Monday, April 21, 2014

Intrinsic Value - Part II

A follow up to this post. In it, the more quantifiable aspects of intrinsic value were covered while noting that meaningful estimates of value must go beyond what can easily be quantified.

In fact, I chose to use an example outside of the investment discipline -- Lord Kelvin's error in estimating the earth's age -- in an attempt to illustrate the point.

Berkshire's insurance 'float' is one example of a tough to quantify but important contributor to value.

The Insurance section of Warren Buffett's latest Berkshire Hathaway (BRKa) shareholder letter explains the following:

"So how does our float affect intrinsic value? When Berkshire's book value is calculated, the full amount of our float is deducted as a liability, just as if we had to pay it out tomorrow and could not replenish it. But to think of float as strictly a liability is incorrect; it should instead be viewed as a revolving fund."

He goes on to say:

"If our revolving float is both costless and long-enduring, which I believe it will be, the true value of this liability is dramatically less than the accounting liability."

And later adds:

"A counterpart to this overstated liability is $15.5 billion of 'goodwill' that is attributable to our insurance companies and included in book value as an asset. In very large part, this goodwill represents the price we paid for the float-generating capabilities of our insurance operations. The cost of the goodwill, however, has no bearing on its true value. For example, if an insurance business sustains large and prolonged underwriting losses, any goodwill asset carried on the books should be deemed valueless, whatever its original cost.

Fortunately, that does not describe Berkshire. Charlie and I believe the true economic value of our insurance goodwill – what we would happily pay to purchase an insurance operation possessing float of similar quality to that we have – to be far in excess of its historic carrying value. The value of our float is one reason – a huge reason – why we believe Berkshire's intrinsic business value substantially exceeds its book value."

Deferred taxes are worth mentioning in this context. As the Berkshire owner's manual explains (under principle number 7), deferred taxes have much in common with insurance 'float' in terms of advantages to the long-term investor:

"...Berkshire has access to two low-cost, non-perilous sources of leverage that allow us to safely own far more assets than our equity capital alone would permit: deferred taxes and 'float,' the funds of others that our insurance business holds because it receives premiums before needing to pay out losses."

Buffett then adds the following:

"Better yet, this funding to date has often been cost-free. Deferred tax liabilities bear no interest. And as long as we can break even in our insurance underwriting the cost of the float developed from that operation is zero. Neither item, of course, is equity; these are real liabilities. But they are liabilities without covenants or due dates attached to them. In effect, they give us the benefit of debt – an ability to have more assets working for us – but saddle us with none of its drawbacks."

Well, consider that, while most of us would find it difficult (at the very least) to gain access to high quality 'float' from insurance underwriting, just about anyone can benefit from the interest-free 'loan' that is deferred taxes.

Charlie Munger wrote the following in the 1998 Wesco letter:*

"Of course, so long as Wesco does not liquidate, and does not sell any appreciated assets, it has, in effect, an interest-free 'loan' from the government equal to its deferred income taxes on the unrealized gains, subtracted in determining its net worth. This interest-free 'loan' from the government is at this moment working for Wesco shareholders..."

The interest-free 'loan' to Wesco at the time was about $127 per Wesco share. However, since the 'loan' must be paid back someday as assets are sold, Munger thought at that time the value of the interest-free loan was probably more like $30 per Wesco share -- or less than one quarter of the 'loan'. Now, his estimate should necessarily come down to the specific situation. In other words, the estimated value should reflect a best judgment about how soon the appreciated assets might be sold. Munger's estimate likely took this into account.
(In fact, Wesco did sell shares in the years that followed. Their sale of Freddie Mac shares -- and its substantial capital appreciation -- was mostly responsible for what became a much reduced interest-free 'loan'. So it seems likely that Munger's estimate of value reflected at least some expectation that appreciated assets would be sold sooner than later.)

In contrast, if the appreciated assets are expected to be held longer -- especially if most are closer to indefinite holdings than not -- then the estimated value as a proportion of the interest-free 'loan' should, all things being equal, be larger. This estimate of value can't be known precisely but should at least be roughly meaningful.

Munger went on to explain the impact of the interest-free 'loan' on Wesco's intrinsic value per share:

"After the value of...the interest-free 'loan' is estimated, a reasonable approximation can be made of Wesco's intrinsic value per share. This approximation is made by simply adding (1) the value of the advantage from the interest-free 'loan' per Wesco share and (2) liquidating value per Wesco share. Others may think differently, but the foregoing approach seems reasonable to the writer as a way of estimating intrinsic value per Wesco share."

Naturally, this means of valuation is specific to Wesco.**

In any case, when one chooses to trade marketable stocks in a hyperactive fashion, they forgo access to such a low, or actually, no cost loan.

In the short run, such a loan does not have a big impact; in the long run, it very much does have an impact on value.

The power of compounding.

Finally, there's the "'what will they do with the-money' factor".  It's an element of value that's necessarily the most difficult to quantify.

From page 110 of the annual report:

"This 'what-will-they-do-with-the-money' factor must always be evaluated along with the 'what-do-we-have-now' calculation in order for us, or anybody, to arrive at a sensible estimate of a company’s intrinsic value. That’s because an outside investor stands by helplessly as management reinvests his share of the company's earnings. If a CEO can be expected to do this job well, the reinvestment prospects add to the company’s current value; if the CEO's talents or motives are suspect, today's value must be discounted. The difference in outcome can be huge. A dollar of then-value in the hands of Sears Roebuck's or Montgomery Ward’s CEOs in the late 1960s had a far different destiny than did a dollar entrusted to Sam Walton."

There are certainly stocks that are more straightforward than Berkshire as far as estimating per share intrinsic value.

That being said, some of the lessons that come out of learning how to estimate Berkshire's value, can be applied to other investments.


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

Some related posts:
Asset Growth & Stock Returns, Part II - March 2014
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

* Also mentioned in other Wesco letters.
** Munger in the same letter added the following: "Wesco is not an equally-good-but-smaller version of Berkshire Hathaway, better because its small size makes growth easier. Instead, each dollar of book value at Wesco continues plainly to provide much less intrinsic value than a similar dollar of book value at Berkshire Hathaway. Moreover, the quality disparity in book value's intrinsic merits has, in recent years, been widening in favor of Berkshire Hathaway." Buffett has said that book-value -- which is a meaningless measure for most other businesses -- is a useful if understated proxy for Berkshire Hathaway's intrinsic value. From the 2011 Berkshire letter: "We have no way to pinpoint intrinsic value. But we do have a useful, though considerably understated, proxy for it: per-share book value. This yardstick is meaningless at most companies." So it's a convenient proxy but I think it's important to consider all the elements that contribute to Berkshire's value for it to become well understood. That way one can draw conclusions as to what it's worth using their own assumptions and making their own judgments. The proxy -- multiplied by the factor that the investor believes reasonably well represents the current relationship between Berkshire's book value and intrinsic value, of course -- is, to me, at best useful as a quick check after the other work has been done. Well, in order to figure out the relationship between book value and intrinsic value, it requires that the necessary work gets done in the first place. That work itself needs to be done by whoever is putting the capital at risk. Using someone else's judgments and assumptions is likely to lead to future mistakes. If nothing else, the conviction level just isn't going to be there when needed. In other words, when difficulties or uncertainties, from time to time, inevitably emerge.
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