Thursday, May 31, 2012

Berkshire's Book Value & Intrinsic Value

Since the end of 1999, Berkshire Hathaway's (BRKa) per share book value has grown from $ 37,987 to $ 99,860 at the end of last year (a 163% increase).

1999 Berkshire Letter

A little more than 2 months into the next year, the NASDAQ closed at its peak of 5,048.

Not long after that, the S&P 500 closed at its peak up to that point of 1,527.

Berkshire Hathaway's stock (Class A) was selling at $ 41,300/share back then.
(When the NASDAQ hit its peak.)

So price to book value back then was 109% of book value.

Price to book value = $41,300/$ 37,987 = 109%

It didn't remain at that level for long.

At yesterday's close, Berkshire's stock was selling at $ 119,250.
(A 189% increase since the NASDAQ hit its peak.)

That puts price to year end 2011 per-share book value closer to 119%.
(Actually it would be a bit cheaper using book value from the end of the 1st quarter...more like 112%.)

So Berkshire's book value and stock performed relatively well in a period when most major indexes performed poorly (to say the least).* Of course, what's most important is whether intrinsic value has increased.

Changes in book value, according to Warren Buffett, is not a bad way to estimate Berkshire's intrinsic value.

From the Berkshire owner's manual:

Inadequate though they are in telling the story, we give you Berkshire's book-value figures because they today serve as a rough, albeit significantly understated, tracking measure for Berkshire's intrinsic value. In other words, the percentage change in book value in any given year is likely to be reasonably close to that year's change in intrinsic value.

Buffett has been clear when they'll buyback the stock. Here's what he wrote in the latest shareholder letter:

At our limit price of 110% of book value, repurchases clearly increase Berkshire's per-share intrinsic value. And the more and the cheaper we buy, the greater the gain for continuing shareholders. Therefore, if given the opportunity, we will likely repurchase stock aggressively at our price limit or lower.

So Buffett obviously considers Berkshire's intrinsic value to be much higher than 110% of book value** but, of course, doesn't say by how much.

What may seem at least somewhat surprising (in today's valuation context) is that, for much of the mid-to-late 1990s, the Berkshire's valuation spent most of the time at 200% of book value and even, at times, more than 300% of book value. Those valuation levels made it very difficult for investors who bought at that time to get satisfactory long-term returns.

Well, at least they were destined to returns that were less than the intrinsic value that Berkshire would create.

In fact, the stock was overvalued enough so in 1996 that Berkshire issued the following warning in its prospectus for the Class B Common Stock:

WARREN BUFFETT, AS BERKSHIRE'S CHAIRMAN, AND CHARLES MUNGER, AS BERKSHIRE'S VICE CHAIRMAN, WANT YOU TO KNOW THE FOLLOWING (AND URGE YOU TO IGNORE ANYONE TELLING YOU THAT THESE STATEMENTS ARE "BOILERPLATE" OR UNIMPORTANT)...

The prospectus then added...

Mr. Buffett and Mr. Munger believe that Berkshire's Class A Common Stock is not undervalued at the market price stated above. Neither Mr. Buffett nor Mr. Munger would currently buy Berkshire shares at that price, nor would they recommend that their families or friends do so.

and...

In recent years the market price of Berkshire shares has increased at a rate exceeding the growth in per-share intrinsic value. Market overperformance of that kind cannot persist indefinitely.

Unlike the 110% of book value that Buffett now seems to consider a reasonable price to pay for Berkshire, those shares were being offered back then at more like 200% and, as the chart in this article shows, even higher.

The per-share book value back when the Class B Common Stock was being offered to the public was $ 14,426. So per-share book value has increased nearly 7-fold since then to $ 99,860 at the end of 2011. Since, as Buffett says, book-value is a rough "albeit significant understated" estimate of intrinsic value it's not a bad if possibly somewhat conservative way to see how much value has been created over that time frame.

Other thoughts:

- It would be nice if guidance on valuation like the one in the Berkshire prospectus was closer to the norm but I suspect that won't be happening anytime soon. Getting the price as close to intrinsic value as possible would allow new long-term owners, alongside existing long-term owners, to make a return roughly consistent with how the business performs (whether it creates or destroys intrinsic value). If new owners pay a price for shares well above intrinsic value they, by definition, will have returns less than what the business itself produces in value over time (unless somehow shares were also sold well above intrinsic value). 

- Obviously, it's no surprise those selling shares to the public attempt to raise money at the highest price possible. That's not going to suddenly change. I'm just suggesting an effective process with some integrity to it would often find a good balance. Existing owners would get a fair price for the portion of the business they are selling, while the new partner-owners pay something close to what the business is actually worth. It's not just because this might improve how effectively capital is formed and allocated. It's because those who'd like to establish a healthy long-term oriented ownership culture among its investors should want it. CEOs can play a role in guiding investors in the same manner Buffett attempted to do in the Class B Common Stock prospectus (even though it didn't work in that case). I realize many buy shares of an IPO to flip for quick profit, but the process could better serve those who are willing to put capital at risk with a company's long-term prospects in mind.***

- Due to its sheer size, Berkshire can't generate wealth as fast as it did in the past but still created wealth at nice clip during a period when most major indexes could not. I'm guessing it will do just fine going forward.

- Since 2000, many good businesses that make up the S&P 500 increased their intrinsic value much more than the index would suggest. The index underperformed for the straightforward reason that many stocks in the index were selling above intrinsic value back then. So naturally performance of the index suffered as intrinsic value caught up to price. Berkshire just happened to be hitting valuation lows, and was selling at a reasonable price compared to intrinsic value, when the NASDAQ and S&P 500 were hitting their highs.

When a particular stock seems to have been dead money for an extended period, it is sometimes useful to see if that's because the business hasn't performed, or the result of coming into a particular period overvalued.

Check out page 99-100 of the 2011 annual report for a good explanation of how Warren Buffett and Charlie Munger view Berkshire's intrinsic value.

Adam

Long BRKb

* Both indexes are obviously still selling below their peaks in 2000 (down 44% for the NASDAQ but only 14% for the S&P 500). At least the dividends make the picture a little less ugly but more so for the S&P 500.
** 110% of the book value or a 10% premium over the book value. It's been described both ways in different publications.
*** Buffett tried to make it clear Berkshire's stock was expensive but the shares were still purchased by many at that very high valuation. So, if the environment is sufficiently euphoric, it's not easy to discourage plainly expensive shares relative to approximate intrinsic value from being purchased. In addition, a less proven business than Berkshire (even those with exciting prospects) are, by their nature, more speculative and have difficult to estimate per share intrinsic value. Yet, in many cases I think knowing what's reasonable is more obvious than some might admit.
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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, May 30, 2012

Graham on Investment: "Most Intelligent When It Is Most Businesslike"

"Shares are not mere pieces of paper. They represent part-ownership of a business. So, when contemplating an investment, think like a prospective owner." - Warren Buffett

From Chapter 20 of Benjamin Graham's book The Intelligent Investor:

"Investment is most intelligent when it is most businesslike. It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they have gained success in their own undertakings. Yet every corporate security may best be viewed, in the first instance, as an ownership interest in, or a claim against, a specific business enterprise. And if a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles if it is to have a chance of success."

He then goes on to articulate what he means by "accepted business principles" and later adds...

"'If you have formed a conclusion from the facts and if you know your judgment is sound, act on it—even though others may hesitate or differ.' (You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.)"

Graham closes Chapter 20 with the following thought:

"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks."

From the Berkshire Hathaway (BRKaowner's manual:

"Charlie and I hope that you do not think of yourself as merely owning a piece of paper whose price wiggles around daily and that is a candidate for sale when some economic or political event makes you nervous. We hope you instead visualize yourself as a part owner of a business that you expect to stay with indefinitely, much as you might if you owned a farm or apartment house in partnership with members of your family."

Among other things, the better businesses usually have, give or take, some or ideally many of the following characteristics:

- High return on capital
- Little debt (or, in the case of financials, substantial capital and liquidity)
- Easily understandable (within an investor's circle of competence)
- Accounting profits backed by healthy free cash flow
- A durable franchise with pricing power or long run cost advantages
- No need for a genius to run it
- Owner-oriented, competent, and honest managers

Consistently making sound business judgments, buying with a margin of safety, staying within one's limits, and not getting distracted by all the noise (having the right temperament) improves results.

On the other hand...

"...the exciting possibility of high near-term returns from playing the stocks-as-pieces-of-paper-that-you-trade game blinds investors to its foolishness." - Seth Klarman in the introduction to his book: Margin of Safety

Investors profit from the fractional ownership of underlying businesses based upon their core long run economic performance (alongside other long-term investors, of course).

No unusual trading skills required.

Minimal frictional costs.

Traders, in contrast, buy and sell shares with the intention of profiting from near term price action.
(treating shares of stocks like they are commodities to be traded.)

That's an entirely different game.

Speculators, as a whole, are playing a zero sum game. In fact, it's necessarily a negative sum when frictional costs (commissions, fees, and taxes) are included. So the most active participants incur these costs while long-term owners mostly do not.

At the current levels of hyperactivity in the markets these costs are substantial.

Ultimately, the returns for market participants as a whole is dictated by what the underlying assets produce over the long haul minus all the frictional costs. In aggregate, speculation adds nothing and, once all costs are considered, actually subtracts from returns.

Some individual active traders might even do just fine but, to me, the right choice in the long run for most participants seems pretty clear.


Liquidity serves a purpose but only up to a certain point.

Adam


Related posts:
John Bogle on Speculation & Capitalism's "Pathological Mutation"
Bogle: Back to the Basics - Speculation Dwarfing Investment
Buffett on Gambling and Speculation
Buffett on Speculation and Investment - Part II
Buffett on Speculation and Investment - Part I

Intro. 11
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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.

Tuesday, May 29, 2012

Dell's Valuation

Clearly, there are businesses with better stories to tell than Dell (DELL) these days.

The company is going through a tough transition and those convinced it won't work out are probably smart to stay away. Dell's economic moat seems anywhere from extremely small to non-existent. As I've said previously, my bias is against tech stocks as long-term investments even if I do happen to own a small number of Dell shares.*

Having said that, let's look at some numbers.

Based upon Dell's closing price, its market value sits at $ 22.1 billion.

Cash and investments is $ 17.2 billion.

Short-term and long-term debt equals $ 9.0 billion.

That puts Dell's net cash at over 37% of market value and puts the company's enterprise value (market cap minus net cash and investments) at just under ~$ 14 billion.

Even after the recent "disappointing" quarterly results (and they certainly were not great), Dell is currently expected to earn close to $ 2/share or more than $ 3.4 billion. Time will tell if that's optimistic but Dell doesn't need to earn anywhere near that much at its current valuation.

The question isn't whether it can earn a little less than $ 2/share or something close to that number.

The question is whether the business is in some kind of hard to stop tailspin.

If it isn't, we have a bit of a disconnect here.

Now, the amount of money needed to buy back all the shares outstanding NOT owned by Michael Dell near the current market price turns out to be ~ $ 19 billion.

So that means in a bit more than half a year, all the shares not owned by Mr. Dell could be bought back using the cash and investments on the balance sheet plus the company's earnings.**

While the company will still have the above $ 9 billion of debt to service, the interest costs on that debt would continue to be small fraction compared to current earnings.
(Even if earnings shrank more than a bit and continued to disappoint for some time, it easily covers the interest expense.)

Otherwise, just as a too high price eventually trumps the most wonderful business story, a low price (compared to a conservative estimate of value) also eventually trumps an ugly story.

Besides, what if, after shrinking somewhat, it turns out the company eventually ends up resuming a growth trajectory post-transition?

If a price is paid where nothing good has to happen to make a nice return, then I doubt long-term investors will complain much if something unexpectedly good ends up occurring.

There are reasons why the aggressive buyback scenario will likely not happen in the real world and is not even a wise thing to do.***

Until repaired with future free cash flow, the buyback would make the balance sheet much less conservative (and uncomfortably leveraged for a tech business with little or no moat facing rapid change). This would temporarily make the company less flexible/resilient under economic stress and may even prevent important strategic investments from happening.

It also may lead to more expensive borrowing costs and more difficulty getting financing when it comes time to roll over the outstanding debt (especially if a crisis hit at just the wrong time).

So there's plenty of risk to such a move. A more balanced capital allocation approach almost certainly makes more sense.

Yet, the even bigger risk is a catastrophic drop in earnings power instead of an earnings trajectory that's on a more gentle downward slope.

Those who think that's going to happen obviously have a legit argument against the stock's current valuation.

The fact is that, within three years, Michael Dell could not only own all the shares outstanding of the entire company but have it debt free if the stock price and earnings power stays near current levels (whether earnings will remain persistent does seem at least doubtful at this point). Alternatively, he could reduce debt to more conservative levels, rebuild cash on the balance sheet, while still making strategic acquisitions and other investments over that time frame.

It's a useful exercise but that doesn't mean Dell is a wise investment. Though I do own a small number of shares, the stock is just barely worth the bother considering alternatives. While it sells for a low multiple of earnings, a very large margin of safety is needed due to the wide range of possible outcomes.

Basically, I won't be surprised if those who own the stock first end up enduring much suffering while the business challenges are being sorted out over time. What seems cheap will probably just get cheaper in the near-term or even longer. I'm willing to look past the awful price action (with eye toward possible attractive longer run outcomes) but it will always be a very small position in the portfolio considering the specific risks.

I'll follow-up with some more thoughts on Dell in a separate post.

Adam

Small long position in Dell

Related posts:
Dell's Valuation - Part II (follow-up post)
Technology Stocks (prior post)

My current position in Dell is a small one and far from a favorite. Unlike the stocks I favor the most (those that have wide moats/less dynamic competitive environments), Dell's shares will always remain, at most, a very small position that's accumulated slowly as the price declines. A much larger than typical margin of safety is needed. As I said in this post and others, there's just no technology company that I'm comfortable with as a long-term investment. That doesn't make owning shares of Dell a short-term trade. A situation this challenging is unlikely to be resolved quickly. I rarely buy anything -- and that includes Dell -- unless I'm willing to own the shares for several years or even longer (though frequent traders likely consider several years to be long-term). When I say long-term, I mean that shares of good businesses (bought initially at a fair price or better) can often be held indefinitely. That's just not the case with most tech stocks. So owning some Dell shares fits a very different investing model than what I traditionally favor. (Long-term favorites are in the Six Stock Portfolio and Stocks to Watch. The stocks listed in those two posts are mostly core long-term positions. I generally buy more shares of these if and when they sell at a discount to my judgment of value. Unfortunately, most are not all that cheap these days.) As always, I never have an opinion on what a stock will do in any time frame less than a few years. I'll let others try to figure out short or even intermediate run price action though I won't be surprised if Dell's shares drop substantially from here and remain lower for quite some time. My focus is risk-adjusted returns over longer time frames. As I've said in other posts, it's actually beneficial when the stock price of a sound business franchise drops further for continuing long-term shareholders. Less money is required to buy each additional share over time while each buyback dollar goes further. The same amount of intrinsic value, whatever it happens to be, is bought for less. Of course, intrinsic value must be judged well and that's far from easy to do with Dell. The question is always what the core economics of a business will be over the long haul. Well, the company has -- to say the least -- difficult competitive threats. So whether it is a sound business franchise is reasonably in doubt. That's where the very low multiple of earnings and margin of safety comes into play. Time will tell whether it can all be sorted out in a way that generates attractive returns. There's certainly a wide range of outcomes. Those that think Dell's business prospects are on a path to negative free cash flow (or similar undesirable outcomes) are naturally wise to avoid the shares. Otherwise, the valuation is such that Dell's business can actually shrink substantially from here and still deliver shareholders a satisfactory long-term result. 
(i.e. They don't have to become the next IBM: IBM. They need to manage technology shifts, deal with the related operational challenges, enhance competitiveness in key areas, and allocate capital effectively. Dell needs to focus on developing sustainable advantages and avoid the high cost pursuit of growth. It won't be an easy transition.)

There are huge execution risks and smart capital allocation will be crucial (not overpaying for acquisitions, buying back the stock when cheap). There's also the real risk that a buyout occurs below intrinsic value (a subject worth covering in a follow up post at some point). Trying to understand the risks to a business franchise and whether a sufficient discount exists considering those risks is a good use of time and energy. Guessing what the near-term stock price action will be, at least for me, is not. A heavily price action oriented culture may dominate the market environment these days but it's still an option (and in my view wise) to choose to not participate in it.
** $ 17.2 billion of cash and investments plus $ 1.8 billion of the roughly $ 3.4 billion the company is expected to earn (though, of course, it's hardly certain that they will earn that much) could buy all the shares not owned by Michael Dell at the current price. So ,after a full year, that would leave $ 1.6 billion of cash on the balance sheet assuming no other investments happen. Net debt, using these assumptions, would be ~ $ 7.4 billion ($ 9 billion minus the $ 1.6 billion) at that time. Keep in mind that there are acquisitions yet to close that will reduce Dell's cash position and capacity to do this. These numbers are more meant to reveal the company's substantial financial flexibility.
*** First of all, buying back that much stock would almost certainly move the share price up. Also, some cash resides outside the U.S. (though less for Dell than some large cap tech peers), while Dell earns a substantial percentage of profits from outside the United States. So there would be tax issues related to repatriation of the cash.
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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 are never a recommendation to buy or sell anything.

Friday, May 25, 2012

Buffett Will Be 'Hands Off' With Newspapers

On Wednesday, Warren Buffett sent an e-mail to the publishers and editors of the newspapers Berkshire Hathaway (BRKa) owns.

What did it say?

From this Omaha World-Herald article:

Buffett: I'll be 'hands-off' with newspapers

"I believe newspapers that intensively cover their communities will have a good future. It's your job to make your paper indispensable to anyone who cares about what is going on in your city or town," Buffett said in his letter.

He also said:

"I have some strong political views, but Berkshire owns the paper I don't. And Berkshire will always be non-political..."

In addition to pledging to be "hands-off" he also made the following points:

- Berkshire does not use its resources to speak on behalf of its 600,000+ owners, and

- the purchase of more small and mid-sized newspapers is probable.

He also emphasized, and this will not be surprising to anyone who's read the Berkshire owner's manual or some other Buffett missives, something that he's talked about on prior occasions:

"Berkshire Buys for keeps."

From the owner's manual:

You should be fully aware of one attitude Charlie and I share that hurts our financial performance: Regardless of price, we have no interest at all in selling any good businesses that Berkshire owns. We are also very reluctant to sell sub-par businesses as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations. We hope not to repeat the capital-allocation mistakes that led us into such sub- par businesses.

The manual later adds that to engage in "gin rummy managerial behavior" is not their style:*

True, we closed our textile business in the mid-1980's after 20 years of struggling with it, but only because we felt it was doomed to run never-ending operating losses. We have not, however, given thought to selling operations that would command very fancy prices nor have we dumped our laggards, though we focus hard on curing the problems that cause them to lag.

That's one of many things that makes selling a business to Berkshire a unique destination relative to other corporations.

It also should reinforce the point that Buffett's not buying these newspapers as a public service.

He expects them to be good investments for Berkshire and is likely in it for the long haul.

Adam

* Discarding the businesses that have the least promise at any given moment in favor of those with more promise.
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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.

Thursday, May 24, 2012

Large Cap Valuations

A little less than ten years ago, with the S&P 500 was down nearly 50% from its highs and was hitting the lows of the bear market.
(The NASDAQ dropped more like ~80%.)

At that 2002 bottom for the S&P 500, here are some examples of market valuations for certain large cap stocks:

Microsoft (MSFT)*
Price Per Share: $ 23.19
Earnings Per Share: .70
P/E: 33x

Wal-Mart (WMT)
Price Per Share: $ 51.64
Earnings Per Share: 1.81
P/E: 29x

Johnson & Johnson (JNJ)
Price Per Share: $ 56.80
Earnings Per Share: 2.16
P/E: 26x
Coca-Cola (KO)
Price Per Share: $ 51.46
Earnings Per Share: 1.60
P/E: 32x

So high valuations persisted even at the very bottom of a bear market. I could have used other examples but chose stocks with relatively stable earnings so the high multiples would not be a reflection of cyclical lows in earnings power.

Well, these days the market is obviously no where near the lows of 2009 for the stock market but, and this probably won't come as a surprise, check out the valuations relative to current consensus earnings estimates for the same stocks.

Microsoft
Price Per Share: $ 29.11
Earnings Per Share: 2.72
P/E: 11x

Wal-Mart
Price Per Share: $ 64.58
Earnings Per Share: 4.91
P/E: 13x

Johnson & Johnson
Price Per Share: $ 62.66
Earnings Per Share: 5.12
P/E: 12x

Coca-Cola
Price Per Share: $ 74.55
Earnings Per Share: 4.09
P/E: 18x

Not surprisingly, even if purchased at the market bottom in 2002, none of these stocks produced spectacular 10-year returns.

The reason seems clear enough. They were simply still too expensive even at the 2002 market bottom to make good returns. Their business prospects were just fine and lots of intrinsic value was created but long-term investors had very little to show for it because of the price paid.

Some may say if the multiples continue to contract returns will continue to be subpar. While that's certainly true in the near term or maybe even intermediate term, the contraction only delays and, in fact, enhances the long-term returns (by allowing shares to be bought back below intrinsic value).

So if you are trading with shorter term outcomes in mind this clearly is a real problem.

On the other hand, if you are investing and have a longer time horizon it is anything but a problem.

Look to something like Altria (MO) for an example of a stock that outperformed** since the 2002 lows (substantially...it's up ~ 6-fold including dividends).

It did so not because the business itself did so much better than the others (each of these quality franchises had, give or take, solid decades of business performance).

Instead, Altria outperformed for the straightforward reason that it was selling at a single digit multiple of earnings back then while the others were not (MO now sells at a multiple in the mid-to-low teens).

This doesn't necessarily mean any of these stocks make sense to buy***, but it is a reminder just how different the valuation environment is these days for quality large capitalization businesses.

Adam

Long all the stocks mentioned at much lower than recent market prices

* When you subtract Microsoft's net cash and investments per share its multiple drops to more like a bit over 8x.
** Returns depend on what owners did with the Kraft (KFTand Philip Morris International (PM) Spin-offs.
*** Coca-Cola may sell at a lower multiple than 10 years ago, but it is still not all that inexpensive near current prices. Wal-Mart's has rallied quite a lot lately even if the earnings multiple remains in the low teens.
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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.

Wednesday, May 23, 2012

Why Is Warren Buffett Buying Newspapers?

Warren Buffett has been rather busy with deals related to smaller newspapers lately.

Late last year, Buffett bought Omaha World-Herald:

Buffett's Berkshire Hathaway buys Omaha newspaper group

Here's what Buffett said about Omaha World-Herald in this press release:

Berkshire Hathaway Inc. Chairman and CEO Warren Buffett and Terry Kroeger, CEO of the Omaha World-Herald Company, owner of The World-Herald, six other daily newspapers and several weekly newspapers across Nebraska and Southwest Iowa announced that Berkshire will acquire the Omaha World-Herald Company.

Later in the press release...

"The World-Herald delivers solid profits and is one of the best-run newspapers in America, and we are pleased to have Terry Kroeger and his team join Berkshire Hathaway," said Warren Buffett...

Here's a Wall Street Journal article from back in April that explores the following question:

Warren Buffett Building Newspaper Empire?

Buffett has been buying up loans in the recently bankrupt newspaper publisher Lee Enterprises (LEE) and, according to the Wall Street Journal, apparently now also has a 4.1% stake in the company.

As of today, according to the company's website, Lee Enterprises publishes 48 daily newspapers (including the St. Louis Post-Dispatch) and nearly 300 other specialty publications.

In addition to Omaha World-Herald and Lee Enterprises (and already owning the Buffalo News and a stake in The Washington Post Company: WPO), Buffett did the following deal last week with Media General (MEG), an owner of a collection of newspapers.

Berkshire Buys Media General Newspaper For $ 142 million

According to the Media General press release, Berkshire will purchase all of the newspapers owned by Media General (with the exception of the Tampa group) for $ 142 million. From the press release:

The newspapers being purchased include...63 daily and weekly titles in Virginia, North Carolina, South Carolina and Alabama, in addition to digital assets, including websites and mobile and tablet applications. The newspapers also have a substantial commercial printing business.

Berkshire is also providing a $ 400 million loan and $ 45 million revolving credit line to Media General. As part of the deal, Berkshire will get a nearly 20% stake in the company via warrants. Here's what Buffett said in the press release:

"In towns and cities where there is a strong sense of community, there is no more important institution than the local paper," said Warren Buffett, Chairman of Berkshire Hathaway. "The many locales served by the newspapers we are acquiring fall firmly in this mold and we are delighted they have found a permanent home with Berkshire Hathaway."

Here is another Wall Street Journal that covers some of Buffett's recent newspaper business activity:

Warren Buffett Loves Newspapers (He Was Only Kidding In 2009)

Bloomberg Businessweek weighed in on why Buffett is getting involved in buying these kind of assets.

Why Warren Buffett Really Likes Newspapers

The following Time Magazine article also had some thoughts and background on why Buffett is buying newspapers.

Why Warren Buffett Is Buying Newspapers

Buffett said at the 2009 shareholder meeting that, when it comes to most newspapers in the U.S., "we wouldn't buy them at any price" and that they are likely to have "unending losses".

While at first these moves may seem a bit confusing (especially considering what he was saying back in 2009) I think this likely comes down to a few things:

- There's less competition in local papers so their economics are more attractive and under less pressure to deal with the digital transition.

- Clearly some financing was needed (at least in the case of Lee Enterprises and Media General) and Berkshire, with its long-term view and strong balance sheet, is in a unique position to provide it.

- While we don't have financials on Omaha World-Herald or Media General, a good guess is there is some decent free cash flow here once the balance sheet is straightened out. Their weak balance sheets almost certainly puts Buffett in a position to get deals done that are attractive to Berkshire. Lee Enterprises actually had some nice free cash flow in recent years (and also the past couple quarters of this fiscal year) but filed for Chapter 11 bankruptcy protection to refinance roughly $ 1 billion of debt.

Finally, the newspaper business is something Buffett and Munger certainly know well.

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, May 22, 2012

Volcker on Derivatives and Trading

Here's some of what Paul Volcker had to say in front of the Senate Banking Committee (Subcommittee On Consumer Protection) earlier this month:

The newly enacted prohibitions on proprietary trading and strong limits on sponsorship of hedge and equity funds should be much more significant. The impact on the sheer size of the largest U.S. commercial banking organizations and the activities of foreign banks in the United States may be limited. They are, however, an important step to deal with risk, conflicts of interest, potentially compensation practices and, more broadly, the culture of banking institutions.

The justification for official support and protection of commercial banks is to assure maintenance of a flow of credit to businesses and individuals and to provide a stable, efficient payment system and safe depository. Those are both matters entailed in continuing customer relations and necessarily imply an element of fiduciary responsibility. Imposing on those essential banking functions a system of highly rewarded – very highly rewarded – impersonal trading dismissive of client relationships presents cultural conflicts that are hard – I think really impossible – to successfully reconcile within a single institution. In any event, it is surely inappropriate that those activities be carried out by institutions benefiting from taxpayer support, current or potential.

Similar considerations bear upon the importance of requiring that trading in derivatives ordinarily be cleared and settled through strong clearing houses. The purpose is to encourage simplicity and standardization in an area that has been rapidly growing, fragmented, unnecessarily complex and opaque and, as events have shown, risk prone.

There is, of course, an important legitimate role for derivatives and for trading. The question is whether those activities have been extended well beyond their economic utility, risking rather than promoting economic growth and efficient allocation of capital.

The battle over things like "Volcker Rule" and related continues but I think it is a good idea to listen to what Volcker has to say unfiltered.

Here are some related articles:

Volcker Defends a Rule Bearing His Name

Four Years After AIG, Wall Street Back to Its Old Tricks

JPMorgan's soap opera

For Some, Disaster Is Spelled CDS

Don't Save The Whales

Considering the scale, complexity, what's at stake, and the entrenched interests involved (and the mess that it is), I think how long it is taking to resolve these issues is hardly surprising.

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 are never a recommendation to buy or sell anything.

Monday, May 21, 2012

Buffett's Prior 12-Month Buys & Sells

For a number of quarters, I've been posting a summary of Berkshire Hathaway's (BRka) 13F-HR changes.

It may also be useful to step back and see what the bigger changes have been to the Berkshire Hathaway portfolio over the past year.
(The 13F-HR is useful, but there's plenty of noise that comes from some of the smaller moves.)

So, especially since the portfolio is so concentrated, I've focused the following on changes to Berkshire's larger holdings from the end of the 1st quarter of 2011. This also will pick up substantial other investments in marketable securities that were made over the past year that are not in the 13F-HR.
(Something like Tesco PLC: TSCDY will not show up in the 13F-HR unless Berkshire buys the ADR.)

The changes to smaller positions (less than ~ $ 1 billion) are generally thought to be the work of the new investment managers (Ted Weschler or Todd Combs).

So here are the larger Berkshire positions that are are either new or were added to since the end of 1st Quarter 2011:

                                                Price to Earnings (P/E)
IBM (IBM)                                      13.0x
Wells Fargo (WFC)                         9.4x
Tesco PLC (TSCDY)                       9.2x
Wal-Mart (WMT)                          12.7x

Some things worth noting:

- IBM is an ~ $ 11 billion addition and by far the biggest change.

- The other larger additions were around $ 1 billion or less.

- IBM, Wells Fargo, and Wal-Mart are selling above Berkshire's cost basis.

- Tesco PLC is selling below Berkshire's cost basis.

- IBM and Wells make up 1/3 of equity portfolio.

- Buffett also added ~ 4% to Berkshire's sizable position in Munich Re since the end of 2010, but it's not clear if that happened in the 1st quarter of 2011 or more recently.

- There was also the $ 5 billion investment in Bank of America preferred shares.

Here are the larger positions sold since the end of 1st quarter of 2011 and their P/Es.

                                              Price to Earnings (P/E)
Kraft (KFT)                                  15.3x
Procter & Gamble (PG)             16.4x
Johnson & Johnson (JNJ)       12.4x

It's also worth noting that even after all of these sales, each of these stocks remain relatively large positions within the equity portfolio. Procter & Gamble actually remains in the top five.

1. Coca-Cola (KO)
2. IBM (IBM)
3. Wells Fargo (WFC)
4. American Express (AXP)
5. Procter and Gamble (PG)

Coca-Cola, IBM, Wells Fargo together make up more than 1/2 of the equity portfolio.

Each position is ~4-5x larger than the entire investment portfolios of Weschler and Combs.

Adam

Other than IBM, established long positions in all stocks mentioned. TSCDY is, and if not sold likely will remain, a very small position.
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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.

Friday, May 18, 2012

Is One Apple Really Worth Less Than Four Facebooks?

Lots of wealth has been created by the smart people at Facebook in what has been a relatively short amount of time. Bravo to Facebook's early investors and especially to all the people who helped to build the business.

Quite an accomplishment.

It's all very impressive and the company certainly seems to have no shortage of great prospects.

None of this means (and you probably guessed this was coming) its current valuation makes sense. At the price it is selling at as I write this, Facebook's (FB) enterprise value is more than one quarter Apple's (AAPL).

So market participants who plan to buy the stock today (with the idea of owning it longer term), have to be hopeful that somehow one Apple being equal to roughly four Facebooks is justified.

Also, they are obviously hoping Facebook can grow that value substantially from here. If not, why put the capital at risk?

Let's look at this a bit further. Facebook's enterprise value (market cap minus net cash) is around $ 100 billion based upon what it initially began trading (~ $ 42/share) at earlier today. According to Facebook's S-1, here's how Facebook performed in its most recent quarter.

Revenue grew an impressive 45% from $ 731 million in the 1st quarter of 2011 to $ 1.058 billion in the 1st quarter of 2012.

Earnings declined 12% from $ 233 million to $ 205 million.

Free cash flow was negative in both periods.

Apple's enterprise value is roughly $ 390 billion. Here's the same numbers for Apple:

Revenue grew 59% from $ 24.7 billion in the 1st quarter of 2011 to $ 39.2 billion in the 1st quarter of 2012.

Earnings grew 93% from $ 6.0 billion to $ 11.6 billion.

Free cash flow grew 124% from $ 5.6 billion to $ 12.5 billion.

Unlike other posts, I won't waste any time comparing the ratios.

To me, the chasm between those relative numbers speak for themselves.

Having seen this movie (unfortunately too many times) before, I know I'll still hear many tortured justifications in the coming weeks about Facebook's valuation.

I'm guessing some will discount the Apple comparison as just one mere inconvenient real world special case.

So Facebook may be a company with an incredible future, but it does not seem worth more than a fraction of its current valuation.

At least not yet.

I don't doubt it may grow into its market valuation and more someday. It's just tough to make great risk-adjusted returns paying now what something may be worth someday.
(I'm more a fan a paying a meaningful discount to what something is plainly worth now, especially if it has a good probability of growing that value over time.)

Now, let's say Facebook grows earnings (hopefully someday backed by free cash flow) 30% a year over the next five years. If Facebook does grow that much, it will produce, in total (adding the five years together), roughly $ 12 billion of earnings.
(again, I'd use free cash flow but they have none to grow yet)

So, in that scenario, they'll earn over five years roughly what Apple earned in just the past 90 days or so.*

Think of it this way: Apple could stop growing today and, at its current run rate, have $ 370 billion of cash to return to owners at the end of that five-year period (whether they actually return it is another question). Also, at least presumably, Apple should still be a halfway decent business with substantial intrinsic value at that point five years in the future (capable of producing even more cash for shareholders going forward).

It's worth noting that the aforementioned $ 370 billion of cash is nearly equal to Apple's current enterprise value. So if you believe, as I do, in the principle don't pay too much for promise (ie. a premium paid for a promising future not realized is costly) then there are plenty of alternatives to Facebook that offer attractive risk-adjusted returns. As always, the price paid is the best way to manage the risk of permanent capital loss.

The alternatives, at least some, may lack Facebook's upside (and downside) but that's just the nature of the principle. At a minimum, those who like Facebook can't just ignore some of the other large cap tech stocks with relatively modest valuations and not exactly terrible prospects. I'm not even convinced that some of the large cap tech stocks with relatively low P/Es don't have superior future prospects.

Most technology businesses lack the kind of clear durable advantages that I require to invest. Their nature is inherently unpredictable. Technology change, shifts in consumer behavior, and a changing competitive landscape assures it. As I said here and on other occasions, there's just no technology business that I'm comfortable with as a long-term investment. Yet, at least the prices of some large cap tech stocks seem to provide a decent or better margin of safety. What's unattractive at one price often becomes interesting once low enough.

In a few years, Facebook's long-term strengths may become more apparent (well, at least apparent to me).

Others might already see its potential vividly. If it turns out I'm underestimating Facebook (and I certainly may be), the stock is just something I don't mind missing near its current valuation considering alternatives.

The near term market voting machine may produce some rather remarkable price action in Facebook's stock but, as always, I'm not talking about trading here. Those in the business of playing the price action game are working with a very different time horizon.

Adam

Long position in Apple established at much lower than recent market prices.

Related posts:
Facebook Drops Ahead of IPO: 1st Quarter 2012 Results
Facebook Files for IPO: What the S-1 Reveals
Facebook's IPO: $ 100 Billion Valuation?
Facebook's 1st Half Revenue Doubles to $ 1.6 Billion
Is Facebook Worth $ 100 Billion?
Technology Stocks

* To be clear, I can think of many businesses that I'm more comfortable with than Apple. This comparison is just a useful way to look at relative valuations.
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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.

Thursday, May 17, 2012

Munger's Daily Journal Corp. - Investment Portfolio Now Equals Nearly 90% of Market Capitalization

In a previous post, I noted the following about the Daily Journal Corporation (DJCO):

At the end of December 2011, the Daily Journal's cash and investments in total were worth $ 79.3 million.

There's no debt now so, of course, net cash and investments also equals $ 79.3 million.

Market Capitalization = ~$ 101 million

Enterprise Value (EV = market capitalization minus cash and investments) = ~$ 22 million

The portfolio made up nearly 80% of the company's value at that time. Well, it is now nearly 90%.

Daily Journal had earned a little over $ 7 million on average over the previous five years giving it an enterprise value to earnings multiple that was roughly 3x. So investor's when I wrote the above were only willing to pay roughly 3x what the business itself earned on average over the prior five years.

Naturally, what matters is what it will earn going forward.

Let's look at the it the same way using the most recently reported quarterly results:

At the end of March 2012, the Daily Journal's cash and investments in total were now worth $ 104.1 million.
($ 90 million of it is common stocks, $ 7.7 million bonds, and U.S. Treasury Bills now just $ 500k. The rest is $ 5.9 million of cash and cash equivalents.)

That's a 31% increase in value. In the 10-Q filing they do not note any new purchases (the last purchase they noted was the "common stock of another Fortune 200 company" during the 1st quarter of fiscal 2012. The quarter they just reported is their fiscal 2nd quarter.) so the increase in value most likely comes down to the securities they own have increased in market value substantially since they last reported.

There's still no debt now so, of course, net cash and investments also equals $ 104.1 million.*

Market Capitalization = ~$ 117 million
(Based upon yesterday's $ 84.98/share. The stock has moved up quite a bit this year but considering how well the marketable securities portfolio has performed...not surprising. Of course its not like the short-term "voting machine" has to necessarily make sense.)

Enterprise Value (EV)  = ~$ 13 million

Using the 5 year average earnings that puts the enterprise value to earnings multiple at less than 2x.

Yet, what matters is what they will earn on a normalized basis going forward. In the 1st half of this year they earned $ 3.75 million so it seems they are on pace to be in the ballpark of the five year average. The problem is that the $ 3.75 million is a decline year over year and that's a trend that's likely to continue.

Consider this from the latest 10-Q:

The traditional business segment revenues are very much dependant on the number of California and Arizona foreclosure notices. The number of foreclosure notices published by the Company decreased by 21% during six months ended March 31, 2012 as compared to the prior year period. Because this slowing is expected to continue, we anticipate there will be fewer foreclosure notice advertisements and declining revenues in fiscal 2012. We do not expect to experience an offsetting increase in commercial advertising as a result of this trend because of the continuing challenges in the commercial advertising business.

So, as I mentioned in the other post, it's probably wise to assume earnings in recent years were much stronger than they will be going forward (again, nothing wrong with expecting lower levels and being pleasantly surprised). The investment portfolio performance, effective allocation of future free cash flow, and the sustainability of the traditional business (even if at a lower level of free cash flow) remains the key to value creation at Daily Journal.

I'd feel more comfortable with this if I understood roughly what earnings will look like over the next five to ten years.

Still, when you consider that 1) Charlie Munger and his investing principles inform the capital allocation process*, and 2) much of the market capitalization is supported by the marketable securities alone (securities that are unlikely to be speculative in nature), there certainly seems to be some margin of safety here.

As I mentioned previously, insiders own a bunch of the stock and shares trade in an extremely illiquid fashion. Anyone interested in the shares had better avoid market orders.

Adam

No position in DJCO

* There's a good chance the market value of the marketable securities is down a bit since the end of March. The important thing, of course, is what the intrinsic value of those securities happen to be and how much they increase in value (hopefully) over time. 
** From the 10-Q: The Company's Chairman of the Board, Charles Munger, is also the vice chairman of Berkshire Hathaway Inc., which maintains a substantial investment portfolio. The Company's Board of Directors has utilized his judgment and suggestions, as well as those of J.P. Guerin, the Company's vice chairman, when selecting investments, and both of them will continue to play an important role in monitoring existing investments and selecting any future investments.
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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, May 16, 2012

Berkshire Hathaway 1st Quarter 2012 13F-HR

The Berkshire Hathaway (BRKa1st Quarter 2012 13F-HR was released yesterday.

For comparison purposes here's the 4th Quarter 2011 13F-HR. This quarter some new positions were added while they continued to build upon several existing positions.

There also was a bit of selling.

This post summarizes the previous Berkshire Hathaway 13F-HR.

Here's what changed during the 1st quarter:*

New Positions
General Motors (GM): Bought 10 million shares worth $ 222 million
Viacom (VIA-B): 1.6 million shares worth $ 75 million

Considering the small size both new positions are likely to be shares bought by one of the two portfolio managers (Todd Combs or Ted Weschler).

Added to Existing Positions
IBM (IBM): Bought 490 thousand shares worth $ 97.5 million (1% increase), total stake $ 12.8 billion
DirecTV (DTV): 2.65 million shares worth $ 124 million (13% increase), total stake $ 1.08 billion
Wells Fargo (WFC): 10.6 million shares worth $ 343 million (3% increase), total stake $ 12.7 billion
BNY Mellon (BK): 3.8 million shares worth $ 81 million (213% increase), total stake $ 118 million
DaVita (DVA): 3.3 million shares worth $ 273 million (+124%), total stake $ 493 million
Liberty Media (LMCA): 1.3 million shares worth $ 137 million (+76%), total stake $ 253 million
Wal-Mart (WMT): 7.67 million shares worth $ 455 million (+20%), total stake $ 2.77 billion

In the 1st Quarter of 2012, there was at least something purchased but kept confidential. The filing says: "Confidential information has been omitted from the Form 13F and filed separately with the Commission."

From time to time, the SEC allows Berkshire Hathaway to keep certain moves in the portfolio confidential. The permission is granted by the SEC when a case can be made that the disclosure may cause buyers to drive up the price before Berkshire makes its additional purchases.

A look at the cash flow statement from the most recent 10-Q reveals that over $ 3.4 billion of equity purchases were made in the 1st quarter.

The total of the above purchases equals only an estimated $ 1.5 billion. That means roughly $ 1.9 billion of another new purchase or purchases (ie. equities that sell on exchanges outside the U.S. or mystery purchases/confidential trades inside the U.S.) were transacted by Berkshire Hathaway during 1st quarter 2012 that have yet to be disclosed.

Reduced Positions
Verisk (VRSK):  Sold 1.2 million shares worth $ 59 million (35% decrease), total stake now $ 109 million
Intel (INTC): 3.75 million shares worth $ 101 million (33% decrease), total stake $ 208 million
Kraft (KFT): 9 million shares worth $ 350 million (10% decrease), total stake now $ 3.03 billion
Dollar General (DG): 860 thousand shares worth $ 40 million (19% decrease), total stake now $ 170 million
Procter & Gamble (PG): 3.5 million shares worth $ 224 million (5% decrease), total stake now $ 4.7 billion
Ingersoll-Rand (IR): 600 shares worth ~$ 26,000 (hardly worth noting), total stake now $ 27.2 million
U.S. Bancorp (USB): 100 shares (yes, 100) worth ~$ 3,000 (also hardly worth noting in a portfolio this size), total stake now $ 2.16 billion.

Sold Positions
It appears the very small stake in Comdisco (CDCO) has been sold outright.

Todd Combs and Ted Weschler are responsible for a portion of Berkshire's portfolio. As I mentioned above, any changes involving the smaller positions will generally be the work of the new portfolio managers.

The total value of reduced and sold positions was under $ 1 billion during the quarter according to the 10-Q.

Top Five Holdings
After the changes, Berkshire Hathaway's portfolio of equity securities is made up of ~ 34% financials, 30% consumer goods, 18% technology, and 8% consumer services. The remainder is primarily spread across healthcare, industrials, and energy.

1. Coca-Cola (KO) = $ 15.3 billion
2. IBM (IBM) = $ 12.8 billion
3. Wells Fargo (WFC) = $ 12.7 billion
4. American Express (AXP) = $ 8.8 billion
5. Procter and Gamble (PG) = $ 4.7 billion

As is almost always the case it's a very concentrated portfolio.

The top five often represent 60-70 percent and, at times, even more of the equity portfolio. In addition, Berkshire owns equity securities listed on exchanges outside the U.S.**, plus cash and cash equivalents, fixed income, and other investments that brings the total portfolio value to somewhere north of $ 175 billion.

The portfolio, of course, excludes all the operating businesses that Berkshire owns outright.

Here are some examples of the non-insurance businesses:

MidAmerican Energy, Burlington Northern Santa Fe, McLane Company, The Marmon Group, Shaw Industries, Benjamin Moore, Johns Manville, Acme Building, MiTek, Fruit of the Loom, Russell Athletic Apparel, NetJets, Nebraska Furniture Mart, See's Candies, Dairy Queen, The Pampered Chef, Business Wire, Iscar Metalworking, and Lubrizol among others.

In addition, the insurance businesses (BH Reinsurance, General Re, GEICO etc.) owned by Berkshire have naturally provided plenty of "float" for their investments over time and continue to do so.

See page 101 of the annual report for a full list of Berkshire's businesses.

Adam

Long positions in BRKb, KO, WFC, AXP, PG, USB, WMT, KFT, and INTC established at lower than recent market prices.

* All values based upon yesterday's closing price. Naturally, what was actually paid can't be known from the information disclosed.
** Berkshire Hathaway's holdings of ADRs are included in the 13F-HR. What is not included are the shares listed on exchanges outside the United States. The status of those shares are updated in the annual letter. So the only way any of the stocks listed on exchanges outside the U.S. will show up in the 13F-HR is if Berkshire happens to buy the ADR. Investments in things like preferred shares (and related warrants) are also not included in the 13F-HR.
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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.

Tuesday, May 15, 2012

Amazon, Apple, and Margin of Safety

A follow up to this post on Amazon (AMZN).

Amazon 1st Quarter 2012 10-Q

The following Amazon numbers sure look kind of small (to say the least) next to the $ 11.6 billion that Apple (AAPL) earned in its latest quarter. Amazon's Q1 income after tax over the past three years was as follows:

Q1 2010: $ 301 million
Q1 2011: $ 218 million
Q1 2012:  $  41 million

Nice trend by the way. The $ 41 million Amazon earned represents roughly what Apple earned on average during every 8 hour period of last quarter yet Apple's enterprise value is only ~ 4.3x Amazon's.

Makes sense, right?

In addition to the $ 41 million, Amazon did make some money in the 1st quarter of 2012 on equity method investment activity. This resulted in a gain for Amazon of $89 million (making net income $ 130 million) and comes from companies in which Amazon has a minority equity stake.

The quality and sustainability of those earnings seems not at all clear to me. Since, at least in most of the preceding quarters, equity method investment activity has generally generated small losses it would be nice to have some more clarity on this source of net income.

Is the $ 89 million a one time gain or does it represent something more sustainable?

The company bought back $ 960 million of stock in the 1st quarter of 2012 or many times what they earned. In fact, the company bought back a total of $ 1.24 billion of stock over the past 12 months. Remarkably, even with these actions, share count still rose a bit compared to where it was in the 1st quarter of 2011.*

At the current share count and using yesterday's closing price Amazon's market value is bit over $ 102 billion.

Amazing.

This may all work out very well in the long run but the margin of safety principle certainly isn't the first thing that comes to mind.

Adam

No position in AMZN; long position in AAPL

Related posts:
Amazing Amazon
Barron's on Bezos: Time to Reign in Amazon's CEO?
Amazon's Jeff Bezos On Inventing & Disrupting
Amazon Sells Kindle Fire Below Cost
Technology Stocks

* Shares outstanding can rise even when there's a share buyback due to stock option dilution. The share count of Amazon has grown more than 20% over the past decade.
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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, May 14, 2012

Montier: The Flaws of Finance

On May 6th, 2012, James Montier gave this speech with the title: The Flaws of Finance.

Video: The Flaws of Finance - James Montier

Also, here's a post by Thomas J. Brakke on Montier's speech.

So what are the flaws?

According to Montier, the flaws fall into four categories:

- Bad Models
- Bad Policies
- Bad Incentives
- Bad Behavior

First of all, finance isn't physics but damaging models exist that seem to assume otherwise.

Finance is a social science yet that's somehow misunderstood and/or ignored by some industry participants and their regulators. Popular models like capital asset pricing model (CAPM) and value-at-risk (VaR) mostly fail in reality even if interesting in another, more academic, context.

Once tested under real world conditions they've proved to be flawed and dangerous.

Things that seem to work until they don't.

Policy makers, at least in the past, have tended to buy into some the flawed models (created by the banks themselves no less) leading to what is a great example of regulatory capture.

There are too many poorly constructed incentives in the investment business and throughout the financial system. These incentives often reinforce the wrong behavior and play right into the cognitive biases and other errors in judgment that adversely impact investor decision-making.

Check out Montier's full speech.

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 are never a recommendation to buy or sell anything.

Friday, May 11, 2012

Tom Russo: First Mover Advantage and the "Capacity to Suffer"

From an interview with Tom Russo in the latest Graham & Doddsville newsletter:

"The three prongs that I look for when investing in a business are: the fifty cent dollar bill, the capacity to reinvest in great brands and the 'capacity to suffer.' The 'capacity to suffer' is key because often the initial spending to build on these great brands in new markets has no initial return."

It's not hard to see why first-mover advantage is so valuable. If a brand becomes firmly established in the minds of consumers in a new market ahead of competitors, it is more likely to have sustainable higher margins and returns. Russo later added the following:

"...invest a lot of money upfront to build your store presence, distribution, advertising, etc. Then you become a first mover and your brands become identified with a particular product category."

The problem is that to gain this type of advantage, it warrants patience and the acceptance of what seem like unattractive returns in the early stages while the brand and distribution are being built.

Sometimes, a substantial business expansion opportunity (think along the lines of a move into a key new market like China or India) demands a willingness to invest persistently over a sustained period where explicit returns may not be obvious for some time.

Companies like* Coca-Cola (KO) or Diageo (DEO), at least if management is doing its job well, are making long-term investments in new markets now but the returns from these efforts are not yet visible.

If their efforts are being well-executed, that lack of early stage returns is likely a good sign. Why? Focus on showing a profit too soon and the advantage may be lost.

Weak upfront investment opens the door to competition that can make the long-term economics less attractive.

It's best to enter a new market forcefully (and for an extended period) so a brand gets favorably entrenched earlier than the rest. This makes it difficult for competitors to drive down future margins and erode long-term returns.

If efforts to move into a market are well-executed, and what Russo calls the "capacity to suffer" exists, it can end up paying off for the long-term investor in a meaningful way.

Just expect it to do so on a substantial lag. It helps if management and the owners are on the same page so the necessary patience is there.

The bottom line: The push for profits too soon probably lowers long-term returns.

For an investor the tough part can figuring out who is actually doing this kind of thing well.

Adam

Established long positions in KO and DEO at much lower prices. Great businesses but these aren't bargains near current market prices.

* The examples Russo uses in the interview are Nestle (NSRGY), Unilever (UL), and Heineken (HINKY).
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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 are never a recommendation to buy or sell anything.
 
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