Monthly Archives: October 2009

Valuation of Berkshire Hathaway

If you own Berkshire Hathaway’s stock or are interested in following the company, I recommend paying attention to Ravi Nagarajan at The Rational Walk. Ravi is an excellent analyst who does a first-rate job of following the company.

Here are links to various articles at The Rational Walk on Berkshire’s valuation:

How Useful is Berkshire’s Book Value for Valuation Purposes?

How Did Berkshire Hathaway’s Book Value Fare is Q3, 2009?

Berkshire Valuation Two Column Approach – This is one approach implicitly endorsed by Buffett in recent shareholder letters.

Whitney Tilson on Berkshire Hathaway’s Intrinsic Value – Ravi’s take on Berkshire’s valuation by noted buffett follower Whitney Tilson.

Below are links to Ravi’s detailed five-part estimate of Berskshire Hathaway’s intrinsic value (this is reminiscent of the highly recommend valuation done by Alice Schroder in 1999 when she was an insurance analyst at PaineWebber):

Part 1
Part 2
Part 3
Part 4
Part 5

Disclosure: The author owns shares of Berkshire Hathaway.

Joel Greenblatt on the Process of Valuation

Here are some excellent points about valuation and investing from an interview with Joel Grennblatt done by value investor Shai Dardashti.

1. While studying the footnotes is crucial, the big picture is most important: Earnings yield and ROIC are the two most important factors to consider, with the key being figuring out normalized earnings.

2. High earnings yield, based upon normalized earnings, is important in order to have a margin of safety. High ROIC (again based on normalized earnings) simply tells you how good a business it is.

3. Independent thinking, in-depth research, and the ability to persevere through near-term underperformance, are three keys to being a successful value investor.

4. Worrying about near-term volatility has nothing to do with being a successful value investor.

5. Think of a concentrated portfolio as if you lived in a small town and had $1 million to invest. If you have carefully researched to find the best 5 companies, the risk is minimal (As Charlie Munger says, “The way to minimize risk is to think.”)

6. Special situations are just value investing with a catalyst.

7. International investing may offer the best opportunity, at least in terms of cheapness.

8. Finding complicated situations that no one else wants to do the work to figure out is a way to gain an advantage. (You have discussed and given examples of many such situations in your book, You Can Be a Stock Market Genius.)

9. Looking at the numbers best way to learn about management. What have they done with the cash? What are the incentives? Is the salary too high? Is there heavy insider selling? What is their track record?

10. Focus on understanding and buying good businesses on sale, and don’t worry about the macro economy. Everything is cyclical, so value can always be found somewhere.

11. Focus on situations that are not of interest to big players (usually small- and mid-cap, although currently large caps are cheap; spin-offs may be such opportunities, but the key is to figure out the interests of insiders; bankruptcies, restructurings, and recapitalizations may also be such opportunities).

12. Trust no one over 30, and no one under 30; must do your own work, rather than simply ride coat-tails.

13. Risk is permanent loss of invested capital, and not any measurement of volatility developed by statisticians or academicians.

14. All investing is value investing and to make a distinction between value and growth is meaningless.

(Read more)

Some Thoughts on Selling

Selling is an important part of the overall discipline of value investing. At the risk of oversimplifying things, value investors generally fall into one of two camps: those who sell their holdings when they reach intrinsic value and those who hold indefinitely, as long as the intrinsic value continues to grow.

Examples of investors in the first group are David Einhorn and Seth Klarman. Investor and writer Vitaliy Katsenelson has written a book called Active Value Investing which argues that investors should sell stocks when they reach intrinsic value because we are likely to be in a long-term range-bound market. His argument is worth considering.

Klarman has said that he frequently sells too early. I suspect that this due not only to his aversion to speculating, but also because of his understanding of intrinsic value. Klarman, like Graham before him, sees intrinsic value not as a specific precise number, but as a range of values. Therefore, it makes sense to sell as the stock price move up into the lower end of this range of values. Otherwise, the higher the price goes, the more you become dependent on the “greater fool” to bail you out.

The best known example of the second camp (buy and hold) is Warren Buffett. Another example is the Tweedy, Browne Company. A major incentive for this approach is that it defers capital gains taxes into the future, in effect getting an interest-free loan from the government. (Obviously, this is only an advantage for taxable holdings.) Buffett did not practice this approach in his partnership and would typically sell when a holding reached intrinsic value.

Why the change for Buffett? I think there are several reasons. First, the opportunities for Graham style asset plays diminished with time as the shock of the great depression faded and equities regained popularity with a new generation of investors. Second, Buffett began to focus on “good” businesses that had the capability of growing intrinsic value at a high rate over a long period of time. (During the Buffett partnership, most of the money was made from the stock price closing the gap between the purchase price and intrinsic value as opposed to growth in intrinsic value.) Also, as Buffett’s capital ballooned it became increasingly impractical to jump in and out of stocks. In addition, as Buffett became very wealthy he began to value the relationships with the management and owners of his holdings, for example with Kay Graham at the Washington Post.

Buffett has long favored the outright purchase of a business, if possible, because it allows him to control capital allocation. His emphasis on buy-and-hold has allowed him to create a competitive advantage vis-a-vis competing buy-out firms. He is able to attract and be first-in-line on a number of deals because the sellers know Berkshire will allow management to stay in place and run the business as they see fit and they needn’t fear the business will be dismantled or leveraged up.

So, how can we reconcile the two camps? I don’t think we need to. They both can work. The important thing, as with all investing, is to carefully think through your position in advance. Having a sell strategy will then help provide a framework against emotional reactions in the “heat of battle”. Also, it doesn’t need to be an “all or nothing” proposition. It would be perfectly rational to have mixture of long-term holdings that were increasing intrinsic value over time and event driven asset plays that you intend to sell when they reach your estimate of intrinsic value.

Also, regardless of which approach you adopt, there can be times when selling is the only rational thing to do. This occurs when a stock reaches a state of extreme overvaluation. In this case, take your profits. It makes no sense to hold a stock whose price anticipates a decade or more of robust growth in the intrinsic value of the underlying business.

Another time to consider selling is if you find a stock that is materially more undervalued than an existing holding. There is no set rule of thumb here, but, as a general guideline, I would say that it makes sense to do if, all else being equal, you can double your earnings yield. For example, if a given portion of your investing capital is earning X, redeploy it if you can find an opportunity where it would earn 2X. This should more than cover capital gains taxes, especially if they are long-term, and provide you with some margin of safety in your decision.