Tuesday, March 22, 2011

Buffett: "Two Types of Assets"

Warren Buffett had the following to say on CNBC about buying assets that produce something versus those that do not:

So there's two types of assets to buy. One is where the asset itself delivers a return to you, such as, you know, rental properties, stocks, a farm. And then there's assets that you buy where you hope somebody else pays you more later on, but the asset itself doesn't produce anything...I regard the second game as speculation. Now there's nothing immoral or illegal or fattening about speculation, but it is an entirely different game...

Investing is about what something produces over time not the quoted price tomorrow, next week or even next year.

Speculating is about buying something you hope someone will pay you more for at a later time. 

In the most recent Berkshire Hathaway Shareholder Letter (BRKa), Buffett added the following about Coca-Cola (KO):

Coca-Cola paid us $88 million in 1995, the year after we finished purchasing the stock. Every year since, Coke has increased its dividend.In 2011, we will almost certainly receive $376 million from Coke, up $24 million from last year. Within ten years, I would expect that $376 million to double. By the end of that period, I wouldn't be surprised to see our share of Coke's annual earnings exceed 100% of what we paid for the investment. Time is the friend of the wonderful business.

If the focus is on what a quality asset is likely to produce in the future, instead of the near term price fluctuations, it should alter how an investor expends energy.

In speculation, the focus is on whether:
  • the quote on the computer screen flashes red or green tomorrow, 
  • the chart looks healthy, or 
  • a recent event impacts near term price action etc. 
In contrast, long-term owners of productive assets tend to use their energy think about things like:
  • Did I pay a fair price relative to estimated intrinsic value? 
  • In what way is the competitive position of the business under threat? 
  • Is the management team in place effective? 
  • Is capital being allocated wisely?
The focus becomes thinking through the things that any business owner needs to think about.

Coca-Cola a decade from now or so will be producing earnings (both the dividend and the undistributed earnings* portion)  at a rate that exceeds the average price Buffett paid for Coca-Cola up until a little over 15 years ago (Buffett bought the stock between 1988-1995). So even if Coca-Cola stops growing (unlikely) from that point on the earnings will return to shareholders more than 100% each year from earnings (if not in perpetuity then for a very long time). Every 1.5 years or so, the cash dividend alone paid directly into Berkshire's coffers will likely equal the full initial investment made by Buffett.

How much does the quoted price of the stock matter at that point?

While Coca-Cola is an exceptional business there are many other productive assets in the form of public companies that accomplished remarkably similar results over the same time frame. (You'll find that things like Hershey - HSY, Pepsi - PEP, and Johnson & Johnson - JNJ among others have had similar enough outcomes for decades.) So the quality assets are not entirely unique or hard to find. It's Buffett's behavior that is unique. The wisdom to buy with the intent to own for a very long time a good asset when a favorable price comes along.

What happens with these assets going forward cannot be known precisely, but odds are that gaining partial ownership of a few great franchises at a fair price will produce good results over the long haul.

Buying gold or art is about whether someone else will be there to buy it at a price you are happy with when you need to sell it.

I'll take the ownership of assets that produce something over other assets any day of the week.

Adam

Long positions in stocks mentioned with the exception of HSY

* From the Berkshire Hathaway owners manual on "look-through" earnings: "We attempt to offset the shortcomings of conventional accounting by regularly reporting "look-through" earnings...The look-through numbers include Berkshire's own reported operating earnings, excluding capital gains and purchase-accounting adjustments...plus Berkshire's share of the undistributed earnings of our major investees - amounts that are not included in Berkshire's figures under conventional accounting."

"Look-through" earnings for Berkshire Hathaway was more important when they had fewer operating businesses and an equity portfolio that represented a significant portion of intrinsic value.
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