Wednesday, March 05, 2008

Warren Buffett’s Letter To Shareholders Berkshire Hathaway Annual Report,

One of the financial world’s most anticipated events is the Berkshire Hathaway Annual Report full of commentary from Warren Buffett, Chairman of the Board and the world’s most famous investor.

What I liked about this report –

There were many things to like about this years’ letter from the Oracle of Omaha. He turned his attention once again to a few basic themes of great importance to investors, particularly those interested in investment strategy. First and foremost, his letter included a review of the four conditions for which he and Charlie Munger look when making an investment. Knowing what to look for is the most important and most difficult discipline in investing, and in my opinion is the factor that separates successful investors from unsuccessful ones. Added to that, he provided an example of a great investment (and subtly contrasted it with the sorts of investments offered by CNBC). He also covered a few of his errors and went on to talk about important issues of accounting and how they affect financial statements. This year, having finally won expensing of stock options, he chose to focus on an even more important topic – pension accounting. Here’s to hoping that he treats deferred tax assets and liabilities next year.

I present seven key insights for investors that I gleaned from Buffett’s letter, together with my own thoughts on each one.

Key insight #1: Control affects investment returns. While he has done well in purchasing publicly traded stocks, Buffett’s outsized returns more often came from businesses over which he acquired control.

I have often argued that Buffett’s single greatest investment was his purchase of 15% of the Washington Post in 1973 for the bargain price of US$11mn. Today this investment is worth $1.6bn and generates more dividend income every year than his initial investment. No wonder it was among the first listed stocks to attain the status as a “permanent” holding of BH. In spite of this investment, Buffett's returns on the publicly traded investment portfolio have not significantly outpaced the market. In fact, were it not for WaPo, he might be about average, at least in recent years. The investments that have really driven BH stock are the operating businesses.

See’s Candies is a successful chain of chocolate shops primarily doing business in the Western US. Buffett was able to purchase this business for $25mn in 1972. At the time the business was generating $30mn in revenue, and earning $5mn on book of $8mn, for an RoE of 62.5%. Buffett actually managed to acquire this business for 5x earnings (the See’s family was looking for 6x). If you find something like this, please tell me.

Over time, the capital of See’s has had to grow as new stores were added and new capital expenditures were made. Nevertheless, 40 years later, the company still has book value of only $40mn, meaning that (after depreciation) the company has only required a subsequent investment of $32mn in capital. In return, it has produced $1.35bn in free cash for BH to go on and make acquisitions.

See's has been able to take this slow, but highly profitable growth track (growing volume about 2% per year) because Buffett has controlled the asset. A public company would have been under far more pressure to generate faster return growth and to expand into many markets and/or segments, or risk being acquired and becoming a boutique of Hershey or Cadbury Schwepps. Buffett's control over the capital expenditure has ensured steady growth with very small but incremental market share gains.

Of course, having control has also meant that Buffett has had to make those decisions himself. He is a very good manager (which explains much of his outsized peformance -not his security selection).

Key Insight #2: Growth is gravy. Great investments are those that require little if any additional capital investment (i.e. are those from which all future CapEx can be financed out of cash flows from the asset).

Buffett’s point is this – Great investments are almost always those where the cash flows cannot be reinvested at similarly high internal rates of return. That is not to say that it isn’t desirable to do so, but rather that a truly great investment, like See’s, generates so much cash it would simply be impossible to reinvest it all in the business. There aren’t enough good opportunities.

In contrast, there are a great many “solid” investments that can grow earnings every year, often by double digits. But in order to do so, many require huge capital expenditure and working capital increases to support the higher volume. This often leads to lower returns on capital employed: the law of diminishing returns require more and more capital to be invested in order to get progressively less and less out of the system. Worse yet are those investments that require so much cash that the actual cash from operations are insufficient to support the required CapEx. These businesses promise that in the future CapEx will decline with growth and the firm will turn cash flow positive, but an investor always has to worry about a cash flow chart that starts out deep in the hole.

Future cash flows are notoriously dangerous to predict, particularly in fast growing businesses. Worse, because the company may have earnings (or not) but is experiencing rapid top line growth, the market seems to think that the stock should trade at a significant premium, reflecting the present value of the massive and hoped for cash flows. It is much more likely that the hoped for flows will not materialize and that expectations will not be met. Buffett eschews such businesses almost entirely (he is working with one manager to build a new insurance business and has paid up for anticipated future earnings, but this is a rarity).

Even if there isn’t huge investment in long-term assets, often working capital requirements eat a business alive. As revenue increases, inventory and receivables increase proportionally. If a firm sustains its high share price by maintaining high revenue growth, often working capital increases even faster than sales, because sales are often extended to customers with shaky credit or ability to pay in order to book the sale.

Key insight #3: Know what you are looking for

So what does Buffett look for? Four things –

  1. Management – honest and shareholder friendly
  2. Simple and understandable business
  3. Reliably profitable, with a solid moat to protect it and ensure earnings in good times and bad
  4. A good price

Because Buffett knows what he is looking for, he can rapidly eliminate from among his investment possibilities those investments that don’t meet his criteria. Think about it, there are some 8000 publicly listed stocks in America and orders of magnitude more closely held businesses. If we expand our universe to global firms we multiply orders of magnitude again, and if we move beyond businesses to also include bonds, commodities, currencies, real estate and other products, not to mention the derivative investments from these, the investment universe becomes impossible to cover effectively.

One must have a system by which one can eliminate the vast majority of uninteresting investments in order to devote time to those that offer the most promise. I had the opportunity to meet a successful technology entrepreneur during my MBA. He had developed a framework which he titled the “Technology Bridge”. The purpose of the bridge was to eliminate technologies weak, for his purpose, commercializing them. Using such as system meant picking the things that would disqualify the most technologies the fastest. Surprisingly, the first thing on the list wasn’t the technology – it was ownership.

Incidentally, there is no “right” formula here. Just because Buffett avoids tech doesn’t mean someone else should. This is part of developing one’s unique investing strategy (which, Professor Porter would remind us involves UNIQUE activities, since advantage comes from doing something different than others).

Key Insight #4 – People are the key

Buffett’s success as a CEO is driven by the fact that he hires great CEOs. Since BH is really a holding company it is vital that the people who control the physical assets, the businesses, treat those assets in a way consistent with shareholder value. The tendency of management to use corporate assets in ways that are more in line with their own interests than those of shareholders (corporate jets, one-way stock options, etc) is known as the “agency problem” and is difficult to control. Buffett’s solution is to simply hire great managers.

Buffett achieves his objective primarily by offering a unique place for owners of businesses to park their business when it is time to diversify. He offers the potential to sell the business but retain control of operations and remain invested in the business (retain a minority stake).

Small investors can follow Buffett’s principles, either by purchasing investments where it is possible to obtain control (real estate, a franchise, small business) or in making retail investments, look first at management and its behaviour.

Key Insight #5 – “Forever” is not Buffett’s only holding period

Buffett has often stated that his (and Charlie Munger’s) favourite holding period for an investment is “forever”. Usually this is linked to his discussion of the “permanent” holdings of BH, such as the Washington Post and Coca-Cola. This is usually taken to mean that the ideal holding period for any security, once purchased, is as long as possible. Based on Buffett’s own actions and comments from both himself and Munger, however, I think we can conclude that “forever” is a holding period that is only appropriate for certain investments.

This statement has been regularly borrowed by the asset management industry as a justification for a buy and hold strategy for investing in securities. Ironically, many of the securities being sold with this justification are actively managed mutual funds with high turnover rates – thus the “buy and hold” investor is actually exposed to rapid portfolio churn. Less ironic and more sobering is the realization that asset managers have a real incentive to advocate such a strategy, since their own compensation is driven by assets-under-management (AuM). Convincing investors to park their money results in an annuity income stream with rising payments over time (as the asset base is increased through regular contributions and, hopefully, investment gains). Such annuity streams of income command high multiples in the event of a sale of the asset management business. (Gains which, it can be assumed, fall disproportionately into the pockets of the managers and only incidentally into the pockets of the investors).

Buffett has done little to clarify or disabuse the public of this understanding. He regularly rails against efforts at active management – noting, rightly, that in the aggregate investors in common stocks cannot beat the market, but they can lag it due to fees, from which we deduce that Buffett favors a “forever” holding strategy in passive index funds.

This year, Buffett discussed the decision of BH to sell a large position in PetroChina. He described his estimate of fair value during the purchase in 2002-2003 and noted that BH has had a huge gain, as intrinsic value has increased along with energy prices and the market has simultaneously increased its understanding of that value. Thus his financial returns have outpaced growth in intrinsic value and he has decided to sell. But how does this square with a “forever” holding period?

One possibility is that he expects energy prices to moderate and for intrinsic value to actually decline in the future. Another is that he does not trust management to continue to generate outsized growth in intrinsic value. But if these are reasons to sell PetroChina, aren’t they actually good reasons to sell other investments as well? Munger echoes this in an earlier post of mine. Investment opportunities are relative. It is true that there is a transaction cost and so there should be a bias toward holding, but if that cost can reasonably be overcome because of more attractive investments or increased risk related to the asset itself, this is still a good idea.

So what should we make of the “forever” as favourite holding period? I take it more attitudinally. There is simply nothing better than an investment that can be held permanently that more or less permanently generates high returns on capital employed, requires little or no additional capital investment and generates massive free cash flow (e.g See’s). Naturally, we would all like to have such investments and then our holding period would be forever. But there is no reason to assume that forever represents a superior investment strategy, in and of itself. Sometimes, selling makes sense.

I equate it to eating dinner. My favourite dinner is steak (filet mignon, rare, please). Given a choice to have anything I want, that is what I would choose. But that doesn’t mean that it is all I have for dinner. Circumstances (like the need for a balanced diet) mean that my “favourite” is not necessarily the best option in all cases.

Key Insight #6 – Long term assets often predict the future

In accounting parlance, an asset is a future benefit (and liabilities future obligations). Therefore, long term assets and liabilities more than current ones, can indicate the future condition of the company. As a good example, we can cite GM, which was forced to write down some $38bn of deferred tax assets. These were estimated cash value of the tax loss carry-forwards that the company could use to offset tax payments on future earnings. By writing them off, GM essentially said that, based on the estimates of management, the company would not generate enough profit to actually take advantage of the carry forwards. Management ought to know, since they are the ones with the 10 and 15 year product, revenue and profit plans. The carry forwards aren’t gone - if the company makes a miraculous recovery, it can still use them, but management does not expect to be able to use them before they expire (over the next 20 years).

Buffett chose my other favourite long-term asset and a friend of any management that wants to manipulate earnings: their pension accounts. I will not go into pension accounting mechanics here (its another post unto itself). But suffice it to say that this line item can be very large and is almost entirely up to management’s opinion about the future. If the estimates seem too rosy, they probably are and the company’s obligations are larger than anticipated. The increase in liability which is sure to be booked in the future will be a major drag on future earnings.

Key Insight #7 – Read the footnotes

This is the crappy part of stock investing. The footnotes to the financial statements are often tortuous, repetitive and almost always boring. But without them an investor cannot really understand the financial statements. The key ones that I always read first, because they help me discard possible investments are the statement of significant accounting principles, equity compensation (stock options), pension rules (estimated rates of return) and goodwill and other impairments (which business units and why).

If these haven’t ruled out the investment then it is then time to read the statements, risk assessment and review of operations and all of the footnotes taken together.

1 comment:

  1. Gauhar Kachchhi5:36 AM, June 07, 2008

    Awesome... :)

    Thank you very much for this interesting and informative article.

    I have read a book by Peter Lynch titled "One Up on the Wall Street", and it was great too.

    I believe it is better to concentrate on a few good stocks rather than to diversify, or to trust a fund manager, who may, despite his enormous knowledge and access to in depth information, have his constraints.

    I still feel reading a Financial Statement is very boring, unless you can understand what the numbers mean, and where he trend is going, and what the current developments in that field of business are, and what would we expect from such changes.

    I love your blog. You are Awesome... :) :D

    ReplyDelete