Tuesday, February 26, 2013

Charlie Munger & Warren Buffett: Market Fluctuations, Price Action, and Productive Assets

In October of 2009, Charlie Munger was interviewed on the BBC.

Here's what he had to say about Berkshire Hathaway's (BRKa) stock (it was down quite a bit at the time) and, more generally, the decline in common stocks.

So how much does Charlie worry when Berkshire's common stock declines?

"Zero. This is the third time that Warren and I have seen our holdings in Berkshire Hathaway go down, top tick to bottom tick, by 50%. I think it's in the nature of long term shareholding of the normal vicissitudes, in worldly outcomes, and in markets that the long-term holder has his quoted value of his stocks go down by say 50%. In fact, you can argue that if you're not willing to react with equanimity to a market price decline of 50% two or three times a century you're not fit to be a common shareholder, and you deserve the mediocre result you're going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations."

In this BBC interview with Warren Buffett, also from back in 2009, here's what he had to say about the nature of stock markets.

"The very liquidity of stock markets causes people to focus on price action. If you buy an apartment house, if you buy a farm, if you buy a McDonald's franchise you don't think about what it's going sell for tomorrow or next week, or next month, you think about how is this business going to do. But stocks with this huge liquidity suck people in and they turn what should be an advantage into a disadvantage."

Then, later in the interview, Buffett said this about investment: 

"...you compare the net return to how much money you are laying out, that's investment." 

Finally, he added this:

"...you can still get in trouble if you pay too much, but you are focusing on the right thing if you look at the stream of income that the asset is going to produce over time."

Berkshire Hathaway's stock has, not exactly surprisingly, rallied quite a bit since those interviews. It recently reached a new all-time high and is currently selling near that all-time high.

For investors, the focus should be what something is intrinsically worth per share and how it might change over time. As Buffett says, it's what the asset is capable of producing for investors over the long haul.

The estimated value comes from discounting the stream of excess cash that will be produced -- beyond what's necessary to competently run the business -- over its remaining life. The excess cash must be truly excess cash. In other words, not needed to at least maintain the "economic moat" (and ideally the "moat" is being enhanced while still producing an attractive return for investors) of the core existing business. Cash that can either be returned to shareholders in some form or invested incrementally at high return on behalf of shareholders.

Otherwise, wide price fluctuations driven by the liquidity of short-term oriented market participants should be expected. Recent price action is only relevant to the long-term investor in a particular asset if it allows more of something to be purchased at a discount when it's attractively valued (including via dividend reinvestment and buybacks).*

As Buffett explains in the Berkshire owner's manual (in the Intrinsic Value section on page 4), estimating intrinsic business value is by its nature imprecise.

No two investors are likely to come up with the same number.

It is, instead, more a range of values.

Now, there's several ways to go about estimating Berkshire's per share intrinsic value at any time but, of course, there's is no perfect way to do so. Estimating value is, in fact, necessarily imprecise for any business but, at least in the case of Berkshire, book value can be thought of as a useful if understated measure.**

At the end of 2007 -- the first time the stock price was near current levels -- Berkshire reported that its book value per Class A equivalent share was $ 78,008.

We'll see what the latest number is when the annual report is soon released, but it's very likely to be at least somewhat higher than the $ 111,718 per Class A equivalent share reported for the 3rd quarter of 2012.

Berkshire's intrinsic value happens to be quite a bit higher than book value. Here's how Buffett explains the reason for this gap in the Berkshire owner's manual:

"The limitations do not arise from our holdings of marketable securities, which are carried on our books at their current prices. Rather the inadequacies of book value have to do with the companies we control, whose values as stated on our books may be far different from their intrinsic values."

One thing to consider is the fact that Buffett has said they would buy back Berkshire's stock at no higher than 10% over book value. Well, it would not be wise to be buying back shares of Berkshire unless 10% over book value represented a nice discount to intrinsic value.

Again, this is just one convenient way of estimating the value of Berkshire. There are other ways to estimate value, of course, but they're all at least somewhat less convenient and straightforward. In the end, like any asset, what determines Berkshire's value still comes down to the excess cash, discounted appropriately, that can be produced over the long haul.***

So book value may be a convenient way to quickly estimate Berkshire's value, but I'd argue it's insufficient for making an investment decision.

Still, changes to Berkshire's book value can be useful in that it likely indicates a roughly similar percentage change in intrinsic value.

For many other businesses, book value is too often mostly useless when it comes to estimating what something is intrinsically worth.


Long position in BRKb established at much lower than recent market prices

* Obviously, it's a very different story for someone that has a shorter time horizon. (Whether a trader or a long-term investor who's ready to exit for whatever reason. High opportunity costs, misjudged prospects, extreme valuation among other things can naturally turn someone who intended to be in it for the long haul into someone ready to move on.)
** See Berkshire owner's manual"...Berkshire's book-value figures because they today serve as a rough, albeit significantly understated, tracking measure for Berkshire's intrinsic value." As I've said before the manual also provides a useful explanation of intrinsic value.
*** Whether it is paid out as dividends, used for buybacks, or put to other high return use.
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