Intelligent Investor Club

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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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)

                                                    Yield

     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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Taxes

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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At Berkshire, after-tax overhead costs are under 1% of their reported operating earnings and less than 0.5% on their look-through earnings. They have no legal, personnel, public relations, investor relations or strategic planning departments. And no need of support personnel such as guards, drivers and messengers.

Some companies spend up to 10% (or even more) of their operating earnings on corporate expenses. Warren Buffett observes no correlation between high corporate costs and good corporate performance.

In actual fact, he feels that the simpler and lower operation is more likely to operate effectively than one saddled with bureauracy.

If the operating earnings of two companies are similar but one spends 10% on corporate costs while the other spends only 1%, then shareholders of the first business lose 9% in the value of their holdings due to this corporate overheads.

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Accounting Rules

A major accounting change, which was to be implemented by January 1, 1993, requires that businesses recognize their present-value liability for post-retirement health benefits.

For some reason, these were not required to be recorded on the books previously even though pensions to be paid in the future (something similar) were.

By ignoring the built-up of such liabilities, some companies had left themselves vulnerable to open-ended liabilities in the future.

The result of this new rule will many companies to record a huge balance-sheet liability (and a consequent reduction in net worth).

Warren Buffett tends to avoid companies with significant post-retirement liabilities when he is making his acquisitions.

Stock Options

Despite the accounting rule change for health benefits, no such change was required for stock options.

Stocks options were still illogically treated for in the accounts.

Some people have argued that “out-of-the-money” options (those with an exercise price equal to or above the current market price) have no value when they are issued.

Others have said that options should not be viewed as a cost because they “aren’t dollars out of a company’s coffers.”

Warren Buffett sees these as flawed as they would open up possibilites for companies to instantly improve their reported profits.

For example, they could now eliminate the cost of insurance by paying with it using options.

As long as something of value changes hand (and not just when cash changes hands), there will be a cost involved.

The arguement that options should not be recognised in the accounts because it is difficult to value them is also not right.

Currently, estimates are being used in accouting anyway. Examples include depreciation of a plane, a bank’s annual loan loss charge and losses of property-casualty ompanies.

In summary,

“If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”

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Fixed Income Securities

While Berkshire has done well with negotiated purchases of fixed income securities over the years, their purchases in the secondary market has performed better.

This corresponds with Warren Buffett’s belief that an intelligent investor in common stocks will do better in the secondary market than by buying new issues.

Why is this so?

First of all, the timing of new issues is determined by controlling stockholders and corporations. If the market is unfavorable, they can avoid an offering altogether.

The sellers in a public offering or negotiated transaction are also unlikely to offer a bargain. Most to the time, they are motivated to sell only when they can get a good price.

On the other hand, there are always times in the secondary market whereby mass folly takes place. No matter how low the price may be at that time, you can always find a few buyers who are willing to sell at that price.

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Value Investing

Compared to that stated 15 years ago, the only change in the equity-investing strategy of Warren Buffett is the addition of the word “very”:

“We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety. We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and (d) available at a very attractive price.”

The question one now needs to ask is how to decide what is attractive. Unlike most analysts who choose between either a growth or value approach, Buffett feels that growth is always a component of value. The important of which can vary from negligible to large, and the effects can be from negative to positive.

The term “value investing” is also redundant as all investing seeks to buy something of value that justifies the price paid. Overpaying for something in the hope of selling it at an even higher price is not investing, but speculation.

A “value investment” is not determined in any way by its price-earnings ratio, price to book ratio or even a high dividend yield.

Neither is it determined by the growth. While most growth often has a positive impact on value, it only benefits investors when each additional dollar used to finance the growth creates more than a dollar of long-term market value.

If business returns are low, growth actually hurts the investor.

Taken from The Theory of Investment Value written in 1937 by John Burr Williams, value can be defined as:

The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.

You will notice that the same formula is used for stocks as well as bonds. An important difference to take note is that for bonds, the future cash flows can be accurately determined from the coupon rate and maturity dates. While for stocks, the future cash flows has to be estimated.

This is the part where most people can go wrong.

Berkshire overcomes this problem by:

1) Dealing only with businesses that they understand, are simple and stable in nature. The best businesses to own are those that can employ large amounts of incremental capital at very high rates of return over an extended period of time. The worst businesses to own are those that does the opposite – that is, consistently employ ever-increasing amounts of capital at very low rates of return.

2) Having a margin of safety (as strongly emphasized by Ben Graham) in the purchase price.

Using the discounted-flows-of-cash calculation, the investment that is shown to be cheapest should be brought. Other factors like growth, earnings volatility, book value wouldn’t matter at all as these would all have been factored in.

And if the calculations show that bonds are cheaper, then they should be bought instead.

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