Monthly Archives: July 2010

Links of Interest – July 31, 2010

My interview with Zeke Ashton of Centaur Capital | Street Capitalist: Event Driven Value Investments – Good advice and information from a value investing pro.

Resources – Great collection of letters and articles by Graham, Buffett and Klarman.

TJX’s Sales Growth Not Bad Considering the Economy — Seeking Alpha – Good showcase for YCharts, an interesting research tool.

Distressed Debt Investing: Wisdom from Seth Klarman – Part 1 – Loaded with the usual deep insights which have made Klarman followed by so many.

Buffett, Railroads, and the Lessons of History (BRK-A) – A lesson on doing your homework.

Selected Notes from Sequoia Fund, Inc. Meeting May 14, 2010 – A few good nuggets in anticipation of the official meeting notes.

The Most Underrated Part of Warren Buffett’s Success (BRK-A, BRK-B) – Roger Lowenstein opines about Buffett.

Who Will Follow Buffett?

Who is Buffett’s New Man?

Munger on Li Lu as One of Buffett’s Successors: “It’s a foregone conclusion”

An article in today’s Wall Street Journal discusses the possibility that Li Lu will eventually be named as one of Warren Buffett’s successors at Berkshire Hathaway. What is newsworthy in this article is that it is the first time to my knowledge that Buffett or Munger has acknowledged that a specific individual is actually a candidate.

Mr. Li, 44 years old, has emerged as a leading candidate to run a chunk of Berkshire’s $100 billion portfolio, stemming from a close friendship with Charlie Munger, Berkshire’s 86-year-old vice chairman. In an interview, Mr. Munger revealed that Mr. Li was likely to become one of the top Berkshire investment officials. “In my mind, it’s a foregone conclusion,” Mr. Munger said.

What is also newsworthy is that Buffett does not rule out bringing a manager such as Lu on board prior to his stepping down.

“I like the idea of bringing on other investment managers while I’m still here,” Mr. Buffett says. He says he doesn’t preclude making a move this year, though he adds that there is no “goal” to bring on an additional manager that quickly either. Mr. Buffett says he envisions a team approach in which the Berkshire investment officials would be “paid as a group” from one pot, he says. “I don’t want them to compete.”

Here is a comment I posted at the Wall Street Journal in response to the article.

I have listened to Lu’s lectures at Columbia and was impressed. The article suggests he could be a one-trick pony: “But hiring Mr. Li could be risky. His big bet on BYD is his only large-scale investing home run. Without the BYD profits, his performance as a hedge-fund manager is unremarkable.”

What impressed me is the way he thinks. He has a very sound investment process, very much grounded in the principles of Buffett and Munger. It’s not just about the outcome – but about how much risk was taken to achieve it. Lu only invests when there is a huge margin of safety and he does an incredible amount of homework before investing. He views himself as a kind of deep-research journalist.

Picking Lu would also be a bet on the person and his track record – which Buffett likes to do as extraordinary people are rare.

Lu is clearly a special guy having risen from poverty to earning three degrees at Columbia and starting a successful hedge fund. Along the way he emerged as a leader in an important human rights campaign within China. On top of that, he managed to impress Charlie Munger, who is not easily impressed.

“When I call Charlie with an idea,” according to Buffett, “and he says, ‘That is really a dumb idea,’ that means we should put 100% of our net worth into it. If he says, ‘That is the dumbest thing I’ve ever heard,’ then you should put 50% of your net worth into it. Only if he says, ‘I’m going to have you committed,’ does it mean he really doesn’t like the idea.”

After meeting Lu, Munger gave him a portion of his wealth to invest.

Finally, here are links to more information about Lu. Berkshire Hathaway shareholders will be particularly interested in understanding all they can about Lu. If you’re not a shareholder, Lu is worth a careful study as he is a deep thinker and a first-rate investor.

  1. Li Lu’s 2010 talk at Columbia.
  2. Transcript of Lu’s 2010 talk at Columbia (courtsey of Street Capitalist)
  3. Lu’s tribute to Charlie Munger
  4. My research articles on BYD (Lu was an early investor and brought the idea to Buffett who invested $230 million (10% stake); current value is approximately $1.5 billion)

Price-to-Book Ratio and ROE Offer Strong Value Clues

There is a direct relationship between the return on equity of a stock and its price to book value. Understanding this relationship can give you insight into whether a stock is undervalued. Here’s the way valuation expert Aswath Damodaran of the Stern School of Business at NYU illustrates this relationship:

(click to enlarge)

This makes sense if you follow Buffett and look at a stock as an equity bond. The primary difference between an equity bond and an actual bond is that the equity bond does not have a fixed coupon – it’s up to the business analyst to estimate it – and an equity bond frequently has a growing coupon, owing to the reinvestment of earnings back into the business, just as would happen if you reinvested interest back into a savings account.

It follows that there is a general relationship between the return on equity of a business and the price to book ratio at which it trades. For example, you can expect a decent business that generates an ROE of 6-8% to trade around 1x book. On the other hand, a business that is able to generate an ROE of 24% should trade around 4x book, especially if the business enjoys a durable competitive advantage and its long-term prospects are promising.

We can see this mathematically if we consider the following formula:

PV (present value) = initial earnings x 1/(R – G) where R is the cost of capital and G is the growth rate of earnings. In this case, following Buffett, we will assume that the cost of capital is the risk free rate of return on long-term government bonds. Buffett does not look for safety in using a higher discount rate because he thinks it is a poor substitute for the certainty he demands in an equity investment.

For the first business earning an ROE of 6% and assuming equity of $100 million, the PV is $100 million. This assumes long-term government bonds are paying 6%.

$100 million = $6 million x 1/(6% – 0)

For the second business earning an ROE of 24% and assuming equity of $100 million, the PV is $400 million.

$400 million = $24 million x 1/(6% – 0)

It follows that the second asset will sell for four times the price of the first asset. If the equity base is growing the difference in value is even more pronounced. Consider a $100,000 15-year bond that is paying 24% with a payout ratio of 60% that lets you reinvest the balance at 24%. The invested capital will grow by 9.6% annually. [G (growth) = (1 – Payout ratio) * Interest rate]

Such a bond would have a NPV of $584,130. Here’s the data.

A business with similar economics could be expected to trade at as much as 6x book value. Consider American Express which has had an average ROE in the mid to high twenties over the past decade and a payout ratio (dividends and share repurchases) of 60-70%. It has generally traded at 3x to 7x book value over the past decade.

(click to enlarge)

Obviously, the relationship between price-to-book ratio and return on equity is not fixed and can vary greatly depending on the business and its prospects. Investing can never be reduced to a simple one-variable formula. However, this relationship can give you insight into whether a business is over or undervalued.

It also underscores the tremendous value of a business that can earn a high return on equity and reinvest most or all of it back into the business at a high ROE. These types of businesses are rare. It is not widely appreciated that a large part of Berkshire Hathaway’s stellar track record owes itself to Buffett being able to do precisely this for four decades.

Bruce Greenwald: Averaging Down, Plus Selling On the Way Up, Drives Returns for Sonkin and Schloss

In a 2004 interview, Bruce Greenwald, Columbia business professor and value investing expert, spoke about micro-cap investor Paul Sonkin. Value investors continue to track Sonkin because of his excellent reputation and track record. During the 4 1/2-year period preceding the interview, Greenwald points out that Sonkin generated average annual returns of 25% compared to 3% for the general stock market.

What is fascinating is that Greenwald points out that the vast majority of Sonkin’s returns came from buying additional stock if an investment declined after the initial purchase. Greenwald explains that for this to work, an investor needs to have a great deal of confidence in his valuation methodology. Other prominent value investors have also advised buying additional shares if a security declines after your initial purchase.

The key here is knowing what you are doing. Greenwald also states that, in the case of Sonkin and Walter Schloss, their investing process included selling a portion of their shares on the way up. Of course, if you do not have a robust valuation methodology or simply bought shares because a given security was going up in price and you figured you could offload them to someone else at a higher price, this strategy is unlikely to work. You’re more likely to do just the opposite and dump your shares out of fear if your position moves against you.

Investing like Sonkin and Schloss also requires only investing when you have a margin of safety.

Here the relevant part of the interview:

Greenwald: . . . And the third thing you have to have is discipline and patience. In the story I’m going to tell you about discipline and patience and the value strategy is about Paul Sonkin — his name is on the book — who was put into business by a set of value investors, myself among others. He’s just performed phenomenally. He’s been in four and a half years, and you can’t really tell on a four-and-a-half-year record, but his returns after fees have averaged about 25% with a market around 3.

TMF: That’s incredible.

Greenwald: He has a strategy of very, very small stocks. So if he buys half a million dollars, then he has to file a 13D [required when you buy more than 5% of a company’s stock] in some of these companies. But that means he’s the only one there. So he satisfies the first criteria. He’s got the basic valuation methodology. But one of the things we did in looking at his trades is that we looked at what he would have made if, when he made the first purchase of the stock — the first time he bought it — he just bought it there and he’d sold it at the first sales. So that he’d just done one buy decision and one sell decision, as opposed to buying it first, finding out, oops, the stock has continued to go down, but continuing to buy on the down side, having confidence in your valuation judgment. Of the 25% return, about 22% of it came from purchases at lower prices than the initial purchase. We’ve got Walter Schloss’s archives, and it looks like — we haven’t got the numbers yet — a large percentage of Walter Schloss’s returns have come also over time from knowing that you’re buying something worth buying. And then when it goes down, not getting frightened and dumping it, but continuing to buy. And then selling on the way up. Looks like that does a lot better than just averaging down. [emphasis added]

TMF: I recently spoke with Mary Chris Gay, who is Bill Miller’s colleague. That’s their strategy, she said: Lowest average cost wins. I suppose that’s confirmed now.

Greenwald: That’s exactly right. But notice what that depends on. You have to have confidence in your valuation. And you have to have the discipline to stick with it, that if this is a good stock and nothing has changed about the underlying value of the company, then if it’s a good stock at 8, then it’s a better stock at 4, rather than people who will see a stock go from 8 to 4 and say, “Oh crap, something’s going on here that I don’t know about.”

TMF: And there are a lot of people who think like that.

Greenwald: Who would think that and dump the stock.

Here’s the interview in its entirety.

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:

Buffett: Growth vs. Value is a False Distinction – It’s What You Get for Your Money

Imagine that you had just inherited $100,000 and you wanted to invest it in a savings account to get a return on your money.  Further imagine that your town had two banks from which to choose.  The first paid 8%, but you could not reinvest it. The second bank paid 5% on your initial deposit, but, unlike the first bank, it would let you reinvest your earnings at a rate of 12%. Finally, assume that each bank required a 25 year commitment and that your investment was insured and safe.

Which would you choose?  Buffett used this example at the 1992 Berkshire Hathaway shareholders meeting to illustrate the way we should think about growth and value when considering a prospective investment. Buffett acknowledged that the example was a simplification, but that it nevertheless underscored the importance of understanding the basic mathematics of investing. (1)

So which would you choose? What if you needed to pay a $20,000 sales charge to gain access to the second offering?

(Pause, and think about your answer.)

It turns out that the net present value of the second account is double that of the first. Even though the initial rate of return at the first bank is 60% higher than that of the second, over time the ability to reinvest your earnings at 12% makes a huge difference.

Here’s the data.

If we equate these bank accounts to stocks, we can imagine the first bank being a stock selling at 1x book value with an 8% return on equity that pays out all its earnings in dividends. We can liken the second bank account to a stock selling at 2.5x book with a 12% return on equity. Because you would need to pay a premium to net worth of 2.5x, your earnings on your average carrying value would be reduced to 5%.

However, all retained earnings would earn a much more generous 12% and the compounding of those retained earnings at 12% would really add up over time.

The takeaway here is a greater insight into the power of investing in businesses that can generate a high return on incremental reinvested capital over the long-term (which are rare), even if you need to pay up to do so. It also illustrates the potential pitfalls of relying on a single valuation metric such as price to book ratios as a substitute for thinking deeply about the net present value of the dollars you lay out when you make an investment.

Finally, Buffett may not actually do a discounted cash flow analysis when evaluating an investment. Charlie Munger has said he’s never seen Buffett do one. Nevertheless, it seems likely, based on this example and others, that Buffett has done the math and has these types of models committed to memory which he can immediately draw upon when sizing up an investment.

(1) Berkshire Hathaway annual meeting, 1992, Outstanding Investor Digest, June 22, 1992, p. 51.

Ben Franklin’s Thirteen Virtues

  1. Temperance
    Eat not to dullness; drink not to elevation.
  2. Silence
    Speak not but what may benefit others or yourself; avoid trifling conversation.
  3. Order
    Let all your things have their places; let each part of your business have its time.
  4. Resolution
    Resolve to perform what you ought; perform without fail what you resolve.
  5. Frugality
    Make no expense but to do good to others or yourself, i.e., waste nothing.
  6. Industry
    Lose no time; be always employed in something useful; cut off all unnecessary actions.
  7. Sincerity
    Use no hurtful deceit; think innocently and justly, and, if you speak, speak accordingly.
  8. Justice
    Wrong none by doing injuries or omitting the benefits that are your duty.
  9. Moderation
    Avoid extremes; forbear resenting injuries so much as you think they deserve.
  10. Cleanliness
    Tolerate no uncleanliness in body, clothes, or habitation.
  11. Tranquillity
    Be not disturbed at trifles, or at accidents common or unavoidable.
  12. Chastity
    Rarely use venery but for health or offspring, never to dullness, weakness, or the injury of your own or another’s peace or reputation.
  13. Humility
    Imitate Jesus and Socrates.

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 « – Bill Gurley’s insightful take on why Google is undervalued.

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


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.

Longleaf Partners’ Mason Hawkins: “Equities Offer a Superior Opportunity for Investors Today”

Longleaf’s second quarter letter to shareholders was just released and in it highly regarded value investors Mason Hawkins and Staley Cates make the case that equities are still attractive.  They view the market as overly fixated on negative macroeconomic news, namely debt, demographics, doom and the possibility of a double-dip recession.

Equities offer a superior opportunity for investors today, particularly compared to fixed income. The earnings yield of the S&P 500 based on 2011 projected EPS is 9.4%. If adjusted for the approximately $100 of cash imbedded in the S&P, the operating earnings yield increases to 10.4%. The numbers are slightly more attractive overseas. Based on 2011 estimates, the EAFE Index earnings yield is 9.8%. If earnings grow organically from today’s depressed levels at only 5% per year (a rate that does not require the reinvestment of earnings because of current excess capacity), and even if the P/E ratio remains below the long-term average, an investor’s five year average annual return will be in the mid-teens.

By contrast, corporate bonds with fixed, taxable coupons yield much less than the growing, after-tax coupon that companies produce. The following table compares corporate earnings yields to bond yields at bear market lows since 1932. When stocks have been at their lowest levels, earnings yields have been an average of 2.8% higher than Aa2 bond yields. At the beginning of July earnings yields are 4.3% above debt yields or almost twice stocks’ relative attractiveness to bonds at bear market lows.We have rarely witnessed this much disparity in the benefits of being an owner of a growing coupon versus being a lender to a fixed one.

Here’s a link to the letter. The table they reference with their data is on page 2 and is worth a look.

The potential flaw with Hawkins’ argument is that it is based on the assumption that 1) the S&P’s earnings in 2011 will be approximately $96 (the S&P was at 1022.58 on July 2; the yield of 9.4% assumes 2011 earnings of $96) and 2) interest rates will stay at these historically low levels. Both could happen, but I think it is prudent to consider that these assumptions could prove to be wrong. For the record, per Robert Shiller’s data the all-time high earnings on the S&P 500 were $84.92 in June, 2007.