Monthly Archives: October 2010

Links of Interest – October 29, 2010


Investment Checklist for Stock Selection | Old School Value

Meet the leading contender for managing Berkshire’s billions – Oct. 25, 2010

The man behind Buffett’s new man: Stephen Friedman – Fortune Finance

How to Save the News – Magazine – The Atlantic

Jeremy Grantham’s GMO Quarterly Letter – October 2010

Zeke Ashton’s Value Investing Congress Presentation – October 2010

A Framework for Selling a Stock

Determining a good strategy for when to sell a stock is both important and difficult. In simple terms, your returns are going to come from two primary sources: 1) the reappraisal of an undervalued holding to its intrinsic value and 2) growth in intrinsic value. Many investors sell their holdings if the price appreciates to fair value. Others, like Buffett, Russo, Greenberg, etc. hold their stocks for the long-term and look for gains from growth in intrinsic value.

Both of these approaches work and have generated a great deal of wealth.

In September, I posted a 1999 interview with hedge fund manager Morris Mark. Mark began his career at First Manhattan, an investment advisory firm founded by Sandy Gottesman, a large shareholder ($2 billion) and board member of Berkshire Hathaway.

Here’s what Mark said about selling Coca-Cola.

“We sold it three years ago because the valuation it was trading at in relation to our anticipated rate of earnings growth on a near to long term basis seemed to be well discounted versus our rate of return objectives. Generally, we would sell a position when something bothers us, otherwise the sale is likely related to valuation.”

This strikes me as an immanently rational framework which I would tweak only slightly:

Sell a stock when, after due consideration of taxes and opportunity costs, its anticipated rate of total return is well discounted versus your rate of return objectives.

This framework works for all types of investing and allows for the fact that different investors have different hurdle rates. Of course, considerable judgment is involved in making this determination, but these are the type of issues that should have been considered carefully before making a purchase. If you can’t figure out how much intrinsic value will grow in the long-term, the stock should probably be sold when it is no longer undervalued.

I would love to hear your comments about when you sell a stock.

Buffett Taps Combs – Confirms Principles

Warren Buffett surprised the financial world this week when he announced that Todd Combs would take over the management of Berkshire Hathaway’s investment portfolio when Buffett steps aside or dies.

If Buffett is anything, he is consistent, and the selection of Combs only further shows Buffett’s adherence to his core principles.

Trust your own judgment

Many times over his career, Buffett has referred to Benjamin Graham’s maxim that, “You’re neither right nor wrong because other people agree with you. You’re right because your facts are right and your reasoning is right—and that’s the only thing that makes you right. And if your facts and reasoning are right, you don’t have to worry about anybody else.”

Most of us would reflexively pay lip service to this maxim, but in reality we tend to seek at least some level of comfort from the warmth of the herd. We may dress up our conclusions with the garb of facts, when indeed we are actually only justifying a position we came to as a result of being influenced by the opinions of others.

Buffett made up his own mind about Combs based on his own judgment and reasoning. He is perfectly comfortable in doing so because he has been operating this way his entire adult life. He is not looking for approval, and it means little to him how it was received by others.

For the record, Buffett has a pretty good track record picking talent. After Buffett interviewed Lou Simpson for the GEICO CIO job, he called then GEICO chairman Jack Byrne and said, “Stop the search. That’s the guy.” Simpson’s performance at GEICO has been outstanding.

When Buffett wound up his investment partnership, he referred limited partners to Bill Ruane, who started the Sequoia Fund to manage funds for former Buffett limited partners. Ruane went on to build a superlative long-term track record.

Process over outcome

Investors should focus on process instead of outcome in selecting both investments and investment managers, knowing that if you get the process right, the outcome will take care of itself. If you focus solely on the outcome you may be disappointed down the road to learn that is was achieved by chance or in conjunction with a dangerous level of risk.

Buffett obviously saw in Comb’s work an investment process that would serve Berkshire shareholders well over the long term – one that per Jason Zweig’s article yesterday in the Wall Street Journal, focuses, first and foremost, on the downside, that is grounded in deep fundamental research and staying within Comb’s circle of competence, that is long-term oriented, and that tends away from closet indexing towards concentration.

Temperament is key

Buffett has said that genius is wasted on investing and, given a certain level of intelligence (which Buffett pegs as an IQ of 130); the important thing is to have the right temperament. That temperament includes a great respect for risk, the ability to wait (and wait) for the right opportunity to come along, the ability to be fearful when others are greedy and greedy when others are fearful, the ability to think for yourself (see first point), and a high level of passion for what you’re doing.

I believe Buffett saw the right temperament in Todd Combs. Here’s Buffett, “He is a 100% fit for our culture. I can define the culture while I am here, but we want a culture that is so embedded that it doesn’t get tested when the founder of it isn’t around. Todd is perfect in that respect.”

Once again, Buffett has surprised us by doing the unanticipated. In reality, he was following a set of well-tested principles that date back to his mentor and friend Ben Graham. Time will tell, but I would be surprised if Combs does not work out well.

The Mark of a Good Business: High Returns on Capital (Part 2)

“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” – Warren Buffett 1992 Berkshire Hathaway Shareholder Letter

Last week, I wrote a post that looked at return on incremental equity. The post explained a way to measure return on incremental equity over a multi-year period. It also considered how, in a stable business with a durable competitive advantage, the return on incremental equity and can be used, in conjunction with the rate of reinvestment, to predict the growth in earnings.

Today, I am writing about another tool used by Buffett to measure the returns on an investment: return on average tangible net worth.

Beginning with the 2003 Berkshire Hathaway letter to shareholders, Buffett began providing a simplified balance sheet of the manufacturing, service and retailing operations segment, a widely diversified group which includes building products, carpet, apparel, furniture, retail, flight training, fractional jet ownership and distribution.

Buffett breaks out the four broad segments of Berkshire – insurance, utilities, finance, and manufacturing, service and retailing operations – because they each have different economics which are harder to understand if considered as one undifferentiated mass. This is obviously useful to remember when analyzing a business with two or more disparate operating segments.

When he reports on the results of the manufacturing, service and retailing operations segment, Buffett focuses on the return earned on average tangible net worth, which for example in 2003, was in Buffett’s words “a hefty” 20.7%.

To calculate tangible net worth, take the equity on the balance sheet and subtract goodwill and other intangible assets. Buffett averages the tangible net worth that is on the books at the beginning and end of the year so as not to upwardly bias the return if the earnings were in part the result of a large injection of capital into the segment during the year.

On average, the segment enjoys very strong returns on average tangible net worth, typically in the low 20’s. This is highly meaningful because it not only shows the excellent economics of these businesses, but also it shows the returns that can be expected from additional capital that is invested into these businesses.

Here is the simplified balance sheet for the years since Buffett began providing it along with the calculations.

Here are some additional observations.

Buffett also provides the returns on Berkshire’s average carrying value. This is the same calculation as return on average tangible net worth without subtracting goodwill. Berkshire had to pay a substantial premium over book value to purchase these businesses given their excellent economics. Over the long-term, the return on incremental equity will be the major determinant of Berkshire’s returns on these investments as the retained earnings become an ever larger portion on the capital employed. As an investor, you want to pay close attention to both the premium you pay to buy a great business and the returns on incremental capital.

Omitting goodwill and intangible assets from the equation is appropriate because Berkshire will not need to pay a premium on incremental capital employed in the existing businesses. Berkshire does, however, need to pay a premium going forward to acquire businesses to add to this segment. This is evident from the goodwill and intangible assets line item which has grown from $8.4 billion in 2003 to $16.5 billion in 2009. Overall, to put that in context, Buffett invested an additional $15 billion in that segment over the same time period.

In analyzing an investment, you want to consider whether future growth will come from acquisitions, in which case you can expect additional goodwill, or organic investment, in which case the returns on tangible net worth would be a more appropriate metric.

Unfortunately, from the standpoint of providing opportunities for Berkshire to deploy capital going forward, some of Berkshire best businesses, which are found in this segment, are both small in scale as compared to Berkshire as a whole and require very little incremental capital.

Finally, it is fairly clear that this segment’s earning power has been materially impacted by the recession. If it is able to return to pre-recession levels, this group should earn net income of approximately $3 billion.

My Watchlist – October 25, 2010

I have reviewed issue 9 of Value Line and added companies that have exceptional returns on equity. I am moving the posting of this list to Monday in order to make it more timely. The list is not perfect and some judgment is required in deciding whether to include a particular stock. As always, I welcome your feedback and comments.

The idea here is to have a dashboard of substantially all the larger-cap high quality businesses in the U.S. in one place that you can review at least weekly to see what Mr. Market is making available to you.

Here is the updated watchlist.

Stocks Added This Week

Caterpillar Inc. (CAT)

Donaldson Company, Inc. (DCI)

Graco Inc. (GGG)

The Middleby Corporation (MIDD)

Stanley Black & Decker, Inc. (SWK)

The Toro Company (TTC)


Danaher Corporation (DHR)

Honeywell International Inc. (HON)

ITT Corporation (ITT)

3M Company (MMM)

United Technologies Corporation (UTX)


Goldman Sachs Group, Inc. (GS)

TD Ameritrade Holding Corp. (AMTD)

Check Point Software Technologies Ltd. (CHKP)

Matthews International Corporation (MATW)

A few thoughts…

Many stocks are close to new highs and are well above their lows. Some caution is in order.

The key to getting the most out of the list is to review it on a regular basis. In time, some obvious opportunities will emerge.

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.

Links of Interest – October 22, 2010

Fall 2010 Issue of Graham and Doddsville

Goldman Eyes Repaying Buffett IOU –

StockPup Blog

Jeremy Siegel: Now is a Golden Opportunity for Stock Investors —

CNBC Stock Market News — HED — Stock Blog —Best Time to Buy Stocks Since 1980’s: Legg Mason’s Miller – CNBC

Distressed Debt Investing: Exclusive Interview: Greenstone Value Opportunity Fund

Investment Strategy – Bank Balance Sheets ‘Full of Rotten Stuff’: Jim Rogers – CNBC

Warren Buffett: Forget gold, buy stocks – Yahoo! Finance

Tap Your Inner Buffett –

Harness Technology to Stay Informed During Earnings Season | The Rational Walk

The Warren Buffetts Next Door: The World’s Greatest Investors You’ve Never Heard Of and What You Can Learn From Them – Sample Chapter

Charles Brandes on Investing Lessons from Benjamin Graham

Longleaf Partners Shareholder Letter

Gold Hiding in Plain Sight

“Finance properly taught should be taught from cases where the investment decisions are easy,” said Munger. “And the one that I always cite is the early history of National Cash Reigster Company. It was created by a very intelligent man who bought all the patents, had the best sales force, and the best production plants. He was very intelligent man and a fanatic, all of whose passions were dedicated to the cash register business. And of course, the invention of the cash register was a godsend to retailing. You might even say that cash registers were the pharmaceuticals industry of a former age. If you read an annual report when Patterson was the CEO of National Cash Register, an idiot could tell that here was talented fanatic – very favorably located. Therefore, the investment decision was easy.” [emphasis added] – Damn Right, Janet Lowe, p. 234.

If you had read NCR’s early annual reports, it would have been obvious. That is what you should be looking for – situations that are obvious. You may only be able to find one or two a year, but that is enough to make you rich. Of course, you need to also make a meaningful investment when you find one.

The point is that the fact that NCR was a no-brainer jumped off the pages of its annual report. John Patterson was laying it all out for anyone willing to read it. This underscores the importance of spending a lot of time reading annual reports. That’s what Buffett does. The greatest investor of our time is intensely focused and jealous of his time, yet he spends most of his day reading annual reports.

Buffett is intensely critical of annual reports that are written by the PR department and have little to say of real meaning. The bad news is that there are a lot of annual reports written in this fashion. The good news is that when you find one that actually says something – where the CEO is laying out the case for why the business is a great opportunity – you may really be on to something.

There is no way to screen for these types of annual reports. You have to go out and find them one by one.

I remember the first time I read Fairfax Financial’s annual reports. It was clear that Prem Watsa was an unusual CEO and that Fairfax was an unusual company. The data was all there and the way it was presented spoke volumes. Berkshire’s shareholder letters are the same way.

History doesn’t repeat itself, but it rhymes.

Another lesson here is not just to read annual reports, but to go back and study the histories of great companies and also great failures in order to build a set of mental models that you can draw upon in analyzing and evaluating prospective investments.

When I read Munger’s description of John Henry Patterson, I could not help but be struck by how much it reminded me of his description of Wang Chuanfu, the chairman of BYD. “This guy,” Munger told Fortune, “is a combination of Thomas Edison and Jack Welch – something like Edison in solving technical problems, and something like Welch in getting done what he needs to do. I have never seen anything like it.” Did Munger’s study of NCR put him in a position to see and appreciate the merits of investing in BYD when the opportunity came along?

The lessons learned from investing and studying businesses are cumulative. That’s why Munger argues Buffett is better now than he’s ever been and that he continues to get better. You should make it a point to study these past winners and losers and add them to your library of mental models. Henry Singleton of Teledyne is another example, about whom I posted recently.

As always, I welcome your own thoughts and feedback.

Francis Chou

In the past, I have mentioned the great Canadian value investor Francis Chou. Chou has been part of Prem Watsa’s investment team at Fairfax Financial for over twenty-five years. He also runs the Chou Funds where in 2005 he was named the Canadian fund manager of the decade.

I came across an article on Chou in Canadian Business Online that contains some good information on Chou.

Chou invests using three different tactics:

First, he keeps his eyes peeled for what he calls “special situations” — companies facing short-term problems that result in temporary mispricings under unusual circumstances.

Second, he likes to buy shares in what he jokingly refers to as CRAP (Cannot Realize A Profit) companies. Chou says the market is prone to overreacting when stocks are heading for the toilet, so failing companies are often irrationally valued for less than they would be worth if they liquidated their assets. He buys baskets of such companies, knowing that he may lose money on three out of 10, but more than make up for those losses with profits on the other seven.

His final tactic is more akin to the way that Warren Buffett invests and it’s increasingly Chou’s favorite. It entails spending countless hours searching for well-run companies with growth potential that, for some reason, are trading for much less than they’re worth. Because the market is so efficient, such companies are extremely rare and often only found among those with short-term problems, but they offer excellent long-term prospects if they’re blessed with strong management. Chou is lucky to find one or two during a whole year of searching. But once he’s found one, Chou doesn’t hesitate to bet 5% or more of his portfolio on that single stock. “When you know you’re buying a good company, it’s like getting a straight flush,” he says. “They’re hard to find, so when you’ve got one, you have to capitalize on it.”

Here are some additional observations from the article:

1. Chou thinks most investors make the mistake of buying a stock because its price is going up instead of buying stocks when they are on sale – the way people like yo buy their groceries or other merchandise.

2. Chou wants his investments to be made with a margin of safety. He typically wants to buy a stock when its is selling for a 40% to 50% discount from his estimate of intrinsic value.

3. Chou is not averse to making a concentrated bet when he has conviction and a large margin of safety. At one point he had 16% of his fund in Sears Holdings. Chou estimated that the company’s real estate holdings were worth $40 to $50 per share and Chou was able to buy it at $25 per share.

4. Chou does not attribute his investing success to having a high IQ. “George Athanassakos, professor of finance and the Ben Graham Chair in Value Investing at the Richard Ivey School of Business in London, Ont., thinks that Chou might be right: perhaps he’s not outperforming because of superior intelligence, better connections or charisma. Maybe it’s because Chou’s natural disposition just happens to be a perfect match to the investing style he’s chosen.”

According to Buffett, “Investing is not a game where the guy with the 160 IQ beats the guy with a 130 IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”

For many, this may be the X-factor that is the key to outsized returns.

5. It is fascinating to me that Chou mentions that buying good businesses is increasingly becoming his favorite tactic. I have seen Joel Greenblatt make similar comments.

More on Chou:

Semi-Annual Report 2010

Class Act of the Year

Follow the Leader

The Mark of a Good Business: High Returns on Capital

“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” – Warren Buffett, 1992 Berkshire Hathaway Shareholder Letter

A good business is one that can earn very high returns on capital. Rarely can such a business invest all of its capital back into the business. One way to find companies that can is to look for companies that have grown book value at a high rate on a per share basis.

A business can still be a good investment if it can’t reinvest all of its earnings back into the business. An example is American Express. Prior to the 2008 economic crisis, Amex was earning over 30% on equity but was only reinvesting about a third of its earnings back into the business. The remaining two-thirds were paid out in the form of dividends and share repurchases.

There are numerous ways to measure return on invested capital. None of them is perfect. Any of the various metrics and ratios investors use to analyze a business are abstractions and, as such, typically tend to oversimplify the economic reality of the business. They are short-cuts we use to point us in the right direction so we can spend our precious time researching businesses that offer the most opportunity.

Return on Incremental Equity

I like to look at the total amount of equity that has been added to a business over the past decade and then calculate the return on that additional investment. This approach also allows me to calculate what percentage of the company’s earnings was reinvested, which in turn is useful in forecasting the future growth in earnings.

I typically use Value Line when I do this because the layout is very conducive to this type of analysis. It is one reason why investors like Buffett, Munger and Li Lu like Value Line.

It is useful here to remember Buffett’s reminder that it is not necessarily a cause for celebration if a business grows its earnings year after year. The same thing happens to a savings account if you add more capital each year, which does not make a savings account a good investment. It’s the return on this additional capital that determines whether something is a good investment or not.

To illustrate, let’s look at Johnson & Johnson (JNJ). In 2000, JNJ had shareholders’ equity of $18.8 billion. At the end of 2009, its shareholders’ equity had grown to $50.6 billion. We can calculate that, since 2000, JNJ invested $31.8 billion back into the business.

During that same time, earnings grew $8.1 billion, from $4.8 billion in 2000 to $12.9 billion in 2009.

By dividing the additional earnings of $8.1 billion by the additional $31.8 billion in capital, we can see that JNJ earned a return of 25.5% on its investment, which is very good.

It is also useful to look at what percentage of its total net earnings JNJ reinvested back into the business. The reason is that this is suggestive of how much of its future earnings JNJ is likely to reinvest. By multiplying the rate of reinvestment by the return on that investment, we can then calculate an expected growth rate for earnings.

Since 2000 through 2009, JNJ earned a total net profit of $89.7 billion. Since we already know that JNJ reinvested $31.8 billion over that same time period, we can calculate that JNJ’s rate of reinvestment is 35.5%.

If JNJ can continue to earn 25.5% on equity and reinvest 35.5% of its earnings, earnings should grow at about 9% (.255 x .355).

Keep in mind that this does not include dividends or share repurchases. The latter would cause earnings per share to grow at a faster rate. Also, it does not include an analysis of where JNJ is selling in relation to its intrinsic value which could have a material impact on the expected total return. Finally, this type of analysis works best with a stable business that enjoys durable competitive advantages, such as JNJ.

Another example is Southwest Airlines which is a successful airline that operates in the highly competitive and capital intensive airline industry. Between 2000 and 2009, Southwest’s shareholders’ equity increased by $2 billion. Earnings were $140 million in 2009 compared to $625 million in 2000 and have generally bobbed around over that time period. The return on that additional $2 billion has been relatively poor.

Calculating the return on incremental equity over a long-period of time should prove a useful tool in your analysis of prospective investments. Coupled with the rate of reinvestment, it can also allow you to get an idea of how fast a company can be expected to grow its earnings.

You can also use this approach to invert an expected rate of earnings growth to examine what combination of ROE and rate of reinvestment will be required to produce it.

In succeeding related posts, I’ll look at Buffett’s use of return on average tangible net worth and Greenblatt’s use of return on tangible capital employed to determine whether a business is good.

My Watchlist – October 18, 2010

I have reviewed issue 8 of Value Line and added companies that have exceptional returns on equity. I am moving the posting of this list to Monday in order to make it more timely. The list is not perfect and some judgment is required in deciding whether to include a particular stock. As always, I welcome your feedback and comments.

The idea here is to have a dashboard of substantially all the larger-cap high quality businesses in the U.S. in one place that you can review at least weekly to see what Mr. Market is making available to you.

Here is the updated watchlist.

Stocks Added This Week

AFLAC Incorporated – AFL

E.I. du Pont de Nemours & Company – DD

FMC Corporation – FMC

Abbott Laboratories – ABT

Allergan, Inc. – AGN

Bristol Myers Squibb Co. – BMY

Forest Laboratories, Inc. – FRX

Gilead Sciences, Inc. – GILD

GlaxoSmithKline plc (ADR) – GSK

Hospira, Inc. – HSP

Eli Lilly & Co. – LLY

Merck & Co., Inc. – MRK

Novartis AG (ADR) – NVS

Novo Nordisk A/S (ADR) – NVO

Pfizer Inc. – PFE

Stocks within 10% of a 52-week low:


Stocks with an earnings yield greater than 8%:

Gilead Sciences, Inc. – GILD

Eli Lilly & Co. – LLY

Merck & Co., Inc. – MRK

A few thoughts…

The majority of stocks in these sectors are close to new highs and are well above their lows. Some caution is in order.

The pharma stocks exemplify the potential danger of blindly extrapolating past growth rates into the future. Their earnings going forward will not be a function of what they did in the past but what they are able to do in the future. Predicting the future success of these companies’ pipelines is difficult.