Monthly Archives: August 2010

Michael Price at Columbia: Profitable Lessons from a Great Investor

The following are my notes from Michael Price’s lecture at the Columbia business school in the spring of 2006. I thought his remarks on how he values pharmaceuticals, how he uses the newspaper to generate investment ideas and how he sizes his positions were noteworthy. He pays great attention to publicly disclosed data in acquisitions calling it a treasure trove of information for valuing companies.

Here is Michael Price’s profile from

Michael F. Price is the 271st richest person in the world, according to Forbes. A renowned money manager, he learned finance as a $200-a-week research assistant under Max Heine. Mr. Price earned reputation for buying undervalued companies, and raising he@#. He has often tussled with management of companies held in his portfolios. He sold Heine Securities in 1996 to Franklin Resources for $670 million. Now, Price manages the private firm, MFP Investors, with $1.6 billion under management, much of it his own money.

Bruce Greenwald mentions that Price helped train Seth Klarman when he worked for Max Heine.

Price thinks that the capital structure comes down to two things: 1) equity, where you own part of a company, and 2) debt, where you lend money to a company. Everything, in Price’s view, else has been invented by Wall Street to rip you off and generate fees.

He tries to boil down a potential investment to these two components to help him evaluate the opportunity. He tries to simplify things and focus on the essentials.

He likes to focus on the balance sheet and the notes to the financials. He is not interested in complex securities such as CDO’s. It is hard enough to figure out what is cheap and buy it. He tries to focus on the steak, not the sizzle. He tries to figure out the worth of the steak and buy it at big discount – $.60 on the dollar. He doesn’t like to pay anything for sizzle.

He does not believe that Graham’s net-nets are generally available, but they do show up from time to time. In general, you will wait a long time – perhaps too long, if you limit your investments to net-nets.

If you can’t find cheap stocks, you wait.

He gave the example of 3M that was doing well in 2006, but the stock had been knocked down from $90 to $70 because Wall Street was focused on how 3M was going to keep up its performance. My takeaway was that Wall Street’s focus on this type of superficial headline risk can make stocks available at a bargain (Mr. Market).

He doesn’t mind style drift if you are pursuing the best value available. The context here was that he usually focuses on smaller companies and special situations, but, at the time of lecture, a number of large caps offered compelling value not usually available.

Proxy Statements Hold Value

You must read the proxy statements because they reveal the self-dealing and cheating. The merger proxies also give rich data that you can use to do comparables of other companies. Price likes to compute intrinsic value using what smart investment banks pay for companies after doing lots of due diligence. This is a lot more meaningful than Morgan Stanley saying a stock should be trading at 17x earnings and you can buy it for 13x earnings.

To Price, when a businessman buys control of a business using cash or securities, that indicates intrinsic value. He does not approach valuation by discounting a stream of future earnings which he views as much too hard to do, nor does he use price-to-book or price-to-EBITDA, which he views as awful. You have to go to where there are transactions and see what companies are doing with their cash flows.

Read the merger proxies and bankruptcy disclosure documents which are a treasure trove of industry data. Typically many buy and sell side analysts are not going to read these documents. As an analyst and investor, you must read these documents.

The real way to make money is to do original research. This is different from inside information. Meaningful data from original research are hard to find. It takes getting creative – reading trades, going to court, talking to reporters, etc.

His mentor was Max Heine who did not like buying shares without voting rights. Price is sympathetic to this viewpoint. Two classes of stock can become an issue if the company is an acquisition candidate. You can buy two-class shares if you have high confidence in the management or family that controls the company. He carefully considers the incentives of the controlling parties. Are there 4th generation family members who are creating pressure to monetize their holdings?

On How He Reads Newspapers to Generate Investment Ideas

He reads the WSJ, New York Times and Financial Times every day. He also suggests reading trade papers such as American Banker. He loves the Lex Report in the FT. He is looking for examples of change – new management, restructuring, restatements, acquisitions, busted deals, lawsuits, etc. Also, he looks at who is wasting money on large ads. He likes to look at the worst performing groups domestically and globally. He looks at tender offer tombstones and dividend cuts.

You need to do your work when a stock starts going down on news so that, if it opens down a huge amount, you are in a position to buy – preparation meeting opportunity.

On How He Sizes His Positions and Trades Around Positions

He won’t buy unless he can identify value.  He wants 3-5% in his top five names. He wants 2% in his next ten names and then 20-30 positions with 1%. With the 1% positions he is looking to build larger positions, because if he bought them cheap and they go down he wants to buy more. With the 5% positions – which is his size limit – he is looking whether he should leave them alone or bring them down.

He trades around positions where he has done the research and where the stock will do well over time. For example, if he buys 500,000 shares at $10 and the stock moves up, he won’t buy more. If it goes to $20, he might sell 100,000 shares. If the stock drops back to $11, he won’t buy more because it is not cheap enough. He’s OK with that because he has confidence based on his research that it will do well over time. You need to constantly re-evaluate if you want to be in a given stock; that is why you don’t want to have 300 names – it’s too many to track.

How He Values Pharmaceuticals

Value investors never traditionally looked at pharmaceuticals because they sold at high P/E’s. Price bought Merck when its stock price declined under the specter of HillaryCare.

To value a pharmaceutical company, he takes all the drugs they are currently selling, assumes an 85% profit margin, and does a discounted cash flow projection based on the remaining life on each drug’s patent. Ideally, you want to buy the stock at a discount to these cash flows and get the pipeline for free; this, according to Price, doesn’t happen very often. He noted that pharmaceutical companies have good balance sheets, the prospects of consolidation – because the industry needs it, and strong dividends that provide a floor for the stocks.

The investment business is all about having a point of view, after having done the work, and acting upon it.

Charlie Munger: What Would he Make of Stock Recommendations and Incentives?

Charlie Munger has wisely drawn attention to the power of incentives to drive human behavior. For example, he cites the case of FedEx’s challenge of having the night shift finish processing packages on schedule. FedEx tried all kinds of things to accomplish this objective without success. Finally, they stopped paying the night shift workers by the hour and started paying them a fixed amount for the entire shift. Workers were free to go home when all the packages were processed. Problem solved.

If you are using any type of service that produces stock recommendations on a regular basis – monthly, weekly, or even daily – it makes sense to examine the recommendations in light of Munger’s thoughts on incentives. For this post, I’m not talking about the obvious incentive bias involved when someone is touting a stock. Here I’m talking about legitimate services that produce a steady stream of recommendations.

Is it possible to find such a stream of stock picks that are available at a compelling bargain price according to some fixed cycle or publishing schedule? Would subscribers keep coming back to a stock recommendation service that announced week after week that no compelling bargains were available?

In spite of Munger’s staunch disdain for efficient market theory as traditionally taught in academia, Munger teaches that the market is actually quite efficient most of the time. He likens the market to a pari-mutual race track where the odds generally reflect the capabilities of the various horses.

Here’s Munger in a talk at the USC Business School in 1994.

The model I like – to sort of simplify the notion of what goes on in a market for common stocks – is the pari-mutuel system at the racetrack.  If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds change based on what’s bet.  That’s what happens in the stock market.

Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on.  But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2.  Then it’s not clear which is statistically the best bet using the mathematics of Fermat and Pascal. The prices have changed in such a way that it’s very hard to beat the system.

Munger goes on to say that in spite of this situation, there are a select few people who are able to make good money betting on horses, even after the track taking 17% off the top. They do it by totally focusing on nothing but the performance of the horses and waiting – as long as it takes – until they see an anomaly where the odds are clearly in their favor. Then they bet heavily.

It’s something to think about the next time you turn to a source that cranks out recommendations like clockwork for scores of stocks. Think about whether it would be possible to make a living at the track trying to bet every race because you thought you could accurately handicap them all – or you used a publication that purported to do so – in a way that profitably exploited the available odds net of all transaction costs.

Reflections on Hedge Fund AltaRock’s Investment Process – Part 2

Today, I continue my commentary on hedge fund AltaRock’s investment criteria as laid out in their first half 2010 letter. As I explained in yesterday’s post, I have structured my remarks using my investing blueprint as the framework.

6.  Buy the Cheapest Business Available. AltaRock looks to buy businesses that are cheap. You can infer from their letter that, in general, they are looking for businesses that will deliver more present value dollars of cash than an investment of equal value in a market index, such as the S&P 500. They know that if they do this consistently, over the long term, they create a real mathematical expectancy of beating the market. Similarly, you want to put together a portfolio of investments that ideally is both cheaper than the market and that has an intrinsic value that is growing faster than that of the market.

7.  Focus on Your Best Ideas. AltaRock has 84% of its capital in its top five holdings and 94% of its “look through” earnings. Here they follow Buffett who tracks his share of the earnings of his equity holdings. The idea here is that even though these earnings are not reported in Berkshire’s financials because of GAAP, the earnings still accrue to the economic benefit of Berkshire.

8.  Practice Patience. The letter opens by saying that AltaRock underperformed the S&P 500 in the first half of 2010. They don’t put undo emphasis on short-term results, nor should you. He goes on to say that their strategy tends to generate short periods of superior performance and underperformance. They look to outperform over the long-term.

You should adopt a similar approach. No one can produce positive or superior results every quarter unless they are fudging (Madoff). Plus it’s the long-term that matters. Focus on total returns not getting a smooth ride. Volatility is not a good proxy for risk.

9.  Avoid Stupid Mistakes. In the letter, AltaRock apologizes for holding too much cash – they averaged 30% – over the past decade, characterizing it as a mistake. I’m not so sure. They beat the market by a substantial margin with arguably less risk.

There may be times to be 100% long, but, more often than not, it is prudent to have a portion of your capital in liquid short-term assets. You never know when Mr. Market will become manically depressed; not holding cash can have a high opportunity cost. In his October 16, 2008 “Buy American” op-ed in the New York Times, Buffett wrote that he was previously 100% in U.S. government bonds prior to starting to buy equities.

AltaRock manages macro-economic risk by consciously building a portfolio that is exposed to faster growing emerging markets. They simultaneously hedge their exposure to currency and inflation risks in highly indebted developed countries.

Of note, although the letter does not mention it, is that AltaRock’s portfolio also appears well positioned for a deflationary period. The types of large caps stocks they invest in typically pay a relatively high dividend, particularly if purchased at their current depressed multiples. In addition, sales in AltaRock’s portfolio companies should hold up relatively well since they sell tend to sell necessities.

An important point regarding their discussion of cash holdings is that they have taken the time to go back and review their past performance in order to learn from it. Nobody, of course, can avoid making mistakes. Hopefully, you can learn from them by doing post mortems.

10.  Be a Learning Machine. AltaRock’s document does not directly address how they seek to continually learn. We can deduce that, like many investors, they are grappling with the lessons learned from the most recent recession and market shocks and that they are trying to position their portfolio in a way that puts them in a position to succeed if the macro environment continues to be a major headwind.

Reflections on Hedge Fund AltaRock’s Investment Process – Part 1

On August 14, 2010, I posted hedge fund AltaRock’s mid-year letter. There is so much good information in the letter, that I thought it would be profitable to go through it carefully and post my observations. The first thing that struck me was the amount of overlap between AltaRock’s process and my investment blueprint. This is not surprising since both draw heavily upon the teachings of Buffett and Graham.

I have organized my comments using the investment blueprint, which has ten steps.

1. Search Broadly and Continually for New Investment Ideas. The AltaRock letter does not specifically talk about how they go about finding new ideas, but it does clearly define what they are looking for. If you clarify exactly what you’re looking for, you’ll save yourself a lot of time by quickly eliminating anything outside of your strike zone.

Also, alla Munger, because they have already put together a portfolio of high-quality companies in which they have conviction, they can also use their existing holdings as a benchmark when evaluating prospective investments.

2.  Act Like an Owner. Following Buffett, they view themselves as partial owners of businesses, not primarily holders of stock certificates. Why does this matter? James Montier has stated that having a long-term horizon is the most important advantage you can have over short-term speculators. In order to profit from this advantage you need to sit on your holdings for long periods of time. You won’t do this if you don’t understand the business (see point 3); you need to have the same mind-set you would have if you were buying a farm, office building, or small manufacturing plant in your home town.

AltaRock goes so far as viewing their holdings as a conglomerate, The AltaRock Conglomerate, for which they track key economic performance data. This is a good idea if it helps drive home that when you own a stock you own a piece of a real business and that your long-term fortunes, or lack thereof, will be primarily dependent on the long-term performance of the businesses you own.

3.  Only Buy Things You Understand. Massey writes that, “Successful investing involves getting to know the true nature of a business and becoming so comfortable with its characteristics and valuation that you would happily buy the entire company at today’s price with the intention of holding it for many years, if not forever.”

It is self-evident that you cannot reach this level of conviction if your don’t understand a business. Understanding a business can be defined in the more generic sense of having a deep insight into the business  – how it operates and makes money – and also in the more specific way in which Buffett uses it – having the ability to project what earnings will look like in ten years with a high level of certainty.

4.  Buy Good Businesses. AltaRock invests in companies that have a durable competitive advantage – Buffett’s moat – and that are highly profitable. They grade their holdings’ competitive position on a scale of 1 to 10. Specifically, they are looking for companies that possess some combination of economies of scale, network effect, or strong brand. See Competition Demystified by Bruce Greenwald and Judd Kahn for an in-depth treatment of these competitive advantages.

Their investments have an average profit margin of 33% vs. 6% for the S&P 500. They are not looking to beat the performance of the market by guessing, but by buying pieces of businesses that collectively have superior economics than those of the index.

They also want businesses that achieved good results without undue leverage – too much debt – and that have both a strong balance sheet and strong free cash flow. They note that their investments are producing cash flow equal to their earnings. Some businesses and industries consume far more cash than what is reported as GAAP earnings, leaving little leftover for shareholders. Over time, this is reflected in the price of the stock.

Finally, they want to invest in businesses that have a good growth platform where there is a basis for projecting growth out both 10 and 30 years.

5.  Invest in Companies with Great Management. AltaRock looks for managers who they can trust to return cash to shareholders if they cannot find additional high-return uses of capital. They judge this by looking at the long-term track record of management. Trust buy verify.

When considering an investment, go over the financials for the past ten years and see what management did with the cash. Steer clear if there is a history of poorly allocating capital, for example using undervalued shares to make an acquisition at an inflated price, or of disgorging an unfair share of the profits.

Tomorrow, I will look at AltaRock’s approach in light of the remaining five tenets my investing blueprint.

The Pomodoro Technique: A Way to Manage Your Time

What is it?

The Pomodoro Technique™ is a way to get the most out of time management. Turn time into a valuable ally to accomplish what we want to do and chart continuous improvement in the way we do it.

How  can I start?

The basic unit of work in the Pomodoro Technique™ can be split in five simple steps:

  1. Choose a task to be accomplished
  2. Set the Pomodoro to 25 minutes (the Pomodoro is the timer)
  3. Work on the task until the Pomodoro rings, then put a check on your sheet of paper
  4. Take a short break (5 minutes is OK)
  5. Every 4 Pomodoros take a longer break

Learn More

Hedge Fund AltaRock’s Rock Solid Investing Process

Last Monday, August 9, 2010,, which does a superlative job tracking the portfolios of prominent hedge funds, posted the mid-year letter of hedge fund AltaRock. I am re-posting it here because AltaRock’s investing process is a good template of how to put one together. summarizes what they are looking for in the following list:

– Sustainable Competitive Advantage
– Strong Profitability
– Shareholder Friendly Management
– Sell Necessities
– Global Diversity
– Strong Balance Sheet
– Strong Free Cash Flow
– Good Growth
– Cheap Valuation
– Current Long-Term Expectations
– Historical Context

Here’s the letter.


Links of Interest – August 13, 2010

13D Research – Asset Allocation & Investment Research – Interesting thoughts on “how to think”

Op-Ed Contributor – Four Deformations of the Apocalypse – – candid assessment of U.S. deficits by David Stockman, Ronald Reagan’s budget director

Fairfax Financial Holdings Limited – good set of slides for better understanding Fairfax Financial

Ted Rogers School of Management ePresence Presentation Portal – Engaging India – The second half has a good discussion with Prem Watsa about the economy and investing.

James Montier Resource Page – Leading thinker in behavioral finance and modern application of Ben Graham’s teachings

Transcription of Bruce Greenwald’s Lecture on the Investment Process at the Gabelli Value Investing Conference, August 4, 2005

Greenwald 2005 Inv Process Pres Gabelli

Bruce Berkowitz’s Game Plan for Getting Rich

I’m a big fan of focusing on the investing process and letting the outcome take care of itself. As I have written before, in this regard investing is like the draft in pro sports. You can’t really tell how well you’ll do for a number of years, so you better focus intensely on the process.

That was the lesson from Michael Lewis’s bestselling book Moneyball which chronicled how Billy Bean, despite lacking funds to compete head-on with the dominant baseball franchises, built a championship team by drafting unknown and lesser known talent using a superior recruiting process.

Today, Bruce Berkowitz is a financial celebrity with $15 billion under management. Over the past decade, he trounced the S&P 500, delivering annual returns of approximately 13% versus a loss for the index. Ten years ago he was virtually unknown with only $11.5 million under management. Today his results attract billions of new investment dollars, yet it was his process that got him there. He laid it out in an October 2, 2000 article in BusinessWeek.

I think our philosophy makes a lot of sense. We’re doing nothing more than what the wealthiest individuals in the world have done. We act like owners. We focus on very few companies. We try and know what you can know. We try and only buy a few companies which we believe have been built to last in all environments. We recognize that you only need a few good ideas in a lifetime to be fabulously wealthy…. We’re always trying to wonder what can go wrong. We’re very focused on the downside.

Here’s my brief take on Berkowitz’s approach.

Invest like the wealthiest individuals have always done. Recently several articles were published about Tiger 21.  According to an article published on, Tiger 21 is, “A peer network of 140 ultra-high-net-worth individuals who collectively control $10 billion in investable assets (i.e., the average member’s assets exceed $70 million). The group’s top holding is Berkshire Hathaway. Other top holdings include Brookfield Asset Management, Leucadia National, Loews and Markel, all of which follow the same principles – for example, as found in this list – that Berkowitz and Buffett use in allocating capital.

Act like owners. This is one of the ten tenets of my investing blueprint. Most people treat stocks like pieces of paper that can be bought and sold on a whim as they try to guess and exploit short-term price movements. This doesn’t work because in the short term chance and psychology drive prices and these cannot be predicted on a consistent basis. Do your homework and buy a fractional piece of a great business you understand. Then, be patient and let it compound.

Focus your investments. It’s hard to come up with a great idea – one you truly understand and where everything lines up. When you do, reason dictates that you make a meaningful commitment. Also, why waste time with your 30th best idea, if your best idea, or your second best, is available at a reasonable price?

Concentrate your research on what is knowable. Be true to yourself. Use checklists and be on guard against your behavioral weaknesses. Over confidence bias is very easy to fall prey to. Get the facts by doing the work yourself, i.e. reading the 10-K’s and the 10-Q’s. Some things are important and knowable, some things are important and unknowable – concentrate on the former, don’t waste time on the latter.

Buy companies that are “built to last in all environments”. Find companies with durable competitive advantages that can ideally hold up in both deflationary and inflationary environments. Buffett has said that a business’s moat is the most important consideration when making an investment.

Understand that you only need a few good ideas to get rich. Be patient. Munger says that intelligent investing is like patiently fishing at a stream where a fish may only come by once a year.

Worry about the downside. A lot of people have gone back to zero. Never do that. Learn what you’re doing and focus on avoiding permanent loss of capital. Don’t overpay and always insist on an identifiable margin of safety.

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%.

(click image to enlarge)

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%.

(click image to enlarge)

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.

(click chart to enlarge)

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.

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