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Archive for March, 2007

Intrinsic Value and Capital Allocation

When managers make capital allocation decisions, it is important that they act in ways that increase per-share intrinsic value and avoid things that decrease it.

For example, in considering business mergers and acquisitions, many managers tend to focus on whether the transaction would be immediately dilutive or anti-dilutive to earnings per share. This is insufficient.

Consider our previous example on college education. If a 25-year-old first year MBA student were to merge his future economic interests with that of a 25-year-old laborer, it would enhance his near-term earnings since he isn’t earning anything at the moment.

But such a deal would be downright silly for the MBA student.

Similarly in corporate transactions, it is important to look not just at the current earnings of the prospective acquiree, but to look at the effect on the intrinsic value of the acquiree.

Unfortunately, with the way many major acquisitions are done, they only serves to benefit the shareholders of the acquiree and increase the income of the acquirer’s management, but reduces the wealth of the acquirer’s shareholders.

A really good business will always end up generating more cash than it can use after its early years. While this money could be distributed to shareholders by way of dividends or share repurchases, often the CEO will engage some consultants or investment bankers for acquisition advice.

As Warren said, “That’s like asking your interior decorator whether you need a $50,000 rug.

In Berkshire, the managers of the individual businesses will first look for ways that they can deploy their excess capital in their own businesses. The balance that is left will be sent to Warren Buffett and Charlie Munger, who will use those funds in ways that build per-share intrinsic value.

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Book Value and Intrinsic Value

Warren Buffett considers intrinsic value as the only logical way to evaluate the relative attractiveness of investments and businesses. It is defined as the discounted value of cash that can taken out of a business during its remaining life.

This value is highly subjective as it depends on estimations of future cash flows and changing interest rates.

An example of college education is used by Warren to illustrate the possible divergence from book value and intrinsic value.

First, let’s treat the cost of education as it’s “book value”.

Then, we must estimate the earnings that will be earned by the graduate over his lifetime and subtract what he would have earned if he didn’t have his college education.

This excess earnings should then be discounted back to graduation day using an appropriate interest rate. The final value represents the intrinsic value of the college education.

Some graduates may calculate that the book value of their education exceeds the intrinsic value, which meant they overpaid. Other graduates may calculate and find the converse, which meant that capital was wisely deployed.

No matter what, it is clear that book value does not figure as a calculation for intrinsic value.

Now, let’s look at a real life Berkshire example.

Scott Fetzer was bought by Berkshire at the beginning of 1986 for $315.2 million, which at the time of purchase had $172.6 million of book value. A premium of $142.6 million was paid as Warren Buffett believed the intrinsic value of the company was close to 2 times the book value.

This premium would have to be written-off against earnings annually as shown in the table below:

                 Beginning     Purchase-Premium      Ending
Purchase Charge to Purchase
Year Premium Berkshire Earnings Premium

---- --------- ------------------ --------
(In $ Millions)

1986 ........... $142.6 $ 11.6 $131.0
1987 ........... 131.0 7.1 123.9
1988 ........... 123.9 7.9 115.9
1989 ........... 115.9 7.0 108.9
1990 ........... 108.9 7.1 101.9
1991 ........... 101.9 6.9 95.0
1992 ........... 95.0 7.7 87.2
1993 ........... 87.2 28.1 59.1
1994 ........... 59.1 4.9 54.2

By the end of 1994, the premium had been reduced to $54.2 million.

The change in book value, earnings and dividends of Scott Fetzer over the years is as follows:

                  (1)                                 (4)
Beginning (2) (3) Ending
Year Book Value Earnings Dividends Book Value

---- ---------- -------- --------- ----------
(In $ Millions) (1)+(2)-(3)

1986 .......... $172.6 $ 40.3 $125.0 $ 87.9
1987 .......... 87.9 48.6 41.0 95.5
1988 .......... 95.5 58.0 35.0 118.6
1989 .......... 118.6 58.5 71.5 105.5
1990 .......... 105.5 61.3 33.5 133.3
1991 .......... 133.3 61.4 74.0 120.7
1992 .......... 120.7 70.5 80.0 111.2
1993 .......... 111.2 77.5 98.0 90.7
1994 .......... 90.7 79.3 76.0 94.0

Despite the book value remaining fairly constant, the earnings showed a steady increase. Consequently, the return on equity became extraordinary.

If you look at the carrying cost of Scott Fetzer on Berkshire’s books at the end of 1994, it has already been reduced to $148.2 million (54.2+94).

This amount is less than half their carrying cost at the point of purchase, yet the earnings was twice of what it was then.

This meant that the difference between Scott Fetzer’s intrinsic value and the carrying cost on Berkshire’s books has grown to quite huge at the end of 1994.

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In 1994, Berkshire has a networth of $11.9 billion compared to $22 million when they first started. While their investment strategies will continue to work (and there are as many good businesses as ever), it is now useless for them to make purchases that are too small.

Any investment amount worth less than $100 million won’t even be considered. As such, Berkshire’s investment universe has shrunk significantly.

One major distraction for many investors are political and economical forecasts and events.

No one could have predicted the Vietnam War, oil shocks, dissolution of the Soviet Union, resignation of a president and so on.

Despite all these events, Benjamin Graham’s principles still hold true. Some of Warren Buffett’s best purchases were made when fear about some macro event were at a peak.

Other major shocks are sure to occur in the future. These cannot be predicted with any certainty. As long as Warren Buffett can continue to identify businesses similar to what he has purchased in the past, these external surprises will have little effect on his long term results.

Share prices will continue to fluctuate; and the economy will hav its ups and downs. Over time, good businesses will continue to increase in value.

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In Warren Buffett’s yearly letter to Berkshire shareholder, he always itemized the major shareholdings.

While I do not think a “buy what Warren Buffett is buying” strategy can be sustainable, here’s a comparison of the 2005 and 2006 letter which was just published on 1st March 2007 anyway.

A look at the major shareholdings (more than $700 million) at the end of 2005 and 2006 shows up these additional names:

1) Ameriprise Financial, Inc
2) Johnson & Johnson
4) Tesco
5) US Bancorp
6) USG Corp

This does not mean that the above six counters were bought in 2006. (They could have been bought before 2006.) It only meant that the value of Berkshire’s holdings in the 6 holdings had risen above $700 million at the end of 2006.

Of the six, POSCO is a korean steelmaker and at current market price, Berkshire’s stake is already worth 1.3 billion dollars; much more than the 572 million dollars that they paid.

There were also two additional counters with a market value of 1.9 billion that were not itemized in the letter. The reason given by Buffett was that it was because they were still in the process of buying more shares in them.

Buffett says , “I could of course, tell you their names. But then I would have to kill you“.

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Corporate Governance

There are three fundamentally different manager/owner situations that exist in public companies.

The first and most common board situation is where there is no controlling shareholder. Directors should evaluate management’s performance in the long term interest of a “single absentee owner”.

The directors are responsible for changing the management if their performance is poor. A single director would be unable to make such changes on his own. He will need to persuade the other directors to his views.

For this first type of board situation, Warren Buffett believes the number of directors should be little (ten or less) and come mostly from the outside. They should be business savvy, owner-oriented and have interest in the job.

The second board situation is where the controlling owner is also the manager (This situation occurs at Berkshire). In this situation, directors do not act as an agent between owners and management.

There is nothing much a director can do (except object) if the owner/manager is under-performing. If there is no change, the next best thing a director can do is to resign. This will send a signal to outsiders on their doubts about management.

The third situation occurs when there is a controlling owner who is not involved in management (This will be the case at Berkshire after Warren Buffett has passes away).

In this situation, if the directors are unhappy with the competence or intergrity of the management, they can approach the controlling shareholder (who might also be on the board). If the controlling shareholder is intelligent, he can make decisions that are pro-shareholder and fair.

This third scenario is the most effective to ensure first-class management. In the first case, directors often find it difficult to affect change while in the second, a lousy owner is not going to fire himself.

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