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Archive for February, 2007

Market Correction

Just as I was writing about market volatility and risks in my previous post, the markets received a severe correction.

Dow Jones suffered their biggest drop since the September-11 incident, and my local market at one point shed close to 9% over two days.

Sometimes, when I read news articles on market movements, I really can’t stop laughing.

“This time round, it is different.”
“Market drops on investor concerns over xxxx.”
“Market drops over rise in oil prices.”
“Market drops over fall in oil prices.”
“Market rises on technical rebound.”

I can probably pre-write hundreds of such articles and keep on rotating them for publication.

Which is the cause, and which is the effect?

Value investors, remember that market volatility is your friend. If stock prices track their business intrinsic value accurately, your returns are at best what the business provides.

On the other hand, if they don’t, you can obtain a higher return than what the business would have given you.

If Mr Market quotes you a ridiculously high price for a stock, you are free to ignore him.

If he quotes you a ridiculously low price for a stock, you can take advantage of him.

At the end of the day, know the value of what you are buying and provide for yourself a margin of safety.

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Portfolio Turnover

If a parent company owns a subsidiary with excellent long-term economics, is it likely for the subsidiary to be sold regardless of price?

Not likely.

That is the same mindset that you, as a small investor, needs to adopt when you own a small piece of an excellent company. The worst advice you can possibly get from your broker is, “You can’t get broke taking a profit”.

$40 invested in Coke in 1919 will have grown to $3277 by the end of 1938. A fresh $40 invested at the end of 1938 would have grown to $25,000 by the end of 1993.

An investment lifetime is just too hard to make hundreds of smart decisions.

Risk – Buffett’s definition

Is it riskier to hold less stocks? Risk, as Warren Buffett defines, is “the possibility of loss or injury”.

A policy of portfolio concentration may even reduce the risk as the investor would have to think even harder about a business and its economic characteristics before he invests into it.

If you are a know-something investor who is able to understand business economics and find five to ten well-priced companies that possesses long-term competitive advantage, then diversification makes no sense for you.

It simply makes no sense as to why you would want to buy more of a company that is your 20th favorite, rather than buying more of your top choices.

The real risk that an investor must assess is whether his after-tax returns from an investment will give him at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake.

While you can’t calculate it precisely, these are the factors (in his exact words) that Warrren Buffett tells us to consider:

1) The certainty with which the long-term economic characteristics of the business can be evaluated;

2) The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows;

3) The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself;

4) The purchase price of the business;

5) The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor’s purchasing-power return is reduced from his gross return.

Risk – Academic definition

Academics like to define risk as the volatility of a stock or a portfolio of stocks compared to a large universe of stock. So, the higher the volatility (or beta), the riskier the stock.

Isn’t it absurb that if a stock suddenly suffers a massive drop in price, it’s volatility has increased and thus it has become riskier at a lower price?

The true investor welcomes volatility. In Chapter 8 of The Intelligent Investor, Benjamin Graham introduces us to Mr Market, a person who shows up every day to buy from you or sell to you.

Whatever the price of the day, you have the option of wanting or refusing to transact with Mr Market.

Now, if the prices are extremely volatile (or riskier as defined by the books), wouldn’t that offer you a chance for you to buy at irrationally low prices once in a while?

How can that be riskier for you when you are totally free to choose whether or not to transact every day?

Despite all these, you will be able to find companies with a very strong competitive moat (like Gillette or Coke) having a volatility that is similar to other run-of-the-mill companies who possess little or no competitive edge.

Equating beta or volatility with investment risks simply makes no sense. Rather, you should be looking at the business risks as given in the five factors mentioned above.

When Diversification is Appropriate

One example when wide diversification is appropriate is when you are doing arbitrage.

If a single arbitrage transaction poses significant risk, overall risk should be reduced by making other mutually independent transactions.

Just make sure that your gain, weighted for probabilities, considerably exceeds your weighted loss, and that you can commit to a number of similar but unrelated opportunities.

This is like a roulette operator who likes to see lots of action because it is favored by probabilities, but will not accept a single, huge bet.

Another example is when an investor does not understand the economics of specific businesses. In this case, he will be better off investing in a basket of stocks through an index fund.

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This is a Q & A session with Warren Buffett in his office in Omaha, NE back in Jan 2005. The video recording was recently made available by Darren Johnson.

The video is about 37min long and seems to end abruptly (Perhaps they run out of batteries towards the end).

In this session, Warren Buffett answers some of these questions:

How he measure intrinsic value.

In terms of opportunity recognition, how he looks for opportunity in the market.

If he were an entrepreneur starting a business, what he would do.

Why we have a huge edge over Warren Buffett.

A couple of his mistakes.

Why he doesn’t do stock splits and dividends.

Where he got lucky.

After watching so many of his talks, it seems to me that he has a few points which he always emphasise on. Simple thoughts that this great investor lives by.

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Analysing Insurance Operations

In the past, Warren Buffett uses a measurement known as the “combined ratio” to evaluation the performance of the insurance industry. This ratio compares the total insurance cost (which includes payouts and expenses) to the revenue from premiums.

A ratio of over 100% represents an underwriting loss, which actually happens quite frequently. How then do insurers stay in business?

The reason for this is simple.

Premiums for most policies are paid upfront, while resolving claims often takes time. Insurers are thus able to hold their policyholders’ money for some time before paying it out. Using these funds that are earmarked to be paid in the future (or “the float”), insureres can invest them. Taking into account the investment earnings from this float, it is therefore possible for insurers to be profitable with a combined ratio of over 100%.

Things are however, not so staightfoward. Often, underwriting losess are usually estimated and have to be corrected later on. Furthermore, no one knows the exact future liabilities owed to the premiums that are collected today.

In this year’s letter, Warren Buffett uses another measure to evaluate the performance of the insurance industry. The reason for this is that interest rates has fallen so the combined ratio method is no longer useful for comparing the profitably from one year to another.

For example, a company writing at the same combined ratio in the 1980s as compared to the 1990s is much more attractive because the interest rates were higher then.

So, the analysis has to take into account both the underwriting results as well as the risk-free rate.

(The actual investment returns from the float should of course be of another major importance. But that is a separate analysis from the one that is dicussed here.)

This is how the figures (In $ Millions) looks like for Berkshire’s insurance business:

         (1)           (2)
     Underwriting                  Approximate   on Long-Term
       Loss        Average Float  Cost of Funds   Govt. Bonds
     ------------ ------------- --------------- -------------
(Ratio of 1 to 2)

1967   profit       $ 17.3      less than zero      5.50%
1968   profit         19.9      less than zero      5.90%
1969   profit         23.4      less than zero      6.79%
1970   $ 0.37         32.4               1.14%      6.25%
1971   profit         52.5      less than zero      5.81%
1972   profit         69.5      less than zero      5.82%
1973   profit         73.3      less than zero      7.27%
1974     7.36         79.1               9.30%      8.13%
1975    11.35         87.6              12.96%      8.03%
1976   profit        102.6      less than zero      7.30%
1977   profit        139.0      less than zero      7.97%
1978   profit        190.4      less than zero      8.93%
1979   profit        227.3      less than zero     10.08%
1980   profit        237.0      less than zero     11.94%
1981   profit        228.4      less than zero     13.61%
1982    21.56        220.6               9.77%     10.64%
1983    33.87        231.3              14.64%     11.84%
1984    48.06        253.2              18.98%     11.58%
1985    44.23        390.2              11.34%      9.34%
1986    55.84        797.5               7.00%      7.60%
1987    55.43      1,266.7               4.38%      8.95%
1988    11.08      1,497.7               0.74%      9.00%
1989    24.40      1,541.3               1.58%      7.97%
1990    26.65      1,637.3               1.63%      8.24%
1991   119.59      1,895.0               6.31%      7.40%
1992   108.96      2,290.4               4.76%      7.39%
1993   profit      2,624.7      less than zero      6.35%

In the event of an underwriting profit, the cost of the float would be negative. Most years, you can see that the cost of the float is less than the risk-free rate. This looks extremely good.

Warren however, cautions looking at the figures in isolation for any single year. The reason is that they write a fairly large amount of “super-cat” policies. When a super catastrophic event occurs, the losses for that year could very well equal three to four times of their underwritiing profits in good years.

This is no way for them to know the true odds on super-cat coverage and it would take them decades to know whether their underwriting rates had been sound.

However, Warren believes that overall, they have a first class insurance business. While results might be highly volatile, their intrinsic value far exceeds their book value.

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What is Warren Buffett Buying Now?

In a few hours time, we will be celebrating Chinese New Year here in Singapore. So, I will be taking a break today and won’t be reading any of Warren Buffett’s letter. Instead, here’s an interesting piece of news for you.

Recently, Berkshire disclosed that they had 1.02 million shares of Minnetonka, Minnesota-based UnitedHealth, the largest U.S. health insurance company, as of 31 Dec 06.

This represents less than 1 percent of UnitedHealth’s outstanding shares. Since Berkshire’s filing for the previous quarter with the Securities and Exchange Commission had no holdings of UnitedHealth, this means that the acquisition was quite recent.

This purchase came despite the fact that the company was being investigated by SEC for backdated stock options and they have not reported financial results since the first quarter of 2006.

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The amount of federal income tax that Berkshire pays (either directly or indirectly) is about 0.5% of the total paid by all American corporations. Their 1993 direct federal income tax comes up to $390 million, about $200 million from operating earnings and $190 million from realized capital gains.

Another $400 million of federal and foreign income tax is contributed by their investees, a figure that can’t be seen on Berkshire’s financial statements.

Warren Buffett and Charlie Munger prefer having a buy-and-hold policy. This is the soundest way to invest and taxes are due only when gains are realized.

Imagine you take a dollar, invest it in company A and it doubles in value after one year. Now, you sell the investment, invest it in company B and it doubles again. Repeat for 20 years and your investment will become $1,048,576. If a capital gains tax of 35% has to be paid every year, the amount will only have increased to $22,370 after 20 years. Another 7.5 years would be needed for it to exceed a million dollars.

On the other hand, if you hold on to a single investment and let it double by itself every year, you will end up with about $200 million pretax after 27.5 years. After paying a tax of $70 million, you will still be left with about $130 million.

You will realize a far, far greater sum from a single investment that compounds internally at a given rate than from a succession of investments compounding at the same rate.

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Look Through Earnings

Warren Buffett continues to use the concept of look through earnings to discuss about the earnings of Berkshire Hathaway. This is the fourth year in a row that he has done so.

For the definition, you can refer to my previous posts on this topic.

Note that the “operating earnings” which is referred to exclude capital gains, special accounting items and major restructuring charges.

Over time, Berkshire’s look-through earnings need to increase at about 15% annually for their intrinsic value to grow at that rate. In the previous year’s letter, Buffett had explained that to meet the 15% goal, these earnings will have to increase to $1.8 billion in the year 2000. Because of the issuance of additional shares in 1993, the amount required has now risen to $1.85 billion.

One managerial practice that Buffett has criticized in the past is that of shooting the arrow of performance and then painting the target. Buffett makes himself accountable to shareholders and boldly paints his target (of 15% goal) first. However, for the target to be achieved, he will need markets that allow the purchase of businesses on sensible terms. If prices are high, there is no need to do something just because there is excess cash.

Over time, Buffett expects the look through earnings to be a conservative estimate of Berkshire’s true economic strength.

For example, in 1986 they bought 3 million shares of Capital Cities/ABC for $172.50/share. When 1/3 of the stake was sold years in 1993, there was a realized profit of $297 after deducting a 35% capital gains tax. If the look through earnings of Cap Cities during those 8 years were distributed to Berkshire after deducting a tax of 14% (this is the tax rate that Berkshire pays for dividends), it would be only $152 million in gains.

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Purchase of Dexter Shoe

In 1991, Berkshire purchased H. H. Brown, a manufacturer of work shoe, boots and other footwear. At the end of 1992, they purchased Lowell Show, a long-established manufacturer of women’s and nurses’ shoes. This time in 1993, they acquired Dexter Shoe, which manufactures popular-priced men’s and women’s shoes.

Five years prior to these purchases, Warren Buffett had no thoughts that he would be getting the shoe business. That’s the way it works at Berkshire. They have no strategic plans about what businesses or industries they will enter in the future. Instead, they focus on the economic characteristics of businesses that they would like to own AND the personal characteristics of the managers running these businesses.

In fact, Warren Buffett feels that when a corporate giant embarks on new ventures because of some grand vision, it usually doesn’t work out too well for the shareholders.

For the case of Dexter Shoe, the owners Harold and Peter, was paid using Berkshire shares. So what they did was they traded 100% interest in a single terrific business for a smaller interest in a large group of terrific businesses. According to Warren, this was good for them (Harold and Peter) for various reasons:

1) They incurred no tax on this exchange.

2) They now own a security that can be easily used for charity, personal gifts or converted to cash. Compare this to complications that often arise when assets are concentrated in a private business and owners want to divest part of this asset.

3) Private companies often find it difficult to diversify outside their industries. By shifting their ownership to Berkshire, they solved a reinvestment problem.

4) Their investment results from owning shares of Berkshire will parallel exactly that of Warren, as the company does not issue him any restricted shares or stock options.

5) They still get to run Dextor Shoe as they did (and treated as partners) even though they only own non-controlling shares in Berkshire.

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Book Value, Intrinsic Value & Market Value

Let’s look at these 3 terms which are discussed at the start of this letter.

Book value is just an accounting term that measures the capital (including retained earnings) that has been put into a business.

Intrinsic value is the present-value of the cash that can be taken out of the business during it’s remaining lifespan. As there is no way we can know the performance of a company in the future, therefore this value has to be estimated.

Market value is simply a price of the share of the company that is quoted on the stock exchange.

Intrinsic value is usually unrelated to book value. Berkshire is an exception and while the two values are different, the book value can be used as a device for tracking the progress of the intrinsic value.

In the long run, the market price and intrinsic value of a company will arrive at about the same price but in the short term, these two prices could be significantly different.

As an example, Berkshire’s book value and intrinsic value both grew by about 14% in 1993, while the market value grew by 39%.

Having said that, Warren Buffett still views Berkshire’s market price as appropriate if (a very big IF) they can continue to meet Berkshire’s long term goal of increasing their intrinsic value at an average annual rate of 15% (in a world of 6-7% long term interest rates). With an ever increasing capital base, this target is getting more and more difficult to meet.

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In January 2007, Warren Buffett hosted a study visit at Berkshire Hathaway with some MBA students from the Terry College of Business (University of Georgia).

During the session, he shared some of the following:

1) Why he bought Berkshire Hathaway back in 1960s.
2) How he would generate 50% returns if he had a capital of only $1 million today.
3) His thoughts on investing in other countries including Korea, China, Russia and Africa.
4) The part of this character that contributed to his success.
5) His views on ETFs.
6) Why he felt estate taxes should remain.
7) His initial land/real estate investments.
8) How he evaluates the managment of companies.
9) His greatest mistake in investment.

You can download the transcript and read all about it.

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