Years ago, Warren Buffett said at the annual shareholders meeting that what he and Charlie try to do is figure out what a company’s Value Line sheet will look like in ten years. Of course, this can only be done in stable businesses with a good long-term record of performance. It is in that spirit that I made a 5-year projection for U.S. Bancorp a la Value Line.
U.S. Bancorp is a well run bank with an outstanding long-term record of performance. It is focused on core banking functions – consumer and business banking, wealth management, wholesale banking, trust services and payments – and has minimal exposure to investment banking and other challenges larger banks are facing with capital markets.
My base or mid case assumes annual asset growth over the next five years of 7%. This is reasonable given U.S. Bancorp’s historical performance and given the continued consolidation in U.S. banking. The base case assumes a 2016 ROA of 1.7%, well below the banks pre 2008 returns and reasonable assuming a modest recovery in housing. U.S. Bancorp had an ROA of 1.53% in 2011. Assuming the bank’s P/E in 2016 is 13 (its long-term median P/E), it would reach a price target of $57 and produce annual capital gains of 12.5%.
I also assumed a normalized payout ratio of 45% on the bank’s 2011 EPS of $2.46 for a yield of 3.5%. I assume this yield would grow in line with earnings. The base case would produce a total annual return of 16%.
It is interesting to note that U.S. Bancorp sold for as low as $21 a share in 2011 when Mr. Market was in a worse mood. Buying at that level would have produced >15% IRR, even under the proposed pessimistic scenario. Of course, all else being equal, the price you pay goes a long way in determining your total return and margin of safety.
Prominent holders with material positions include Buffett, Prem Watsa, Glenn Greenberg and Donald Yacktman.
Of course, you’ll need to provide your own assumptions. It is critically important to quantify. It forces you to make your assumptions explicit and see if your portfolio holdings are reasonably aligned with your expectations. (You can’t from New York to L.A. in four hours with a prop plane that tops out at 300 mph.)
I am long U.S. Bancorp.
A Few Stocks
Buffett has long underscored that GAAP can sometimes obfuscate the economic performance of a business. To wit, Buffett introduced the notion of look-through earnings, which comprise both reported earnings AND any undistributed earnings of a company’s investees. (See Berkshire Hathaway’s Owner’s Manual for more details.) Buffett has underscored that including these earnings in a calculation of a business’s normal earnings power is highly useful in understanding where the business stands and in valuing the business. The tree still falls, even if nobody hears it.
In his 2011 letter to shareholders, Buffett made it a point to note that Berkshire’s share of the earnings of Coca-Cola, American Express, Wells Fargo and IBM – the “Big Four” – was $3.3 billion. Under GAAP, only $862 million of dividends were reported. The press mostly ignores or is ignorant of this reality in reporting Berkshire’s earnings. Therefore, many have a poor understanding of Berkshire’s true earnings power.
I made my own estimate of Berkshire’s 2012 look-through earnings from its equity investments. My estimate is $6.5 billion of which just under $2 billion will be paid to – and reported by – Berkshire as dividends. That leaves $4.5 billion that Berkshire will likely earn in 2012 that will not be reported. That is substantial. Buffett wrote in his 2010 letter that he estimated Berkshire’s normal after-tax earnings power to be $12 billion.
Berkshire’s total 2012 after-tax earnings – including look-through earnings – could be as high as $16.5 billion, or more.
One other detail should be mentioned. Years ago, when Buffett would provide a calculation of look-through earnings in his shareholder letters, he would deduct an amount equal to the additional taxes that Berkshire would have paid if all owner earnings were paid as dividends. In my judgment, that is overly conservative. Buffett is generally a very long-term holder of common stocks. The present value of the deferred taxes on the capital gains that will be derived from these retained earnings will be far less than the taxes due if these earnings were distributed as dividends in the years they were earned. Nevertheless, some adjustment should be made to any estimate of intrinsic value based on look-through earnings to account for Berkshire’s deferred tax liability.
Finally, my estimate is largely based on consensus 2012 earnings estimates for Berkshire common stock investments.
Fairfax Financial Chairman’s Letter to Shareholders (Prem Watsa)
Steve Romick on Bloomberg
How many times have great value investors affirmed the wisdom – and profitability – of this simple advice: average down when buying and average up when selling. How few – even those who understand its inherent logic – fail to do so on a consistent basis. It takes enormous discipline to not take a valuation cue from price action. Yet this is precisely what the great ones do not do – they take their cue from a dispassionate, margin-of-safety-infused estimate of intrinsic value. Without this practice, the Mr. Market parable is of little use, reduced to a quaint anecdote of Buffett’s mentor, Ben Graham.
Gurufocus has a nice feature where you can see both graphically and in tabular form the historic equity purchases of prominent value investors. How often have I observed that the best, focused value investors frequently buy more – sometimes much more – when a newly established position craters down in price. Conversely, I have frequently seen the same investors average up by selling a portion of their shares if Mr. Market makes a particularly tantalizing offer. This can result in a staggering IRR on the sold portion and greatly reduce the risk of capital loss on the remaining shares as they are held for greater gains.
In his recently published 2012 letter to Fairfax Financial shareholders, Prem Watsa – a preeminent practitioner of value investing who has grown book value by over 23% per year over 25 years and generated a 14% annual return on common stock purchases over the past 15 years – recounts how Fairfax Financial generated a realized gain of $341 million from International Coal using precisely this technique. (Prem lays it all out in tabular form). After initiating a position at $4.58 per share, they averaged down, bringing their average cost down to $3.37 per share. They subsequently sold half their position for a gain of 115% at $7.26 per share. The remaining shares were sold only five months later when there was a takeover offer for the company at double that price. (Fairfax sold at $14.60 per share.)
This was done without buying at the low or having any special ability to see into the future. All that was required was the right intellectual framework and emotional discipline. Watsa relates how he has been using exactly the same investing technique for the past 35 years.
Incorporate the same approach into your investing process and you will greatly increase your odds of beating the market.
At its core, investing is about putting out money now to get more in inflation-adjusted dollars in the future. To be done intelligently, this requires you to be able to predict with meaningful accuracy the future economic development of a business. If you cannot do this, it is impossible to handicap the odds and make a rational calculation of the odds of loss times the amount of the possible loss versus the odds of a payoff times the amount of that payoff (the essence of rational investing).
The right framework – and arguably the most important question – is thinking about where the business will be in ten years. It challenges you – if you are honest with yourself – to decide if you really understand the business. For some reason, this is more of an issue with buying stocks than buying an actual business. A buyer of a private business naturally thinks about where the business will be in ten years – perhaps because he intuitively knows that there will be no greater fools around to buy his stock at a higher price. His fate will be entirely determined by the economic performance of the business. The irony here is that the same applies when buying a stock. It is just that so many have been impacted by the faulty thinking so prevalent on Wall Street, which tends to view stocks as lottery tickets rather than pieces of a business.
Thinking about where a business will be in ten years gives you an edge because so many of your competitors are focused on the short term. If they don’t get the short term right, there will be no long term they reason, so they stick close to the herd where they can find refuge in mediocre relative performance.
Thinking about where a business will be in ten years is a powerful filter that will save you research time because it allows you to quickly eliminate businesses where it is impossible to determine (not necessarily impossible per se, but for you, which is all that matters). Generally speaking, change is the most common reason that makes it impossible to judge where a business will be in ten years: rapid technological changes, no moats with competitors flooding in, decaying business models, and creative destruction are all common contributing factors.
As Buffett is fond to stress, it does not matter if the number of businesses you can predict is small. Fortunes have been made concentrating in one business that is deeply understood. Think Rose Blumkin. Put a premium on certainty, even if it means giving up some potential return. Compounding is the wealth engine, and many have disrupted its magic by overreaching. If you are more or less certain that you have a good understanding of where the business will be in ten years and you wait for a price that allows you to meet your hurdle rate, the odds will favor you beating the market.