Sunday, March 08, 2009

Warren Buffett's Letter

Warren Buffett had his worst year ever in 2008. This is not surprising, since it was the worst year for the stock market in Buffett's investing life. Personally, I found the letter thinner on content than usual. There were not pithy observations on accounting rules, nor a simple explanation of the credit markets nor the currency markets. Even his discussion of Berkshire's businesses seemed a bid weak. Only in his explanation of his derivates book did his explanation of his thinking on how to price assets really shine. Nevertheless, I take four points from his letter.

1. Even investing geniuses are still human. Buffett acknowledges many mistakes this year, some are sins of commission and some of omission. As James B. Stewart of Smart Money observes, even Buffett can get caught up in the euphoria. I also made two sins of omission in 2008: not selling Bank of America stock when they acquired Merrill Lynch and not selling Bassett furniture immediately when it became clear that my outlook for the economy (that it would be dismal and that consumer durables would be particularly hard hit) was correct.

In the first case, I liked the strength of the commercial and retail banking franchise of BoA, and assumed that they had an idea of how to integrate Merrill Lynch retail broking and wealth management into their branches, which would be both cost saving and revenue raising at the same time. They may yet execute such a plan, but I suspect that the real hope was to vertically integrate along the asset backed security value chain: originating mortgages, bundling and selling Mortgage Backed Securities (MBS) all in house. That this will be difficult, if not impossible in the short term, is obvious, to say nothing of the credit quality of the combined balance sheet.

In the second case, I was simply blinded by my own assessment that BSET trades for far less than the value of its assets. Indeed, at this point, BSET may be more valuable dead than alive. The real problem was a conditional liability that I missed in the financial statements. Bassett has largely guaranteed their franchisees' leases, and this is a very large number. If, as the market clearly believes likely, many franchisees default, Bassett will be left to find a new tenant, or take over (loss-making) operations directly. Since retail storefronts are now a dime-a-dozen, the probability is quite high, that the company will be left holding the bag for a large amount of non-performing real estate. Ouch. Still, the new store format to which they are migrating does indeed seem to be helping sales, and with a strengthening dollar, the imported furniture that they sell may enable them to maintain margins and supported by cash flows from their investment portfolio, they may get through the next 24 months and recover. One can only hope.

So, sins of omission, but perhaps I shouldn't take it too hard.

2. Buy and hold of passive investments doesn't really work, even for great investors. Buffett has suffered huge declines on his public investments, including American Express, Coca-Cola, Burlington Northern and others. Many are treasured firms whose stock he has owned for years. It begs the question: if the best investor of all time cannot make money "buying and holding" then what should the rest of us do?

In my own portfolio, I have one "permanent" holding, and it is Colgate-Palmolive. This is a stock whose forward dividend yield is now at almost 3%, which continues to raise its dividend by 10% or more per year, which continues to repurchase stock in huge quantities and whose investor-friendly activities are backstopped by rising earnings that I project to be over $4.20 per share in 2009 (providing a dividend coverage ratio of 2.38). Plus, the stock is in a recession-proof business and has avoided making big acquistions. In short, it is the perfect investment.

But I have also watched the value of that investment decline from $80 a share to $56 (I purchased in the low $40s, so I have still had decent returns). Admittedly, at $80 a share in early 2008, it was a bit pricey at 20x forward earnings. Plus, it trades at 10x book (but earns about 90% on book). Why didn't I sell?

The truth is, Buffett has a good reason to have "permanent" holdings. In most cases, his ownership stake is so large and his portfolio so carefully monitored that he would have difficulty disposing of his positions. If Buffett is selling, after all, how exceptional can the value be? Retail investors, myself included, lack this rationale. Even if we hold a few blocks, and few of us do, our transactions are unlike to affect the markets, unless the stocks involved are very thinly traded. So, I conclude that the focus on "permanent" holdings, indeed the very idea of "buy and hold" is mostly the result of a desire for reassurance. Psychologically, we want to believe that we are "right" and that means keeping that which we own.

At these prices though, I am looking to add to my CL holdings, not reduce them. I still believe this is a $100 stock in 24 months, unless equity valuations completely implode, which is possible, but then, it will simply mean that I will have a rising annuity with higher yields than most bonds and insurance products. Not too shabby. More on this in another post.

3. Management counts. The secret of Buffett's success has always been in his ability to recruit the right people. As a investor, he has sought in most cases to have them in situ. He does mention that he has developed a few of his best managers, though obviously they were already natural talents.

As a passive investor, I pay a huge amount of money to professional managers who run my businesses for me. How they do it is probably the single biggest determinant of success or failure. But here, I think point one still applies. Even great managers make mistakes. Ken Lewis is a natural deal-maker - it is how he built BoA into the powerhouse that it is. He made a mistake buying Merrill, and sadly, this was a mistake that was driven by ego.

Lewis always wanted to show the New York crowd that a hick from North Carolina was at least as good as they were. They always looked down on him for building a commercial and retail bank, since everyone in banking knows that the "big swinging dicks" of banking are all "investment" bankers. Acquiring Merrill was Lewis' way to do it. But Lewis' careful and steady build-up of a leading commercial/retail bank was stupendously profitable. Even the disaster with Countrywide was manageable given the strength of the cashflows from the retail network. It remains to be seen if a universal bank can truly be made to function - the economics and compensation may simply be too far apart. For the forseeable future, though, Lewis will be out of dealmaking and will instead have to focus on operations. Is he the right manager for that?

4. Panic and fear are my friends. In spite of my losses on a few securities, I managed to liquidate most of my holdings in April of 2007, when the Dow was at 12,500. I missed the October top, but I have not regretted sitting in cash, where my interest earned actually afforded my a mild gain in 2008. Now, I sit confidently and wait for values to keep coming my way, confident in the meantime that I can suffer no major permanent impairment to capital. Low interest rates now make solid dividend yielding stocks the ideal area to look, though this does expose one to at least temporary capital loss.

In January, I did reenter the market, buying HELE aggressively, only to suffer another loss. However, the stock trades at a clear discount to intrinsic value and I may very well purchase more soon. The problem is, there are even more attractive values now than there were in January.

So, while I believe that the economic bottom will be reached at the earliest sometime in 2010, I continue to watch for individual values, knowing that the market is likely to continue downward movement due to panic selling of index funds by retail investors. I look forward to having a chance to make some significant gains in the next few years.

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