Monthly Archives: November 2011

100 Ways to Beat the Market #20: Buy Berkshire Hathaway at 1.1x book value or less

One simple way to beat the market is to buy and hold Berkshire Hathaway stock at a good price. Buffett acknowledges that it is challenging to find intelligent ways to invest Berkshire’s massive and growing cash holdings. Nevertheless, he is clear that his goal is still to beat the S&P 500 which he believes he can do, albeit at a diminished level of outperformance vis-a-vis Berkshire’s earlier halcyon days. It is worth noting that Buffett is famously conservative in his missives about his ability to continue to outperform.

Berkshire’s recent performance compared to the S&P 500 is noteworthy. Berkshire has outperformed the S&P 500 in each of the ten most recent five-year periods by an average margin of just over 7%. For the record, Berkshire has never had a five-year period where it underperformed the market.

Buffett believes that Berkshire’s stock is undervalued at 1.1x book value (or approximately $109,000 per A share). He’s right. If you net out the equity investments ($67 billion as of Q3, 2011) and use Buffett’s estimate of normalized after-tax earnings ($12 billion), Berkshire has an earnings yield of about 10%. These earnings are being generated by a diversified portfolio of high-quality businesses that includes a number of bullet-proof, growing world-class franchises such as GEICO and BNSF.

Berkshire enjoys a number of advantages which should continue to increase its intrinsic value.

  1. Berkshire has outstanding veteran managers who are unencumbered by bureaucracy or quarterly earnings numbers. They focus solely on building long-term value.
  2. Berkshire can not only purchase operating businesses, but also marketable securities. This gives it a much higher likelihood of finding attractive investments compared to the typical S&P 500 corporation which is constrained to allocate capital within its own industry. Moreover, Berkshire has advantaged access to many deals based on Berkshire’s reputation, deep pockets, and ability to act quickly.
  3. Berkshire has a shareholder-oriented culture. Board members (excluding Buffett) own over $3 billion in stock, and compensation is completely aligned with shareholder interests. Moreover, Berkshire is imbued with a culture of frugality. This means that Berkshire’s wealth will increase the value of shares rather than line the pockets of management.
  4. Berkshire enjoys cheap leverage in the form of insurance float. Although it is impossible to predict with any amount of precision, it seems likely – based on Berkshire’s track record – that float will continue to grow. Berkshire can also borrow at low rates given its strength.
  5. Buffett is still at the top of his game and getting better. The IBM purchase shows his savvy and growing circle of competence and, in my humble opinion, has a reasonable likelihood of adding $10 billion in value over the next 10 to 15 years. Todd Combs and Ted Weschler are warming up in the bull-pen and were hand picked by the same guy who spotted Lou Simpson.

Of course, not losing money should be top of mind when considering an investment. Berkshire has a fortress balance sheet with massive cash holdings as a hedge against economic disruption that puts Buffett in a position of strength to take advantage of opportunities when others are scrambling. Also, Berkshire’s commitment to repurchase shares below 1.1x book puts a floor under the stock.

100 Ways to Beat the Market #19: Avoid businesses subject to disruption

The value of a business is the present value of all future cash flows that it will produce. Determining these future cash flows is the serious work of a securities analyst. Ratios that look at past and present performance often reveal little about a business’s future prospects. Thinking is required, and that can’t be automated or delegated.

Frequently, these future cash flows simply cannot be determined with precision. One risk that you must be on guard against is whether a business is subject to disruption. You need to consider what could kill the business? This is a foundational question, perhaps the most important.

If the business is generating a good return on capital – and these are the types of businesses you should be looking at – you can be certain that there are those who would love to storm the castle and steal the gold.

One of the biggest disruptors is the Internet. We all know that it’s a game changer for many businesses. Before making any investment, you need to think long and hard about whether your prospective investment is subject to Internet disruption and, if so, to what degree. It’s the difference between investing in businesses like Borders or Circuit City that were massively affected by the Internet and BNSF that is largely impervious to Internet disruption.

So how do you think about Internet disruption? A checklist is a good tool here. Make a list of the issues and factors you need to think about and then run it down when contemplating a purchase.

I just came across a good one in Bill Ackman’s analysis of Lowe’s. Ackman is considering the impact of online shopping on home centers such as Lowes and Home Depot.

Here’s Ackman’s checklist of conditions that render on-line shopping most appealing:

  1. Product is relatively high-priced (i.e., sales tax savings are more material)
  2. Product is not needed immediately
  3. Shipping cost is low
  4. Shipping is unlikely to damage the product
  5. Professional installation is not needed
  6. Item is not purchased as part of a larger project
  7. End-user of the product is making the purchasing decision

If you want to beat the market, carefully and systematically think about how your investments could be disrupted. Use a checklist to capture the issues and then have the discipline to put your checklist into practice. You’ll be richer for it.

Links of Interest – November 18, 2011

Latest memo from Howard Marks

Graham & Doddsville – Fall 2011

Bill Ackman – Waiting for a Bounce from the Lowe’s – Ackman makes the case for why Lowe’s is a good bet. Also, provides a template for how to analyze a retail stock.

Pabrai Funds 09 Annual Meeting Transcript – Munger Told Him Less, Not More Diversification

Michael Lewis on the King of Human Error | Business | Vanity Fair

Inspiration vs. Working Hard: Why Working Hard Always Wins | Webdesigner Depot

Investment banking: The big squeeze | The Economist

Farnam Street – Behavioral Economics Reading List

IBM Mini-Roundup

2011 Business Review and 2015 Roadmap

IBM: 1100100 and counting | The Economist

Leaders: Multinationimbles | The Economist

Ruane, Cunniff & Goldfarb Investor Day, May 20, 2011 – See discussion of IBM on page 4. Who Says Elephants Can’t Dance?: Leading a Great Enterprise through Dramatic Change: Louis V. Gerstner – Buffett mentioned he re-read the book in the CNBC interview in which he revealed Berkshire’s purchase of IBM.

IBM’s 2015 Roadmap and 2011 Business Review

IBM’s 2015 Roadmap and 2011 Business Review – source: IBM

IBM has a financial “roadmap” telling investors how profitable it intends to be in the next five years and how it will get there. By 2015 the firm wants its earnings per share almost to double, to “at least” $20. The roadmap also helps, according to Mark Loughridge, the chief financial officer, “to keep the same level of intensity” as during the near-death experience of the early 1990s. “If you ask executives about the roadmap 2015, they can tell you immediately how their plans are lined up to that longer-term goal,” he says. – The Economist

The human platform has an important drawback: it is expensive to maintain and to extend, says Carl Claunch of Gartner, a market-research firm. That also means, however, that it is costly for others to replicate or invade. And given the complexity of the world and how much of it is still to be digitised, IBM’s human platform looks unlikely to reach its limits soon. Perhaps not for another 100 years. – The Economist


100 Ways to Beat the Market #18: “Handle the basics well”

In his 1994 shareholder letter, Warren Buffett extols the phenomenal performance of Scott Fetzer: it earned an extraordinary return on equity without the benefit of a monopolistic position, leverage or strong cyclical tail winds. Scott Fetzer’s return on equity – had it been included in the 1993 Fortune 500 – would have earned it a number 4 ranking. Buffett attributes the company’s success to the managerial performance of Ralph Schey, Scott Fetzer’s CEO.

But here’s the somewhat surprising point. It’s not because of any managerial gymnastics on Schey’s point. It’s because – as Buffett points out – Schey handles the basics extraordinarily well and doesn’t allow himself to get diverted.

Schey, “Establishes the right goals and doesn’t allow himself to get diverted.”

Buffett explicitly points out that this approach applies not only to the management of a business, but also to investing. Extraordinary things are not necessary to get extraordinary results. Yet, the temptation remains to complicate things. We allow ourselves to be pulled in a million directions, even more so today because of the unlimited potential distractions that the Internet provides.

If you want to beat the market, keep it simple. Decide what your goals are. Put in place a rational process to achieve them and then work hard.

“Before the gates of excellence, the high gods have placed sweat.” – Hesiod

100 Ways to Beat the Market #17: Select securities with a higher expected return than the market

If you want to beat the market, you need to have a clear understanding of what drives market returns. Generally speaking, you can expect the returns of the the S&P 500 to be closely correlated with the growth of corporate earnings. Corporate earnings in turn are closely tied to GDP growth. After all, per Buffett, you can’t expect a component part – corporate earnings – to indefinitely grow at a faster rate than the aggregate to which they belong – the overall economy.

You can provide your own estimates, but assuming that real GDP growth averages 3% and that inflation is at 3%, your would get a 6% return. Add in 1.5% for dividends and you are 7.5%. If you are expecting more than this, then you need to provide and defend your assumptions.

Is the market’s return on equity closer to the high end or the low end of its historic average? Are multiples of earnings high of low? What are your expectations for interest rates going forward? These all play a roll in setting expectations.

What is the point of this exercise if you are trying to best the market?

In sports, top athletes carefully study their opponents so they can get an edge. If you clearly understand what drives overall stock market performance, you can make a rule for yourself that you will only buy securities that offer superior expected returns both as a function of the businesses’ underlying economics and also the price you are paying for their securities.

If you buy better businesses at better prices, you will beat the market.

100 Ways to Beat the Market #16: Filter by opportunity cost

Charlie Munger has said that one the most effective filters you can use to optimize the allocation of capital is to compare a prospective stock purchase to your best current holding. If it’s not as attractive, don’t buy it.

Instead, consider buying more of your best holding. This type of thinking will force you to move capital into optimal opportunities and will prevent the dillution of your efforts. Munger also points out that it is a powerful time saver. If your idea is not as good as your best holding, you can forgo wasting time doing any further research.

Another variant of this idea is to compare your idea to buying Coca-Cola. Coke is a great company: virtually unlimited growth prospects, Fort Knox balance sheet, unassailable franchise, low capital intensity, minimal regulatory and litigation risk, strong management, etc. Always remember that (most of the time) you could just buy Coke and your almost guaranteed of getting a good, if not spectacular, result. Run down your idea against Coke and honestly determine if it is worth it on a risk-adjusted basis. This may keep you from doing some dumb things with your precious capital.