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.

Adam

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.
---
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, February 22, 2013

Amazon, Apple, and Intrinsic Value - Part II

A follow up to this post.

Amazon, Apple, and Intrinsic Value

This Fortune article compared Apple (AAPL) and Amazon (AMZN) that also provides some useful charts.

Apple vs. Amazon: Bizzaro valuations revisited

In the prior post I wrote this about Apple:

...Apple may still have more than respectable future prospects but, whenever there's a huge jump in earnings capacity (and going from $ 4.8 billion to $ 41.7 billion in five years certainly qualifies), it creates real challenges for any investor who's trying to figure out the intrinsic value of a company.

It's usually not a good idea to assume that such a jump in earnings will be persistent or that the recent exceptional performance should be extrapolated then used as a basis for valuation.
(Benjamin Graham makes this point in Chapter 12 of The Intelligent Investor. It's often better to use a multiple year average especially when there's been a recent earnings spike.)

That doesn't mean Apple won't continue to do very well. It's just unwise to assume -- in order to avoid big misjudgments -- that the most recent peak somehow represents normalized earnings or, even worse, that the recent growth rates can be logically extrapolated forward.

This recent article is a useful exploration of Apple's valuation and why margins seem likely to decline over time. It makes the point, among other things, that Apple's net margins went from 1.1% in 2003 to 25% in 2012. Likely too low in 2003. Probably too high in 2012.

There are legit reasons to think those net margins won't go back to 1.1% anytime soon. Yet, it's a good example of the underlying challenge that exists when it comes to figuring out Apple's valuation. Margins may not go back to 1.1%, but the premium they can now charge seems unlikely to be maintained over the long haul.
(Though if anyone's going to be the exception to the rule it might just be Apple.)

These sort of concerns don't really exist in a business that's less reliant upon innovation.

So figuring out what levels of free cash flows should be considered proper basis for business valuation is a fairly daunting thing to do with Apple.

Still, between the $ 137 billion of net cash and investments on the balance sheet (an amount that makes up ~ 30% of Apple's current market value) and the free cash flow, a conservative basis for intrinsic value -- possibly within a wider than ideal range -- can be estimated. Consider this quote by Warren Buffett (one I've made reference to before):

"The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase - irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value." - Warren Buffett in the 1992 Berkshire Hathaway (BRKaShareholder Letter

Apple's recent accomplishments are impressive but I'll never really be a fan of the company as a long-term investment. They've done (and will probably continue doing) great things. It's just that they're not in the kind of business who's long run prospects are anywhere near predictable enough.

Figuring out what Apple's business will look like in ten years (or even less) seems difficult at best. That doesn't mean that the price can't get low enough to protect against even the worst outcomes.

"Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach. 

Usually, the range must be so wide that no useful conclusion can be reached." - Warren Buffett in the 2000 Berkshire Hathaway Shareholder Letter

Later in that same letter Buffett adds that...

"Occasionally, though, even very conservative estimates about the future...reveal that the price quoted is startlingly low in relation to value."

What Amazon's done as a business is also impressive in many ways.

It's not hard to understand why so many think highly of the company and its future prospects.

Yet, I will always find figuring out the valuation of the company -- even within a very wide range -- to be incredibly difficult.*

Some investors are willing to pay a huge premiums for the possibility that significantly higher earnings power will someday materialize.

Some of those same investors will quickly lose interest once there is a lack of exciting growth prospects.
(Even if real persistent earnings is actually, after a long wait, now finally being demonstrated. So literally willing to pay more for the promise of future cash flow than when it actually materializes.)

Even if things work out, the premium paid on this can lead to far too little return for the risk that was taken. If things don't work out quite as expected, very real risk of permanent and substantial capital loss.

Reducing the risk of permanent capital loss is (or should be) a priority any investor. Paying so much for a promising but relatively unpredictable future would seem likely to bring unnecessary downside risks with it.

That doesn't mean I think Amazon isn't going to do very very well as a company (and I certainly won't be surprised by whatever the stock ends up doing in the near term or even longer).

Slow or no growth -- all else equal -- clearly is worth a lower price relative to normalized earnings capacity.** Good businesses are sometimes wise to endure near-term pain (what Tom Russo calls the "capacity to suffer"). Forgoing attractive near-term economics so that later what is a bigger opportunity can be captured often makes a whole lot of sense. It's just that, as an investor, paying a large premium for a promising but difficult to predict future that doesn't quite materialize can be expensive. The one or two big mistakes in an otherwise sound portfolio can seriously undermine long run compounding effects. Some underestimate this.

My preference is to pay a price where nothing great has to happen to get a good result. It seems, even if less exciting, a far more reasonable approach. If something great does happen it's just a bonus since the investor didn't pay a premium upfront in the first place.

So I find neither Amazon nor Apple all that attractive as long-term investments but the reasons couldn't be more different.

Even if Amazon pulls off "the dream" so to speak -- and I don't think it's wise to doubt that they will -- the question is whether the returns will be sufficient considering the risks. The problem is not the fundamental prospects, it's the price that was paid upfront.

Price regulates risk and, in fact, should represent a sufficient discount to value that it all but eliminate the risk of permanent capital loss (not temporary paper losses). Sometimes, the lower risk alternatives (and, yes, less exciting) can produce a similar or better result if the right price is paid.

Any investment that requires earnings to increase at an exceptional rate should at least produce exceptional returns.

When an investor pays a big upfront premium, the arithmetic doesn't usually allow that to happen (and, as always, I'm not talking about trading on price action here).

In fact, pay a big premium upfront and exceptional business performance will more likely produce merely a good investing result.

Good business performance, a fair investing result.

Fair performance, a disastrous result.

Of course, that doesn't mean it won't work out for some who own Amazon's stock and are in it for the long-term. It also doesn't mean Amazon won't be intrinsically worth an awful lot someday. It's just that avoiding permanent capital loss starts with always having a nice margin of safety. Something that comfortably protects the investor against the unexpected and unforeseen.

Judging Amazon's intrinsic value seems, at least to an extent, like a leap of faith. If, as an investor, intrinsic value (or the range of value) is difficult to judge, how can the margin of safety be known with any confidence?

As I said in the earlier post, I don't doubt that Amazon is likely being built for the long run into something quite valuable. Just how valuable and the timing is the difficult part.

Amazon seems likely to need an extended period of spectacular business performance for investors to get just a decent fundamental investing result (and they may just do that). Yet, as an investor, something as close to the opposite of that situation is preferable when it comes to managing investment risk. In other words, buy what will deliver attractive investing results for just decent business performance.

Relatively certain favorable returns beats those achieved at higher than necessary risk.

These two companies deserve to be admired for their own specific reasons. They just generally don't fit into my own comfort zone as long-term investments. Others, of course, may know better how to judge these two investments. As always, an investor should only own what's understandable to them and in a proportion consistent with conviction levels. That's necessarily an individual thing. An investor in marketable stocks generally shouldn't be buying or selling based upon what someone else thinks. At least that is my view. Having a justifiably high levels of conviction about what an asset is intrinsically worth is crucial (while unwarranted high levels of conviction is a disaster, of course). Well, it seems unlikely that an investor will have sufficient conviction without reaching their own conclusions after having done the necessary work. Without it, the investor won't be able to hang in there when price action inevitably, even if temporarily, goes the wrong way.

Now, I have been willing to own a very small amount of Apple's stock.

That's simply a reflection of where the stock once sold relative to the company's per share net cash, investments, and stream of free cash flow (even if the future offered a far wider range of outcomes than preferred). So the margin of safety could be reasonably judged.***

Margin of safety makes all the difference but that doesn't make Apple an attractive investment for the long haul in my book. Too much dependence on innovation. Too many well-financed and capable competitors. Too much technological and industry change.

Likely very good for civilization, but not necessarily the investor.

Adam

No position in AMZN; established a long position in AAPL at much lower than recent prices

Related posts:
Amazon, Apple, and Intrinsic Value
Negative Working-Capital Cycle
Amazon, Apple, and Margin of Safety
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

* Ultimately, of course, when it comes to valuation it's the cash that will be generated over an extended period that matters. Near-term earnings may or may not be a good proxy for that. As I've explained previously here and on other occasions, there's just no technology business that I'm comfortable with as a long-term investment. Amazon, of course, is less of a pure tech business than Apple but, at least to me, it still has difficult to predict prospects. Occasionally, certain tech stocks have sold at enough of a discount that owning a very limited number of shares made sense to me. In other words, the price was cheap enough relative to the per share cash generation (and, in some cases, net cash on the balance sheet) that it provided a substantial margin of safety. Otherwise, the future prospects of most tech stocks just aren't predictable enough for my money. So I'm not exactly trying to anticipate the next big thing in tech. The best businesses have durable economic characteristics. Tech stocks too often generally do not. Those with seemingly attractive economics today frequently prove to have far less attractive economics down the road.
** Buffett points out in the above quote from the 1992 letter that price relative to a snapshot of earnings or book value -- whether seemingly very high or low -- often reveals little about business value. (Though, it's worth noting, Buffett has said Berkshire's book value is a rough if quite understated way to gauge the company's intrinsic value.) Otherwise, sometimes what seems a low price against current earnings or book value won't turn out to be cheap at all. The opposite is, of course, also true. Price has to be considered against the expected magnitude and timing of a long run stream of cash, appropriately discounted. Sometimes those future cash flows are just too difficult to estimate. In those cases, it's best to avoid the investment no matter how compelling the story is or cheap it appears. Judging value based upon some simple snapshot measurement will often lead to very big and costly mistakes.
*** For speculators on price action it's a whole different ballgame, of course. A stock price can do just about anything in the near-term or even longer. No opinions on that sort of thing. With speculation, it's about trying to guess whether someone will be willing to pay a higher price (for a long position) at some point in the future. With investment, it's about, for the price paid, whether an asset can produce a satisfactory level of per share free cash flow considering the specific risks over the long haul. It's about whether the cash generated will produce a good result and protect against permanent loss of capital even with the most conservative projections. It's as Keynes once said: Speculation is "forecasting the psychology of the markets." Investment is "forecasting the prospective yield of [an] asset over its whole life."
---
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.

Wednesday, February 20, 2013

Aesop's Investment Axiom

According to Warren Buffett, the formula for valuing an asset purchased for gain is the same now as it was when articulated by Aesop long ago.

From the 2000 Berkshire Hathaway (BRKa) shareholder letter:

"...Aesop and his enduring, though somewhat incomplete, investment insight was 'a bird in the hand is worth two in the bush.' To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush -- and the maximum number of the birds you now possess that should be offered for it. And, of course, don't literally think birds. Think dollars.

Aesop's investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota -- nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.

Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to 'growth' and 'value' styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component -- usually a plus, sometimes a minus -- in the value equation."

Somehow a distinction between growth investing and value investing is frequently still made.

It's a distinction without a real difference.

Some will no doubt disagree.

Investing well over the long run requires many things, of course. Yet it ultimately depends upon understanding how to judge correctly, within a useful range, what something is worth -- regardless of its growth profile -- then paying an appropriate discount for it.

The necessity for a discount reflects the inherently imprecise nature of judging value. It also reflects the fact that not everything that's important can be known and misjudgments will inevitably be made. Simplistic valuation metrics like price to earnings are only useful if they happen to be a meaningful proxy for the amount of future net cash an investment will likely generate.

Unfortunately, that's often not the case.

More from the letter:

"...Aesop's proposition and the third variable -- that is, interest rates -- are simple, plugging in numbers for the other two variables is a difficult task. Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach. 

Usually, the range must be so wide that no useful conclusion can be reached. Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startlingly low in relation to value. (Let's call this phenomenon the IBT -- Inefficient Bush Theory.) To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a well-founded positive conclusion. But the investor does not need brilliance nor blinding insights."

How much cash will be generated, when it will generated, and what the prevailing risk-free interest rate is what's all-important. Once there's a meaningful estimate (within a range), the amount and timing of cash flows can then be discounted using an appropriate interest rate.

So it's not, as some might think, growth per se that's necessarily important.

If interest rates are very high, the cash produced in the future needs to be available to the investor sooner than later.

If prevailing rates are very low, the investor can afford to wait quite some time for that cash.

The investment process ultimately rests upon the foundation of knowing how to judge what something is worth consistently well. Lack that ability and everything built upon that foundation crumbles. Others skills and abilities won't be able to compensate for that shortcoming.

Otherwise, it comes down to thinking independently, an even temperament, discipline, and an awareness of limitations. It's less about IQ than some seem to think.

A speculator will, of course, have an entirely different way of looking at this. For a speculator (with a long position, of course), a large drop in the price of an asset is not a good thing. For an investor, a large drop in the value of an asset is not a good thing.

A drop in value means that the net cash to be produced over the life of an asset was misjudged.

A drop in price may mean the psychology of the market has changed (though it surely could also reflect fundamental factors). A temporary drop in price will be a good thing for the investor who's judged value well.

Speculators try to gauge price action. In general, they try to figure out what someone else will be willing to pay in the future.*

That certainly doesn't mean there's something inherently wrong with speculation. There isn't.

It's just that there is a real difference -- in both required skill set and temperament -- between trying to figure out what others will pay for an asset at some later time, and figuring out what an asset itself can produce over its useful life in economic value.

From this interview with Warren Buffett:

"Basically, it's subjective, but in investment attitude you look at the asset itself to produce the return. So if I buy a farm and I expect it to produce $80 an acre for me in terms of its revenue from corn, soybeans etc. and it cost me $600. I'm looking at the return from the farm itself. I'm not looking at the price of the farm every day or every week or every year. On the other hand if I buy a stock and I hope it goes up next week, to me that's pure speculation."

Let's hope we don't always have to go back 2,600 years or so to find investment wisdom.

Adam

Long position in BRKb established at much lower than recent prices

Related posts:
Aesop's Investment Axiom Revisited - Jul 2014 (Follow up)
Grantham: Investing in a Low-Growth World - Feb 2013
Buffett: Stocks, Bonds, and Coupons - Jan 2013
Maximizing Per-Share Value - Oct 2012
Death of Equities Greatly Exaggerated - Aug 2012
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on Aesop's Formula for Value - Nov 2009
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009

* This doesn't mean no fundamental factors influence a speculator's decision. The difference between investment and speculation is subjective -- far from black and white -- but still very real. It's a matter of proportion, emphasis, and time horizon. Investment and speculation can be considered similar only if one's definition of similar is rather imprecise.
---
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, February 15, 2013

Berkshire Hathaway 4th Quarter 2012 13F-HR

The Berkshire Hathaway (BRKa4th Quarter 13F-HR was released yesterday. Below is a summary of the changes that were made to the Berkshire equity portfolio.
(For a convenient comparison, here's a post from last quarter that summarizes Berkshire's 3rd Quarter 2012 13F-HR.)

There was plenty of stocks bought during the quarter. Some brand new positions were established while Buffett and his portfolio managers continued to build upon existing positions.

Here's what changed during the 4th quarter:*

New Positions
Archer Daniels Midland (ADM): Bought 5.96 million shares worth $ 187 million
Verisign (VRSN): 3.69 million shares worth $ 168 million

Added to Existing Positions
Wells Fargo (WFC): Bought 17.3 million shares worth $ 609 million, total stake now $ 15.5 billion
IBM (IBM): 598 thousand shares worth $ 119 million, total stake $ 13.6 billion
Wal-Mart (WMT): 793 thousand shares worth $ 56.2 million, total stake $ 3.36 billion
DirecTV (DTV): 4.48 million shares worth $ 225 million, total stake $ 1.71 billion
DaVita (DVA): 3.41 million shares worth $ 407 million, total stake $ 1.62 billion
Liberty Media (STRZA): 122 thousand shares worth $ 15.2 million, total stake $ 697 million**
General Motors (GM): 10 million shares worth $ 278 million, total stake $ 694 million
National Oilwell Varco (NOV): 1.11 million shares worth $ 77.9 million, total stake $ 372 million
Precision Castparts (PCP): 728 thousand shares worth $ 134 million, total stake $ 365 million
Wabco Holdings ((WBC): 2.47 million shares worth $ 170 million, total stake $ 280 million

In the 4th Quarter of 2012, there apparently was nothing purchased that was kept confidential. Berkshire's 13F-HR filings will sometimes say: "Confidential information has been omitted from the Form 13F and filed separately with the Commission."

Not this time.

Occasionally, 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.

Reduced Positions
Mondelez International (MDLZ): Sold 17.6 million shares worth $ 468 million, total stake $ 341 million
Kraft Foods Group (KRFT): 8.49 million shares worth $ 400 million, total stake $ 78.7 million
Johnson & Johnson (JNJ): 165 thousand shares worth $ 12.5 million, total stake $ 24.8 million
Lee Enterprises (LEE): 1.04 million shares worth $ 1.52 million, total stake now $ 130 thousand

Berkshire owns both Mondelez International (global snack-food company) and Kraft Foods Group (North American grocery-food business) as a result of the spin-off

The spin-off is now called Kraft Foods Group while the remaining Kraft business has been named Mondelez International. Berkshire would own 30.4 million Mondelez International shares and 10.2 million Kraft Foods Group shares if no selling had been done in 4Q 2012 (as this Bloomberg article explains).

Of course, there was quite a bit of selling as noted above and in the latest 13F-HR filing. 

Todd Combs and Ted Weschler are responsible for an increasingly large number of the moves in the Berkshire equity portfolio, even if they still manage only a small percentage of the overall portfolio.

These days, any changes involving smaller positions will generally be the work of the two portfolio managers.

Top Five Holdings
After the changes, Berkshire Hathaway's portfolio of equity securities remains mostly made up of financial (~ 35%) and consumer stocks (~ 30%).

The remainder is spread across technology (primarily IBM), healthcare, industrials, and energy.

1. Wells Fargo (WFC) = $ 15.5 billion
2. Coca-Cola (KO) = $ 14.7 billion
3. IBM (IBM) = $ 13.6 billion
4. American Express (AXP) = $ 9.5 billion
5. Procter and Gamble (PG) = $ 4.1 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.***

We'll get more details when the annual report is released but the combined portfolio value (equities, cash, bonds, and other investments) should easily be greater than $ 180 billion at this point.

The portfolio, of course, excludes all the operating businesses that Berkshire owns outright with 288,000 employees.

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, Lubrizol, and the recently purchased Oriental Trading Company (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, WMT, and JNJ established at much lower than recent market prices.

* All values based upon yesterday's closing price with the exception of Liberty Media.
** The Starz/Liberty Media spin-off was completed last month (spin-off of Liberty from Starz). Liberty Media changed its name to Starz and trades as STRZA. The spin-off is called Liberty Media Corporation and trades as LMCA. The value shown above for Liberty Media are based upon the closing price as of the last trading day prior to spin-off. So Berkshire would now own shares of both STRZA and LMCA unless portfolio moves related to Starz or Liberty have been made since the end of the quarter.
*** 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.
---
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, February 12, 2013

Coca-Cola Reports Full-Year and 4Q 2012 Earnings

From Coca-Cola's (KO) latest earnings report:
  • Full-year reported EPS was $1.97, up 6%, and comparable EPS was $2.01, up 5%. Fourth quarter reported EPS was $0.41, up 14%, and comparable EPS was $0.45, up 15%.
Nothing spectacular, but solid nonetheless.

Coca-Cola Reports Full Year and Fourth Quarter 2012 Results

Sometimes perspective can get lost when comparing earnings over such a short time frame. It's usually worth stepping back a bit.

How has Coca-Cola's capacity to produce high quality earnings changed over the past 5 or 10 years? Near-term noise can get in the way of understanding that sort of thing. Let's see how Coca-Cola's capacity to earn has progressed:

Full-year earnings for 2012 came in at $ 9 billion.

That compares to $ 5.8 billion five years ago and $ 4.3 billion ten years ago.

So a 55% increase over five years and a 107% over ten years.

Again, not exactly spectacular, but in the context of the company's size, not too bad. Also, in the context of its earnings persistence, not too bad on a risk-adjusted basis.

Coca-Cola's earnings didn't drop off much ($ 5.98 billion in 2007, $ 5.81 billion in 2008, followed by an all-time high at the time of $ 6.82 billion in 2009) during the worst of the crisis. So, when many companies were struggling to make even a fraction of what they were able to earn during better economic times, Coca-Cola continued to do just fine.

A sign of resilience that many businesses just can't match. The risk of permanent capital loss if things don't go quite as expected needs to get at least as much consideration as possible upside. It's easy to make the mistake of focusing too much on the latter.

"Nothing sedates rationality like large doses of effortless money." - Warren Buffett in the 2000 Berkshire Hathaway Shareholder Letter

As markets begin to rally, and the "effortless money" starts to get made, sometimes investors let their guard down. Coca-Cola's core economics and durable advantages have allowed it to generate more than solid increases to intrinsic value over the long haul. Yet, it's been the company's resilience during tougher times that protects an investor against possible permanent capital loss (not temporary paper losses).

It's not just what some might consider a business with "defensive" characteristics.

It's simply a higher quality business.

Of course, what really matters to shareholders is Coca-Cola's per share earnings.

On that basis the picture looks just slightly better since the share count is down somewhat over the past decade.

A 59% increase to per share earnings over five years and 124% over ten years.

Not really a huge difference.

Unfortunately, much like now, the stock has been rarely cheap (and often even quite expensive) this past decade and a half. As a result, the buybacks haven't had as favorable an impact they otherwise would have had on per share earnings and intrinsic value.

As good example as any why it would be better for long-term shareholders if the company's stock remained consistently cheap while the business continued to perform at least roughly just as well.

Ideally, the stock would sell at prices that represent a nice discount to intrinsic value for a good chunk of whatever the investing horizon happens to be.
(Of course, using a portion of free cash flow to buyback a cheap stock will usually require a longer time horizon to have a meaningful per share effect.)

If the shares had been a lot cheaper over the past 10 to 15 years, each buyback dollar would have gone further. Naturally, that's also true going forward. If Coca-Cola's stock were to drop substantially from recent prices, the buybacks would be far more effective and far more enriching to continuing long-term owners.

Coca-Cola remains a fine business. That doesn't mean the company can quite match the long run increases to per share intrinsic value it has achieved in the past. For many reasons it likely will not.

The company will be even less likely to do so if the stock price remains elevated.

Adam

Long position in Coca-Cola established at much lower than recent market prices
---
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.

Friday, February 8, 2013

Grantham: Investing in a Low-Growth World

In Jeremy Grantham's latest letter, he asks whether lower GDP growth logically leads to reduced stock returns.

Grantham answers that question this way:

"This is where I break ranks with many pessimists because I believe theory and practice strongly indicate that lower GDP growth does not directly affect stock returns or corporate profitability.

He adds, parenthetically, that their may be some effects of lower GDP growth that will lower equity returns in a minor way. This gets covered in more detail later in the letter. Otherwise, as far as stock returns go, growth is just not as big a factor as some might think.

All corporate growth has to funnel through return on equity. The problem with growth companies and growth countries is that they so often outrun the capital with which to grow and must raise more capital. Investors grow rich not on earnings growth, but on growth in earnings per share. There is almost no evidence that faster-growing countries have higher margins. In fact, it is slightly the reverse."

In fact, growth can be a negative factor. According to Grantham, it turns out that growth companies and countries underperform...

"The fact that growth companies historically have underperformed the market – probably because too much was expected of them and because they were more appealing to clients – was not accepted for decades, but by about the mid-1990s the historical data in favor of 'value' stocks began to overwhelm the earlier logically appealing idea that growth should win out. It was clear that 'value' or low growth stocks had won for the prior 50 years at least. This was unfortunate because the market's faulty intuition had made it very easy for value managers or contrarians to outperform. Ah, the good old days! But now the same faulty intuition applies to fast-growing countries. How appealing an assumption it is that they should beat the slow pokes. But it just ain't so."

While maybe not intuitive, that high growth rates will have a high correlation with investor returns is far from a given.
(Regular readers obviously know that this has been covered more than a few times on this blog.)

High levels of growth should, of course, generally lead to more desirable investment outcomes, right? As it turns out, not necessarily.

Fast-growing countries, industries, and individual businesses have a whole range of possible investor outcomes with above average returns far from being certain.

"Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive." - Warren Buffett in the 1992 Berkshire Hathaway (BRKaShareholder Letter

Wait, growth can be a negative thing?

Some might choose to treat all this as anomaly. Yet, it's often not a bad idea to explore in some depth what's against conventional wisdom -- what's not intuitive. Occasionally, that's where the more useful insights reside.

Growth, of course, can be a good thing but some seem to think, from an investor point of view, it is always a good thing. What gets in the way? Well, investors often pay too much for attractive future prospects. Also, high growth prospects invite in lots of capital and competition. Lots of well-financed capable competitors can lead to undesirable core economics and a wide range of unpredictable outcomes.*

The real question becomes whether growth will have a favorable impact on the per share value created over a very long time. Sometimes it does. Sometimes it does not.

The primary drivers of long-term returns is the price that's paid relative to well-judged intrinsic value, return on capital**, and whether real durable advantages exist.

A good business needs little capital. It can return the excess capital produced to shareholders. It can use it to finance opportunities at an attractive long-term return. It can do these things while maintaining or even increasing the size and strength of its economic moat (has no trouble defending its core business economics).

This just requires business leaders who do not choose growth for its own sake over per share returns for its shareholders.

Far from a certainty.

Unfortunately, sometimes the fastest growing, most promising, dynamic, and exciting areas of opportunity produce less attractive risk-adjusted returns and a wider range of outcomes.

Adam

Related posts:
Buffett: Stocks, Bonds, and Coupons - Jan 2013
Maximizing Per-Share Value - Oct 2012
Death of Equities Greatly Exaggerated - Aug 2012
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009

* Growth will often have a favorable impact on value. It just happens to be a mistake to think that it always has a favorable impact. In fact, growth can actually reduce value if it requires capital inputs in excess of the discounted value of the cash that will be generated over time. Sometimes, the highest growth opportunities attract lost of capable competition and capital that ruins the long run economics. Sometimes, high growth requires costly yet necessary capital raising (to fund key investments, deal with competitive threats) that dilutes existing shareholders and reduces per share returns.

Finally, even if growth that materializes does have favorable economics, some investors tend to pay a large premium upfront for those growth prospects. That hefty price paid may turn attractive long-term business results into not so attractive investment results.
** The highest possible truly free cash flows relative to the ongoing capital requirements of an enterprise.
---
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, February 6, 2013

Margin of Safety & Mr. Market's Mood

It was not difficult at all to buy stocks cheap (some higher quality, some less so) not too long ago when the Mr. Market's mood was more nervous and, at times, even extremely fearful. Well, in the context of the current environment, consider the following quotes by Ben Graham, Warren Buffett, Charlie Munger, Seth Klarman, and Peter Lynch:

"...the risk of paying too high a price for good-quality stocks—while a real one—is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions. The purchasers view the current good earnings as equivalent to 'earning power' and assume that prosperity is synonymous with safety." - Benjamin Graham in Chapter 20 of his book The Intelligent Investor

"The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money." - Warren Buffett in the 2000 Berkshire Hathaway Shareholder Letter

"...investors seek a margin of safety, allowing room for imprecision, bad luck, or analytical error in order to avoid sizable losses over time. A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes. It is adherence to the concept of a margin of safety that best distinguishes value investors from all others..." - Seth Klarman in his book Margin of Safety

"The idea of a margin of safety, a [Ben] Graham precept, will never be obsolete. The idea of making the market your servant will never be obsolete. The idea of being objective and dispassionate will never be obsolete. So Graham had a lot of wonderful ideas." - Charlie Munger at the 2003 Wesco Annual Meeting

"When the neighbors tell me what to buy, and then I wish I had taken their advice, it's a sure sign that the market has reached a top and is due for a tumble." - Peter Lynch on the fourth and last stage of his "cocktail party" theory*

Three or four years ago the higher quality businesses -- those that tend to have the most durable core economics -- became not at all expensive. Still, they did not drop nearly as much as the lower quality variety during the financial crisis. Buying the lower quality stuff at the height of the crisis may have worked out very well but many of them carried greater risk of permanent capital loss. In other words, after the fact it is easy to see it worked out okay, but the risks of capital loss was very real if the crisis had become even worse.

"Our approach is very much profiting from lack of change rather than from change. With Wrigley chewing gum, it's the lack of change that appeals to me. I don't think it is going to be hurt by the Internet. That's the kind of business I like." - Warren Buffett in Businessweek

Three or four years ago, nice discounts weren't hard to find for the best businesses -- those that Buffett describes as "profiting from lack of change" -- even if some of the lower quality businesses turned out to offer, in some cases, the possibility for huge gains (and, in some cases, maybe big losses).

Well, the situation is now a very different one.

These days, shares of high quality businesses are becoming increasingly difficult to buy with sufficient margin of safety. That, of course, doesn't necessarily mean we're anywhere near the "stage four" that Peter Lynch describes above. It doesn't mean the market won't continue going up. It's just that even the best need to be bought in a way that accounts for the fact that, as Klarman says:

"...valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes."

Rising prices can start drawing investors in because it feels safer. Yet bargains often become increasingly difficult to come by when the market mood improves. There's a greater likelihood of permanent capital loss when increasingly high prices are paid. My primary interest lies in estimating value as well as is possible within my own limitations -- which as Klarman points out is necessarily imprecise -- then only putting capital at risk only when something I understand can be bought with a significant margin of safety.**

That makes the current investing environment increasingly a challenge.

Even if it happens to feel safer, investing, by definition, becomes more difficult and risks are increased as prices climb. If prices happen to go higher from here it's worth remembering the last sentence in the first of the two above quotes by Warren Buffett:

"Nothing sedates rationality like large doses of effortless money." 

Now, this doesn't mean I'd sell shares of an attractive business, bought at a great price, just because market prices begin to fully reflect intrinsic value. That's a recipe for unnecessary mistakes and frictional costs. There's only so many businesses that most investors can understand sufficiently well. Jumping out of something well understood (and bought well) that is temporarily fully valued, or even slightly more than fully valued, but otherwise has attractive long run prospects is just inviting expensive mistakes.***

Once I own enough shares of a good business at a discount to value, then my preference is to just own it for a very long time. That means occasional continued ownership of a good business during periods when it is not particularly cheap (though per share intrinsic value should continue to increase, even if unevenly, over time). Some might attempt to jump out of the stock with the intent to somehow get back in at just the right time.

It's the illusion of control.

There's plenty of evidence to suggest this approach is mostly a good idea in theory only. I'll let others try to pull off that sort of thing.

Sometimes the tide is with you, sometimes it is not.

"Our system is to swim as competently as we can and sometimes the tide will be with us and sometimes it will be against us. But by and large we don't much bother with trying to predict the tides because we plan to play the game for a long time.

I recommend to all of you exactly the same attitude.

It's kind of a snare and a delusion to outguess macroeconomic cycles...very few people do it successfully and some of them do it by accident. When the game is that tough, why not adopt the other system of swimming as competently as you can and figuring that over a long life you'll have your share of good tides and bad tides?" - Charlie Munger interview at the University of Michigan

Charlie Munger: Snare and a Delusion

Learning to judge price versus value effectively, and having the discipline to buy only when selling at a plain discount, seems far more doable (even if far from easy). Consistently make wise judgments on something as complex as macroeconomic cycles seems, at least to me, near impossible. The good news is investing well doesn't really require significant macroeconomic insights.

Adam

* From Lynch's book One Up On Wall Street.
** An investor should always come up with their own valuation/required margin of safety. In other words, never buy a marketable stock based upon what someone else thinks. What's one good reason for this among many? Well, without an in depth feel for what something is really worth, the conviction required for an investor to "hang tough" just won't be there when market price inevitably goes the wrong way. A temporarily reduced price is generally not a problem if intrinsic value has been judged well. It is a problem if the investor ends up selling low out of fear/lack of conviction. This, of course, requires an ability to value the shares of businesses consistently well and a real awareness of limitations.

That's why I think that no investor should be buying a stock that someone else happens to like no matter how good the track record of that investor happens to be. What might make sense for one investor likely does not for another.
*** Including, after taxation, the possibility of not being able to buy a piece of an attractive business cheap again for a very long time. There are times, of course, that selling makes lots of sense. Some examples of circumstances where selling becomes a logical consideration:
- if the economic moat of a business becomes materially damaged;
- if value was judged poorly in the first place (error of commission);
- if an investment becomes plainly very expensive (not just somewhat);
- if a position has become an uncomfortably large part of the portfolio;
- if the opportunity costs of continued ownership are very high.
---
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, February 1, 2013

Amazon, Apple, and Intrinsic Value

Here's a Fortune article that compares Apple (AAPL) and Amazon (AMZN) that also provides some useful charts.

Apple vs. Amazon: Bizzaro valuations revisited

Consider this:

Amazon's average earnings over the past five years was $ 658 million.

If Amazon grows it's earnings 25% per year off of that base for fifteen years, the company's annual earnings would grow to ~ $ 19 billion.

Less than half Apple's current earnings (and roughly equal to Apple's five year average). That kind of growth by any company for that amount of time would be impressive to say the very least. Who knows, maybe Amazon will prove they can pull off that kind of business performance.

Of course, Amazon actually lost money over the past twelve months. That's why I used the company's 5-year average earnings. That way there was actual earnings to use as a base for that 25% earnings growth.

Here's the progression of the Amazon's earnings over the past 5 years:

2008
$ 645 million

2009
$ 902 million

2010
$ 1.152 billion

2011
$ 631 million

2012
$ - 39 million

Over that same time frame Amazon's sales has more than tripled!

Impressive, but they're not making a whole lot of money in the process.

Well, at least not yet. I don't doubt that Amazon is likely being built for the long run into something quite valuable.

Figuring out just how valuable (or the likely range of intrinsic worth) and the timing is the tough part. If, when, and how much the investments they are making now will pay off just isn't easy to judge (at least for me).

As a comparison, Apple's earnings over their past five years (fiscal year ends in September) has gone from $ 4.8 billion in 2008, to $ 41.7 billion in 2012.*

Over the same time frame Apple's sales have increased nearly 5-fold.

Apple's enterprise value (market cap minus net cash and investments) is currently roughly 2.6x that of Amazon's. For some perspective, if Apple's earnings were to shrink at a 10% annual rate from here, in three years the company would approximately still generate as much cash as Amazon's entire current value.
(i.e. Adding together the earnings produced in total over the three years roughly equal Amazon's enterprise value.)

In contrast, at the 25% growth rate assumed above, Amazon would still not produce, in total, enough earnings to equal its current value after fifteen years.
(Again, adding together the earnings from each of the fifteen years. Imagine how long it would take if the company's earnings were to increase at a lesser rate?)

That doesn't necessarily mean Amazon's overvalued (or that Apple is not), but it might at least be a rough indication of which of these two companies, near current valuations, requires an investor to go further out on a limb; which company is more dependent on very good things happening for a very long time to justify their stock price.

What if things don't go quite as well as expected? Margin of safety is always a key principle no matter how favorable a company's prospects seem to be.

Back to Apple. What are normalized earnings for the company? I certainly have no idea. When earnings change that much in a relatively short amount of time it creates a big challenge judging value for any investor. Maybe it's economics are about to go in reverse (and fast). Maybe not. Does the company's earnings power roughly stabilize near current levels? What if normalized ends up being closer to the five year average (or even less)? Considering the amount of competition and the kind of products Apple sells, it's not hard to imagine the company's now exceptional margins coming under some pressure over time.

My point is Apple may still have more than respectable future prospects but, whenever there's a huge jump in earnings capacity (and going from $ 4.8 billion to $ 41.7 billion in five years certainly qualifies), it creates real challenges for any investor who's trying to figure out the intrinsic value of a company.

A spike in earnings like that increases the possibility of valuation misjudgments.**

More on Amazon and Apple in a follow up.

Adam

No position in AMZN; established a long position in AAPL at much lower than recent prices

Related posts:
Negative Working-Capital Cycle
Amazon, Apple, and Margin of Safety
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

Ultimately, of course, when it comes to valuation it's the cash that will be generated over an extended period that matters. Near-term earnings may or may not be a good proxy for that. As I've explained previously here and on other occasions, there's just no technology business that I'm comfortable with as a long-term investment. Amazon, of course, is less of a pure tech business than Apple but, at least to me, it still has difficult to predict prospects. Occasionally, certain tech stocks have sold at enough of a discount that owning a very limited number of shares made sense to me. In other words, the price was cheap enough relative to the per share cash generation (and, in some cases, net cash on the balance sheet) that it provided a substantial margin of safety. Otherwise, the future prospects of most tech stocks just aren't predictable enough for my money. So I'm not exactly trying to anticipate the next big thing in tech. The best businesses have durable economic characteristics. Tech stocks too often generally do not. Those with seemingly attractive economics today frequently prove to have far less attractive economics down the road.
** As always, I have no idea or opinion on how these two stocks might perform in the near future or even longer.
---
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.
 
Site Meter