Intelligent Investor Club

Helzberg’s Diamond Shops

There is a popular technique called “management by walking around” (MBWA). Warren Buffet has his own technique which is called “acquisitions by walking around”(ABWA).

In May 1994, Warren Buffett was crossing the street when a man called Barnett Helzberg, Jr. told him that he owned a business that Berkshire might be interested in. When someone tells Warren that, the usual case is that they have a lemonade stand – with potential to grow quickly in the next Microsoft.

Anyway, the financial statements of Helzberg’s Diamond Shops were subsequently sent over to Warren Buffett and it turned out they were far from a lemonade stand.

Helzberg’s Diamond Shops was started in 1915 as a single store by Bernett’s grandfather and had grew into 134 stores with $282 million in sales. It was currently very well run by Jeff Comment, former President of Wanamaker’s.

The key to Helzberg’s excellent profits was that it had an average annual store sales of about $2 million, far more than their competitors.

The deal was appealing to Warren for two reasons. Firstly, the company was the kind of business that they wanted to own. Secondly, Jeff was the kind of manager they wanted. Without an outstanding manager running the show, they would not have bought the business.

The acquisition was completed using a tax-free exchange of stock, and Barnett shared quite a bit of his proceeds with a large number of his associates. When someone does that, a buyer will know that he will also be treated right.

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Acquisitions

Warren Buffett holds a view that most acquisitions do damage to the shareholders of the acquiring company. Often, the finanical projections made by the sellers paint a more rosy picture than the actual scenario. The seller will always know more about the business than the buyer and they get to pick the best time of sale (from their perspective).

One of the few advantages that Berkshire has in buying companies is that they don’t have any strategic plans. They are free to consider any acquisition opportunities (including the purchase of shares in the stock market) on their own merits without the need to proceed in any particular direction.

Another advantage is that they can offer sellers shares of Berkshire, a company with a collection of outstanding businesses. An individual can defer personal tax indefinitely by exchanging their ownership in a single business for shares of Berkshire.

Also, sellers know that placing their companies with Berkshire will give their managers autonomy to operate as before, with pleasant and productive working conditions.

Warren Buffett likes to deal with sellers who care about what happens to their businesses after the sale, rather than those sellers who are simply auctioning off their businesses. The latter often comes with unpleasant surprises.

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In 1995, Berkshire had an increase in networth of 45%. Despite this, Warren Buffett does not think of it as anything amazing as it is a year in which any fool would have made a great deal in the stock market. As he paraphrases President Kennedy, “a rising tide lifts all yachts“.

There were also three good acquisitions: Helzberg’s Diamond Shops, R.C. Willey Home Furnishings and GEICO. These will be discussed later on. Warren Buffett and Charlie Munger likes to make acquisiton of two types:

1) A negotiated transaction that allows them to buy 100% of a company at a fair price.

2) A modest percentage purchase of an outstanding business from the stock market at a pro-rata price well below what it would take to buy 100%.

The employment of these two strategies gives them an advantage over other people who only stick to one strategy.

In addition, they have two factors operating in their favour:

1) Outstanding managers with strong attachment to Berkshire.

2) Their own considerable experience in allocating capital rationally and objectively.

The main disadvantage that they face is their big size. Instead of coming up with just good ideas, now they need to come up with good ideas that are big.

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2 Mistakes That Warren Buffett Made

Late in 1993, Warren Buffett sold 10 million shares of Cap Cities at $63. At the end of 1994, the price was $85.25, a “loss” of $222.5 million.

This was a “repeat offence” because Warren Buffett had previously sold Cap Cities at $4.30 per share during 1978-1980 and then bought them again for $17.25 in 1986.

However, the top mistake of the year went to the $358 million purchase of USAir preferred stock, made five years ago.

In the analysis of the purchase, Warren Buffett had failed to consider the problems that would affect a carrier whose costs were both high and extremely difficult to lower.

In the beginning, this was not so much a problem as the airlines were protected from competition by regulation. They could absorb high costs by passing them on to consumers using high prices.

Even when deregulation came, the impact was not immediately felt as the capacity of low cost carriers was too small at first. But as the capacity of low cost carriers increased, the high-cost airlines were forced to cut their fares to stay competitive.

This poses serious considerations to their long term viability.

As it turns out, Berkshire’s $358 million worth of preferred stock in USAir was written down to $89.5 million, a loss of 75%.

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Common Stock Investments

The number of companies where Berkshire had a stake of over $100 million continued to be low in number and simple in concept. The big investment ideas is summarised by Warren Buffett as:

“We like a business with enduring competitive advantages that is run by able and owner-oriented people. When these attributes exist, and when we can make purchases at sensible prices, it is hard to go wrong.”

The performance of an investment does not depend on the complexity of the investment. If you can evaluate correctly a company that is simple to understand and enduring, the result is the same if you had correctly analysed another complex investment alternative.

Rather than try to time his purchases, Warren Buffett will determine the fair value and buy when there is a margin of safety.

It is foolish to stop buying shares in an outstanding business whose long-term future is predictable, because of short-term concerns over the economy or stock market.

Also, before buying new investments, Warren will consider adding to old ones first. If a business is attractive in the past, it could still be in the present/future.

Incidently, quite a number of the purchases that Warren Buffett made for Berkshire are what similar to what he bought many years ago as a private investor.

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Compensation For Managers

Today’s post is about Warren Buffett’s views on how managers should be compensated.

First of all, their compensation should be tied only to the results of the operation they are in charge of and control. For example, it makes no sense to tie the compensation of Ralph Schey (who runs Cott Fetzer) to the results of Berkshire.

Secondly, if capital invested in an operation is high, managers are charged a high rate for incremental capital that they use. Conversely, they are credited with an equally high rate for capital that they release.

A meaningful hurdle rate on the earnings of additional capital employed is also set and compensation increases when the target is met. The calculation is symmetrical and if incremental investment yields are sub-standard, it will be costly to the manager.

Using this arrangement, managers have an incentive to send back to Berkshire any cash that they can’t employ advantageously.

The use of stock options does not really align management’s interests with that of shareholders. Rather, it is like a “Heads I win, tails you lose” situation.

Furthermore, the exercise price of the option does not increase to take into account the fact that retained earnings are building up in the company. Even if a manager adds absolutely no value to a company, a policy of low dividend payouts and compound interest will ensure that earnings (and subsequently share prices) increase.

You can even say that by withholding cash to the shareholders, the profit to the option-holding manager increases.

In all cases, Warren Buffett works out the compensation of his managers in a rational and simple way. There is no need of consultants or lawyers to work out complicated compensation plans. The compensation arrangement with Ralph Schey was worked out in about five minutes, and has never changed.

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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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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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