Intelligent Investor Club

Here’s a message from Warren Buffett. Any takers?

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I came across an interesting article about not having to worry about market tops. It involves looking at a recent purchase of Warren Buffett.

One thing about Warren is that he will ignore the overall market sentiments. What he is really concerned about is

1) the economics of the underlying business;
2) the management; and
3) whether the current market price is a good buy.

Anyway, here is the article on Warren Buffett’s purchase for your reading pleasure.

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Over the past 32 years, the per-share book value of Berkshire has grown from $19 to $19,011, at a rate of 23.8% compounded annually.

Due to the purchase of GEICO (becoming a wholly-owned subsidiary), there was a need to restate Berkshire’s 1995 financial statements.

From an economic point of view, the value of the 51% of GEICO owned at year-end 1995 increased significantly when the remaining 49% was bought.

This is because of major tax efficiencies and other benefits.

From an accounting point of view however, it was required for the value of the 51% to be written down at the time Berkshire went to 100%.

As a result, the original 51% of GEICO is now carried on the books at a value that is both lower than its market value at the time the remaining 49% was bought and also lower than the value at which that 49% is carried.

The Relationship of Intrinsic Value to Market Price

Over time, the total gains made by Berkshire shareholders should match the business gains of the company. When the market price temporarily overperforms or underperforms the business, some shareholders (buyers or sellers) will receive outsized benefits at the expense of those they trade with.

While the primary goal of Berkshire is to maximize the amount that their shareholders make, another goal is to minimize the benefits going to some shareholders at the expense of others.

In a public company, fairness prevails when market price and intrinsic value are in sync. This will never happen but a manager can do much to make them close.

The longer a shareholder holds his shares, the more his returns will match Berkshire’s business results; and the less it will depend on what his premium or discount to instrinsic value was when he bought it.

That is one reason Berkshire hopes to attract owners with long-term horizons.

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First, read this statement:

“Along with the release of its 2Q07 results, Roly also announced a proposed voluntary delisting of Roly from the Singapore Exchange. The rationale for the proposed delisting was that the share prices of its listed entities, namely Roly, Linmark and Byford on the relevant exchanges do not reflect the underlying values of these entities.

In addition, Roly also cited high costs and time spend on compliance with listing rules and regulatory matters as further reasons behind the proposal. The exit offer price for shareholders is pegged at S$0.35. The deal is subject to the approval of shareholders at a special general meeting to be held within 3 months.”

The “voluntary” delisting have since been approved to become a mandatory delisting.

So, how have I been ripped off?

The management of this company feels that the market prices of it’s shares are under-valued, then proceeds to make an arrangement for the shareholders to sell out their shares at near market prices.

What kind of logic is that?

We have no choice but to sell our shares at bargain prices.

Ggrrrrrhhhhh….

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Intrinsic Value

Intrinsic value is the discounted value of the cash that can be taken out of a business during its remaining life.

It is not a simple value to calculate and must be estimated. This estimate will also depend on the interest rates and any forecasts of future cash flows. That is why Warren Buffett never gives an estimate of their own intrinsic value.

What is regularly reported is their per-share book value, which can be easily calculated but is of less use. This is because the book value of the companies that Berkshire controls may be far different from their intrinsic value.

For example in 1964, Berkshire’s per-share book value was $19.46. This far exceeded the company’s intrinsic value as all of the company’s resources were tied up in a non-performing textile business.

Now, the situation is reversed and Berkshire’s book value far understates their intrinsic value.

Nevertheless, the book value is still reported as it serves as a rough tracking measure for the intrinsic value. In any year, the percentage change in book value is reasonably close to that year’s change in intrinsic value.

As an analogy, consider a college educaion and think of the education’s cost as “book value”. The intrinsic value of the education is calculated by estimating the earnings of the graduate over his lifetime and subtracting from that figure an estimate of what he would have earned had he lacked his education. The final figure is then discounted back to present day figures using an appropriate interest rate.

Some graduates mya find that their book value of their education exceeds its intrinsic value and some may find otherwise. Whatever the case, it is clear that book value is meaningless as an indicator of intrinsic value.

On The Managing of Berkshire after Buffett’s Death

Warren and Charlie attend mainly to the task of capital allocation and leave all the running to the managers of the subsidiaries. Out of Berkshire’s 217,000 employees, only 19 of them are at headquarters.

The managers have total control over operating decisions and will dispatch any excess cash they generate to headquarters.

On Buffett’s death, none of his shares will have to be sold. They will be left to foundations who will receive them in installments over a dozen or so years.

The Buffett family will not be involved in managing the business but will help to pick and oversee the managers who do. Essentially, Warren Buffett’s job will be spilt into two parts. One executive who will be responsible for investments, and a CEO who will be in charge of operations. Any acquisition decisions will be mabe by the two with the approval of the board. These people have already been identified.

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In June 1996, Warren Buffett issued a booklet called “An Owner’s Manual” to Berkshire shareholders. If you like to read the entire 5-page manual, you can download an updated version of it at the Berkshire Hathaway website.

Here’s a summary of the things that are covered in the manual.

13 Owner-Related Business Principles

1) Shareholders are treated as owner-partners, with Warren and Charlie Munger taking the role of managing partners.

2) Most of Berkshire’s directors have a major portion of their networth invested in the company.

3) The long term economic goal is to maximize Berkshire’s average annual rate of gain in intrinsic business value on a per-share basis.

4) The preference to reach this goal is to directly own a diversified group of businesses that generate cash and consistently earn above-average returns on capital. The second choice is to own parts of similar businesses, obtained through purchases of marketable common stocks by Berkshire’s insurance subsidiaries. The challenge for Berkshire is to generate ideas as rapidly as they generate cash.

5) Because of the two-pronged approach to business ownership, consolidated reported earnings will reveal very little about their true economic performance.

6) Accounting consequence do not influence operating or capital-allocaton decisions.

7) Debt is used sparingly and when it is used, preference will be to structure it on a long-term fixed rate basis. Interesting opportunities will be rejected if there is a need to over-leverage.

8) A managerial “wish list” will not be filled at shareholder’s expense. Only acquisitions that can raise the per-share intrinsic value of Berkshire will be considered.

9) The noble intention of retenting earnings to increase shareholder value will be checked periodically. If they reach a point where retained earnings cannot be used to create extra value, the earnings will be given out to shareholders.

10) Common stock will only be issued when Berkshire can receive as much in business value as they give.

11) Regardless of price, Warren and Charlie have no interest in selling any good business that Berkshire owns. Even for sub-par business, they will be reluctant to sell as long as the business can be expected to generate some cash and they feel good about their managers and labor relations.

12) Warren and Charlie will be candid in their reporting, highlighting both the good and bad. There will not be any accounting maneuvers or restructurings to smooth earnings.

13) Activities in the securities markets will only be discussed to the extent legally required. This is because good investment ideas are rare and any relevation will only serve to invite competition.

Two Added Principles

14) Warren will like each Berkshire shareholder to record a gain or loss in market value during his period of ownership that is proportional to the gain or loss in per-share intrinsic value recorded by the company during that period. For this to come about, the relationship between intrinsic value and market price will have to be constant.

15) Berkshire’s per-share book value will be regularly compared to the performance of the S&P 500. They expect to outperform the S&P in lackluster years for the stock market and underperform when the market has a strong year.

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Berkshire Annual Letter 1995 (Part 9)

In 1996, Warren Buffett proposed having two classes of stock for Berkshire. A class “B” share will be created that has 1/30th of the rights of the existing (or “A”) shares but 1/200th of the voting rights.

In addition, class “B” shares will not be entitled to participate in Berkshire’s shareholder-designated charitable contributions program.

Everyone holding on to the class A share can convert it them into class B shares. This makes it easier for them to use Berkshire shares as gifts.

The motivation behind this exercise is the emergence of many (expense laden) unit trusts aggressively marketed as low priced clones of Berkshire.

Warren Buffett has the view that these Berkshire funds will be mass marketed with huge promises. The not so sophisticated buyers might be mislead by the potential of the funds.

It is likely that commissions and other expenses will eat into the performance, and these investors will be disappointed.

Through the creation of the class B shares, investors can invest directly into Berkshire.

The tradeoffs for Berkshire is that there will be additional costs associated with handling a greater number of shareholders.

A thing to take note for both current and prospective Berkshire shareholders is that the market price of Berkshire and the intrinsic value will not be the same all the time.

Ideally, they should be the same but in reality, there are times when the market value is higher than the intrinsic value and vice versa.

The more informed investors are, the smaller the gap between market value and intrinsic value. By creating class B shares, the merchandising efforts of the Berkshire unit trusts will be blunted and the market value of Berkshire will be closer to the intrinsic value.

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Convertible Stocks

Berkshire made five private purchases of convertible preferred stocks from 1987-1991.

                         Dividend  Year of            Market
 Company                   Rate    Purchase   Cost    Value
 -------                 --------  --------  ------  --------

						(dollars in millions)

Champion International Corp	9 1/4%	1989	$300	$388(1)
First Empire State Corp		9%	1991	40 	110
The Gillette Company 		8 3/4%	1989	600	2,502(2)
Salomon Inc 			9%	1987	700	728(3)
USAir Group, Inc. 		9 1/4%	1989	358	215

When the purchases were made, Warren expected

(a) the returns from them to moderately exceed those from medium term fixed income securities.

(b) they would not beat the returns from a business with wonderful economic prospects.

(c) they would give back at least their capital plus dividends under almost any circumstances.

As it turned out, (a) was met (but only because of the performance of Gillette), (b) was correct and (c) could be wrong (because of USAir Group).

Leaving aside Gillette, the returns of the convertibles would be no more than equal to those earned from medium term fixed income issues.

Furthermore, the returns for Gillette would have been even greater had Warren purchased the shares directly at that time instead of the convertible.

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Berkshire Annual Letter 1995 (Part 7)

In 1995, there were three businesses in the Berkshire staple that underperformed.

The shoe business had depressed earnings but the problem was likely to be a cyclical one.

On the other hand, the industry trends for Berkshire’s newspaper business, The Buffalo News, are not good (This was also previously mentioned in the 1991 Annual Report). Newspapers are less economical attractive now compared to the days when they have a bullet-proof franchise.

Over time, Warren expects their competitive strength to gradually erode, but with many remaining years of being a fine business.

The most difficult problem was in World Book, which had increasingly difficult competition from CD-ROM and other online offerings.

As a result, it had to make major changes in the way it operates, with more electronic products and reduced overheads. Whether these efforts are sufficient remains to be seen.

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Berkshire Annual Letter 1995 (Part 6)

What counts in the insurance business is the amount of float generated (money held but not owned) and the cost of it. There is float because premiums are always paid upfront and it takes time to resolve claims.

Usually, the premiums that an insurer takes in will not cover the losses and expenses that it must pay. This is called an “unwriting loss” and reflects the cost of float.

If this cost of float is lower than market rates for money, then that insurance company is profitable.

At times when there is no underwriting loss, the cost of float is acutually negative, giving “free money”.

In any business, its profitability is determined by three things:

1) What its assets earn;
2) What its liabilities cost; and
3) its utilization of leverage – the extent by which assets are funded by liabilities rather than by equity.

Berkshire has always done well on the first point. What most people don’t realise is that they have also benefited greatly from the low cost of their liabilities.

Often, they are able to generate plenty of float on very advantageous terms.

At the end of 1994, they had $3.4 billion of float. If they had replaced that with $3.4 billion of equity, it would have meant more shares, equal assets and lower earnings attributed to each share.

The acquisition of GEICO will increase their float by $3 billion, with the probability that the cost of the float will be nothing (due to underwriting profits).

Super-Cat Insurance

Berkshire is able to stand out in the field of super-cat and large risk insurance because of:

1) Their unmatched financial strength;
2) Their ability to supply quotes faster than anyone else.
3) Their ability to issue policies with limits larger than anyone else.

The nature of the super-cat insurance business is such that it can show large profits in many years but there could be occassional years of huge losses. Thus, it will take many years to evaluate the profitability.

Both Warren Buffett and charlie Munger are quite willing to accept relatively volatile results in exchange for better long-term earnings.

However, they will never write business at inadequate rates. A bad insurance contract is like hell; you can get surprises from it even 20 years down the road.

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