leading pharmaceutical companies based on consensus earnings estimates for 2010 and 2011. Prices are as of the close on August 4, 2010. Berkshire Hathaway has positions in GlaxoSmithKline, Johnson & Johnson and Sanofi Aventis according to its most recently filed 13F-HR.

(click to enlarge)

(1) Outstanding Investor Digest, December 31, 1999, p. 60.

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.

Fairfax Financial Holdings Ltd. Looks Undervalued

I believe that Fairfax Financial Holdings Limited (Fairfax) (TSE:FFH) (PINK:FRFHF) is undervalued and is worth as much as $574.00 per share. (All dollar amounts in this analysis are in U.S. dollars including the share price.)

As of June 30, 2010, Fairfax had a book value of $382.70 per share. As I write this, Fairfax is trading at $402.00 per share which gives it a price-to-book ratio of 1.05. I believe that Fairfax’s intrinsic value is at least 1.5x book value based on a reasonable mathematical expectancy that it can achieve a 12% return on its investment portfolio going forward. This expectation is further supported by Fairfax’s management talent, the significant concentration of ownership by management, and its long successful track record. For long-term investors, intrinsic value should grow – albeit in what may be a “lumpy” ride – at 12-15% annually for the foreseeable future. If Fairfax grows intrinsic value at 12% and is revalued at a more appropriate 1.5x book value, its intrinsic value could grow to over $1,000 per share over the next 5-years which would yield an annual return of 20% based on an entry price of $402.00.

BOOK VALUE MULTIPLE
If we assume a risk-free return of 3-4% from long-term government bonds and a return on high quality long-term corporate bonds of 4-6%, the present value of Fairfax’s outperformance of 12% over the long-term warrants a fair value multiple of at least 1.5x. See my blog post Price-to-Book Ratio and ROE Offer Strong Value Clues. Of course, the question is whether Fairfax can actually earn a 12% return on equity over the long-term.

As I learned from studying Bruce Berkowitz and Chuck Akre, the key to valuing an insurance stock like Fairfax is to look at the investments per share. Here’s what Berkowitz said in an October 2000 article in Businessweek about how he valued Markel.

Look, the key concept for insurance companies is to take a look at the investments per share. And you can find companies where the investments per share are significantly higher than the stock price. Markel has roughly $400 per share of investments. If they can break even on their underwriting and only make a 5% after-tax investment return, that’s $20 per share. Not bad for a company at $140 per share.

So the trick is to have that investment leverage and at the same time break even or make an underwriting profit.

Fairfax has a high quality investment portfolio that was worth $21.14 billion as of June 30, 2010 which, based on 20,546,935 shares outstanding, equates to $1,028.90 of investments per share. That is a ratio of 2.56 dollars in investments to each dollar of cost of its stock. If Fairfax can earn just 5% on its investments going forward it would be $51 per share and generate a 12.8% return on equity.

Fairfax has grown book value by 25% over the past 23 years, although from a much smaller base. Watsa has a stated expectation of compounding “book value per share over the long term by 15% annually”. Fairfax’s weighted cost of float since inception is 2.7%.

The 5% return seems reasonable given that 17% percent of the portfolio comprises high-quality dividend paying common stocks, including 6,884,300 shares of Johnson & Johnson, 9,949,871 shares of Kraft Foods and 14,074,100 shares of Wells Fargo. The portfolio also includes $12.3 billion of bonds, of which $5.5 billion comprised tax-exempt bonds as of December 31, 2009 purchased at favorable terms during the recent crisis ($3.5 billion of these bonds are insured by Berkshire Hathaway Assurance Corp).

Moreover, Fairfax’s investment record is superlative:

Common stocks:
5 years – 12.2%
10 years – 19.1%
15 years – 16.1%

Bonds
5 years – 9.6%
10 years – 9.3%
15 years – 9.4%

MANAGEMENT
Prem Watsa and his management team have proven to be outstanding long-term investors as evidenced by their long-term track record. Moreover, in the Graham and Dodd tradition, they define risk as permanent loss of capital and attempt to run Fairfax with a margin of safety, which includes prudent investment and reserving, along with underwriting discipline. Watsa showed great skill in anticipating the economic meltdown of the past two years and positioning his portfolio to not only preserve capital but make a significant profit. As further evidence of Watsa’s think-about-risk-first approach, as of June 30, 2010, according to Watsa’s comments on the Q2, 2010 conference call, as a result of the run-up in the stock market, they increased their “hedge ratio to approximately 90% of equity.”

Similar to Buffett, Watsa draws a modest annual salary of C$600,000 and perks of only C$21,000. Watsa’s interests are well aligned with shareholders as he owns individually or otherwise controls a large block of stock. His annual shareholder letters are transparent and informative. They have high “signal” value that Watsa “gets it” and is focused on a legacy of building value for shareholders.

Intrinsic value going forward should be increased by a string of acquisitions. On February 31, 2009, Fairfax announced the purchase of Zenith National Insurance Corp. for $38.00 per share. This price is approximately 1.4x book value, and it represents a fair price for a high-quality company that has tripled its equity in the past decade and has an outstanding average combined ratio of 95% over the past 30 years and 89% over the past 10 years. It has also shown outstanding discipline in a soft insurance market by allowing a drop in underwriting volume rather than write business with a negative mathematical expectancy; it has a long-term track record of similar behavior.

Other recent transactions include the privatization of OdysseyRe, Advent and Northridge and the acquisition of Polish Re, a Polish reinsurance company. Fairfax also has exposure to the fast growing Indian and Brazilian insurance markets.

In summary, Fairfax is a high-quality insurance company that is trading at a discount to its intrinsic value. Long-term holders should benefit from a 12-15% growth in intrinsic value over time driven by intelligent share repurchases, select rational acquisitions, growth in float and premium volume and skillful investing. Management is honest and capable and has a long track record of accomplishment. This will likely be a bumpy ride as there is no attempt to “smooth” or “manage” earnings, but the end result should be worthwhile.

Related links:

2010 Annual Meeting Slide Presentation

Fairfax Financial Holdings Ltd. Q2 2010 Earnings Call Transcript

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.

Goldman Sachs: Total Intrinsic Value of Berkshire A Shares Pegged at $171,235

Here is Goldman Sachs’ June 29, 2010 report on Berkshire Hathaway. It is worth reading. There is a lot of good data in the report. Goldman Sachs calculates that the total intrinsic value of the Class A shares is $171,235. They calculate the “Target Intrinsic Value” as $152,399 based on the fact that it has historically traded at 89% of their calculation of intrinsic value.

Related Links:

Links of Interest – July 24, 2010

More on Large Cap Stocks | Street Capitalist: Event Driven Value Investments – Street Capitalist makes the long case for Exxon and Johnson & Johnson.

BUSINESS without BORDERS | A perfect predator – Interesting profile of Brookfield Asset Management which, along with Markel, Farifax Financial Holdings, Leucadia, and Danaher, is sometimes compared to an earlier-stage Berkshire Hathaway.

My Investing Notebook: Vitaliy Katsenelson Presentation on China – Value investor Vitaliy Katsenelson makes the case that EBay is undervalued (after his macro-analysis of China and Japan).

On Google, Growth, Pricing Power, and Valuation Multiples « abovethecrowd.com – Bill Gurley’s insightful take on why Google is undervalued.

David Einhorn’s Greenlight Capital Q2 Letter courtesy of marketfolly.com. Einhorn makes the long case for Apple, African Barrick Gold, Ensco and NCR.


Greenlight-Capital-Q2-2010

BYD Research Highlights

Recently a second video of Li Lu at Columbia in 2010 surfaced on the Internet. After watching the video, it became clear to me that Lu believes the BYD story has a long way to go. Lu is a large shareholder. The stock trades on the Honk Kong exchange as 1211 and can also be purchased in the U.S. as BYDDF and BYDDY. The first is a single share, the latter 10 shares.

For my internet-based research, I am using a bookmarking tool called Diigo which allows me to highlight and bookmark documents. I can also tag documents and organize them. So far, I am finding it a useful tool. (Check it out.)

As most of you are aware, Berkshire Hathaway made a substantial investment in BYD in 2008. Here is a good summary article from Fortune if you want to get up to speed before diving into to the research documents.

Here are my bookmarks and highlights for BYD.

In all, there are 37 documents. After reading them, you will have a good feel for what the company is doing.

I hope you find these useful, if you are interested in the company. I would very much appreciate your feedback so I know if you would like to see this information for future companies that I am researching.

Quoting Lu, “BYD has not one but three opportunities to change the world–with its electric cars, its rooftop solar panels with battery storage and with large-scale batteries that could be used by electric utilities to store solar or wind power.”

I plan to write more about BYD as I research the company and analyze their financials.

Sokol Pegs Berkshire’s Utility ROE at 11% et al.

According to David Sokol, over the past ten years Berkshire Hathaway has earned an ROE of about 11% on its regulated energy investments – (Video from Fortune’s Brainstorm Green Virtual Conference) (see 19:50 minute mark). Sokol acknowledges that this is a good (not great) business.

In my view, 11% can still be a nice return when you have access to insurance float at zero or negative cost.

Buffett is on record that Berkshire Hathaway will invest billions in the utility business going forward. Understanding the regulated utility business and its rates of return are necessary to estimate Berkshire’s intrinsic value and what the company may look like in ten years.

Interesting investment research tool (Alacra Pulse)

Barron’s cover story makes the case that Google is cheap (Looking Up)

If you’re interested in Google, Henry Blodget’s articles on Google are worth reading:

Google to $2,000 a Share? – Business Insider

So, Is Google Still Going To $2,000 A Share? – Business Insider

Microsoft Is Trashing Us For Not Eating Enough Crow About Bing’s Market Share Gains–So We’ll Eat A Bit More Crow – Business Insider

Full Disclosure: The author owns shares of Google.

Total (ticker: TOT): An Oil Stock with a Supersized Dividend – Barrons.com

An Oil Stock with a Supersized Dividend – Barrons.com

At 6.1 times 2011 earnings, the company is trading at a significant discount to its five-year average price-to-earnings multiple of 9.7. And once new projects ramp up, production could grow considerably.

It appears that investors have taken concerns about the stock into account, and then some. With Total’s shares trading well below their historical average and more production growth on the horizon, this could be the right time to take another look.

Miller: IBM the Most Remarkably Mispriced Name in the Market – Morningstar.com

Miller: IBM the Most Remarkably Mispriced Name in the Market – Morningstar.com

The Legg Mason manager says this tech giant is like Poe’s ‘Purloined Letter’: Hidden in plain sight. Plus, Miller on gaining a behavioral edge in investing.

At the micro level, there is a very pertinent one right now, the oil spill in the Gulf. So that’s caused a huge amount of panic on the part of investors with respect to BP, Transocean, Anadarko and some other companies that have been involved in it. And all those companies have been sold off extremely harshly, despite there being very different underlying data-driven conditions. So BP is responsible for the spill. Anadarko is responsible for part of the spill under certain conditions, and Transocean is responsible for none of the spill and is indemnified by BP, but as a week or so ago Transocean was actually off more than BP was.

Hughes: So, as we look at maybe some more of those names, as you look at the portfolio today, who is the up-and-comer, what’s your favorite idea?

Miller: Well, I guess, the name that I find the most remarkably mis-priced name in the market is IBM. And the reason for that is that IBM I think is representative of what you can get in mega-cap in the U.S. And the reason I use IBM is, it’s been around a 100 years. So, it’s not like Google, which is relatively new or companies that you don’t have a lot of data. You have a 100 years of data on IBM. You have data on how the markets’ valued and how it’s behaved in various economic conditions.

Moreover, IBM is followed by everybody that follows big-cap tech. So, there is a large numbers of people looking at it and trying to figure it out. Maybe, most interestingly, IBM is one of the most transparent companies in the market. They tell you their long-term goals, they tell you their long-term expectations with respect to earnings per share, free cash flow, operating margins, dividend policy. And then they tell you the short-term, too, they gave you – they have already upped their guidance twice this year.

So, if you think about that the long history, the large numbers of people looking at it, and the company being very open, you would expect that if anything is going to be properly priced in the market, it’s going to be IBM. You should be able to earn excess return by buying IBM in the marketplace today. Yet, if you look at their results over the past five years, what you see is IBM has doubled their operating earnings per share in the last five years. The dividend has grown over 20% a year over the last five years. They’ve bought back stock and shrunk the shares outstanding every year.

This year, they will have record earnings and record operating margins again. They had that two years ago actually during the worst recession since the Great Depression. So, if they can navigate through that kind of an environment, when the economy has been arguably as difficult as it’s ever been, when the economy gets better, as is doing right now, they should do even better, which is why they have increased guidance twice this year.

Yet, you can buy IBM today at around 10.5 times this year’s earnings and around 9.8 times next year’s earnings, the lowest multiple it’s ever traded at, with returns on capital in the 25% to 30% range.

If you run it through any valuation model, it will show that it’s 30% to 50% underpriced. Yet, nobody seems to care about it. In fact, when I mentioned it to other investors, they are like, ‘I haven’t looked at IBM in a long time.’ So, I think that’s the – it’s sort of like Poe’s Purloined Letter, it’s hidden in plain sight.