Monday, March 31, 2014

eBay 10 Years Later: Business Performance vs Stock Performance

There was a time, a bit less than 10 years ago, that the enthusiasm for eBay's (EBAY) prospects rivaled some of today's high flyers.

Also, much like today's highest flyers was a stock price that reflected that enthusiasm.

The stock was selling, give or take, for roughly 100x earnings in 2004.

Now, the company has run into it's fair share of challenges -- as even the very best business do -- while management was both smart and fortunate to buy PayPal when they did at a price that, at least with the benefit of hindsight, looks rather cheap. Still, even if it has been a bumpy ride at times, nearly ten years later the company has delivered some fine results.*

                                   2004                       2013
Revenue                 $ 3.3 billion         $ 16.0 billion

Net Income           $ .78 billion         $ 2.9 billion

I think it is reasonable to say that financial performance qualifies as not too bad at all. Though what matters, naturally, is what those numbers indicate, if anything, about the company's future prospects and trajectory.

It's worth noting that the revenue and net income increases have been backed by solid free cash flow**. The company has, more or less, over that time also maintained a healthy balance sheet. So it's just not hard to argue they've put together more than a pretty solid decade.

So the business did just fine but, in 2004, those who were buying eBay's stock at prevailing prices were assuming the recent positive trajectory would continue for, at the very least, quite a long time.

Buyers of the stock back then were willing to pay a very high multiple of earnings in the hopes those earnings would rise dramatically and, well, very quickly.
(It's been long enough that some might forget eBay was once viewed as a high flyer not unlike some of today's favorites.)

The end result being that, while eBay put together quite a nice decade of business performance, the buyers who paid those prevailing late 2004 prices expecting to get an attractive investment result (in contrast to those who might have been betting on a good speculative outcome) have not been rewarded.

At ~ $ 55 per share now, the stock now sells at a price that's not much different than back in late 2004.

The point being, of course, is it's no fun to own a business that delivers good business results over a decade or so yet delivers an unsatisfactory return to the owners.
(The S&P 500's total return has been nearly a double over that same time frame with none of the business specific risks.)

By the way, I'm only using eBay as an example. There are a number of examples over the past 10-15 years of, to varying degrees, an enterprise with good prospects but a valuation that was unlikely to compensate the investor sufficiently (though the most exceptional surely did reward investors).

Again, even very good businesses run into real difficulties from time to time. There's almost certain to be an ebb and flow and it's unwise as an investor to not expect as much. Sometimes, near-term price action is merely a reflection of perceived prospects based upon recent news not actual changes to intrinsic worth.

That's true in both directions.

Emotions and psychology more generally rule price action in the shorter run; intrinsic values drive prices over the longer run.

There is no doubt some high flyers today that are good businesses with fine prospects. Yet, due to the upfront price that must be paid, the returns are also likely to not compensate the long run owner sufficiently.

Of course, some of these high flyers will perform well; others will end up disappointing. Telling them apart beforehand is much easier said than done (or easier to describe after the fact). In fact, a too high risk of permanent capital loss usually exists in or near the same neighborhood as the potential big winners. A wilder ride, maybe, but the combined net impact of those winners and losers will too often offer a less than impressive overall result.

Back in 2004, alternatives to eBay had not only less difficult to judge prospects (and, yes, less exciting price action), but also were priced in a way that increased the likelihood of a nice investment outcome.

Investment must always be viewed in the context of opportunity costs. It's not whether a business can eventually "grow into its valuation". (A description or justification that's so often associated with the high-flyers.) It's whether something well understood is judged likely to deliver -- considering the specific risks and relative to alternatives -- attractive absolute forward returns. If an investment does end up someday validating an initial seemingly high valuation, it doesn't logically follow that the risk of permanent capital loss compared possible rewards was well managed. Sometimes, for example, the price is so high that just about everything has to go right. So it might be a perfectly good business, but justifying the price paid depends on lots of continued good fortune. Well, in those instances, an extreme valuation will too often offer no protection against permanent capital loss if there's an unforeseen bump or two in the road. The price paid should, as a principle, always protect the investor against such unforeseen and often mostly unforeseeable things.
(Another way to think about this: even if eBay had delivered a positive return over those ten years or so, it still might not be a sufficient return considering risks and alternatives.)

The world is always uncertain; pay a price that reflects this reality and protects against surprises (or, at least, all but the very worst outcomes).

Some of the current highest flyers are selling for what certainly looks like extreme valuations. No doubt a number of these will do great things in terms of business performance over the next decade or longer.

More than a few will also inevitably run into business challenges; some that will get sorted out and, well, some that will not.

In enough cases to matter, I'm guessing that the current dreams that are propping up prices will come no where near being realized.

The most exceptional ones, once again, might actually even exceed what now seem like lofty expectations.

The problem is that it's often not at all easy to predict these long-term outcomes; to reliably foresee which high flyers have sustainable advantages and prospects on a scale that ends up making sense of what, in too many cases, now looks like nonsensical valuations. Speaking generally, putting capital at risk based on an optimistic long-term forecast is usually a fool's errand. This becomes especially unwise when the capital at risk depends on consistently and correctly predicting what the economics of businesses in the most dynamic industries will look like many years down the road. It moves from being unwise to just plain financially dangerous when what's paid upfront depends on the best possible outcomes.

Placing capital at risk that's dependent on consistently correct long-term predictions is folly; developing a robust investment process and based upon sound principles is not. The investor may not be able to control outcomes, but still can increase the likelihood of good results with a sound approach.
(Including the development of what Charlie Munger calls "a latticework of models".)

The approach is under investor control. What ultimately happens is not.

For investors, it's just generally more wise to focus less time and energy on that former "p" and more on the latter two.

Margin of safety is, of course, just one of the many essential investment principles but seems rather appropriate to highlight here. It's a recognition of an investor's limitations -- the inevitable mistakes that get made -- and, to varying degrees depending on the business, an uncertain range of future outcomes for the business itself.***

Now, since those high eBay market prices prevailed back in 2004, many opportunities arose to buy shares of the company at more reasonable valuation levels.

In fact, at least in my view, the company's shares sold several years back at a significant discount to intrinsic value for an extended period.
(Though, at or near current prices, to me the shares are very far from being cheap.)

This happened, at least in part, when eBay's perceived prospects changed in the minds of apparently rather impatient market participants (with an assist from the financial crisis). Now, the company did have to transition through some very real difficulties (again, this is almost inevitable from time to time), but its sound core business economics remained mostly intact even if growth, for a time, became subdued. So the very fast growth that some like to pay a premium for wasn't there but, crucially, they continued to produce lots of free cash flow at a high return. They've had a fine business throughout -- even if with real difficulties -- but the price of admission changed dramatically. It's been essentially the same business, but what makes sense to buy at one price makes no sense at another. Business prospects can't be viewed in a vacuum; the price paid dictates risk and reward.

Durable high return on capital in the long run trumps modest growth especially if the right price is paid in the first place.

Of course, the investor who bought eBay's shares when cheap and hung in there had to endure, over several years, many very real unresolved business challenges and the inevitable lousy headlines that followed. Nothing like hearing and reading how stupid it is to own a particular stock day after day to test conviction.
(BTW - possessing a high level of unwarranted conviction is obviously never a good thing. Stubbornness combined with confirmation bias is a great way to lose a lot of money.)

So, beyond buying shares at a plain discount to intrinsic value, owning eBay's shares several years back required lots of patience in combination with the ability to ignore the noise and terrible price action. Attractive discounts don't usually exist when the headlines are rosy and future prospects are clear.
(Though sometimes a business has problems that are just plain intractable. Correctly separating, beforehand, the sound business with real but fixable problems from those that are truly broken is easier said than done.)

Today, eBay's stock appears rather expensive -- though not at all as much so as some of the current highest flyers, or the company's own extreme valuation a little less than a decade ago -- but their overall business prospects continue to appear not too bad at all.

In other words, intrinsic value would seem likely to increase just fine over time. It's just that compensation isn't likely to be sufficient considering risks and alternatives. It's just that margin of safety isn't, at least for me, as plain to see.

The fact is, near the current valuation, risk/reward is nothing like what it was several years back. That's a simple matter of the price one now has to pay, not the prospects for eBay itself.

Still, I won't be surprised at all if eBay does quite well as a business over the long-term. If so, valuation will follow.

In any case, this is not a view of what the shares might do in the next days, weeks, or even several years. Trying to figure out that sort of thing is mostly a waste of time and energy.

"Absent a lot of surprises, stocks are relatively predictable over twenty years. As to whether they're going to be higher or lower in two to three years, you might as well flip a coin to decide." - Peter Lynch

Having said that, my preference is to generally not sell shares of a somewhat overvalued but otherwise good business -- one that was bought at a nice discount in the first place -- unless the opportunity costs are high; my preference is for increases to per share intrinsic value to be the primary driver of returns. To me, attempting to generate satisfactory or better outcomes via the clever trading into and out of various marketable securities is folly. In fact, I'd argue that just about the opposite behavior is what generally gets results, especially when done in a thoughtful and persistent manner.

That usually means, in order for selling to be warranted, the shares need to be plainly expensive -- selling for a significant premium to intrinsic value -- and/or something else well understood needs to become very mispriced on the low side. At times, an investment that has a substantial margin of safety must be funded by another investment that lacks such a margin of safety. When a switch is warranted, the advantage in terms of risk and reward between the investment alternatives should be very obvious.
(Though, reducing the size of a position as the shares become more fully valued often makes sense to me. I've, in fact, recently done just that with eBay. Where I tend to NOT do this is with shares of my favorite businesses. Well, eBay surely does not fall into that category even if it does possess a number of attractive business characteristics.)

Trading into or out of something because it is merely somewhat mispriced makes little sense. Minimizing moves in a portfolio isn't just about reducing frictional costs, it's about reducing mistakes.

Focusing on the upside of a move but not carefully considering the downside of a move is an easy mistake to make.

Mispricings, on both the high and low side, can occur when recent success or difficulties is used to extrapolate forward what something might be worth. Sometimes what's growing takes a pause. The opposite is also true. Paying a premium price that assumes growth will continue indefinitely is just asking for trouble. The fact is it's nearly impossible to foresee what challenges or opportunities might arise much further down the road. If the price paid depends not on continued good fortune to get an attractive result, there'll be no complaints if prospects turn out to be somewhat, or maybe a whole lot, better.

I'd add that a good investment outcome should never depend on selling at a premium price. Those who need to sell at a premium price to achieve a good outcome make themselves vulnerable to something they have no control over. A modest multiple of, conservatively estimated, future per share normalized earning power -- at least 7-10 years down the road and, ideally, even much longer -- should be all that's required, considering risks and alternatives, for a nice overall investment result.

For most assets, it will not be possible to figure out future earnings power. When that's the case it's best to just move on. That doesn't mean the opportunities never appear on the radar with some patience. When they do appear -- and confidence is both high and warranted -- that patience must to be followed by decisive action.

A sound investment approach, applied consistently over a long period of time, still guarantees nothing but can, at least, increase the likelihood that good things more frequently happen and overall results improve.

It's at least worth mentioning -- as I have before on more than a few occasions -- that there's really no pure technology business I'm comfortable with as a long-term investment. Most are involved in exciting, dynamic, and highly competitive industries; that's precisely what makes them unattractive long-term investments. It's the fact that the range of possible outcomes is often just too wide to get, on a consistent basis, the valuation at least mostly right. 

Now, while technology is very important to eBay, it seems not difficult to argue that the company is a very different animal than the most pure of technology businesses.


Long position in eBay established at very much lower than current market prices. This once larger position (bought years back when eBay was experiencing some difficulties) has been reduced to a smaller position near and above recent prices. Generally speaking, my preference is to absolutely minimize buying/selling but, as eBay's margin of safety has decreased (at least by my math and assumptions which, of course, could prove to be very wrong) the position has been trimmed consistent with how I view risk/reward and current alternatives. Those funds will be redeployed if and when shares of an attractive business becomes cheap enough to buy again. We are, in general, surely a long way from the valuation environment that existed 3-5 years ago.

Related posts:
eBay's Valuation
eBay's Free Cash Flow
Technology Stocks

* Rev. (billions $) 2004-13: 3.3, 4.6, 6.0, 7.7, 8.5, 8.7, 9.2, 11.7, 14.1, 16.0;

Net Inc. (billions $) 2004-13: .78, 1.1, 1.1, .35, 1.8, 2.4, 1.8, 3.2, 2.6, 2.9
** Though I'm not a fan of how expensive eBay's stock-based compensation actually is, though I realize some choose to treat it -- and I'd argue incorrectly -- as a non-cash expense. Well, the specific cash cost might not be easy to estimate upfront but that makes it no less real. One alternative way to roughly, but meaningfully, show the true cash cost of equity compensation plans at eBay (and at a number of other companies) is to add up what's been spent on buybacks over several years then compare it to how the share count has been impacted. In eBay's case lots of cash has been expended on buybacks over the past five years yet there's been no reduction in share count. Well, if the share count isn't reduced much (or, in this instance, not at all), that cash used -- to simply offset equity compensation related dilution -- can no longer be returned to or benefit shareholders. So this is hardly some non-cash expense; it's, instead, a very real cost. Naturally, one could simply choose to consider the GAAP stock-based compensation as a useful, if imperfect, way to estimate this cost in the first place. Still, there is certainly no way to do more than very roughly estimate this cost going forward. The above alternative approach is simply one way to help reveal that the equity compensation eventually ends up having a very real economic impact. When stock options are initially granted, and for a period of time after that, the real cash cost is generally not going to be clear but must be accounted for some way to get the economics as right as is possible. So, while it's true that estimating these stock related expenses isn't easy to do upfront, that's hardly a reason to assume they don't exist at all then look past them altogether. (To me, it's still rather amazing that many choose to, when it comes to valuation, ignore what ends up being very costly for long-term shareholders.) When reasonable adjustments are made for these expenses, eBay's free cash flow is meaningfully less than it might first appear to be (though it is still impressive). Keep in mind that, even if share count drops due to a buyback, yet insufficiently compared to the cash used, an adjustment to free cash flow still needs to be made for the cash expended in excess of what should have been needed -- at reasonable prices per share compared to intrinsic value per share -- to lower the share count. In any case, ignoring these costs makes little sense. Naturally, my way of valuing the company takes these real expenses fully into consideration. Put another way, the price to free cash flow (or adjusted P/E) becomes quite a bit higher when the cost of equity compensation is taken into account. In addition, a company that relies on lots of equity compensation -- since the ultimate future impact is difficult at best to estimate -- necessarily leads me to require a larger margin of safety and, all else equal, the preference for a smaller position size. Now, eBay certainly isn't alone in this regard. For many tech and tech related businesses (of more or less quality), these costs must be carefully considered in order to understand the core business economics and to estimate value. As it turns out, there's a number of earnings estimates that do not take into account such costs.
*** I am referring to paying a price now where, let's say 10-15 years down the road, what the business produces -- it's intrinsic worth (incl. dividends, if applicable) on a per share basis -- leads to a good result. I am not referring to near-term or even intermediate-term price action. Once something is barely anchored by value and, instead, maybe is driven more or less by difficult to nail down but exciting future possibilities, just about anything goes. Stocks that sell at apparent speculative prices can easily become 2x, 3x, 4x, and even much more than that speculative amount. Now, I'm not a big believer that speculative activities in the market will end up being particularly lucrative for most, but no doubt some know how to do such things successfully. Buffett recently wrote about, among many other things, his own skepticism about speculating successfully on a sustained basis. From his latest letter: "If you...focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so."
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, March 24, 2014

Buffett on Farms, Real Estate, and Stocks

From Warren Buffett's 2013 Berkshire Hathaway (BRKa) shareholder letter:

"In 1986, I purchased a 400-acre farm, located 50 miles north of Omaha, from the FDIC. It cost me $280,000, considerably less than what a failed bank had lent against the farm a few years earlier. I knew nothing about operating a farm. But I have a son who loves farming and I learned from him both how many bushels of corn and soybeans the farm would produce and what the operating expenses would be. From these estimates, I calculated the normalized return from the farm to then be about 10%. I also thought it was likely that productivity would improve over time and that crop prices would move higher as well. Both expectations proved out.

I needed no unusual knowledge or intelligence to conclude that the investment had no downside and potentially had substantial upside. There would, of course, be the occasional bad crop and prices would sometimes disappoint. But so what? There would be some unusually good years as well, and I would never be under any pressure to sell the property. Now, 28 years later, the farm has tripled its earnings and is worth five times or more what I paid. I still know nothing about farming and recently made just my second visit to the farm."

Buffett's use of his farm to explain the partial ownership of a business helps illustrate a simple but important point: that is, the shares of a good business need not be thought of any differently than his farm. He also provides another good example: a New York retail property near NYU that he bought in 1993. Both non-stock investments provide a useful framework for thinking about the long-term ownership of common stocks. Whether an investor owns all or part of a business -- public or otherwise -- the lessons of those two non-stock investments can be very instructive.

In the farm example, he had someone capable that he trusts available to operate and harvest what is produced each year.

Before buying any business, whether reasonably capable management is in place is a qualitative judgment that must be made. The investor has to be able to have enough confidence that the management, like Buffett's son, has the capability (and integrity) to competently operate and "harvest" -- even if not literally -- for the owners. Much like Buffett's farm, a portion of the net proceeds earned can be paid out as dividends with the rest, if the management is doing their job, put to good use.

Now, consider that most business transactions, to this day, involve substantial frictional costs for buyers and sellers.
(Just think about all the commissions and related costs involved in most real estate transactions, for example.)

In contrast, buying part of a business that happens to trade publicly (i.e. a common stock) can be achieved at low cost and at great convenience via modern capital markets. So anyone with access to one of the many high quality brokerage accounts -- one with solid service and reasonable fees -- can own a piece of some very good businesses (and, of course, many not so great businesses); they can, at the same time, avoid the complexity and cost of most private transactions.

Based upon just about any metric becoming a part owner of a public company can be accomplished with comparative ease and reduced costs versus just about any private business.
(Whether a farm, piece of real estate, or any business that just happens to not trade publicly.)

So the inherent liquidity, convenience, and low cost of modern capital markets should be an advantage.

Yet that convenience and low cost, as it turns out, ends up being a two-edged sword.

It encourages behavior that often turns this inherent advantage into a disadvantage: excessive buying and selling.

This not only increases frictional costs, this also increases the chance for unnecessary errors. Errors will be made, of course, but a sound investment process should eliminate them where possible:

"To kill an error is as good a service as, and sometimes even better than, the establishing of a new truth or fact." - Charles Darwin

There's a tendency to be overly optimistic that the next buy or sell decision will lead to improved results. It's easy to focus too much on the upside of a particular action while not giving appropriate consideration of the downside. That can lead to big mistakes. It's a changeable behavior but, for some, the temptation to trade with great frequency is overwhelming.

Now, even if the temptation to trade hyperactively is kept in check, the equity investor still has to know what to buy within his/her own limits.

The equity investor still has to know the appropriate price to pay (i.e. what price represents a plain discount to value based upon conservative assumptions).

The equity investor still has to learn to mostly ignore the daily quoted prices.*

Those that can't do these things, on a consistent basis, most likely should not be buying and selling stocks.

Somewhat strangely, one of the great advantages of owning a farm, some real estate (or, for that matter, a private business of any kind) happens to be -- though logically it shouldn't be an advantage -- that there is no frequently quoted price to distract the owner. That lack of distraction makes it more easy to put the focus of the owner where it should be: on what the underlying business assets can produce over the long haul.

For stocks the focus should be no different.

There are no doubt exceptions** but, for most participants, it's best to avoid the folly of excessive trading and focus, instead, on what the underlying assets of things they understand can produce -- not what they sell for on any given day -- over longer time horizons. This may not be easiest thing to do but, then again, it's also not exactly impossible with some work, discipline, and awareness of limits.

Those who, within their limitations, know how to judge business value and possess some price discipline (i.e. always operate with a nice margin of safety) have, at their disposal, the incredible convenience and low cost of modern capital markets. They simply need to overcome the temptation to transform the investment process into various forms of speculation and gambling.

There's just no good reason to be cut by the wrong side of that two-edged sword.

Nothing can guarantee good outcomes in an uncertain world but the principles used, and process in place, should be as robust as possible.

In the letter, Buffett provides his thoughts on investing fundamentals and uses his two non-stock investments to help illuminate "certain fundamentals of investing:

- You don't need to be an expert in order to achieve satisfactory investment returns. But if you aren't, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don't swing for the fences. When promised quick profits, respond with a quick 'no.'

- Focus on the future productivity of the asset you are considering. If you don't feel comfortable making a rough estimate of the asset's future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility. But omniscience isn't necessary; you only need to understand the actions you undertake.

- If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so. Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game. And the fact that a given asset has appreciated in the recent past is never a reason to buy it.

- With my two small investments, I thought only of what the properties would produce and cared not at all about their daily valuations. Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.

- Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle's scathing comment: 'You don't know how easy this game is until you get into that broadcasting booth.')

- My two purchases were made in 1986 and 1993. What the economy, interest rates, or the stock market might do in the years immediately following – 1987 and 1994 – was of no importance to me in making those investments. I can't remember what the headlines or pundits were saying at the time. Whatever the chatter, corn would keep growing in Nebraska and students would flock to NYU."

Buffett's advice is no doubt wise but I suspect that won't stop many from trying to profit from near-term (and, for that matter, even intermediate-term) price action.

As Buffett points out there's nothing improper about speculating; it's just that it's too often not very lucrative.


Long position in BRKb established at much lower than recent prices

* Fund investors, in order to prevent becoming their own worst enemy, similarly need to know when to ignore quoted prices even if they're not required to make sound judgments on individual securities.
** I'm just guessing but odds seem reasonably good that there are more who think they're the exception than actually who are the exception.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, March 17, 2014

Asset Growth and Stock Returns, Part II

A follow up to this post that covered, among other things, what this 2008 paper calls "a substantial asset growth effect on firm returns."

Prior post: Asset Growth and Stock Returns

Paper: Asset Growth and the Cross-Section of Stock Returns

What do they mean by "asset growth effect"?

Well, the businesses with low asset growth saw their shares outperform those with the highest asset growth. At least slightly counterintuitive.

In fact, the gap was rather large. From the paper:

"...we find that raw value-weighted (VW) portfolio annualized returns for firms in the lowest growth decile are on average 18%, while VW returns for firms in the highest growth decile are on average much lower at 5%."

The paper also notes that "with standard risk adjustments the spread between low and high asset growth firms remains highly significant at 8% per year for VW portfolios and 20% per year for equal weighted (EW) portfolios."

So, no matter how you slice it, the effect is not exactly small.*

Here's an article with some nice charts that sum up the effect in both the U.S. and Europe. From the article:

"The European evidence is also compelling. Over the period 1985 to 2007, we find that low asset growth firms outperformed high asset growth firms by around 10%..."

That'd be a 10% gap each year.

In the prior post I mentioned the following:

...growth is too often treated as being always a good thing. Well, sometimes growth is of the low (or worse) return variety. Think airlines for many decades. That industry grew impressively for quite some time. In addition, sometimes too much is paid for the privilege of ownership due to the exciting growth prospects. The asset may end up performing well, but the owner doesn't get compensated sufficiently considering risks and alternatives.

Poor results can come from buying an asset with weak core business economics (airlines), simply paying too much in the first place for what might otherwise be a business with fine prospects, as well as the misjudgment of future prospects, among other things.

Occasionally, I'll hear (or read) a justification for the price paid of a particular asset with something along the lines of: "it may look expensive now but will grow into its valuation."**

Well, investment has to be viewed as a process and in the context of opportunity costs. The objective isn't for some investment to justify itself someday; the objective is (or should be) to get the best return at the least risk, within limits (i.e. buying only what's understandable...necessarily unique to each investor), and with alternatives in mind. The investment process can be controlled, at least somewhat, while outcomes, especially in the shorter run, may come down to other factors (luck more than skill). Improving intrinsic value estimation skills, developing the discipline to always buy with a substantial margin of safety, and sticking to what is understood well, are each examples of things within the control of an investor.

What the macro world might throw at an investor down the road generally is not.

This reality doesn't seem to discourage the professional prognosticators nor those who enthusiastically listen to their advice (and even pay for their services).

"We've long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children." - Warren Buffett in the 1992 Berkshire Hathaway (BRKaShareholder Letter

Buffett: Forecasters & Fortune Tellers

From this interview with Charlie Munger:

"Warren and I have not made our way in life by making successful macroeconomic predictions and betting on our conclusions.

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?"

Munger: Snare and a Delusion

So focus on the process instead of trying to predict the mostly unpredictable. As I've said, a sound investment process guarantees nothing but at least increases the chance of attractive long run outcomes.

Now, knowing whether you've paid too much comes down to being able to effectively estimate intrinsic value. Naturally, for partial ownership of a business, intrinsic value must be estimated on a per share basis. 
(For example, when buying shares of a publicly traded common stock though not limited to that. It could also apply to partial ownership of a private business. The point is that the decision to buy, with the long-term in mind, part of a business should always be thought of along the same lines as buying a business outright.)

On the surface, estimating intrinsic business value -- whether partial or outright ownership -- isn't necessarily difficult.

Just figure out what cash can be taken out of a business over the long haul then discount those cash flows, right?

Not so fast. It's the assumptions that have to be made that makes the calculation difficult and, inevitably, at best a range of possible values. Too often, the range of outcomes will be way too wide for comfort.

That's why, for most potential investments, it's better to just move on to something else.

The question is whether the investor can make the estimate into a usefully narrow enough range. That comes down to the capabilities and background of each individual investor, of course. 

When the estimated range of value is narrow enough, then a judgment call can be made as to how much of a discount -- margin of safety -- is appropriate. 

So the right margin of safety is inevitably very specific to each investment and will come down to the comfort level (hopefully one that is warranted) that an investor has with it.

Buffett pointed out in the 2011 Berkshire Hathaway (BRKa) shareholder letter:

"We have no way to pinpoint intrinsic value," but that book value happens to be a "significantly understated" but still useful proxy.***

He also explains it this way in the Berkshire owner's manual:

"Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life. The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover – and this would apply even to Charlie and me – will almost inevitably come up with at least slightly different intrinsic value figures. That is one reason we never give you our estimates of intrinsic value. What our annual reports do supply, though, are the facts that we ourselves use to calculate this value."

The calculation of Berkshire's intrinsic value has been explained in the Intrinsic Value - Today and Tomorrow section of the 2010 letter and toward the end of subsequent annual reports.

His explanation is a useful one because it shows that some of the judgment isn't a precise calculation at all. It's necessary to roughly estimate how well management will put future capital to work. 

That's an educated guess, at best, and has a huge impact of intrinsic value now and, more importantly, how it might change over time. When a company retains the bulk of its earnings that otherwise could be taken out of the business (and invested elsewhere) this hard to quantify element is terribly important.

Some relevant posts related to intrinsic value:

Intrinsic Value - March 2014
Berkshire Hathaway's Second Quarter 2013 Results - August 2013
Berkshire's Manufacturing, Service and Retail Operations - April 2013
Berkshire's Regulated, Capital Intensive Businesses - April 2013
Buffett on Buybacks, Book Value, and Intrinsic Value - December 2012
Berkshire's Book Value & Intrinsic Value - May 2012
Buffett: Intrinsic Value vs Book Value - Part II - May 2012
Buffett: Intrinsic Value vs Book Value - April 2012
Discount Rate - August 2009

So we're not likely to see Buffett nailing down intrinsic value anytime soon.

For many reasons, an investment decision shouldn't be made based upon someone else's estimate of value. One of the reasons? The conviction just likely won't be there when the near-term price action inevitably -- even if temporarily -- goes the wrong way.

Those who use conservative assumptions, and the patience to wait until market prices represent a significant gap to their well-judged estimate of value, increase their chance of favorable long-term outcomes.

Easier said than done though, with some discipline, hardly impossible.

False precision is dangerous in the investment business.

Price should mostly mitigate the possibility of permanent capital loss (i.e. not temporary paper loss due to price action); the discount should be rather obvious and, to get a good result, require nothing spectacular to happen.

If unexpectedly spectacular things do happen, there'll surely be no complaints.

Those who pay up for exciting prospects often end up just stretching to get inferior results at greater risk.

That may make for a more thrilling ride, but can be a costly way of doing business.


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

Other related posts:
Asset Growth and Stock Returns - Feb 2014
Buffett and Munger on See's Candies, Part II - Jun 2013
Buffett and Munger on See's Candies - Jun 2013
Aesop's Investment Axiom - Feb 2013
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 "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

* The paper's conclusion adds: "We document a substantial asset growth effect on firm returns. Over our sample period firms with the low asset growth rates earn subsequent annualized risk-adjusted returns of 9.1% on average while firms with highest asset growth rates earn - 10.4%. The large 19.5% spread is highly significant. Weighting the firms by capitalization reduces the spread to a still large and significant 8.4% per year." The 13% gap noted above is value weighted but not adjusted for risk. Take your pick. These all represent rather significant gaps in performance.

** There are, no doubt, instances when the payment of a premium price makes sense. It's a matter of making sure that, due to the excitement over potential prospects, the margin of safety principle does not end up taking a back seat. That's just never a good idea. Considering what might go wrong -- and paying a price that reflects that possibility -- is of paramount importance in the investment process. There are instances where pushing for rapid growth to establish a tough to dislodge position in an industry makes a lot of sense. Powerful economics moats can be, and certainly have been, created this way. There's no shortage of examples over the past 10-15 years. That doesn't necessarily mean the investor should pay a premium price -- considering the execution/other risks of such a strategy -- for the privilege of ownership. Price shouldn't just reflect what might go right; it should also reflect what might go wrong. Well, sometimes the investor in a business with the most exciting prospects becomes too caught up in the "story". The result? Their bias becomes excessively toward what might go right. In the more dynamic industries -- whether an emerging one or an existing one experiencing some kind of a shift -- identifying who the winner is likely to be beforehand AND paying a reasonable price isn't often easy. It's the kind of investing neighborhood where costly mistakes get made. Becoming convinced, after the fact, that what is now a plain to see business success was obvious all along is just not a good investing habit. Some convince themselves that they're not susceptible to this behavior, when a more clear-eyed assessment would reveal otherwise. Mistakes are inevitably made but, to get good long-term results, investing well requires that they're minimized wherever possible. One big blunder can undo many other good judgments.
*** Book value is often not a very useful proxy for value but only happens to work for a variety of reasons unique to Berkshire. For most businesses, book value reveals not much about economic value. Most of the time, there's just no such thing as a formula or rule of thumb that's going to reveal intrinsic business value on a generalized basis. If it were only that easy. This post may or may not prove a useful starting point but, even if it is, it hardly deals with the more difficult and subjective judgments about value that are all important.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, March 10, 2014

Buffett on "Asset Gathering" vs "Asset Managing"

During this CNBC interview, Warren Buffett and Becky Quick discussed the compensation of his two investment managers, Todd Combs and Ted Weschler:

BECKY: "Both of them were managing their own hedge funds before, and the compensation structure in Berkshire is very different than the two and 20 you would get if you were a hedge fund manager."

BUFFETT: "That's right. If they-- last year they started with about five billion each. If they'd put it under the mattress under the standard hedge fund arrangement they each would've made about $100 million. I mean, that shows you how nutty the arrangement is.

But they would have literally made $100 million by sticking it under the mattress. If they put it in an index fund, and gotten the two and 20, they each would've made over $300 million. All they had to do was buy the vanguard index. And they each would've made over $300 million. They also would've gotten more favorable tax treatment on it then they got by getting a salary from Berkshire.

So imagine I mean, you can retire forever on $300 million. So one year you go, you put the money in an index fund so it just shows that the-- it shows you amounts you get by asset gathering rather than asset managing. I mean even though a great many hedge funds in recent years have not delivered high performance, they've delivered high fees.

But our arrangement is that they get a salary and then they get which to most hedge fund guys would look like nothing, and then they get paid on the excess. They get ten percent of the excess over the S&P performance. But it's done over a three year staggered period. So they can't have just one up year and then another down year, or something of the sort."

Buffett then added...

"So, only if they do better than I can do by sticking the money in an S&P fund do they get paid a dime of performance. And it seems to me that's quite logical, but it's not something that the hedge fund community is out there pushing harder for."
(The above is from page 29-30 of the transcript.)

Berkshire has over $ 200 billion of stocks, bonds, and cash equivalents.

If two and twenty was the compensation structure used by Berkshire, the 2 percent alone would cost the company -- and, of course, the owners -- $ 4 billion per year.

Also, let's say, in a year there is a 10% portfolio return (a $ 20 billion gain). Well, using the traditional hedge fund arrangement, 20% of that gain would become compensation and cost the company an addition $ 4 billion. So that'd be $ 8 billion of additional compensation cost for Berkshire.
(Again, that's per year and, of course, quite a bit more if the portfolio were to perform exceptionally well in a particular year.)

So, those with this arrangement, by gathering enough assets, do more than just fine even with just subpar performance (they still get the 2% of assets under management) and really well in any year they generate some decent or better gains (20% of profits).*

If Berkshire had such an arrangement, this cost would hit the company year after year, dramatically lowering intrinsic value.

But, in my view, that's not all that's of significance here.

Consider the entire amount that Berkshire is spending these days on plant and equipment:

"Our subsidiaries spent a record $11 billion on plant and equipment during 2013, roughly twice our depreciation charge. About 89% of that money was spent in the United States. Though we invest abroad as well, the mother lode of opportunity resides in America." - From Buffett's latest Berkshire Hathaway (BRKa) Shareholder Letter (page 5)

So in a year that the portfolio produces a 10% return -- even if it simply equals the S&P 500 -- those typical hedge fund fees would consume $ 8 billion of the $ 11 billion (there are some accounting and tax considerations but no need to split hairs) of what is mostly rather useful infrastructure (railroads, utilities, and pipelines among other things) that, not only serves shareholders, likely improves the productive capacity of society more generally. That's a big hit to important capital investments year after year. Berkshire's capital expenditures cut across lots of different businesses, but a significant portion comes down to the following (from page 11-12 of the letter):

 - BNSF Railway which "carries about 15%...of all inter-city freight, whether it is transported by truck, rail, water, air, or pipeline" in the United States.

"Indeed, we move more ton-miles of goods than anyone else, a fact establishing BNSF as the most important artery in our economy’s circulatory system."

- MidAmerican is made up of utilities that "serve regulated retail customers in eleven states" and includes a large amount of pipeline infrastructure.**

"...we are the leader in renewables: From a standing start nine years ago, MidAmerican now accounts for 7% of the country’s wind generation capacity, with more on the way. Our share in solar – most of which is still in construction – is even larger."

Buffett notes that, once completed, they'll have spent $ 15 billion on their renewables portfolio alone.

"We relish making such commitments as long as they promise reasonable returns."

The reinforcement and expansion of all this infrastructure would, instead, be undermined by the need to pay those hedge fund like fees.

"...society will forever need massive investments in both transportation and energy. It is in the self-interest of governments to treat capital providers in a manner that will ensure the continued flow of funds to essential projects. It is meanwhile in our self-interest to conduct our operations in a way that earns the approval of our regulators and the people they represent."

Well, if such fees can so materially reduce Berkshire's ability to make important investments -- and I think an $ 8 billion haircut out of $ 11 billion (73%) qualifies as a material hit -- it's not a stretch to suggest that this prevailing compensation system subtracts from the effectiveness of capital formation and allocation in a more general sense.

I mean, is the world really better off with so much capital being quietly siphoned in this way?

I've used this quote by Jeremy Grantham before, but it remains relevant:

"If we [the investment industry] raise our fees from 0.5 percent to 1 percent, we actually raid the balance sheet. We take 0.5 per cent from what would have been savings and investment and turn it into income and GDP. In other words, you're taking money that would have become capital and chewing it up as bankers' bonuses." - Jeremy Grantham

Jeremy Grantham: 'We Add Nothing But Costs'

Anyone who thinks the current system is serving the world anywhere near optimally is kidding themselves or, just maybe, suffers from some kind of self-serving bias.***

The negative compounded effect over time isn't small. Consider that these extreme fees do not only cut into today's capacity for capital expenditures; they also inhibit future increases to capex.

So that would mean Berkshire's capacity to make incremental purchases of plant and equipment -- let's say 10-20 years from now -- ends up a shadow of its potential.

According to this article, the hedge fund industry assets under management stands at $ 2 trillion.

This indicates it's a bit more.

Either way, it has increased substantially over the years. So the overall impact is certainly not getting smaller. The two and twenty arrangement (and similar) against a $ 2 trillion plus asset base doesn't exactly amount to spare change.

Some will argue that eventually at least a portion of all those fees will end up being put to work as capital in some form again. While that's true it is, to me, a terribly inefficient way to go about allocating funds to their most productive uses.

Frictional costs matter.

In the letter, Buffett mentions the "crumbling infrastructure" of the U.S. (though, as he points out, it doesn't apply to railroads). Well, maybe it'd be crumbling just a bit less if the Berkshire model was more the norm instead of the exception.

Berkshire's business prospects would necessarily be a lot different in twenty years if, as in the example above, 70-75% of its capital expenditures were diverted to fees instead of investing in useful and economically sound infrastructure enhancements.

I'm not suggesting the impact, on a compounded basis, is limited to infrastructure; these fees also impact investment more generally.

I'm also not suggesting these frictional costs could be eliminated entirely. There's a vital role to be played by effective investment management and related activities.

There'll always a certain necessary amount of frictional costs, yet I don't think it is hard to argue we are well beyond that amount.

I'm just suggesting, in it's current form and with current norms, these aren't just harmless defects and that obvious room for improvement exists (and it's not just the hedge funds); that a directional shift would be a very good thing should be obvious to all but those who are currently served well by the existing system.

This isn't to say that there are not some very capable hedge fund managers. There certainly are some very talented managers capable of delivering terrific long run results. It's just that the prevailing compensation system is too often a heads-I-win-tails-I-win-more system (for the investment managers, not the investors). Now, it seems pretty tough to blame anyone -- including those who might be somewhat (or even a whole lot) less talented than the very best -- for simply going where the money is. That's a perfectly legitimate and reasonable thing to do even if I happen to think, in its current form, the system doesn't serve its greater purpose nearly as well as it could.

Meaningful changes to behavior don't usually come about without real changes to the system itself.

Considering how lucrative the system is for those who benefit directly, don't expect the change to come from within or, as Buffett said during the interview, change is "not something that the hedge fund community is out there pushing harder for."

It's a fundamental overhaul that, among other things, would alter incentives (and ultimately even culture) but I won't even begin to suggest that there's an easy solution.

That a change is needed seems pretty clear. How to make it come about considering the forces at work is not at all obvious to me.

Still, it remains a big opportunity for someone wise and capable enough to fix some of the defects.

That's not going to happen soon. In the meantime, investors have no shortage of ways to avoid these costs and, well, just might want to act accordingly.


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

* Some will surely argue that you don't gather lots of assets unless the performance warrants it. While this no doubt is true in some cases, at times a somewhat different dynamic is at work. Brilliant performance over several years can attract lots of assets. Several years may seem a long time but, with investing, it's just generally not long enough. It's necessarily difficult to know what previous short and even intermediate performance tells you about future outcomes. Was it sound process or good fortune? Figuring out what previous returns reveal, if anything, to the investor about future outcomes is difficult enough, but judging how much risk was involved is even more so. That's just the nature of risk. Returns are relatively easy to measure; risks often not so much. A fund may seem to perform very well for years until the inherent weakness of an approach is revealed. It's sometimes not obvious that the apparent investment genius was merely a beneficiary of things like but certainly not limited to: random chance, a period that happened to be compatible with a particular approach, lots of leverage, and/or some other form excessive risk-taking that wasn't clear to investors before things went very badly south. Since, at these compensation levels one good year can make someone very rich indeed, the idea that this type of compensation system encourages, on a widespread basis, sound long-term capital allocation, with attractive returns, and smart risk management seems unlikely. Exceptions will always exist, but a well-designed system shouldn't be built around the exceptions. Even if it was broadly contributing to wise capital allocation, the huge frictional costs added to the system as a whole with little to no net benefit seems undeniable. The system will never be perfect; it could be much better.
** From the 2010 letter: "Our pipelines transport 8% of the country's natural gas. Obviously, many millions of Americans depend on us every day."
*** According to these notes, Charlie Munger said the following at USC Law School commencement back in 2007: Thinking that what's good for you is good for the wider civilization and rationalizing all these ridiculous conclusions based on this subconscious tendency to serve one's self is a terribly inaccurate way to think. Of course you want to drive that out of yourself because you want to be wise, not foolish. You also have to allow for the self-serving bias of everybody else because most people are not going to remove it all that successfully, the human condition being what it is. If you don't allow for self-serving bias in your conduct, again you're a fool.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, March 3, 2014

Intrinsic Value

According to the latest letter, Berkshire Hathaway's (BRKa) per-share book value increased to $ 134,973.

In comparison, 49 years ago -- when Warren Buffett began running Berkshire --  per-share book value stood at just $ 19 (no zeros missing here). So that's an overall gain in per-share book value of 693,518% compared to roughly 9,841% for the S&P 500 (or 19.7% annualized gain compared to 9.8% for the S&P 500 over that time).

Now, that S&P 500 performance isn't exactly shabby even if it looks unimpressive by comparison.

Changes to per-share book value compared to the S&P 500 has been the Berkshire performance measurement of choice for some time.

It's a useful measure though far from perfect as is explained on page 107 of the annual report:

"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."

Buffett explains that the gap between intrinsic value and book value has actually been increasing in recent years. In other words, increases to per-share intrinsic value is almost certainly greater than the already astonishing -- I think it's fair to say -- increases to book value over the past 49 years.

In the latest Berkshire shareholder letter (released over this past weekend), Buffett also explains -- as he has on prior occasions -- how he thinks about book value as it relates to intrinsic value:*

"What counts, of course, is per-share intrinsic value. But that's a subjective figure, and book value is useful as a rough tracking indicator."

He goes on to add...

"As I've long told you, Berkshire's intrinsic value far exceeds its book value. Moreover, the difference has widened considerably in recent years. That's why our 2012 decision to authorize the repurchase of shares at 120% of book value made sense. Purchases at that level benefit continuing shareholders because per-share intrinsic value exceeds that percentage of book value by a meaningful amount. We did not purchase shares during 2013, however, because the stock price did not descend to the 120% level. If it does, we will be aggressive.

Charlie Munger, Berkshire's vice chairman and my partner, and I believe both Berkshire's book value and intrinsic value will outperform the S&P in years when the market is down or moderately up. We expect to fall short, though, in years when the market is strong – as we did in 2013. We have underperformed in ten of our 49 years, with all but one of our shortfalls occurring when the S&P gain exceeded 15%."

Buffett goes on to say this later in the new letter:

"As much as Charlie and I talk about intrinsic business value, we cannot tell you precisely what that number is for Berkshire shares (nor, in fact, for any other stock). In our 2010 annual report, however, we laid out the three elements – one of them qualitative – that we believe are the keys to a sensible estimate of Berkshire's intrinsic value."

He then provides an update for the two quantitative elements:

- Per-share investments: $129,253 per share

- Pre-tax earnings from businesses other than insurance and investments: $9,116 per share

"Since 1970, our per-share investments have increased at a rate of 19.3% compounded annually, and our earnings figure has grown at a 20.6% clip. It is no coincidence that the price of Berkshire stock over the 43-year period has increased at a rate very similar to that of our two measures of value. Charlie and I like to see gains in both sectors, but we will most strongly focus on building operating earnings."

Those two quantifiable elements provide a more straightforward starting point (though far from sufficient) for estimating Berkshire's per share value. Even so, no two people are likely to come up with the same estimate.

There are more messy aspects of estimating per-share intrinsic value -- and, yes, in some ways more challenging to judge though no less important -- that shouldn't be ignored. Things that are tough or impossible to quantify but of significance.

With Berkshire specifically, there's what Buffett has called the "'what-will-they-do-with-the-money' factor".
(The importance of this factor is explained on pages 109-110 of the latest annual report. It was initially covered in 2010.)

There's also the performance of Berkshire's float over time.**

Both can have an impact on value, favorable or not, that's very real.

Some might be inclined to minimally consider (if at all) what is, more or less, difficult to calculate or quantify -- and instead, in this case, maybe emphasize the two more quantitative elements -- but for many investments that's a good way to make a costly misjudgment. At times, looking at an entirely different discipline for perspective can be useful way to illustrate the point. Well, consider the following from Freeman Dyson as he writes about Lord Kelvin's large miscalculation of the earth's age. Dyson describes "Kelvin's wrong calculation of the age of the earth" as resulting from "blindness to obvious facts." He then added:

"Kelvin based his calculation on his belief that the mantle of the earth was solid and could transfer heat from the interior to the surface only by conduction. We now know that the mantle is partially fluid and transfers most of the heat by the far more efficient process of convection, which carries heat by a massive circulation of hot rock moving upward and cooler rock moving downward. Kelvin lacked our modern knowledge of the structure and dynamics of the earth, but he could see with his own eyes the eruptions of volcanoes bringing hot liquid from deep underground to the surface. His skill as a calculator seems to have blinded him to messy processes such as volcanic eruptions that could not be calculated."

Convection was important but not easily calculated, so Kelvin instead focused on what could be more easily calculated. Dyson points out that this led to Kelvin's estimate being short by something like 50-fold.

Certainly enough to matter.

The error of focusing too much what can be more easily quantified over what cannot applies to investment just as it applies to science.***

For example, if Berkshire's float remains a low cost (or, as has often been the case for Berkshire, better than free) and stable (i.e. a minimal need to post collateral especially at inopportune times/can't be called away or withdrawn when needed most) source of funds, it will have a significant positive impact on intrinsic value. Fortunately, estimating the impact float has on value isn't as difficult as estimating the earth's age. That's the good news. The bad news it's still not easy to more than roughly figure out what kind of economic value should be attached to it.

From the letter:

"If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit is earned, we enjoy the use of free money – and, better yet, get paid for holding it."

If, instead, significant ongoing underwriting losses were to occur in the future, then Berkshire's intrinsic value would end up being much reduced. Buffett goes on to say that he expect Berkshire's float to be "both costless and long-enduring".

Those who are confident that Buffett is roughly right should come up with at least a somewhat different valuation than those who think he might be too optimistic about how the characteristics of Berkshire's float will change over the long run.

"The value of our float is one reason – a huge reason – why we believe Berkshire's intrinsic business value substantially exceeds its book value."

Two reasonable investors could rightly have differing views on the value of Berkshire's float. But those who think the value of float can be nailed down with some level of precision would be kidding themselves.

What's important to remember is that this cuts both ways when it comes to estimating value. The more difficult -- in some cases even nearly impossible -- to quantify but important stuff can both just as easily subtract from as add to value (and, depending on whether it subtracts or adds, lead to either errors of omission or commission).

So, when it comes to estimating value, the significance of certain elements are tough to specifically pin down beforehand. The value of float may be more easy to roughly quantify than the "'what-will-they-do-with-the-money' factor", but that's not saying much. 

Spreadsheets, no matter how complex and/or thoughtfully done, just won't provide many insights on this.

So, while it may not be easy to figure out the impact on value with any kind of precision, it may be possible to understand it, more or less, directionally. In other words, it's sometimes wise to admit that it's only possible to judge whether the impact is likely to be positive or negative, while maybe not knowing by just how much. Some will surely be uncomfortable with this kind of messiness but, to me, it's an inevitable part of the investment process. It just means the investor has to allow for a somewhat wider range of outcomes and pay a price that takes the low end into account.
(Others might attempt to overcome the messiness by making a complex model that's built on lots of questionable assumptions. Well, the simple and well thought out usually beats the complex. Overly complex models are a great way to create something that appears precise -- falsely so -- and, maybe, creates unwarranted overconfidence in their reliability and utility. Those who possess the ability to think critically, reduce unnecessary errors, and truly know their own limits will probably be more effective in the long run.)

That's where margin of safety comes into play. It may not be very useful to someone who is attempting to estimate the age of the earth. Yet it works just fine, at least up to a point, within an otherwise sound investment decision-making framework. An investor has the luxury of choosing to not invest at all (and moving on to something else) if they're not comfortable with not knowing the hard to quantify stuff. The key thing is to not make the equivalent of Kelvin's mistake: that is, stubbornly continuing to focus on what lends itself to calculation and ignoring what's harder to calculate but possibly, in some cases, more important. This behavior will eventually end up being expensive for those who make it a common practice.

Flexibility beats being rigid.

For investors, choosing not to invest at all works just fine; acting like Kelvin does not. There are plenty of investment alternatives so there's no need to purchase something that's not well understood (necessarily unique to each investor). There's never a good reason to do otherwise.

Those who choose to emphasize what can be quantified in lieu of what matters a whole lot more but just happens to be mostly subjective, qualitative, or difficult to calculate will likely make unnecessary mistakes; they'll also likely miss opportunities.

Of course, a focus only on Berkshire's per-share investments and pre-tax earnings (from businesses other than insurance and investments) to determine intrinsic value wouldn't exactly be the same as the mistake made by Kelvin.

The investor might just decide to view the qualitative stuff as it relates to Berkshire as upside. In other words, pay a discount to value based only on the easy to quantify stuff.

This works when confident that the qualitative stuff won't be some kind of investment wrecking ball.

So that approach might work for a Berkshire investor but, for many others, the hard to quantify but important stuff just might overwhelm everything else. For example, misjudging something like how sustainable the competitive advantage of a particular business is -- not at all an easy thing to measure but terribly important -- could end up being very costly.

The lesson of Kelvin's blunder (and similar) will remain very relevant to investment decision-making.


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

Some related posts:
Berkshire Hathaway's Second Quarter 2013 Results - August 2013
Berkshire's Manufacturing, Service and Retail Operations - April 2013
Berkshire's Regulated, Capital Intensive Businesses - April 2013
Buffett on Buybacks, Book Value, and Intrinsic Value - December 2012
Berkshire's Book Value & Intrinsic Value - May 2012
Buffett: Intrinsic Value vs Book Value - Part II - May 2012
Buffett: Intrinsic Value vs Book Value - April 2012
Discount Rate - August 2009

* See page 107 and page 109-110 of the annual report for more on intrinsic value.
** Buffett's explanation of Berkshire's investments (stocks, bonds, and cash equivalents) -- the first of the three key components for estimating intrinsic value -- includes the following: "...underwriting results are volatile, swinging erratically between profits and losses. Over our entire history, though, we've been significantly profitable, and I also expect us to average breakeven results or better in the future. If we do that, all of our investments – those funded both by float and by retained earnings – can be viewed as an element of value for Berkshire shareholders." So float is is seen as part of the investments component when it comes to estimating value. Now, an investor might reasonably decide that the current essentially costless (or, in fact, often less than costless) and long-enduring characteristics of Berkshire's float will meaningfully change in the future. If so I'd offer that, in effect, that means in some ways it becomes a separate element when considering estimated intrinsic value. (Buffett does provide a useful explanation, as he has previously, of float's value in the Insurance section of the latest letter.) On the other hand, those comfortable with Buffett's future expectations of Berkshire's float can more or less focus primarily on the value of the investments themselves (in addition to the other two components of value).

Of course, even a modest multiple of the per-share pre-tax earnings from businesses other than insurance and investments when added to per-share investments hardly looks unreasonable compared to current market prices. That doesn't, in itself, mean Berkshire is a cheap stock because, for example, an investor might have a pessimistic view of the future prospects of the assets that make up both elements. In addition, this ignores important but more difficult (if not impossible) to quantify things that effect value both positively and negatively. Just some of the reasons why intrinsic value is necessarily a range of values and never a precise number. It's worth mentioning that the 1.2x Berkshire's book value (the level Buffett says he'd buy at aggressively) equals:

$ 161,968 per Class A share ($ 134,973 multiplied by 1.2)


$ 107.98 per Class B share ($ 161,968 divided by 1500)

As I write this, the Class A shares sells for ~ $ 173,000 or just over $ 115 per Class B share.

So it's not quite down to where Buffett says he would buy aggressively, but it's also hardly selling for a big premium to that price.

In any case, it seems rather likely that Buffett wouldn't be buying aggressively at 1.2x book if he thought the stock was selling at only a slight discount to its intrinsic value.

*** Blunders like Kelvin's are a part of progress in science, but there just happens to be a useful lesson in it. Charlie Munger had this to say about the tendency to focus on what can be calculated at the 2002 Wesco annual meeting:

"Organized common (or uncommon) sense -- very basic knowledge -- is an enormously powerful tool. There are huge dangers with computers. People calculate too much and think too little."

More recently, at last year's Berkshire annual meeting, here's an exchange between Warren Buffett and Charlie Munger that was captured on The Wall Street Journal's live blog:

Munger: "You really have to understand the company and its competitive positions. ...That's not disclosed by the math.

Buffett: "I don't know how I would manage money if I had to do it just on the numbers."

Munger, interupting, "You'd do it badly."

Munger also said the following back in 2003:
"...practically (1) everybody overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that."
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