Monthly Archives: August 2009

Alice Schroeder on How Buffett Values a Business and Invests

On November 20, 2008, Alice Schrooder, author of “The Snowball: Warren Buffett and the Business of Life”, spoke at the Value Investing Conference at the Darden School of Business. She gave some fascinating insights into how Buffett invests that are not in the book. I hope you find them useful.

  1. Much of Buffett’s success has come from training himself to practice good habits. His first and most important habit is to work hard. He dug up SEC documents long before they were online. He went to the state insurance commission to dig up facts. He was visiting companies long before he was known and persisting in the face of rejection.
  2. He was always thinking what more he could do to get an edge on the other guy.
  3. Schroeder rejects those who argue that working harder will not give you an edge today because so much is available online.
  4. Buffett is a “learning machine”. This learning has been cumulative over his entire life covering thousands of businesses and many different industries. This storehouse of knowledge allows Buffett to make decisions quickly.
  5. Schroeder uses a case study on Mid-Continent Tab Card Company in which Buffett invested privately to illustrate how Buffett invests.
  6. In the 1950’s, IBM was forced to divest itself of the computer tab card business as part of an anti-trust settlement with the Justice Department. The computer tab card business was IBM’s most profitable business with profit margins of 50%.
  7. Buffett was approached by some friends to invest in Mid-Continent Tab Card Company which was a start-up setup to compete in the tab card business. Buffett declined because of the real risk that the start-up could fail.
  8. This illustrates a fundamental principle of how Buffett invests: first focus on what you can loose and then, and only then, think about return. Once Buffett concluded he could lose money, he quit thinking and said “no”. This is his first filter.
  9. Schroder argues that most investors do just the opposite: they first focus on the upside and then give passing thought to risk.
  10. Later, after the start-up was successfully established and competing, Buffett was again approached to invest capital to grow the business. The company needed money to purchase additional machines to make the tab cards. The business now had 40% profit margins and was making enough that a new machine could pay for itself in a year.
  11. Schroeder points out that already in 1959, long before Buffett had established himself as an expert stock picker, people were coming to him with special deals, just like they do now with Goldman Sachs and GE. The reason is that having started so young in business he already had both capital and business knowledge/acumen.
  12. Unlike most investors, Buffett did not create a model of the business. In fact, based on going through pretty much all of Buffett’s files, Schroder never saw that Buffett had created a model of a business.
  13. Instead, Buffett thought like a horse handicapper. He isolated the one or two factors upon which the success of Mid American hinged. In this case, sales growth and cost advantage.
  14. He then laid out the quarterly data for these factors for all of Mid Continent’s factories and those of its competitors, as best he could determine it, on sheets of a legal pad and intently studied the data.
  15. He established his hurdle of a 15% return and asked himself if he could get it based on the company’s 36% profit margins and 70% growth. It was a simple yes or no decision and he determined that he could get the 15% return so he invested.
  16. According to Schroder, 15% is what Buffett wants from day 1 on an investment and then for it to compound from there.
  17. This is how Buffett does a discounted cash flow. There are no discounted cash flow models. Buffett simply looks at detailed long-term historical data and determines, based on the price he has to pay, if he can get at least a 15% return. (This is why Charlie Munger has said he has never seen Buffett do a discounted cash flow model.)
  18. There was a big margin of safety in the numbers of Mid Continent.
  19. Buffett invested $60,000 of personal money or about 20% of his net worth. It was an easy decision for him. No projections – only historical data.
  20. He held the investment for 18 years and put another $1 million into the business over time. The investment earned 33% over the 18 years.
  21. It was a vivid example of a Phil Fisher investment at a Ben Graham price.
  22. Buffett is very risk averse and follows Firestone’s Law of forecasting: “Chicken Little only has to be right once.” This is why Berkshire Hathaway is not dealing with a lot of the problems other companies are dealing with because he avoids the risk of catastrophe.
  23. He is very realistic and never tries to talk himself out of a decision if he sees that it has cat risk.
  24. Buffett said he thought the market was attractive in the fall of 2008 because it was at 70%-80% of GDP. This gave him a margin of safety based on historical data. He is handicapping. He doesn’t care if it goes up or down in the short term. Buying at these levels stacks the odds in his favor over time.
  25. Buffett has never advocated the concept of dollar cost averaging because it involves buying the market at regular intervals – regardless of how overvalued the market may be. This is something Buffett would never support.

Here is a link to the video: http://www.youtube.com/watch?v=PnTm2F6kiRQ

How Buffett Got an Edge

A commonplace about Buffett that only captures a portion of the truth is that he made his fortune as a virtuoso stock picker. No doubt he has an enviable – but not perfect – record as a stock picker. In addition to great stock picking, he has always looked for en edge to boost performance.

Buffett recognized from Ben Graham that undervalued stocks usually go down in sympathy with, and in proportion to, the general market. Therefore, it was important to try to limit the downside by having a portfolio that went down less than the general market in periods of a declining market. (This is the same reason today’s hedge funds use shorts and attempt to invest in uncorrelated assets.)

Buffett did this by reducing commitments to stocks when the general market was overvalued. He did this – not by forecasting – but by consistently using a few common sense measures of market valuation, such as the earnings yield of the general market compared to that of quality bonds or simply by being increasingly cautious as the market rose faster than the progress of the underlying businesses.

In addition, he invested a material portion of the capital in investments which were not correlated with the general market, such as control situations and arbitrage situations. Again, this allowed him to reduce drawdowns in the portfolio during periods of market decline, which are highly disruptive to long-term compounding – something Buffett understood so well.

Buffett was creative in looking for an edge. When he purchased net-nets (undervalued securities that were selling for less than the value of their current assets less their current liabilities – a level which priced them below liquidation value), he gave himself a safety valve. He knew that if the price went up after he bought stock he would cash out and realize a profit. If the prices stayed low, he would continue to accumulate stock until he obtained a controlling position. He could then make the necessary changes required to realize a profit on his investment. Heads I win, tails I win too.

He also invested in relatively undervalued larger cap stocks where the prospect of accumulating a control position did not exist because of the companies’ size. Here, he feared the risk of an unexpected reduction in the multiple at which these stocks traded. He revealed that he had found a way to hedge the position if the market reappraised all companies at a lower multiple due to an emerging negative outlook on future prospects. Unfortunately, he does not reveal specifics.

Later Buffett would use insurance float as a source of cheap funds to purchase stocks and businesses in amounts far greater than his underlying equity capital would allow.

Buffett is far more than a simple stock picker and is always looking for an edge. He is fully aware that what worked in that past may no longer work given his present circumstances, perhaps because the past opportunity was recognized by too many market participants and was arbitraged away, or perhaps because a given strategy no longer works given the enormous capital he now works with.

It still makes a lot of sense to look for ways to hedge. Few things add more to long-term performance that finding ways to mitigate the downside. Buying right is a great place to start and then having the discipline to make additional purchases after re-checking your valuation work. Becoming fearful as the market rises is another powerful technique. Beyond that, each investor should consider what level of hedging is appropriate, if any, based on skill, experience, etc., remembering that if you don’t know what you’re doing, you’re speculating.

Checklist for Evaluating Spinoffs

Spinoffs provide a great place for value investors to look for investment ideas. A 1988 study at Penn State showed that spinoffs outperformed the S&P500 by 10% per year in the three year period following the spinoff. Parents of spinoff companies outperformed their industry peers by 6%.

I am a big believer in using lists when evaluating investments so I don’t forget to check or think about something. This is also a good way to keep emotions in check. The following is a list I use based on Joel Greenblatt’s book You Can Be A Stock Market Genius, Even if you’re not too smart! Don’t let the title fool you. Greenblatt has one of the best track records I’ve ever seen and the book is excellent.

Here’s the list:

1. Will the spin-off allow the separate businesses to be better appreciated?

2. Will the spin-off separate a lousy business from a good business?

3. Is the multiple of a great business being penalized by being combined with a good business which the spinoff will fix (AMEX spinoff of Lehnan Brothers)?

4. Does one business have steady earnings and one volatile?

5. Will the spinoff allow each business to be properly valued, for example one division would be better valued using cash flow and another using earnings? (In the example given by Greenblatt, large depreciation charges from its TV stations were obscuring Home Shopping’s earnings.)

6. Does the spin-off allow the parent to rid itself of a business it can’t sell and/or off-load debt?

7. Are there tax advantages to the spin-off such as avoiding a large capital gain?

8. Does it solve a problem, for example antitrust or regulatory, that paves the way for another transaction?

9. Are there reasons, unrelated to value, why the spinoff will fall in price making it cheap?

A. the investment merits are obscured by complexity or what, upon superficial analysis, looks like a bad business

B. removed from an index

C. too small to be held by institutions

D. very different business from the original investment

10. What are the insider’s motives?

11. Do insiders want the spinoff?

A. Is the compensation of the new management strongly tied to that of the spinoff?

B. What percentage of the company’s stock is made available to compensate management and employees?

C. Are key managers moving to the spinoff?

D. Is the parent retaining stock in the spinoff?

E. Does management have an incentive to do the spinoff at a low price to set option strike prices low?

12. Is the spinoff positioned to benefit from high leverage (see Host Marriot example on page 70)?

13. On a pro-forma basis, how does the value of the spinoff compare to it industry?

A. Is the implied P/E lower than that of the peer group (see Value Line for industry group valuations)?

B. Is there an identifiable future event that is not yet factored into the earnings that will drive a higher price and/or multiple, i.e. a new production unit, ship, contract, etc.?

14. Look also at the parent company.

15. Does a partial spinoff reveal that the parent is undervalued?

A. Use ratios to compare the implied value of the parent with the value of peers. (The Sears partial spinoff of Allstate and Dean Witter revealed that Sears was trading at 6% of sales vs. 56% at J.C. Penny.)

16. Look at rights offerings.

Lessons from Buffett’s Partnership on General Market Prices

As the general market averages continue to climb, I thought it would be constructive to write about some of Buffett’s thoughts on the general market. These are drawn from his partnership letters.
From the February 6, 1958 letter:
  1. When Buffett ran his partnership he would calculate the intrinsic value of the general market. The intrinsic value calculation for the market as a whole related to blue-chip securities. He felt that all stocks would be affected by a substantial decline in market prices.
  2. Buffett seems to adjust his exposure to undervalued equities based on his calculation of the general market’s intrinsic value.
  3. Although Buffett pays attention to the level of the general market, his primary focus was on finding undervalued securities. He was not making a forecast of either the stock market or general business conditions.
  4. Buffett believes that a market decline is a time of opportunity because there are more undervalued securities available.
  5. Luck is an important factor in short-term performance of the stock market.

From the February 11, 1959 letter:

  1. Market psychology is a major factor in determining the level of the stock market. This affects amateurs and professionals and can continue to drive up market prices as long as these participants believe there is easy money to be made in stocks.
  2. Buffett believes that there may be relationship between the duration of a run-up in stocks and the eventual reaction to it.
  3. The general public, in Buffett’s view, believes that stock market profits are inevitable.
  4. Stock market prices and intrinsic values can move independently.
  5. Buffett looks at a stock market decline as potentially advantageous, if it allows him to add to his position in an undervalued security.
  6. Buffett expects to find fewer undervalued securities when the market level is high.

Buffett does not believe he can predict the future movements of the stock market or general business conditions. He expects that over time there will be down years (some relatively severe), up years and those in between. It is not possible to predict their magnitude or sequence. However, over the long term the level of return will reflect the performance of the underlying businesses. In 1962 he expected this to be 5% to 7% based on a combination of dividends and reinvested earnings.

Charlie Munger’s 10 Rules for Investment Success

Here’s a very useful article on Charlie Munger from The Motley Fool written by Morgan Housel.

Those of you lucky enough to attend a Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) annual shareholder meeting have undoubtedly heard Charlie Munger say, “I have nothing to add.”

In reality, the guy has quite a bit to add. Thankfully for us, Munger is almost as forthcoming with his investment thoughts as his pal Warren Buffett. In his must-read book, Poor Charlie’s Almanac, Munger puts forth a 10-step checklist that even the most inexperienced investors could benefit from.

1. Measure risk
All investment evaluations should begin by measuring risk, especially reputational.

It’s crucially important to understand that from time to time, your investments won’t turn out the way you wanted. To protect your portfolio, don’t set yourself up for complete failure in the first place. Giving yourself a large margin of safety, avoiding people of questionable character, and only taking on risk when you can be sure you’ll be satisfactorily rewarded are all steps in the right direction. Companies like Chipotle (NYSE: CMG) might have perfectly bright futures, but when their shares are priced for perfection, they might nonetheless prove too risky for savvy investors.

2. Be independent
Only in fairy tales are emperors told they’re naked.

With stockbrokers often rewarded for activity, not successful investments, it’s critically important to make sure you believe that what you’re doing is right. Chasing others’ opinions may seem logical, but investors like Munger and Buffett often succeed by going against the grain. Big Berkshire investments such as Coca-Cola (NYSE: KO), and more recently Petrochina (NYSE: PTR), were largely ignored by the masses when they were first made.

3. Prepare ahead
The only way to win is to work, work, work, and hope to have a few insights.

It shouldn’t surprise you that the best investments aren’t the ones we typically read about in the paper. The diamonds in the rough are out there, but finding them requires effort. Buffett reads thousands of annual reports to cultivate ideas — even if he only comes up with a few candidates each year. Munger advocates a constant curiosity for nearly everything in life. If you never stop asking the “whys” in what you do, you won’t have trouble staying motivated.

4. Have intellectual humility
Acknowledging what you don’t know is the dawning of wisdom.

Perhaps most crucially to Berkshire’s success, its leaders never stray away from their comfort zones. In investing, a clear idea of what the business will look like in the future counts most. If you struggle to comprehend what the business does today, you might as well be throwing darts. While companies like Google (Nasdaq: GOOG) and Boston Scientific (NYSE: BSX) are certainly titans in their own right today, they might look drastically different in five to 10 years.

5. Analyze rigorously
Use effective checklists to minimize errors and omissions.

The numbers don’t lie. When researching investments, Buffett and Munger like to try to estimate the security’s worth before they even look at its price. They are businessmen, not stock-market junkies. They focus their brainpower on the value of businesses, not convoluted economic forecasts or intricate market-timing techniques. Munger is incredibly brilliant, but the analytical rigor of his investment decisions is based around simplicity, not complexity.” [Continue Reading]

Don’t Miss the Easy Ones

Have you ever been looking at a stock you like and you see that in the past year it traded at a price that was way too cheap? It’s frustrating. You’re working hard to find the next bargain, and you realize that, on such and such a day, a stock you understood was available at a price that you would snap up in an instant if it were available to you today.

These are somewhat like Buffett’s “sins of omission” – situations where he should have loaded up, but he did not pull the trigger. What I’m talking about is a little different. In Buffett’s case, he had the elephant in his sights and did not pull the trigger. In the case I’m talking about (to stretch the analogy a bit), the elephant was right in your backyard, but you did not even realize it.

What can we learn from these situations?

  1. You need to do your homework. In order to pull the trigger with confidence, you need to have identified at least a handful of prospects that you understand and a price at which buying them would be a “no brainer”. John Templeton would do his valuation work, put in rock-bottom good-til-cancelled buy orders when the market’s outlook was still rosy and wait.
  2. You need to have cash to buy when stocks are low and fear is predominant. This requires holding your powder and not committing your capital to mediocre opportunities. Set a minimum required ROI and don’t invest unless it’s clear you can get it. Buffett is said to use a 15% minimum hurdle.
  3. Learn how to think (properly) about market prices. As Buffett has said many times, people are happy when the items they buy everyday – food, gas, clothes, etc. – go on sale because they can purchase them at a bargain. But when stocks go on sale, most “investors” want the safety of cash or the warmth of the herd. This is folly and damaging to your long-term returns. Learn what you’re doing so you can buy with confidence when others are heading for the exits. (Study carefully chapter 8 of The Intelligent Investor.)
  4. Set up a system so things don’t fall through the cracks. As human beings we are subject to numerous frailties. One of them is the tendency to neglect things that are important to us – to “take our eye off the ball”. Important – sometimes critical – things come onto and off of our radar all the time, things that it is in our interest to stay on top of. To counter this we need systems. It does not matter so much what the system is as long as it is in place and you stay with it. Resolve today, if you have not already done so, to put a system in place so you don’t miss the next investing “fat pitch”. Maybe it’s checking the new low list EVERY week, or going through Value Line on a regular basis, or running a basic screen each week of low P/E stocks. None of these is perfect and there are lots of other ways to generate ideas, but such a minimal system will pay off if done consistently. One day in the future you’ll wake up, check your system, and one of those big fat moving elephants will be right in your sights.

We don’t back into decisions

While we’re at it, I mention that I sold a few stocks on Friday into the strength of the rally. I chose a few stocks that have been in my portfolio for a while and that were holdovers from a managed account I used to have. A couple showed good gains; one did not, which is beside the point. I sold them because I did not understand them well (I did not pick them in the first place) and therefore I could not value them with confidence. I believe a good portfolio is one where the investment thesis for each holding is clear. “If you don’t know where you’re going, any road will take you there.”

Buffett talks about this in his 1998 shareholder letter regarding Berkshire Hathaway’s purchase of General Re. “Once we knew that the General Re merger would definitely take place, we asked the company to dispose of the equities that it held. (As mentioned earlier, we do not manage the Cologne Re portfolio, which includes many equities.) General Re subsequently eliminated its positions in about 250 common stocks, incurring $935 million of taxes in the process. This “clean sweep” approach reflects a basic principle that Charlie and I employ in business and investing: We don’t back into decisions.”

The end of value investing?

One of the blogs I have been following is called Greenbackd: Undervalued Asset Situations with a Catalyst. They do a nice job of covering traditional “Ben Graham” type stocks where the entire company sells at a discount to its net asset value. They like situations where an activist value-oriented investor is involved to help insure that assets are not dissipated by a management team that is more interested in lining its pockets than unlocking value.

In a recent post they respond to an article in The Atlantic called “What Would Warren Do?” , which argues that technology and widespread and immediate access information has eroded, if not eliminated, much of the edge of value investors.

“Megan McArdle has written an article for The Atlantic, What Would Warren Do?, on Warren Buffett and the development of value investing, arguing that better information, more widely available, will erode the “modest advantage” value investors have over “a broader market strategy” and Warren Buffett’s demise will be the end of value investment. We respectfully disagree.

The article traces the evolution of value investing from Benjamin Graham’s “arithmetic” approach to Buffett’s “subjective” approach. McCardle writes that the rules of value investing have changed as Buffett – standard bearer for all value investors – has “refined and redefined” them for “a new era”:

“When Benjamin Graham and David L. Dodd wrote the value-investing urtext, Security Analysis, in 1934, the rules were more hard-and-fast. Graham and Dodd looked for companies whose price was less than their intrinsic value, and offered various formulas for divining this value.

Buying stock in firms where the intrinsic value of the assets is higher than the market capitalization worked well in the depths of the Great Depression, when investors were wary of holding equity. Between 1929 and 1932, the Dow lost just about 90 percent of its value, bottoming out at 41.22. What economists call the “equity premium”—the extra return that investors demand to compensate for the risk of holding stocks—has never since been so high. That’s why Graham and Dodd could find companies whose liquidation value offered a substantial “margin of safety” for people who bought their equity.

Moreover, book value and other balance-sheet-based metrics have become less useful, as the market, and the economy, have changed. Persistent inflation means that the historical cost of the assets on the balance sheet in many cases bears only passing resemblance to their actual worth. Meanwhile, firms get more and more of their value from intangible assets, like intellectual property or strong brands, that don’t show up in the financial statements. Geico, one of Buffett’s crown jewels, gets much of its value not from physical equipment or even investment savvy, but from a sterling brand name built on relentless advertising.”

McCardle says that the rules have changed so much that Graham’s approach no longer offers any competitive advantage:

“Much of what Graham and Dodd did so well was simply hard coolie labor. In an era before spreadsheets or financial databases, they looked at company reports and painstakingly did the arithmetic to see where a company stood. That effort offers no competitive advantage in today’s information-saturated market. So while value investors still hew to the core notion of determining a company’s intrinsic value, waiting for the market to misprice the stock, and then buying on the cheap, nowadays that determination has much more of a subjective skill element.” [Continue reading]

Charlie Munger’s Ten Rules for Investment Success

I have in my files a book review by Joseph Dancy, a law professor at SMU, of the book Damn Right! by Janet Lowe. The book is a biography of Charlie Munger, the Vice-Chairman of Berkshire Hathaway and Warren Buffett’s long-time partner. Dancy’s review includes a useful distillation of Munger’s wisdom in the form “ten rules for investment success”.

Munger is a deep thinker whose interests go far beyond investing. He is largely credited with influencing Buffett to move beyond looking solely for businesses that are statistically cheap by traditional metrics – low P/E, low P/B, etc. – and to look for so called “good” businesses that enjoy high returns on invested capital and strong competitive positions. Graham did not generally invest in these types of businesses because they were not backed by quantifiable hard assets.

CHARLIE MUNGER: BERKSHIRE’S OTHER HALF

Numerous books have been written on Warren Buffett and his investment philosophy, but few journalists have focused on Buffett’s lawyer-investor partner Charlie Munger. Munger played a key role in building Berkshire Hathaway, and provided a significant influence on Buffett’s investment theory and strategy.

Good Investment Ideas

Portfolio volatility does not bother Munger according to Janet Lowe, author of a book on him entitled “Damn Right!” She notes that Munger tends to focus on a few good investment ideas, concentrates his portfolio in these ideas, and lets the long term growth of these firms compound his returns.

Both Munger and Buffett ignore beta – the measure professional investors use to gage volatility and hence “risk” – preferring to focus instead on the risk/reward relationship of the business over the longer term. “Volatility over time will take care of itself” according to Munger, provided favorable odds exist that the business will grow.

In addition to his law practice and the real estate activities, Munger also owned an investment partnership at the firm of Wheeler, Munger & Company. Wheeler Munger was set up as a classic hedge fund, similar to those that have become so popular today – but the returns were very volatile.

During the market decline in the early 1970s an investment of $1,000 in the Munger partnership on January 1, 1973 would have been worth only $467 two years later – and while Munger was not concerned because he knew longer term value would surface, reporting temporary losses to his investors was painful.

Munger’s Ten Rules for Investment Success

Several themes appear in the book help explain Munger’s incredible success accumulating wealth as an investor: [Continue Reading]

S&P 500 Price to Peak Earnings: Another Perspective

One of the limitations of Price to Earnings (P/E) Ratios is the volatility of earnings from year to year, particularly in a recession. The combination of reverse leverage, where earnings fall faster than revenues, and write-offs can cause P/E ratios to actually expand in down markets. There are several approaches to normalizing earnings to make the P/E ratio more meaningful. One that I like to use is the Price to Peak Earnings Ratio. This was made popular by investment manager John Hussman. Other approaches to normalizing earnings include looking at Price to 10-Year Average Earnings, which is used by Yale Economist Robert Schiller.

Currently, the Price/(Peak Earnings) ratio is 11.65. To me, it looks like the general market is neither markedly under or overvalued based on this indicator. As always, these indicators should be taken with a “grain of salt” – they all have their limitations. One factor that currently favors stocks is the level of interest rates, which were higher at previous bear market lows. Ultimately, stocks must compete for the yield available from competing assets. Currently CD’s, High Yield Money Market Accounts, and Treasuries offer very little yield.

Here is a link to my data. I will also add a link to the data on the blog’s main page.

Lowest Average Cost Wins

In a 2004 interview in The Motley Fool, Bruce Greenwald gives an example which drives home the importance of having the patience and discipline to average down in order to optimize performance. Greenwald talks about Paul Sonkin, who, at that time, had averaged about 25% after fees for the previous four and a half years.

Greenwald observed that Sonkin would often make additional pruchases if a stock declined after he bought it. Greenwald looked at Sonkin’s trades and determined that, of the 25% return, fully 22% was from purchases made after the initial purchase. Greenwald also notes that he was looking at the performance of legendary value investor Walter Schloss who averaged 15.3% over five decades. It appeared that much of Schloss’s returns came from the same practice and then selling on the way up. As Bill Miller says, “Lowest average cost wins.”

Takeaways:

  1. Follow-up purchases that lower the cost basis in a stock can have a powerful impact on returns.
  2. Caution! This strategy only works if you have a strong valuation methodology so you can avoid expensive “value traps” and “falling knives”.
  3. This approach requires having a certain self-mastery coupled with a proper orientation on how to think about market prices. For that, study chapter 8 of The Intelligent Investor.