Tilson: Berkshire Hathaway Analysis

Here is an analysis of Berkshire Hathaway (BRKa) by Whitney Tilson that is updated from time to time.

Whether you agree with the valuation or not, Tilson's analysis is an easy way to get more familiar with an increasingly complex company.

Adam

Long BRKb

Link to Whitney Tilson's Analysis

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.

Book Review: How to Read a Financial Report

I haven't read How to Read a Financial Report but this review of it is favorable. Sounds like it may provide a convenient way to learn accounting in general and how to interpret financial statements.

One weakness of the book may be that it only spends a small amount of time on managerial accounting.

From the review:
John Tracy discusses at length the connection between the balance sheet and the income statement. He believes many accountants do not appreciate the connection between the two. He devotes a large segment of the book to the relationship between operating expenses and accounts payable, inventory and accounts payable, cost of good sold and inventory and other interconnections between the two financial reports.

Dr. Tracy devotes a short segment of the book to managerial accounting, I especially enjoyed this segment. Although, as Dr Tracy himself notes he could write a separate book regarding managerial accounting alone, in the few pages he writes about managerial account he provides readers some valuable insights. He asks what is better a 5% sales increase or a 5% price increase. In the fictional company used by Dr. Tracy a 5% price increases profit before fixed expenses by 22.3% whereas a 5% sales would increase the number by only 5%. This is because there are variable expenses that rise with increases in sales volume i.e. sales commission, cost of goods sold. Many managers will focus on increasing sales just to gain market share even if it would be more profitable to simply raise prices.

Maybe Dr. Tracy will write a good book on managerial accounting at some point. This one's probably still worth checking out.

Adam

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.

'Black Swan' Author: Buffett May Just Be Lucky

Just luck?

From this CNBC article:

Nassim Taleb says there isn't enough evidence to show that Warren Buffett's skill, and not his good luck, is responsible for the billionaire's enormous investing success over the decades.

No surprise but I'm gonna take a different view. Here's how Taleb explains his thinking:

"I am not saying Buffett doesn't have skill — I'm just saying we don't have enough evidence to say Buffett isn't doing it by chance."

Late last year he also said:

I Can't Believe I Live In A World Where Bernanke Could Be Reappointed

What I am seeing and hearing on the news -- the reappointment of Bernanke -- is too hard for me to bear. I cannot believe that we, in the 21st century, can accept living in such a society. I am not blaming Bernanke (he doesn't even know he doesn't understand how things work or that the tools he uses are not empirical); it is the Senators appointing him who are totally irresponsible - as if we promoted every doctor who caused malpractice.

Taleb added...

No news, no press, no Davos, no suit-and-tie fraudsters, no fools. I need to withdraw as immediately as possible into the Platonic tranquility of my library, work on my next book, find solace in science and philosophy, and mull the next step. I will also structure trades with my Universa friends to bet on the next mistake by Bernanke, Summers, and Geithner. I will only (briefly) emerge from my hiatus when the publishers force me to do so upon the publication of the paperback edition of The Black Swan.

So not much respect for Buffett or Bernanke...to say the least!

Now that's self-confidence.

Right or wrong the self-imposed silence equals loss of entertainment.

Adam

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.

Charlie Munger: Nebraska Furniture Mart

Charlie demonstrating the utility of simple microeconomics during a talk he gave to the University of California, Santa Barbara Economics Department in 2003.

"Berkshire Hathaway just opened a furniture and appliance store in Kansas City. At the time Berkshire opened it, the largest selling furniture and appliance store in the world was another Berkshire Hathaway store, selling $350 million worth of goods per year. The new store in a strange city opened up selling at the rate of more than $500 million a year. From the day it opened, the 3,200 spaces in the parking lot were full. The women had to wait outside the ladies restroom because the architects didn’t understand biology. (Laughter). It’s hugely successful.

Well, I've given you the problem. Now, tell me what explains the runaway success of this new furniture and appliance store, which is outselling everything else in the world?

[Pause]

Well, let me do it for you. Is this a low-priced store or a high-priced store? (Laughter). It's not going to have a runaway success in a strange city as a high-priced store. That would take time. Number two, if it's moving $500 million worth of furniture through it, it's one hell of a big store, furniture being as bulky as it is. And what does a big store do? It provides a big selection. So what could this possibly be except a low-priced store with a big selection?

But, you may wonder, why wasn't it done before, preventing its being done first now? Again, the answer just pops into your head: it costs a fortune to open a store this big. So, nobody's done it before. So, you quickly know the answer. With a few basic concepts, these microeconomic problems that seem hard can be solved much as you put a hot knife through butter. I like such easy ways of thought that are very remunerative. And I suggest that you people should also learn to do microeconomics better."

While Charlie doesn't mention it in the above talk, the team that manages Nebraska Furniture Mart has also developed a significant cost advantage over the years. Warren Buffett put it the following way in his 1983 letter:

"One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it. I'd rather wrestle grizzlies than compete with Mrs. B and her progeny. They buy brilliantly, they operate at expense ratios competitors don't even dream about, and they then pass on to their customers much of the savings." - Warren Buffett

So some of that cost advantage comes from scale but much of it is successful buying and other operating practices that go back to the founder, Mrs. B.

Adam

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.

The Volcker Rule

Below is some excerpts of Paul Volcker responding to Senator Mike Johanns in front of the Senate Banking Committee yesterday.

Senator Johanns didn't seem to consider the "Volcker Rule" to be all that relevant and appeared deeply skeptical. Several other Senator's expressed similar skepticism.

First, some background on the so-called "Volcker Rule". The rule is not intended to solve all the problems that were at the root of the financial crisis. Volcker said as much during the hearing. It is intended to limit speculative activity by bank's that have the benefit of FDIC and Federal Reserve backing.

The main criticism of it seems to be that it doesn't solve every problem that caused the crisis. Since when is it necessary for something to solve every problem to have merit?

The idea of the rule is to push the more speculative activity to places that can be allowed to fail without destabilizing the broader financial system.

Volcker Video

Senator Johanns: "Tell me the evil that you're trying to wrestle out of the system by this rule, if we were just to say great, were with ya, we pass it the way you want it passed. What evil disappears?"

Volcker: "Well I don't know whether you want to call it evil but I feel that I've failed if you are more confused than you were before. What I want to get out of the system is taxpayer support for speculative activity. And I want to look ahead. If you don't bar that it's gonna become bigger and bigger and it becomes/adds to what is already a risky business. And I don't want my taxpayer money going to support somebody's proprietary trading. I'll make it as simple as that."

Then later...

Senator Johanns: "It kinda reminds me what the chief of staff said: 'never let a good crisis go to waste.' And what we are doing here is we're taking this financial reform and we're expanding it beyond where we should be. And I just question the wisdom of that unless somebody can make the case to me that had this been in place the world would be different."

Volcker's response:

Volcker: "The chairman made the point that I would emphasize. The problem today is to look ahead, and try to anticipate the problems that may arise that will give rise to the next crisis. And I tell you, sure as I am sitting here, that if banking institutions are protected by the taxpayer and they are given free rein to speculate, I may not live long enough to see the crisis, but my soul is going to come back and haunt you."

We need more Volcker's.

Adam

Related post:
Volcker on Financial Innovation
---
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.

James Grant on Economic Forecasting

Here's an article from nymag.com on some of James Grant's latest thinking. He has seemingly turned pretty optimistic in the past year.

The article points out the limits of what is knowable in economic forecasting (the article says that Grant considers it to be "a pseudo-intellectual parlor game"). Here's an excerpt from the article:

"In the industrial history of the United States, there have only been about 30 economic recoveries, a minuscule sample size. (If somebody touted a medical breakthrough based on a study of 30 patients, who would rush to sign up for this new wonder drug?) As for the data itself, consider that the dominant measure of economic activity, gross domestic product, is an antique that does a poor job of capturing the intangible investments that abound in the information economy. The numbers that drive the markets up and down, like jobless figures, are glorified guesses subject to constant revision. The latest issue of Grant's Interest Rate Observer notes that annualized GDP growth for the third quarter of 1983 has been revised ten times, including just this fall! How much can we possibly know about the future if we’re still unsure about 1983?"

Good to see someone in the business of economic forecasting admitting the limits of that game. Most of the investors that have served as models for my own investing have consistently reinforced the point that macroeconomics is of little use in equity investing.

In 2003, Munger said this at a speech to the University of California, Santa Babara Economics Department:

"My fourth criticism [of how economics is currently taught] is that there's too much emphasis on macroeconomics and not enough on microeconomics. I think this is wrong. It's like trying to master medicine without knowing anatomy and chemistry. Also, the discipline of microeconomics is a lot of fun. It helps you correctly understand macroeconomics. And it’s a perfect circus to do. In contrast, I don’t think macroeconomics people have all that much fun. For one thing they are often wrong because of extreme complexity in the system they wish to understand."

Also, at a Wesco meeting back in 2004 Charlie said:

"Gigantic macroeconomic predictions are something I've never made any money on, and neither has Warren [Buffett]."

Deteriorating macroeconomic conditions at some point in the future should be taken as a given. Why (or why not) a businesses has long-term competitive advantages, whether it is likely to produce durable high returns on capital, and judging the margin of safety is where I spend my energy.

Adam

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.

Error of Pessimism

The following quote seems rather relevant these days

"The error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born not an infant, but a giant." - British economist Arthur C. Pigou

Here's another article that references the same quote.

Adam

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.

Volcker on Financial Innovation

An article in the timesonline.co.uk with some of Paul Volcker's comments to a conference of senior level bankers late last year.

Some excerpts:
...a clearly irritated Mr Volcker said that the biggest innovation in the industry over the past 20 years had been the cash machine. He went on to attack the rise of complex products such as credit default swaps (CDS).

"I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth — one shred of evidence," said Mr Volcker...

He said that financial services in the United States had increased its share of value added from 2 per cent to 6.5 per cent, but he asked: "Is that a reflection of your financial innovation, or just a reflection of what you're paid?"

Also, here are some of Volcker's comments from a separate article in the telegraph.co.uk covering the same event. He told some of the world's most senior financiers...

...that their industry's "single most important" contribution in the last 25 years has been automatic telling machines, which he said had at least proved "useful".

Mr Volcker told delegates who had been discussing how to rebuild the financial system to "wake up". He said credit default swaps and collateralised debt obligations had taken the economy "right to the brink of disaster" and added that the economy had grown at "greater rates of speed" during the 1960s without such products.

Mr Volcker argued that banks did have a vital role to play as holders of deposits and providers of credit. This importance meant it was correct that they should be "regulated on one side and protected on the other". He said riskier financial activities should be limited to hedge funds to whom society could say: "If you fail, fail. I'm not going to help you..." 

Well said, Mr. Volcker.

 Adam

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.

Amazon vs eBay

When Amazon (AMZN) reports earnings it seems lately nothing can go wrong.

Free cash flow (FCF) at Amazon was $ 2.92 billion and grew at a 114% clip.

Impressive right?

Yes, but in this case, maybe not quite as impressive as it seems. A good chunk of that growth in FCF came from accounts payables increasing faster than accounts receivable and inventories. Not exactly the highest quality source of FCF, but the company does have a rather brilliant negative working capital cycle in place.

Well, at least they do as long as the growth persists.

Essentially, it's a source of "float" that provides lots of cheap funding for expansion as long as the exceptional growth can be sustained. Of course, if invested consistently well, that funding might lead to future earning power that isn't all that obvious today.
(More than a few seem willing to pay what seems a premium valuation for those prospects.)

Now, I happen to think a more conservative and closer reflection of Amazon's full year operating FCF is net income + depreciation - capex = $ 902 + $ 378 - $ 373 = $ 907 million.

That's more than a $ 2 billion difference in FCF and much of it comes down to the working capital model. It is the increases to accounts payable (relative to more modest increases to accounts receivable and inventories) and also additions to unearned revenue (relative to amortization of previously unearned revenue) that make up quite a bit of that gap.

At the current price of $ 129/share, Amazon's Market Cap is ~$ 59.4 billion with an Enterprise Value (EV = Market Cap - Net Cash and Marketable Securities + Debt) of ~$ 53.2 billion.
(Amazon has ~$ 6.2 billion in net cash on the balance sheet.)

So the EV/FCF for Amazon = 58.7x

(vs 18.2x using the reported number)

Look at Amazon's performance over the past 3 years using net cash provided by operating activities minus capex to calculate FCF. Over those 3 years, Amazon averaged FCF of $ 1.82 billion/year.

So using that number the EV/FCF for Amazon = 29.2x

That may or may not seem too expensive for a stellar company, but here's why I think that FCF calculation doesn't reflect economic reality. It's not just that much of the so-called FCF is coming from a great working capital model and unearned revenue that shouldn't really be considered quality operating FCF.

There's also a boost from the company's stock-based compensation.*

If you adjust for these things EV/FCF is, once again, north of 50x.

Now lets try the same calculation for eBay (EBAY), who is currently treated like the "George" compared to Amazon's "Elaine".
(George being the serial underachiever on Seinfeld. Well, at least until becoming transformed in the classic 86th Seinfeld episode: "The Opposite". In that episode, successful Elaine becomes like George and vice versa.)

eBay's average 3 year FCF = ~ $ 2.3 billion

At the current price of $ 23.30/share, the market cap of eBay is approximately $ 30.8 billion and an EV = ~ $ 25.9 billion.
(eBay has ~$ 4.9 billion of net cash on the balance sheet)

So the EV/FCF for eBay = 11.4x

Unlike Amazon, the cash flow of eBay is not boosted by changes in working capital (actually eBay's FCF is reduced somewhat by changes in working capital). Like Amazon, it is boosted by stock-based compensation. Adjusting FCF lower to account for stock-based compensation raises the EV/FCF multiple to more like 13.4x.

Here is eBay's most recent results.

Amazon's operating FCF is currently increasing faster than eBay's (who knows going forward). Using my math, they actually grew it at around 50% year-over-year (not 100% plus, but still impressive). I wouldn't bet that growth rate is sustainable for very long but, who knows, maybe it is. At its current FCF multiple, eBay doesn't need to increase FCF much to justify its valuation. In contrast, to justify its multiple, Amazon has to increase FCF rapidly for a long time. The question comes down to how much confidence one has in the future prospects and what's the appropriate margin of safety.

I like the long run prospects of both businesses but am only comfortable with eBay's stock. This comes down to margin of safety. To figure out what price represents a comfortable margin of safety, the per share intrinsic value must be estimated. Well, someone else may know how to figure that out for Amazon but I don't.**

Amazon seems to be executing brilliantly (even if it's far from easy to judge -- at least for me -- the company's value), while eBay has been working through problems in its Marketplace business. Well, problems are all relative. Even during eBay's struggles, the company sustained very solid free cash flow. The recent results seem to indicate eBay has made some good progress in their Marketplace business while PayPal continues to perform very well.

So, to some degree, Amazon's premium valuation compared to eBay may be warranted, but it at least appears a bit extreme. If nothing else, the premium requires that the company continue doing very well for quite some time to produce even a satisfactory investing result.***

Now, what happens if Amazon ends up like Elaine in that Seinfeld episode and becomes George? Having Amazon's valuation normalize would certainly hurt.

All eBay has to do is keep on being George.

Even if eBay continues to be the seen as underachiever with unexciting growth prospects, it at least seems not much has to go right.

Considering the valuation, it appears that the company need only continue to generate solid free cash flow, solidify its moat, and use its excess capital wisely. No small feat (and far from a certainty) but, if nothing else, not much of its current value looks to be based upon a promising future not quite yet realized.
(Of course, it's also possible that the prospects for eBay -- real or perceived -- might even improve. A bonus when a premium isn't paid in the first place.)

Interestingly, Amazon also announced their intention to buy back up to $ 2 billion of the stock.

Amazing.

Adam

Long position in eBay

* FCF -- if calculated using net cash provided by operating activities minus capex -- for both Amazon and eBay is reduced when you adjust for stock-based compensation (which is added back in operating cash flow since it is a non-cash expense). Stock-based compensation may be a non-cash expense in an operational sense, but cash would have to be used by each company buying back shares to maintain share count (cash paid to buy shares minus what was paid to the company depending on the exercise price). That's a real cost to shareholders. Basically, if stock-based compensation is ignored, both companies boost free cash flow only in appearance. Now, the stock-based compensation number is not a perfect way to estimate the real cost, but the bottom line is FCF should be adjusted lower in order to make a more meaningful if rough estimate of the true economic per share impact on shareholders. There's a number of ways to make an informed though imprecise adjustment but, no matter how one decides to estimate the cost, it plainly can't be ignored.
(The lack of precision comes down to the number of variable involved and the inherent limitations of accounting.)
** Especially when it comes to managing the downside risk of an investment, it's best to only buy what one understands. That's necessarily unique to each investor and dependent on individual knowledge, expertise, and limitations.
*** Not via the skillful trading of price action but via increase to per share intrinsic value. I don't doubt both of these businesses might actually end up being quite valuable down the road. One just seems to have a less difficult to estimate margin of safety at this time. As far as price action goes, premium valuations can proceed to become even more so (and, similarly, a discount to value can become an even bigger discount and stay that way quite a while). In the short run and even much longer, just about anything can happen as far as stock price action goes. No view is offered here on that front. Figuring out how market prices might fluctuate near-term and beyond is difficult at best. I'll leave that game to others. In contrast, figuring out how price compares to intrinsic value is, at least occasionally, more doable. Not easy but doable. Well, at least it can be for certain assets one understands. If value is consistently judged well, and a nice discount is always paid to that estimated value, reasonably good outcomes and fewer mistakes become more likely. 
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

eBay 2008 10-K

BRKb Joins the S&P 500

Turns out Berkshire Hathaway (BRKb) will replace Burlington Northern in the index. It will also be added to the S&P 100. Stock is up 8% in the pre-market to $ 73.50/share (or what used to be $ 3,675 per share pre-split).

Adam

CNBC article

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.