Friday, March 26, 2010

Capital Productivity

From a recent white paper by James Montier:

"According to data from the New York Stock Exchange, the average holding period for a stock listed on its exchange is just 6 months. This seems like the investment equivalent of attention deficit hyperactivity disorder. In other words, it appears as if the average investor is simply concerned with the next couple of earnings reports, despite the fact that equities are obviously a long-duration asset. This myopia creates an opportunity for those who are willing or able to hold a longer time horizon."

James Montier: Was It All Just A Bad Dream? Or, Ten Lessons Not Learnt

The average holding period for stocks from the early 1930s until the late 1970s was in the 4 to 8 year range. So for 40+ years or so 4 years was the low end average holding period for stocks. In the 1980s it dropped below that to levels similar to that of the 1920s (the last time we obviously had troubles with excess speculation and leverage) to just under 2 years.

These days the average holding period is down to more like a 6 months.

"When we should be teaching young students about long-term investing and the magic of compound interest, the stock-picking contests offered by our schools are in fact teaching them about short-term speculation." - John Bogle in his book, The Battle for the Soul of Capitalism

John Bogle calls this a "rent-a-stock system".

Intuitively, most know what happens to an asset like a automobile when it's rented vs owned. The adverse effect of a large percentage of US businesses being "rented" for 6 months at a time is not much different.

With that time horizon, "renters" are not going to worry much about with long-term prospects and challenges of the business. This is a major disadvantage over time. The wisdom and quality of investment decision-making by the owners and managers has a huge impact on future wealth creation and living standards. This happens to be one of Berkshire's great assets; most of the shareholders are patient capital oriented. It's just more likely that assets will be mispriced when such a short time horizon is the dominant force at work (i.e. who cares if I paid too much I'm gonna sell it to someone else who'll pay even more too much).

Hardly optimal. Consider the trends in our capital productivity numbers. Just after WWII, it took around $2 of investment to produce $ 1 of GDP growth. Recently, this article by Byron Wien pointed out the following about trends in US capital productivity in the 1st decade of this century:

"Because of profligate spending on over-priced housing and other assets that declined seriously, as well as deficit spending by the government, by the end of the decade it took $6 of capital to produce $1 of growth" - Byron Wien

As for the "other assets" that Byron Wien refers to in the quote, I'd say that technology stocks circa 2000 are a good example.

James Montier points out the situation does present opportunities for patient long-term investors. While that is true, the status quo is far from satisfactory.

Capital is being misallocated more frequently than it should because of the culture in place and systemic defects.

Not fixing at least some of what's broken likely means that improvements to living standards end up less than what they might be otherwise.

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Tuesday, March 23, 2010

Health Care Cost Conundrum

Why are U.S. health care costs so high? Check out this article in The New Yorker written by Dr. Atul Gawande.

Here's Warren Buffett commenting on CNBC about Dr. Gawande earlier this month:

"...he had an article last summer that was absolutely magnificent. My partner Charlie Munger sat down and wrote out a check for $20,000 to him and he's never met him, never had any correspondence with it, he just mailed it to the New Yorker and he said, `This article is so useful socially.' He says, 'Just give this as a gift to the--to Dr. Gawande.' It compared medical costs in McAllen, Texas, to El Paso, and it just showed how, with no better results, that in McAllen they were, you know, they were spending close to twice as much per person. And you have these enormous variances around the country."

Below is an excerpt from Dr. Gawande's article in The New Yorker. In the article he describes having dinner with six McAllen doctors. He told those doctors that McAllen was the country's most costly place as far as health care goes and he showed them the data to back it up.

"Maybe the service is better here," the cardiologist suggested. People can be seen faster and get their tests more readily, he said.

Others were skeptical. "I don’t think that explains the costs he's talking about," the general surgeon said.


"It's malpractice," a family physician who had practiced here for thirty-three years said.
 


"McAllen is legal hell," the cardiologist agreed. Doctors order unnecessary tests just to protect themselves, he said. Everyone thought the lawyers here were worse than elsewhere. 


That explanation puzzled me. Several years ago, Texas passed a tough malpractice law that capped pain-and-suffering awards at two hundred and fifty thousand dollars. Didn't lawsuits go down? 


"Practically to zero," the cardiologist admitted.


Come on," the general surgeon finally said. "We all know these arguments are bullshit. There is overutilization here, pure and simple." Doctors, he said, were racking up charges with extra tests, services, and procedures.


Check out the full article by Dr. Gawande.

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Thursday, March 18, 2010

Inexpensive stock? If return on capital is low...it's probably not.

Well, at least over the long term.

One of the things that matters a whole lot in investing is return on capital (ROC) and how sustainable it is over time.

"If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result." - Charlie Munger in a 1994 speech 

"Time is the enemy of the poor business and the friend of the great business. If you have a business that's earning 20% to 25% on capital, time is your friend. But time is your enemy if your money is in a low-return business." - Warren Buffett at the 1998 shareholder meeting

An investor can always attempt to find mispriced lower quality businesses. The downside is that time is usually not an ally. The investor can own the shares until the price becomes closer to per share intrinsic value. Of course, then that investor has to sell and hunt for something else to buy (another opportunity but also another chance to make a mistake).

Overpay somewhat for a low ROC enterprise (i.e. misjudge current value) and rapidly compounding growth in intrinsic value will not be there to dig you out of the hole.

In contrast, a durable high ROC enterprise can still end up working well in the long run even when a small misjudgment leads to too much being paid.  Misjudge value somewhat and the higher quality business -- at least with the benefit of time -- can still produce an attractive rate of return in the long run. Not true for lower quality businesses.

So the durable high ROC business can help an investor to reduce mistakes and lower risk.

That doesn't mean it's okay to overpay. Whenever possible, an appropriate margin of safety should exist before making an investment but, inevitably, misjudgments get made. If a business has sustainable advantages and quality economic characteristics, those misjudgments should often end up being a whole lot less costly in the long run.

Judging whether a business is in fact going to maintain attractive economics over time is, of course, the tough part.

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Tuesday, March 16, 2010

Baupost: Lessons of the Crisis

In Seth Klarman's most recent annual letter, he lists some of the true and false lessons of the financial crisis. Here are some selected ones that I like (taken from the true section) in no particular order:

9. You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.

10. Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically created for sunny days and are almost never stress-tested for stormy weather. Securitization is an area that almost perfectly fits this description; markets for securitized assets such as subprime mortgages completely collapsed in 2008 and have not fully recovered. Ironically, the government is eager to restore the securitization markets back to their pre-collapse stature.


12. Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.


13. At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.


14. Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.


There are a total of 30 lessons (20 true, 10 false) on the list.

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, March 15, 2010

Horse-and-Buggy in a Formula One World

With the 2010 Formula 1 season getting underway this past weekend in Bahrain, the line near the end of this article in The New Yorker seems timely.

Carried-Interest
Managers of a typical private equity fund "usually pay only long-term capital gains—even though they put up hardly any of the fund’s actual capital, most of which comes from outside investors." 

"A general principle of good taxation is that similar jobs, and similar kinds of compensation, should be taxed the same way..."


"But the carried-interest tax break upends this rule. If you manage money for a mutual fund or a public company, you pay regular income taxes; do it for a private fund, and you pay capital gains."

'Simple Ventures'
"...when the law governing partnerships was passed, back in 1954, the goal was to make it easier for people to run what one law professor has termed 'simple ventures.' No one imagined that the law would end up covering an industry that manages trillions of dollars in assets, and would cost the government billions in tax revenue."

The article closes with the following:

"Too often, we're using horse-and-buggy laws to deal with a Formula One world. We shouldn't be too surprised when we get run over."

Check out the full article.

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, March 12, 2010

Munger's Four Ps

"Our experience...tends to confirm a long-held notion that being prepared, on a few occasions in a lifetime, to act promptly in scale, in doing some simple and logical thing will often dramatically improve the financial results of that lifetime. A few major opportunities, clearly recognizable as such, will usually come to one who continuously searches and waits, with a curious mind, loving diagnosis involving multiple variables. And then all that is required is a willingness to bet heavily when the odds are extremely favorable, using resources available as a result of prudence and patience in the past." - Charlie Munger in the 1996 Wesco Shareholder Letter

Munger's Four Ps seem to be:
  1. Preparation
  2. Prompt Action in Scale
  3. Prudence
  4. Patience
Actions by the Daily Journal (DJCO), where Munger is chairman, over the past decade seem consistent with what he describes above. Daily Journal generally remained in US Treasuries for most of the decade.

In early 2009 that changed.

Specifically, at the start of 2009 the company still held less than $ 24 million in cash and US Treasuries. Then, when the market was in turmoil and prices became very attractive, much of the portfolio was converted into common stocks.

That portfolio is now worth nearly $ 64 million with more than 70% now made up of equity investments.

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Thursday, March 11, 2010

Seatbelts, Safety, and Investing

In April of 2009 the NHTSA released the following:

"Lower fatalities and higher seat belt use are trends we want to see," said Secretary LaHood. "States like Michigan are raising the bar on seat belt use, making communities safer and keeping families intact." 

In Michigan, the belt use rate was 97.2 percent in 2008. By contrast, Massachusetts was 66.8 percent.

Massachusetts seat belt usage rate is basically terrible. The worst.

Separately, this December of 2009 Forbes article pointed out the following:

It turns out, however, that as much as these measures help, there isn't a correlation between more laws on the books and fewer accidents. Sometimes, it's the states with fewer rules--but more educational initiatives--that have safer roads. For example, New Hampshire joins Rhode Island and Vermont on our list of the safest states for drivers. But New Hampshire has enacted neither a primary nor secondary seatbelt law for adults.

Now, if you look at the NHSTA FARS reporting system, you will see that the most recent data shows that the safest U.S. states -- the only states with fewer than 1 death per 100 million vehicle miles traveled (VMT)* -- were as follows:

Safest States
1 Massachusetts (.79 per 100 million VMT)
2 Rhode Island (.80)
3 Vermont (.86)
4 Minnesota (.89)
5 Connecticut (.92)
6 New Jersey (.95)
7 New Hampshire (.96)
8 New York (.97)

25% of the states in the U.S.  have fatality rates that are more than 2x as high as the best on this list.

So strangely, some of the safest states have either terrible seatbelt usage habits and/or (I probably don't have to say it) a reputation for an impolite, aggressive driving style. Obviously, this is not meant to suggest seat belts need not be worn. The above places are safer despite the lack of seat belt usage.

Why bring this up in the context of investing? I think when facts/results are inconsistent with prevailing wisdom there's a better chance that a mispricing (or misjudgment) has occurred. Often those facts will, at least initially, be discounted or ignored because it contradicts a popular prevailing view. Because of that, I try to look for these kinds of inconsistencies. Most of the time it does not yield a useful investment thesis or insight (though it's still fun) but every now and then...it does.

Philip Morris International (PM)/Altria (MO) are examples I've used that fits into this category. The popular prevailing view of the tobacco (taxes and declining demand would crush margins, that they'd be sued out of existence..etc.) kept their stocks mispriced for decades. The reasons for it being a great investment over the past 5+ decades can be counterintuitive but...once understood...useful, insightful, and enlightening.

In this case, I have no explanation why these states have better safety records. I'm sure someone with the right background can figure it out. Some others may think they know why. Having consistently the lowest fatality rates with low seat belt usage rates and generally more aggressive drivers. Really? C'mon right? It's, at least, a bit surprising if not the basis of a new investment idea.

Adam

Long PM and MO

* The standard measure used by NHTSA.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Wednesday, March 10, 2010

Berkshire Hathaway's Operating Businesses

In addition to the many common stocks (Coca-Cola, Wells Fargo etc.), the 2009 Annual Report provides a convenient summary of the operating subsidiaries that Berkshire owns.
  • GEICO, the third largest private passenger auto insurer in the United States.
  • General Re and the Berkshire Hathaway Reinsurance Group - Two of the largest reinsurers in the world.
  • National Indemnity Company and affiliated insurance entities, Medical Protective Company, Applied Underwriters, U.S. Liability Insurance Company, Central States Indemnity Company, Kansas Bankers Surety, Cypress Insurance Company, BoatU.S. and several other subsidiaries referred to as the "Homestate Companies."
  • MidAmerican Energy Holdings Company (“MidAmerican”) - an international energy holding company owning a wide variety of operating companies engaged in the generation, transmission and distribution of energy. MidAmerican’s operating energy companies are Northern Electric and Yorkshire Electricity; MidAmerican Energy Company; Pacific Power and Rocky Mountain Power; and Kern River Gas Transmission Company and Northern Natural Gas.
  • HomeServices of America - a real estate brokerage firm (owned by MidAmerican).
  • Burlington Northern Santa Fe Corporation (“BNSF”) - acquired by Berkshire on February 12, 2010, operates one of the largest railroad systems in North America. In serving the Midwest, Pacific Northwest and the Western, Southwestern and Southeastern regions and ports of the U.S., BNSF transports a range of products and commodities derived from manufacturing, agricultural and natural resource industries.
  • Berkshire's finance and financial products businesses primarily engage in proprietary investing strategies (BH Finance), commercial and consumer lending (Berkshire Hathaway Credit Corporation and Clayton Homes) and transportation equipment and furniture leasing (XTRA and CORT).
  • McLane Company - a wholesale distributor of groceries and nonfood items to discount retailers, convenience stores, quick service restaurants and others.
  • The Marmon Group - an international association of approximately 130 manufacturing and service businesses that operate independently within diverse business sectors.
  • Shaw Industries - the world’s largest manufacturer of tufted broadloom carpet.
  • Benjamin Moore - a formulator, manufacturer and retailer of architectural and industrial coatings.
  • Johns Manville - a leading manufacturer of insulation and building products.
  • Acme Building Brands - a manufacturer of face brick and concrete masonry products.
  • MiTek Inc. - produces steel connector products and engineering software for the building components market.
  • Fruit of the Loom - Licenses and distributes apparel.
  • Russell - Licenses and distributes apparel.
  • Vanity Fair, Garan, Fechheimer, H.H. Brown Shoe Group and Justin Brands manufacture - also license and distribute apparel and footwear under a variety of brand names.
  • FlightSafety International - provides training to aircraft operators.
  • NetJets - provides fractional ownership programs for general aviation aircraft.
  • Nebraska Furniture Mart, R.C. Willey Home Furnishings, Star Furniture, and Jordan’s Furniture - retailers of home furnishings.
  • Borsheims, Helzberg Diamond Shops and Ben Bridge Jeweler - retailers of fine jewelry.
  • The Buffalo News - a publisher of a daily and Sunday newspaper.
  • See's Candies - a manufacturer and seller of boxed chocolates and other confectionery products.
  • Scott Fetzer - a diversified manufacturer and distributor of commercial and industrial products.
  • Albecca - a designer, manufacturer and distributor of high-quality picture framing products.
  • CTB International - a manufacturer of equipment for the livestock and agricultural industries.
  • International Dairy Queen - a licensor and service provider to about 5,800 stores that offer prepared dairy treats and food.
  • The Pampered Chef - the premier direct seller of kitchen tools in the U.S.
  • Forest River - a leading manufacturer of leisure vehicles in the U.S.
  • Business Wire - the leading global distributor of corporate news, multimedia and regulatory filings.
  • Iscar Metalworking Companies - an industry leader in the metal cutting tools business.
  • TTI, Inc. - a leading distributor of electronic components.
  • Richline Group - a leading jewelry manufacturer.
In 40 years, through smart capital allocation, a small New England textile mill, banking, and insurance operation producing less than $ 5 million in earnings in 1970 has been converted into:

1) The operating subsidiaries listed above employing over 270,000 people and earning an average of $ 9 billion/year* and

2) a $ 140 billion portfolio of predominantly stocks, bonds, cash.

Intrinsic value is an approximation. There's no one absolutely correct estimate of it. Still, using the numbers above it should not be difficult to see why Berkshire's intrinsic value is now over $ 200 billion. If the $ 140 billion portfolio can grow at 7%/year (excluding dividends) it will ~ $ 10 billion in new value next year. So lets assume Berkshire can also earn $ 10 billion from the operating businesses (not much more than the 5 year average and Berkshire now owns Burlington Northern which should easily earn an additional ~$ 1.5 billion/year). So, in this case, a reasonable forecast of near term growth in intrinsic value is in the $ 20 billion/year range.

Would you pay $ 200 billion for a company that owns a variety of durable businesses that can grow its intrinsic value at a $ 20 billion/year?
(on my current Stocks to Watch list the buy @ or below price for Berkshire corresponds with $ 165 billion valuation because it includes a margin of safety.)

There are a number of embedded assumptions here that should by no means taken as a given. Each needs to be thought through and challenged but in an attempt to bring clarity, I've deliberately simplified this analysis. It's easy to get lost in the weeds with so much information. Ultimately, Berkshire is a very complex company these days.

If you think the assumptions are too conservative or aggressive adjust accordingly. Again, it's just an estimate.

BTW - In 1970, Berkshire's intrinsic value was probably not much more than $ 100 million.

Adam

* Average earnings over the last 5 years. It will likely be substantially higher than that over the next 5 years.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Wednesday, March 3, 2010

Upton Sinclair

In this The Atlantic interview, John Bogle said he believes that the current business school curriculum is too narrow and should have "a much greater emphasis on the classics":

"The Odyssey will tell you an awful lot about human nature and life, and therefore about business, and societal values. Read the Odyssey. Read Dante's Inferno. You can also learn a lot by reading Seneca’s essay on the shortness of life or Montaigne's essay on vanity."

Later in the interview he went on to say...

As to why speculation is so hard to curb, despite repeated warnings over the years, Bogle once again dug back into a classic for his answer. "There's a quote by Upton Sinclair," he replied. "It's amazing how difficult it is for a man to understand something if he's paid a small fortune not to understand it."

With that paraphrase of Sinclair's quote in mind, don't expect some of the more logical changes to the financial system to occur anytime soon.

Entrenched interests are paid too much "not to understand" why the casino should be reigned in.

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Tuesday, March 2, 2010

Buffett on Competitive Dynamics: Berkshire Shareholder Letter Highlights

From Warren Buffett's 2009 Berkshire Hathaway (BRKa) shareholder letter:

Charlie and I avoid businesses whose futures we can't evaluate, no matter how exciting their products may be. In the past, it required no brilliance for people to foresee the fabulous growth that awaited such industries as autos (in 1910), aircraft (in 1930), and television sets (in 1950). But the future then also included competitive dynamics that would decimate almost all of the companies entering those industries. Even the survivors tended to come away bleeding.

Just because Charlie and I can clearly see dramatic growth ahead for an industry does not mean we can judge what its profit margins and returns on capital will be as a host of competitors battle for supremacy. At Berkshire we will stick with businesses whose profit picture for decades to come seems reasonably predictable. Even then, we will make plenty of mistakes.


Avoiding the big mistakes is key. As Charlie Munger has said:

It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.

Both Charlie Munger and Warren Buffett have said this in a variety of different ways over the years. It seems an underestimated factor in their success.

Adam

Long BRKb
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, March 1, 2010

Buffett's 2009 Shareholder Letter

Here's Warren Buffett's latest letter to Berkshire Hathaway's (BRKa) shareholders.

Somme excerpts:

On Derivatives
We are delighted that we hold the derivatives contracts that we do. To date we have significantly profited from the float they provide. We expect also to earn further investment income over the life of our contracts.

We have long invested in derivatives contracts that Charlie and I think are mispriced, just as we try to invest in mispriced stocks and bonds. Indeed, we first reported to you that we held such contracts in early 1998. The dangers that derivatives pose for both participants and society – dangers of which we’ve long warned, and that can be dynamite – arise when these contracts lead to leverage and/or counterparty risk that is extreme. At Berkshire nothing like that has occurred – nor will it.


On Acquisitions
I have been in dozens of board meetings in which acquisitions have been deliberated, often with the directors being instructed by high-priced investment bankers (are there any other kind?). Invariably, the bankers give the board a detailed assessment of the value of the company being purchased, with emphasis on why it is worth far more than its market price. In more than fifty years of board memberships, however, never have I heard the investment bankers (or management!) discuss the true value of what is being given. When a deal involved the issuance of the acquirer's stock, they simply used market value to measure the cost. They did this even though they would have argued that the acquirer's stock price was woefully inadequate – absolutely no indicator of its real value – had a takeover bid for the acquirer instead been the subject up for discussion.

When stock is the currency being contemplated in an acquisition and when directors are hearing from an advisor, it appears to me that there is only one way to get a rational and balanced discussion. Directors should hire a second advisor to make the case against the proposed acquisition, with its fee contingent on the deal not going through. Absent this drastic remedy, our recommendation in respect to the use of advisors remains: "Don't ask the barber whether you need a haircut."
* * * * * * * * * * * *
I can't resist telling you a true story from long ago. We owned stock in a large well-run bank that for decades had been statutorily prevented from acquisitions. Eventually, the law was changed and our bank immediately began looking for possible purchases. Its managers – fine people and able bankers – not unexpectedly began to behave like teenage boys who had just discovered girls.

They soon focused on a much smaller bank, also well-run and having similar financial characteristics in such areas as return on equity, interest margin, loan quality, etc. Our bank sold at a modest price (that's why we had bought into it), hovering near book value and possessing a very low price/earnings ratio. Alongside, though, the small-bank owner was being wooed by other large banks in the state and was holding out for a price close to three times book value. Moreover, he wanted stock, not cash.

Naturally, our fellows caved in and agreed to this value-destroying deal. "We need to show that we are in the hunt. Besides, it's only a small deal," they said, as if only major harm to shareholders would have been a legitimate reason for holding back. Charlie's reaction at the time: "Are we supposed to applaud because the dog that fouls our lawn is a Chihuahua rather than a Saint Bernard?"


Check out the full letter. As always, well worth reading.

Adam

Long BRKb
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Stocks to Watch

Shares of public companies I like* for my own portfolio at the right price. Nothing on my radar is a screaming buy right now (unlike a year ago) but still lots of good businesses here for the long-term.

As always, those below the dashed line are companies I like but prevailing prices have become too high. Several are just barely above or below the highest price I am willing to pay. The objective, of course, is to buy them well below that price whenever possible.

BRKb has been adjusted for the 50-1 split. I've also adjusted the price I'd being willing to pay higher (from the split adjusted $ 60 to $ 68/share). This increase in valuation has nothing to do with the split. The increase is due to my estimate of the growth in the intrinsic value of Berkshire Hathaway's assets over the past year subtracting a reasonable margin of safety. I consider Berkshire Hathaway to to be worth at least $ 90/share (in other words, I believe its intrinsic value to be roughly $ 10/share higher than a year ago) and prefer to buy it at a 25% discount to current value (25% discount of $ 90 = ~$ 68). Each year most of the companies on this list should increase their intrinsic value. If Berkshire Hathaway were a lower quality business I would require a larger margin of safety.

As always, the stocks in bold have two things in common. They are:

1) currently owned by Berkshire Hathaway (as of 12/31/10) and,
2) selling below the price that Warren Buffett paid in the past few years.

There are several other Berkshire Hathaway holdings on this list but they don't have the 2nd thing going for them.

These are all intended to be long-term investments. A ten year horizon or longer. No trades here.

Stock/Max Price I'd Pay/Recent Price (2-26-10)
JNJ/65.00/63.00 - Buffett paid ~$ 62
KFT/30.00/28.43 - Buffett paid ~$ 33
NSC/54.00/51.43
KO/55.00/52.72
COP/50.00/48.00 - Buffett paid ~$ 82...sold some shares at a loss
WFC/28.00/27.34 - Buffett paid ~$ 32
---------------------
USB/24.00/24.61 - Buffett paid ~$ 31
MCD/63.00/63.85
PM/45.00/48.98
PG/60.00/63.28
PEP/60.00/62.47
MHK/45.00/51.58
LOW/19.00/23.71
AXP/35.00/38.19
ADP/37.00/41.61
DEO/60.00/65.28
BRKb/68.00/80.13
MO/16.00/20.12
HANS/30.00/41.58
PKX/80.00/115.46
RMCF/6.00/8.54
(Splits, spinoffs, and similar actions inevitably will occur going forward. Will adjust as necessary to make meaningful comparisons.)

Stocks removed from list:
  • BNI - I liked purchasing BNI up to $ 80/share. It was bought out by Berkshire Hathaway for $ 100/share in late 2009. Deal closed in early 2010.
The max price I'd pay takes into account an acceptable margin of safety** and differs for each company. In other words, I believe these are intrinsically worth quite a bit more than the max price I've indicated in this post and in prior Stocks to Watch posts. I also believe most of these companies generally have favorable long-term economics (i.e. the best of them have high and durable ROC) and, as a result, intrinsic values will increase over time. Of course, I may be wrong about the core economics and that margin of safety could provide insufficient protection against a loss. Still, a year from now I would expect to be willing to pay more for many of these based upon each company's intrinsic value growth over that time frame.

Some of these stocks have rallied quite a bit compared to not too long ago. So they're more difficult to buy with a sufficient margin of safety. Still, that doesn't mean the risk of missing something you like when a fair price is available (error of omission) won't ultimately be more costly than suffering a short-term paper loss.

Here are some thoughts on errors of omission by Warren Buffett from an article in The Motley Fool.

And also...

"During 2008 I did some dumb things in investments. I made at least one major mistake of commission and several lesser ones that also hurt... Furthermore, I made some errors of omission, sucking my thumb when new facts came in." - Warren Buffett's 2008 Annual Letter to Shareholders

In other words, not buying what's still attractively valued to avoid short-term paper losses is far from a perfect solution with your best long-term investment ideas.

To me, if an investment was initially bought at a fair price, and is likely to increase substantially in intrinsic value over 20 years, it makes no sense to be bothered by a temporary paper loss. Of course, make a misjudgment on the quality of a business and that paper loss becomes a real one (error of commission).

There is no perfect answer to this problem. When highly confident that a great business is available at a fair price it's important to accumulate enough while the window of opportunity exists.

Sometimes accepting the risk of short-term losses is necessary to make sure a meaningful stake is acquired.

Adam

* This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to remain long the above stocks (at least those that at some point became cheap enough to buy) unless market prices become significantly higher than intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
** The required margin of safety is naturally larger for a bank than for something like KO. When I make a mistake and misjudge a company's economics in a major way, the margin of safety may still not be sufficient. Judging the durability of the economics correctly matters most. If the economics remain intact but the stock goes down that is a very good thing in the long run.
 
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