Wednesday, April 15, 2015

Berkshire's 'Big Four'

Warren Buffett, in his latest Berkshire Hathaway (BRKa) shareholder letter, wrote the following about what he calls the 'Big Four':

- American Express (AXP)
- Coca-Cola (KO)
- IBM (IBM)
- Wells Fargo (WFC)

"Berkshire increased its ownership interest last year in each of its 'Big Four' investments – American Express, Coca-Cola, IBM and Wells Fargo. We purchased additional shares of IBM (increasing our ownership to 7.8% versus 6.3% at yearend 2013). Meanwhile, stock repurchases at Coca-Cola, American Express and Wells Fargo raised our percentage ownership of each. Our equity in Coca-Cola grew from 9.1% to 9.2%, our interest in American Express increased from 14.2% to 14.8% and our ownership of Wells Fargo grew from 9.2% to 9.4%. And, if you think tenths of a percent aren't important, ponder this math: For the four companies in aggregate, each increase of one-tenth of a percent in our ownership raises Berkshire's portion of their annual earnings by $50 million."

It's worth noting that there's no attempt to bet on exceptional growth here. Some seem to think that high growth is a necessity to generate high returns. Well, consider the kind of businesses (whether through common stocks or outright purchases) Berkshire has owned over the past several decades. For the most part the returns have come from businesses that were not dependent on high growth over an extended period. Also, the returns generally have not come from businesses in industries that experience lots of change and require continuous product innovation. Instead, the emphasis has been on owning sound -- even if rather unexciting -- businesses that will be around for many decades. Ultimately, it's about increasing Berkshire's portion of what those businesses earn over time and the power of compounding effects.

So it's an emphasis on what the business can produce (in excess cash) over time. Those who, more or less, attempt to cleverly buy and sell stocks in order to profit from price action -- often with a rather not long time horizon in mind -- are engaged in a very different activity.
(This is the case whether or not the decisions are based upon business fundamentals. The fact that fundamentals are considered doesn't necessarily mean the activity isn't more speculation than investment.)

This approach works best if the business franchise remains competitive while real but manageable challenges keep the stock cheap for an extended period. A languishing stock can be a very good thing. In fact, the long-term investor in shares of a good business does not -- or, at least, should not -- logically want the share price to rise near-term or even intermediate-term.

Buffett recently said that some have a "misconception when we buy a stock we like it to go up. That's the last thing we want it to do."

For the investor who plans to be an owner for decades a rising stock price is not a good thing. What's much preferred is if the shares persistently sell at a discount to per-share intrinsic value.* When that happens -- at least for a business with sound long-term core economics -- future results improve as intrinsic value gets transferred from those who are impatient to those who are less so.**

"Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient." - From the 1991 Berkshire Letter

A rising stock simply makes buybacks less effective and makes it tougher to accumulate more shares over time via dividend reinvestments or incremental purchases at a proper discount.***

Why Buffett Wants IBM's Shares "To Languish"

Ultimately, it's about the discounted per-share value of the excess cash that's produced as long as the business can at least maintain or, better yet, improve its competitive position.

Buffett explains in the latest letter that Berkshire's portion of the 2014 earnings from these four businesses "amounted to $4.7 billion (compared to $3.3 billion only three years ago). In the earnings we report to you, however, we include only the dividends we receive – about $1.6 billion last year. (Again, three years ago the dividends were $862 million.) But make no mistake: The $3.1 billion of these companies' earnings we don't report are every bit as valuable to us as the portion Berkshire records."

That's just one of the reasons why Berkshire's price to earnings generally isn't a terribly useful thing to consider.

Adam

Long positions in AXP, KO, WFC, BRKb established at much lower than recent prices. Long position in IBM established at slightly higher than recent prices.

Here's how Buffett explains intrinsic value in the Berkshire Hathaway 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."
** If a dollar of value is consistently bought back for 70 cents then the other 30 cents of value doesn't just disappear, it ends up being transferred to the continuing owners. So an intelligent buyback can lead to what is effectively an intrinsic value transfer from those too focused on near-term price action to those focused on per-share intrinsic value and long-term effects.
*** From the 2011 letter: "If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day's supply.

Charlie and I don't expect to win many of you over to our way of thinking – we've observed enough human behavior to know the futility of that – but we do want you to be aware of our personal calculus."
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