***Updated***
Warren Buffett writes about what he describes as "the prototype of a dream business" in the 2007 Berkshire Hathaway (BRKa) Shareholder Letter:
"Let's look at the prototype of a dream business, our own See's Candy. The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn't grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See's, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry's earnings."
So, beyond See's, there just isn't much profitability to be had in the boxed-chocolates industry.
As far as volume growth goes:
- From 1972 to 2007, the growth rate of See's was roughly 2% in terms of volume.
- 16 million pounds of chocolate was being sold each year when Berkshire bought See's in 1972.
- At that 2% growth rate, volume had increased to roughly twice that amount when he wrote the 2007 letter.
So why exactly is this a "dream business?"
During this feature last year on See's, Charlie Munger highlighted the following about the reasons for their business success in an industry that actually hasn't done all that well overall.
Warren and Charlie and the Chocolate Factory
Charlie Munger said:
- They've made lots of correct decisions before and after Berkshire's purchase
- They've worked hard to avoid cannibalization of its stores
- They've got a cautious nature that led to long-term success
Their cautious nature, in part, means they didn't chase low return growth for its own sake. Munger also points out that "We haven't basically touched it at all" and highlighted the importance of See's as a gift:
"Who wants to give a gift that announces 'I'm a cheap ... ' You know."
In the same article, Warren Buffett said this:
"It was sort of the first non-insurance company we bought, or non-financial type company, and so I used to spend a lot of time. I used to be able to tell you which store numbers were which stores. But that's because we didn't have any other companies. Now we have 70-something companies."
Buffett later also said this about See's:
"We almost missed it. Charlie wouldn't have missed it. I would have missed it, and I would have never known what I missed."
Still, this doesn't really quite explain what makes See's such a great business.
Well, it's basically a great business because of durable competitive advantages that were built up over time.
Put simply, it's a great regional brand with "share of mind" developed over many years, primarily in California, that provides the pricing power. It's the fact that the business can at least maintain its competitive advantages with rather modest incremental capital requirements.
Back in 1998, Warren Buffett said the following about See's Candy at the University of Florida:
Buffett at Univerisity of Florida 1998
"We bought See's Candy in 1972, See's Candy was then selling 16 m. pounds of candy at a $1.95 a pound and it was making 2 bits a pound or $4 million pre-tax. We paid $25 million for it—6.25 x pre-tax or about 10x after-tax. It took no capital to speak of. When we looked at that business—basically, my partner, Charlie, and I—we needed to decide if there was some untapped pricing power there. Where that $1.95 box of candy could sell for $2 to $2.25. If it could sell for $2.25 or another $0.30 per pound that was $4.8 on 16 million pounds. Which on a $25 million purchase price was fine. We never hired a consultant in our lives; our idea of consulting was to go out and buy a box of candy and eat it.
What we did know was that they had share of mind in California. There was something special. Every person in California has something in mind about See's Candy and overwhelmingly it was favorable."
Buffett later added...
"I bought it in 1972, and every year I have raised prices on Dec. 26th, the day after Christmas, because we sell a lot on Christmas."
The fact is, most don't buy boxed chocolate for themselves, they buy them as gifts. Christmas is the biggest season of the year -- more than 90% of the earnings from the business back in 1998 comes from the three weeks prior to Christmas -- while Valentine's Day is the single biggest day:
"Guilt, guilt, guilt—guys are veering off the highway right and left. They won't dare go home without a box of chocolates by the time we get through with them on our radio ads. So that Valentine's Day is the biggest day.
Can you imagine going home on Valentine's Day—our See's Candy is now $11 a pound thanks to my brilliance. And let's say there is candy available at $6 a pound. Do you really want to walk in on Valentine's Day and hand—she has all these positive images of See's Candy over the years—and say, 'Honey, this year I took the low bid.' And hand her a box of candy. It just isn't going to work. So in a sense, there is untapped pricing power—it is not price dependent."
It takes some discipline to run a business where basically everything it earns happens around two holidays.
When Berkshire bought See's back in 1972, the capital required was around $ 8 million. The return on that invested capital was already very attractive (roughly 50-60% pre-tax) when they bought the business, but it has only become more so over time as they've raised prices. More from the 2007 Berkshire letter:
"Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories.
Last year See's sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See's has given birth to multiple new streams of cash for us. (The biblical command to 'be fruitful and multiply' is one we take seriously at Berkshire.)"
All that from a business that has grown volumes just 2% annually. The key thing to consider is that if a business can raise price a certain percentage each year and it mostly sticks (i.e. there's no real hit to volume), the increase all falls to the bottom line after taxation. If that same business instead had a similar percentage increase in revenue via greater unit volume, there inevitably has to be an incremental cost -- sometimes significant -- associated with each additional unit. The result being -- at least when there's real pricing power -- not as much of an equivalent increase in revenue actually falls to the bottom line.*
In fact, the added unit volume might also require more capital to be employed.
Either way, it should mean less return on capital compared to just increasing the price of a powerful brand.
Of course, a good business might offer both opportunities to pursue high return increased pricing as well as high return incremental volume. It's just that sometimes an easier way to generate returns exists (via an increase to price), but the harder thing to do (increases to sales sometimes at reduced prices) is pursued with the justification being to grab market share or something similar.
I'm not saying it's not that it never makes sense to grab market share. I'm suggesting that, from an owner's point of view, it probably is at least worth being a little skeptical when you see this being pursued as a prolonged strategy.
(This, of course, necessarily comes down to the specifics of the competitive landscape, technology shifts, unique advantages and disadvantages of each individual business, etc.)
I'm also not saying that sometimes it makes sense to invest in a big opportunity now with a bigger payoff in mind much further down the road. It's worth mentioning that some of the best businesses can afford to forgo near-term profitability -- sometimes even for an extended period of time -- while they build out a great franchise (developing brand and distribution in a new region, for example) for the long-term.
Tom Russo: First Mover Advantage and the "Capacity to Suffer"
The best also have the financial wherewithal and competitive strength to invest in such things.
More on See's in a follow up.
Adam
Related posts:
Aesop's Investment Axiom - February 2013
Grantham: Investing in a Low-Growth World - February 2013
Buffett: Stocks, Bonds, and Coupons - January 2013
Maximizing Per-Share Value - October 2012
Death of Equities Greatly Exaggerated - August 2012
Stock Returns & GDP Growth - July 2012
Why Growth Matters Less Than Investors Think - July 2012
Ben Graham: Better Than Average Expected Growth - March 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Buffett: What See's Taught Us - May 2011
Buffett on Coca-Cola, See's & Railroads - May 2011
Buffett on Pricing Power - February 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - June 2010
High Growth Doesn't Equal High Investor Returns - July 2009
The Growth Myth Revisited - July 2009
Pricing Power - July 2009
The Growth Myth - June 2009
Buffett on Economic Goodwill - April 2009
Long position in BRKb established at much lower than recent prices
* Even if a modest drop in volume were to occur, the increased price may still make sense as far as total return goes. It all comes down to how much pricing power actually exists. What some might describe as being price inelastic.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.
Showing posts with label Berkshire Shareholder Letter Highlights: 2007-Present. Show all posts
Showing posts with label Berkshire Shareholder Letter Highlights: 2007-Present. Show all posts
Wednesday, June 19, 2013
Friday, April 19, 2013
Berkshire's Manufacturing, Service and Retailing Operations
Berkshire Hathaway's (BRKa) Manufacturing, Service and Retailing Operations covers, as Warren Buffett says, everything from "lollipops to jet airplanes". These businesses earned $ 3.7 billion combined in 2012.
Buffett said the following about the group of wide-ranging businesses in the latest Shareholder Letter:
"...we are getting a decent return on the capital we have deployed in this sector. Furthermore, the intrinsic value of the businesses, in aggregate, exceeds their carrying value by a good margin. Even so, the difference between intrinsic value and carrying value in the insurance and regulated industry segments is far greater. It is there that the huge winners reside."
Specific examples of businesses in this sector include (in no particular order): Benjamin Moore, Dairy Queen, Nebraska Furniture Mart, and See's Candy, Fruit of The Loom, Russel Athletic Apparel, NetJets, The Pampered Chef, Business Wire, Iscar Metalworking, The Marmon Group, McLane Company, Shaw Industries, Johns Manville, and Lubrizol among many others.
Some might be surprised to hear Buffett say that the biggest difference between intrinsic value and carry value comes from the insurance and the regulated, capital intensive businesses. A reflection of the inherent limitations of accounting.
Of course, as I've mentioned in earlier posts, how effectively capital is allocated* going forward will have a great impact on Berkshire's intrinsic value over time. The quality of future capital allocation is a significant factor over the long haul even if it may be hard to estimate in advance:
"We, as well as many other businesses, are likely to retain earnings over the next decade that will equal, or even exceed, the capital we presently employ. Some companies will turn these retained dollars into fifty-cent pieces, others into two-dollar bills.
This 'what-will-they-do-with-the-money' factor must always be evaluated along with the 'what-do-we-have-now' calculation in order for us, or anybody, to arrive at a sensible estimate of a company's intrinsic value." - From Page 104-105 of the 2012 Annual Report (initially seen in the letter of the 2010 Annual Report)
That something happens to be difficult to measure makes it no less important. Sometimes, the hard to quantify stuff matters a whole lot while the easier to quantity stuff matters little. It can be a big mistake to overweight something just because it happens to be easily measurable while underweighting to tough to measure but far more important.
"Not everything that counts can be counted, and not everything that can be counted counts." - Sign hanging in Albert Einstein's office at Princeton
"...practically (1) everybody overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that." - - Charlie Munger in this speech at UC Santa Barbara
Berkshire also has some value in the Finance and Financial Products sector but its contribution to Berkshire remains rather small. That sector includes things like XTRA, CORT, Clayton Homes, and Berkadia Commercial Mortgage.
In total, Berkshire now owns 68 different non-insurance companies.
The bulk of Berkshire's intrinsic value comes from investments (funded, in part, by cheap or often even better than free float provided by the insurance businesses and retained earnings), earnings from the non-insurance businesses**, plus the very important but more difficult to quantify "'what-will-they-do-with-the-money factor".
Check out page 104-105 of the 2012 Annual Report for Warren Buffett's complete explanation of how to think about Berkshire's intrinsic value.
Adam
Long position in Berkshire established at much lower than recent prices
* As do frictional costs. Berkshire is currently built to minimize frictional costs and, even if certain expenses seem very likely to go up, there's little reason to think their low cost ways will change in a material way going forward. Berkshire's inherently low frictional costs is no small advantage.
** Earnings from sources other than what's produced by investments and the insurance underwriting.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.
Buffett said the following about the group of wide-ranging businesses in the latest Shareholder Letter:
"...we are getting a decent return on the capital we have deployed in this sector. Furthermore, the intrinsic value of the businesses, in aggregate, exceeds their carrying value by a good margin. Even so, the difference between intrinsic value and carrying value in the insurance and regulated industry segments is far greater. It is there that the huge winners reside."
Specific examples of businesses in this sector include (in no particular order): Benjamin Moore, Dairy Queen, Nebraska Furniture Mart, and See's Candy, Fruit of The Loom, Russel Athletic Apparel, NetJets, The Pampered Chef, Business Wire, Iscar Metalworking, The Marmon Group, McLane Company, Shaw Industries, Johns Manville, and Lubrizol among many others.
Some might be surprised to hear Buffett say that the biggest difference between intrinsic value and carry value comes from the insurance and the regulated, capital intensive businesses. A reflection of the inherent limitations of accounting.
Of course, as I've mentioned in earlier posts, how effectively capital is allocated* going forward will have a great impact on Berkshire's intrinsic value over time. The quality of future capital allocation is a significant factor over the long haul even if it may be hard to estimate in advance:
"We, as well as many other businesses, are likely to retain earnings over the next decade that will equal, or even exceed, the capital we presently employ. Some companies will turn these retained dollars into fifty-cent pieces, others into two-dollar bills.
This 'what-will-they-do-with-the-money' factor must always be evaluated along with the 'what-do-we-have-now' calculation in order for us, or anybody, to arrive at a sensible estimate of a company's intrinsic value." - From Page 104-105 of the 2012 Annual Report (initially seen in the letter of the 2010 Annual Report)
That something happens to be difficult to measure makes it no less important. Sometimes, the hard to quantify stuff matters a whole lot while the easier to quantity stuff matters little. It can be a big mistake to overweight something just because it happens to be easily measurable while underweighting to tough to measure but far more important.
"Not everything that counts can be counted, and not everything that can be counted counts." - Sign hanging in Albert Einstein's office at Princeton
"...practically (1) everybody overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that." - - Charlie Munger in this speech at UC Santa Barbara
Berkshire also has some value in the Finance and Financial Products sector but its contribution to Berkshire remains rather small. That sector includes things like XTRA, CORT, Clayton Homes, and Berkadia Commercial Mortgage.
In total, Berkshire now owns 68 different non-insurance companies.
The bulk of Berkshire's intrinsic value comes from investments (funded, in part, by cheap or often even better than free float provided by the insurance businesses and retained earnings), earnings from the non-insurance businesses**, plus the very important but more difficult to quantify "'what-will-they-do-with-the-money factor".
Check out page 104-105 of the 2012 Annual Report for Warren Buffett's complete explanation of how to think about Berkshire's intrinsic value.
Adam
Long position in Berkshire established at much lower than recent prices
* As do frictional costs. Berkshire is currently built to minimize frictional costs and, even if certain expenses seem very likely to go up, there's little reason to think their low cost ways will change in a material way going forward. Berkshire's inherently low frictional costs is no small advantage.
** Earnings from sources other than what's produced by investments and the insurance underwriting.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.
Wednesday, April 10, 2013
Berkshire's Regulated, Capital-Intensive Businesses
Berkshire Hathaway (BRKa) has two large operations, BNSF and MidAmerican, that, due to their capital-intensiveness, are quite different from most of their other businesses. From the latest Shareholder Letter:
"A key characteristic of both companies is their huge investment in very long-lived, regulated assets, with these partially funded by large amounts of long-term debt that is not guaranteed by Berkshire. Our credit is in fact not needed because each business has earning power that even under terrible conditions amply covers its interest requirements."
BNSF and MidAmerican combined earned $ 4.84 billion ($ 4.7 applicable to Berkshire) in 2012.
Some things that were also highlighted about these two businesses in the letter:
BNSF carries roughly 15% of all inter-city freight and, in fact, the railroad moves more ton-miles of goods than anyone else (truck, rail, water, air, or pipeline).
BNSF carries a ton of cargo roughly 500 miles on a gallon of diesel fuel. Trucks use about four times as much.
MidAmerican's utilities serve ten states. Only one other utility in the U.S. serves more. The utility accounts for 6% of the U.S. wind generation and ~ 14% of solar-generation capacity.
These projects are huge commitments of capital for Berkshire. The renewable energy investments will have cost Berkshire $13 billion once completed. In the letter, Warren Buffett says they "relish" these investments as long as they promise at least reasonable returns.
"...on that front, we put a large amount of trust in future regulation.
Our confidence is justified both by our past experience and by the knowledge that society will forever need massive investment in both transportation and energy. It is in the self-interest of governments to treat capital providers in a manner that will ensure the continued flow of funds to essential projects. And it is in our self-interest to conduct our operations in a manner that earns the approval of our regulators and the people they represent.
Our managers must think today of what the country will need far down the road. Energy and transportation projects can take many years to come to fruition; a growing country simply can’t afford to get behind the curve."
Buffett added this about infrastructure:
"Whatever you may have heard about our country's crumbling infrastructure in no way applies to BNSF or railroads generally. America's rail system has never been in better shape, a consequence of huge investments by the industry. We are not, however, resting on our laurels: BNSF will spend about $4 billion on the railroad in 2013, roughly double its depreciation charge and more than any railroad has spent in a single year."
In total, Berkshire invested $9.8 billion on plant and equipment in 2012 across all of its businesses (19% higher than the previous year and 88% of it in the United States). They should spend even more on plant and equipment in 2013.
Now, consider if going forward -- and I've covered this in previous posts -- Warren Buffett were paid just the 2% portion of the 2 and 20 compensation structure that's often used by the hedge fund industry. A structure that's commonly used even if there are many variations to it.
(2 and 20: 2% of assets under management plus 20% of the profits usually above a certain level.)
If so, Buffett would be paid, give or take, $ 3.6 billion (again, for just the 2% portion multiplied by the roughly $ 180 billion in Berkshire investments) over the next year instead of the $ 100,000 per year he's been getting paid for a very long time.* Over the long haul those incremental funds would either have to come out of the company's earnings (and, even for a company the size of Berkshire, that'd be a real hit to earnings) or that $ 9.8 billion (and growing) of plant and equipment.
(Over the short run they could borrow, of course, to fund the huge new compensation cost but that's obviously a nonsensical use of debt.)
Either way, over time, it would have a meaningful immediate negative impact on Berkshire's intrinsic value (mostly due to reduced earnings capacity now, of course, but also due to having less incremental capital to allocate over time) and lots of likely quite useful infrastructure wouldn't be built by the company (though the money paid to Buffett would surely flow into the economy in other ways over time).**
Certain types of assets require capital not only in meaningful amounts, but also enough investors with the patience, discipline, and willingness to provide funding with the long-term in mind. Big financial scale focused on outcomes that require longer time frames to come to fruition. There's a price paid for short-termism and excessive frictional costs. Maybe if there was more wise capital development, fewer casino-like activities (bets on near-term price movements), and reduced frictional costs (Jeremy Grantham once said when fees are raised "we actually raid the balance sheet") we'd end up with better long-term outcomes. More actual wealth creating activities instead of less than zero-sum -- at least in the aggregate due to the frictional costs if not fund by fund -- activities. I'm certainly in that camp even if I realize that fixing the problem will be difficult at best.
Obviously, these fees are currently what the market will pay for these investment services but there are and have been important economic consequences to the norms as they've evolved over time. Tough to measure precisely, but real and hardly ideal. I certainly can't blame anyone whose able to get these kinds of fees for high performance. That doesn't mean that, in its current form, it's a wonderful system in totality.
There's also the hidden cost of the brain drain by the way. Lots of engineering and scientific talent "distracted".
(Can't say I really blame them either. They're just going where the money currently is.)
No one can know whether a bridge or something else useful wasn't built because of the current flaws. Counterfactuals are a tough sell for a good reason. I've focused on Berkshire's capital intensive businesses as one example but this issue clearly doesn't just apply to infrastructure. Most really useful innovations and hard to solve problems require patient capital of all kinds, allocated wisely, and in meaningful quantities.
(There continues to be no shortage of incredibly dynamic and innovative capacities around the world. That hasn't changed. I'm merely suggesting that the way some parts of the financial system currently operates is one real factor that puts unnecessary wind in the face of that dynamism.)
The bulk of Berkshire's intrinsic value comes from their investments (stocks, bonds, cash and equivalents) funded, in part, by low cost insurance float, earnings from the non-insurance businesses plus, as explained on page 104-105 of the 2012 Annual Report, the quality of future capital allocation. The quality of what will be done with the funds over time might be difficult to estimate but it's no less real. Each must be considered to make a reasonable judgment of intrinsic value:
"This 'what-will-they-do-with-the-money' factor must always be evaluated along with the 'what-do-we-have-now' calculation in order for us, or anybody, to arrive at a sensible estimate of a company's intrinsic value. That's because an outside investor stands by helplessly as management reinvests his share of the company's earnings. If a CEO can be expected to do this job well, the reinvestment prospects add to the company's current value; if the CEO's talents or motives are suspect, today's value must be discounted. The difference in outcome can be huge. A dollar of then-value in the hands of Sears Roebuck's or Montgomery Ward's CEOs in the late 1960s had a far different destiny than did a dollar entrusted to Sam Walton." - From Page 105 of the 2012 Annual Report (initially seen in the letter of the 2010 Annual Report)
To that I'd add the frictional cost of the capital allocation. Buffett doesn't need to mention frictional costs in his intrinsic value calculation because Berkshire is, at its core, built to minimize these costs. I mean, I think it's more than fair to say that the frictional costs at Berkshire are very low compared to the assets being managed and compared to just about any other investment vehicle.***
At least it is for now.
If those frictional costs were to become materially higher down the road, the intrinsic value of Berkshire -- or any other business/investment vehicle for that matter -- would plainly be reduced.
(Berkshire's frictional costs seem certain to become somewhat higher in the future but likely not enough to matter much. Materially higher frictional costs would seem to be a stretch considering the company's culture and the way it is structured.)
It certainly couldn't hurt the world if more long-term oriented capital allocation, done at some scale, with more modest system-wide frictional costs was encouraged. Those that manage large amounts of money but generally make shorter term bets -- especially if done for rather lucrative fees -- are playing an entirely different game. Whether one thinks, as I do, that both speculation and investment (and I realize sometimes the line between the two seem blurred) are necessary for a healthy system, the proportion still matters. As does the cost. As it stands, the frictional costs and the proportion of actual long-term capital allocation compared to short-term bets on price action seem far from being at healthy or optimal levels.
Not all what's loosely often described as capital allocation is created equal. If something at least directionally closer to the Berkshire model (and that doesn't require literally entering the insurance business) were to become the norm it wouldn't be a bad thing at all.
Adam
Long position in BRKb established at much lower than recent prices
* 2% of the more than $ 180 billion in Berkshire investments does exclude all the operating businesses. Of course, he'd get paid much more if he were to also get the 20% of investment-related profits. Oh, and then there's the operating businesses with nearly 300,000 employees that earn, give or take, $ 10 billion per year (that number excludes Berkshire's investment related returns). I mean, some pay for those additional responsibilities wouldn't seem unreasonable...
Buffett's wealth over the past 40 plus years has come almost exclusively from appreciation of his Berkshire shares not from fees paid for the privilege of his investing skills (though he was certainly paid fees before he shut down the partnerships back in the 60s). The capital he put at risk inside Berkshire long ago is the primary basis of his substantial wealth. For his entire time as CEO his salary hasn't exceeded $ 100,000 (it was at one time less than $ 100,000). As in previous years, he received no stock, stock options, or bonuses last year but Berkshire does cover his security costs.
** It's still, at least, a "detour" along the way to the funds becoming a more long-term oriented capital investment. Of course, since in this hypothetical instance it would be in the hands of Warren Buffett, those funds seems rather likely to be put to good use sooner than later.
*** An apples-to-apples comparison to hedge fund frictional costs would also include all the operating costs of Berkshire's corporate office (though much of those costs are presumably related to the operating businesses Berkshire owns outright) and related (including the costs associated with the two investment managers). Consider how small these costs are in the context of Berkshire's assets overall. The difference in frictional costs is still measured in orders of magnitude compared to a typical hedge fund. So let's not split hairs. This difference, I think, speaks for itself.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.
"A key characteristic of both companies is their huge investment in very long-lived, regulated assets, with these partially funded by large amounts of long-term debt that is not guaranteed by Berkshire. Our credit is in fact not needed because each business has earning power that even under terrible conditions amply covers its interest requirements."
BNSF and MidAmerican combined earned $ 4.84 billion ($ 4.7 applicable to Berkshire) in 2012.
Some things that were also highlighted about these two businesses in the letter:
BNSF carries roughly 15% of all inter-city freight and, in fact, the railroad moves more ton-miles of goods than anyone else (truck, rail, water, air, or pipeline).
BNSF carries a ton of cargo roughly 500 miles on a gallon of diesel fuel. Trucks use about four times as much.
MidAmerican's utilities serve ten states. Only one other utility in the U.S. serves more. The utility accounts for 6% of the U.S. wind generation and ~ 14% of solar-generation capacity.
These projects are huge commitments of capital for Berkshire. The renewable energy investments will have cost Berkshire $13 billion once completed. In the letter, Warren Buffett says they "relish" these investments as long as they promise at least reasonable returns.
"...on that front, we put a large amount of trust in future regulation.
Our confidence is justified both by our past experience and by the knowledge that society will forever need massive investment in both transportation and energy. It is in the self-interest of governments to treat capital providers in a manner that will ensure the continued flow of funds to essential projects. And it is in our self-interest to conduct our operations in a manner that earns the approval of our regulators and the people they represent.
Our managers must think today of what the country will need far down the road. Energy and transportation projects can take many years to come to fruition; a growing country simply can’t afford to get behind the curve."
Buffett added this about infrastructure:
"Whatever you may have heard about our country's crumbling infrastructure in no way applies to BNSF or railroads generally. America's rail system has never been in better shape, a consequence of huge investments by the industry. We are not, however, resting on our laurels: BNSF will spend about $4 billion on the railroad in 2013, roughly double its depreciation charge and more than any railroad has spent in a single year."
In total, Berkshire invested $9.8 billion on plant and equipment in 2012 across all of its businesses (19% higher than the previous year and 88% of it in the United States). They should spend even more on plant and equipment in 2013.
Now, consider if going forward -- and I've covered this in previous posts -- Warren Buffett were paid just the 2% portion of the 2 and 20 compensation structure that's often used by the hedge fund industry. A structure that's commonly used even if there are many variations to it.
(2 and 20: 2% of assets under management plus 20% of the profits usually above a certain level.)
If so, Buffett would be paid, give or take, $ 3.6 billion (again, for just the 2% portion multiplied by the roughly $ 180 billion in Berkshire investments) over the next year instead of the $ 100,000 per year he's been getting paid for a very long time.* Over the long haul those incremental funds would either have to come out of the company's earnings (and, even for a company the size of Berkshire, that'd be a real hit to earnings) or that $ 9.8 billion (and growing) of plant and equipment.
(Over the short run they could borrow, of course, to fund the huge new compensation cost but that's obviously a nonsensical use of debt.)
Either way, over time, it would have a meaningful immediate negative impact on Berkshire's intrinsic value (mostly due to reduced earnings capacity now, of course, but also due to having less incremental capital to allocate over time) and lots of likely quite useful infrastructure wouldn't be built by the company (though the money paid to Buffett would surely flow into the economy in other ways over time).**
Certain types of assets require capital not only in meaningful amounts, but also enough investors with the patience, discipline, and willingness to provide funding with the long-term in mind. Big financial scale focused on outcomes that require longer time frames to come to fruition. There's a price paid for short-termism and excessive frictional costs. Maybe if there was more wise capital development, fewer casino-like activities (bets on near-term price movements), and reduced frictional costs (Jeremy Grantham once said when fees are raised "we actually raid the balance sheet") we'd end up with better long-term outcomes. More actual wealth creating activities instead of less than zero-sum -- at least in the aggregate due to the frictional costs if not fund by fund -- activities. I'm certainly in that camp even if I realize that fixing the problem will be difficult at best.
Obviously, these fees are currently what the market will pay for these investment services but there are and have been important economic consequences to the norms as they've evolved over time. Tough to measure precisely, but real and hardly ideal. I certainly can't blame anyone whose able to get these kinds of fees for high performance. That doesn't mean that, in its current form, it's a wonderful system in totality.
There's also the hidden cost of the brain drain by the way. Lots of engineering and scientific talent "distracted".
(Can't say I really blame them either. They're just going where the money currently is.)
No one can know whether a bridge or something else useful wasn't built because of the current flaws. Counterfactuals are a tough sell for a good reason. I've focused on Berkshire's capital intensive businesses as one example but this issue clearly doesn't just apply to infrastructure. Most really useful innovations and hard to solve problems require patient capital of all kinds, allocated wisely, and in meaningful quantities.
(There continues to be no shortage of incredibly dynamic and innovative capacities around the world. That hasn't changed. I'm merely suggesting that the way some parts of the financial system currently operates is one real factor that puts unnecessary wind in the face of that dynamism.)
The bulk of Berkshire's intrinsic value comes from their investments (stocks, bonds, cash and equivalents) funded, in part, by low cost insurance float, earnings from the non-insurance businesses plus, as explained on page 104-105 of the 2012 Annual Report, the quality of future capital allocation. The quality of what will be done with the funds over time might be difficult to estimate but it's no less real. Each must be considered to make a reasonable judgment of intrinsic value:
"This 'what-will-they-do-with-the-money' factor must always be evaluated along with the 'what-do-we-have-now' calculation in order for us, or anybody, to arrive at a sensible estimate of a company's intrinsic value. That's because an outside investor stands by helplessly as management reinvests his share of the company's earnings. If a CEO can be expected to do this job well, the reinvestment prospects add to the company's current value; if the CEO's talents or motives are suspect, today's value must be discounted. The difference in outcome can be huge. A dollar of then-value in the hands of Sears Roebuck's or Montgomery Ward's CEOs in the late 1960s had a far different destiny than did a dollar entrusted to Sam Walton." - From Page 105 of the 2012 Annual Report (initially seen in the letter of the 2010 Annual Report)
To that I'd add the frictional cost of the capital allocation. Buffett doesn't need to mention frictional costs in his intrinsic value calculation because Berkshire is, at its core, built to minimize these costs. I mean, I think it's more than fair to say that the frictional costs at Berkshire are very low compared to the assets being managed and compared to just about any other investment vehicle.***
At least it is for now.
If those frictional costs were to become materially higher down the road, the intrinsic value of Berkshire -- or any other business/investment vehicle for that matter -- would plainly be reduced.
(Berkshire's frictional costs seem certain to become somewhat higher in the future but likely not enough to matter much. Materially higher frictional costs would seem to be a stretch considering the company's culture and the way it is structured.)
It certainly couldn't hurt the world if more long-term oriented capital allocation, done at some scale, with more modest system-wide frictional costs was encouraged. Those that manage large amounts of money but generally make shorter term bets -- especially if done for rather lucrative fees -- are playing an entirely different game. Whether one thinks, as I do, that both speculation and investment (and I realize sometimes the line between the two seem blurred) are necessary for a healthy system, the proportion still matters. As does the cost. As it stands, the frictional costs and the proportion of actual long-term capital allocation compared to short-term bets on price action seem far from being at healthy or optimal levels.
Not all what's loosely often described as capital allocation is created equal. If something at least directionally closer to the Berkshire model (and that doesn't require literally entering the insurance business) were to become the norm it wouldn't be a bad thing at all.
Adam
Long position in BRKb established at much lower than recent prices
* 2% of the more than $ 180 billion in Berkshire investments does exclude all the operating businesses. Of course, he'd get paid much more if he were to also get the 20% of investment-related profits. Oh, and then there's the operating businesses with nearly 300,000 employees that earn, give or take, $ 10 billion per year (that number excludes Berkshire's investment related returns). I mean, some pay for those additional responsibilities wouldn't seem unreasonable...
Buffett's wealth over the past 40 plus years has come almost exclusively from appreciation of his Berkshire shares not from fees paid for the privilege of his investing skills (though he was certainly paid fees before he shut down the partnerships back in the 60s). The capital he put at risk inside Berkshire long ago is the primary basis of his substantial wealth. For his entire time as CEO his salary hasn't exceeded $ 100,000 (it was at one time less than $ 100,000). As in previous years, he received no stock, stock options, or bonuses last year but Berkshire does cover his security costs.
** It's still, at least, a "detour" along the way to the funds becoming a more long-term oriented capital investment. Of course, since in this hypothetical instance it would be in the hands of Warren Buffett, those funds seems rather likely to be put to good use sooner than later.
*** An apples-to-apples comparison to hedge fund frictional costs would also include all the operating costs of Berkshire's corporate office (though much of those costs are presumably related to the operating businesses Berkshire owns outright) and related (including the costs associated with the two investment managers). Consider how small these costs are in the context of Berkshire's assets overall. The difference in frictional costs is still measured in orders of magnitude compared to a typical hedge fund. So let's not split hairs. This difference, I think, speaks for itself.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.
Friday, March 22, 2013
Warren Buffett on "The Key to Investing"
Warren Buffett had this to say in a Fortune article that was written as the tech bubble was coming to an end:
"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."
In the article, Buffett also points out that many of the most "glamorous" businesses -- many that have changed the world dramatically for the better -- did not ultimately reward their investors.
One often has little to do with the other.
At the time, he was saying that stocks, due to excessive valuations and the high expectations of investors, were likely to disappoint (of course, he supposedly didn't get the "new paradigm"). Yet, Buffett was still optimistic that the businesses themselves would keep increasing in value and that, over time, investors would be "considerably wealthier, simply because the American business establishment that they own will have been chugging along, increasing its profits..."
The intrinsic worth of American business has been increasing since that article was written. Businesses just needed a good chunk of the past decade plus for the per-share value to catch up to the then prevailing premium market prices.
At the time that article was written, Buffett made it clear he wasn't predicting what stock prices might do in the near-term or even longer. Those who have read and listened to him over the years knows Buffett has never really been interested in that sort of thing.
Instead, he was thinking in terms of how price compared to valuation, and likely longer term outcomes, not trying to predict price action. Eventually, value is what counts, but individual marketable securities, and markets more generally, are capable of moving in ways that have little to do with value for very long periods of time.
The intrinsic worth of American business might be increasing over time, but stock prices may not necessarily reflect that until much later.
So while valuations may be less nonsensical these days, it still reveals nothing about what stocks might do over the next several years. Attempting to judge where market prices stand in relation to per-share value is time well spent. Guessing what the price action might be over the next month or even several years is not.
Buffett added this in the most recent Berkshire Hathaway (BRKa) Shareholder Letter:
"American business will do fine over time. And stocks will do well just as certainly, since their fate is tied to business performance. Periodic setbacks will occur, yes, but investors and managers are in a game that is heavily stacked in their favor. (The Dow Jones Industrials advanced from 66 to 11,497 in the 20th Century, a staggering 17,320% increase that materialized despite four costly wars, a Great Depression and many recessions. And don't forget that shareholders received substantial dividends throughout the century as well.)
Since the basic game is so favorable, Charlie and I believe it's a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of 'experts,' or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it."
It's understandable, even if not particularly enriching, that investors and other market participants weigh the risk of loss versus the possibility of gains asymmetrically.
Loss aversion is a very powerful thing.*
Having said that, those who think they can "dance in and out" effectively (and many certainly seem to try!) might want to carefully consider the last line in the above excerpt from the letter.
Adam
* Those who underestimate the potential impact of loss aversion on long-term results are likely making an expensive mistake. This potent bias can be, to an extent, overcome, but requires first that it be taken seriously followed by some kind of trained response to counter it. For me, learning to manage the tendency only begins with an awareness of and respect for its significance.
"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."
In the article, Buffett also points out that many of the most "glamorous" businesses -- many that have changed the world dramatically for the better -- did not ultimately reward their investors.
One often has little to do with the other.
At the time, he was saying that stocks, due to excessive valuations and the high expectations of investors, were likely to disappoint (of course, he supposedly didn't get the "new paradigm"). Yet, Buffett was still optimistic that the businesses themselves would keep increasing in value and that, over time, investors would be "considerably wealthier, simply because the American business establishment that they own will have been chugging along, increasing its profits..."
The intrinsic worth of American business has been increasing since that article was written. Businesses just needed a good chunk of the past decade plus for the per-share value to catch up to the then prevailing premium market prices.
At the time that article was written, Buffett made it clear he wasn't predicting what stock prices might do in the near-term or even longer. Those who have read and listened to him over the years knows Buffett has never really been interested in that sort of thing.
Instead, he was thinking in terms of how price compared to valuation, and likely longer term outcomes, not trying to predict price action. Eventually, value is what counts, but individual marketable securities, and markets more generally, are capable of moving in ways that have little to do with value for very long periods of time.
The intrinsic worth of American business might be increasing over time, but stock prices may not necessarily reflect that until much later.
So while valuations may be less nonsensical these days, it still reveals nothing about what stocks might do over the next several years. Attempting to judge where market prices stand in relation to per-share value is time well spent. Guessing what the price action might be over the next month or even several years is not.
Buffett added this in the most recent Berkshire Hathaway (BRKa) Shareholder Letter:
"American business will do fine over time. And stocks will do well just as certainly, since their fate is tied to business performance. Periodic setbacks will occur, yes, but investors and managers are in a game that is heavily stacked in their favor. (The Dow Jones Industrials advanced from 66 to 11,497 in the 20th Century, a staggering 17,320% increase that materialized despite four costly wars, a Great Depression and many recessions. And don't forget that shareholders received substantial dividends throughout the century as well.)
Since the basic game is so favorable, Charlie and I believe it's a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of 'experts,' or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it."
It's understandable, even if not particularly enriching, that investors and other market participants weigh the risk of loss versus the possibility of gains asymmetrically.
Loss aversion is a very powerful thing.*
Having said that, those who think they can "dance in and out" effectively (and many certainly seem to try!) might want to carefully consider the last line in the above excerpt from the letter.
Adam
* Those who underestimate the potential impact of loss aversion on long-term results are likely making an expensive mistake. This potent bias can be, to an extent, overcome, but requires first that it be taken seriously followed by some kind of trained response to counter it. For me, learning to manage the tendency only begins with an awareness of and respect for its significance.
Friday, March 8, 2013
Buffett on Berkshire's Float
A follow up to this post.
As I mentioned in the prior post, a big part of Berkshire's advantage is the $ 73.1 billion of "float" -- essentially free money if they break even on underwriting -- that comes from their various insurance businesses.
Well, the fact is that Berkshire has actually had underwriting profits for ten straight years. So they've done a whole lot better than breakeven. Having costless and enduring float (and, at times, even better-than-costless) is not a minor strength.
From the 2012 Berkshire Hathaway (BRKa) Shareholder Letter:
"If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit is earned, we enjoy the use of free money – and, better yet, get paid for holding it. That's like your taking out a loan and having the bank pay you interest."
It's not just the quantity of the float, it's the quality. Buffett then added:
"...we have now operated at an underwriting profit for ten consecutive years, our pre-tax gain for the period having totaled $18.6 billion. Looking ahead, I believe we will continue to underwrite profitably in most years. If we do, our float will be better than free money."
The quality of Berkshire's float is a big source of the gap between Berkshire's book value and intrinsic value.
"So how does our attractive float affect the calculations of intrinsic value? When Berkshire's book value is calculated, the full amount of our float is deducted as a liability, just as if we had to pay it out tomorrow and were unable to replenish it. But that's an incorrect way to look at float..."
and...
"The value of our float is one reason – a huge reason – why we believe Berkshire's intrinsic business value substantially exceeds its book value."
Berkshire's float being free -- never mind getting paid to hold it -- is far from an industry norm. Property-casualty ("P/C") insurers, of course, receive their premiums upfront then pay the claims at a later time. Well, in the letter, Buffett makes the point that P/C industry premiums have not covered claims plus expenses in 37 of the 45 years.*
So, for the industry as a whole, underwriting losses are the norm. As a result, industry returns for decades have been subpar. In fact, the industry's returns are worse than the average return of American industry more generally. It gets worse:
"A further unpleasant reality adds to the industry's dim prospects: Insurance earnings are now benefitting from 'legacy' bond portfolios that deliver much higher yields than will be available when funds are reinvested during the next few years – and perhaps for many years beyond that. Today's bond portfolios are, in effect, wasting assets. Earnings of insurers will be hurt in a significant way as bonds mature and are rolled over."
Consider what they've accomplished in a bit more than four decades in terms of float. In 1970, Berkshire's float was just $ 39 million.
Adam
* Ending in 2011.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.
As I mentioned in the prior post, a big part of Berkshire's advantage is the $ 73.1 billion of "float" -- essentially free money if they break even on underwriting -- that comes from their various insurance businesses.
Well, the fact is that Berkshire has actually had underwriting profits for ten straight years. So they've done a whole lot better than breakeven. Having costless and enduring float (and, at times, even better-than-costless) is not a minor strength.
From the 2012 Berkshire Hathaway (BRKa) Shareholder Letter:
"If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit is earned, we enjoy the use of free money – and, better yet, get paid for holding it. That's like your taking out a loan and having the bank pay you interest."
It's not just the quantity of the float, it's the quality. Buffett then added:
"...we have now operated at an underwriting profit for ten consecutive years, our pre-tax gain for the period having totaled $18.6 billion. Looking ahead, I believe we will continue to underwrite profitably in most years. If we do, our float will be better than free money."
The quality of Berkshire's float is a big source of the gap between Berkshire's book value and intrinsic value.
"So how does our attractive float affect the calculations of intrinsic value? When Berkshire's book value is calculated, the full amount of our float is deducted as a liability, just as if we had to pay it out tomorrow and were unable to replenish it. But that's an incorrect way to look at float..."
and...
"The value of our float is one reason – a huge reason – why we believe Berkshire's intrinsic business value substantially exceeds its book value."
Berkshire's float being free -- never mind getting paid to hold it -- is far from an industry norm. Property-casualty ("P/C") insurers, of course, receive their premiums upfront then pay the claims at a later time. Well, in the letter, Buffett makes the point that P/C industry premiums have not covered claims plus expenses in 37 of the 45 years.*
So, for the industry as a whole, underwriting losses are the norm. As a result, industry returns for decades have been subpar. In fact, the industry's returns are worse than the average return of American industry more generally. It gets worse:
"A further unpleasant reality adds to the industry's dim prospects: Insurance earnings are now benefitting from 'legacy' bond portfolios that deliver much higher yields than will be available when funds are reinvested during the next few years – and perhaps for many years beyond that. Today's bond portfolios are, in effect, wasting assets. Earnings of insurers will be hurt in a significant way as bonds mature and are rolled over."
Consider what they've accomplished in a bit more than four decades in terms of float. In 1970, Berkshire's float was just $ 39 million.
Adam
* Ending in 2011.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.
Tuesday, March 5, 2013
Buffett on Berkshire's "Powerhouse Five" & "Big Four"
From the 2012 Berkshire Hathaway (BRKa) Shareholder Letter:
Berkshire's "Powerhouse Five" Businesses
Berkshire's five most profitable non-insurance businesses are BNSF, Iscar, Lubrizol, Marmon Group and MidAmerican Energy.
Of these five, Berkshire only owned MidAmerican Energy as of eight years ago. At that time, MidAmerican earned just under $ 400 million pre-tax.
In acquiring the other four businesses since, Berkshire has used mostly cash to do so.
In fact, the company added just 6.1% to shares outstanding as a result of the BNSF deal. Otherwise, the deals were done with cash.
Well, those five businesses earned $ 10.1 billion pre-tax in 2012. Last year, Buffett had said he expected this to happen and, well, it did.
So a rather substantial $ 9.7 billion increase in pre-tax earnings while adding few shares outstanding. More from the letter:
"...the $9.7 billion gain in annual earnings delivered Berkshire by the five companies has been accompanied by only minor dilution.That satisfies our goal of not simply growing, but rather increasing per-share results."
Not all dilution is equal.
Dilution can make sense if it increases per-share value.
Dilution can make sense if investors get at least sufficient value per-share relative to what's being given up in value per-share.
Buffett covers this in the 1982 letter:
"...we will not issue shares unless we receive as much intrinsic business value as we give. Such a policy might seem axiomatic. Why, you might ask, would anyone issue dollar bills in exchange for fifty-cent pieces? Unfortunately, many corporate managers have been willing to do just that."
The above acquisitions, at least in combination, clearly worked out just fine on a per-share basis for investors.
Still, as Buffett explained in the 1997 letter, it's not often going to make sense to use Berkshire's stock as a currency in acquisitions:
"For a baseball team, acquiring a player who can be expected to bat .350 is almost always a wonderful event -- except when the team must trade a .380 hitter to make the deal.
Because our roster is filled with .380 hitters, we have tried to pay cash for acquisitions..."
In all too many deals, getting sufficient value in return is hardly the norm. A particular acquisition may result in a larger entity overall, but ends up not necessarily making sense on a per-share intrinsic value basis. In fact, per-share value too often gets destroyed in pursuit of an expanded domain.
Naturally, what a transaction does to intrinsic value on a per-share basis is ultimately what matters to investors.
Page 104-105 of the 2012 Annual Report provides an explanation of the elements that Buffett thinks should go into an - even if necessarily imprecise -- estimate of Berkshire's intrinsic value.*
Two of the elements are quantitative:
- Investments in stocks, bonds, and cash. These investments are funded by retained earnings and "float". If Berkshire ends up breakeven on insurance underwriting that float is free. Of course, over their history they've generated underwriting profits so those funds have actually been better than free. (That means they've, in fact, been paid to hold the money.) Well, if Berkshire is just breakeven going forward on their insurance underwriting results, then the investments can be considered an element of value. Key measure: per-share value of investments.
- Earnings that come from sources other than investments and insurance underwriting. Key measure: per-share earnings from non-insurance businesses.
One element is not:
- How well will Berkshire's retained earnings be deployed over time. That's, of course, necessarily more subjective, difficult to measure, yet hardly unimportant.
Berkshire's "Big Four" Investments
American Express (AXP), Coca-Cola (KO), IBM (IBM) and Wells Fargo (WFC).
Berkshire's ownership interest in each increased during the year. That happened even though they purchased additional shares of only two of them:
"We purchased additional shares of Wells Fargo (our ownership now is 8.7% versus 7.6% at yearend 2011) and IBM (6.0% versus 5.5%). Meanwhile, stock repurchases at Coca-Cola and American Express raised our percentage ownership. Our equity in Coca-Cola grew from 8.8% to 8.9% and our interest at American Express from 13.0% to 13.7%."
Buffett then makes the following point:
"At Berkshire we much prefer owning a non-controlling but substantial portion of a wonderful business to owning 100% of a so-so business. Our flexibility in capital allocation gives us a significant advantage over companies that limit themselves only to acquisitions they can operate."
Berkshire's portion of the "Big Four's" 2012 earnings was $ 3.9 billion but a whole lot less than that $ 3.9 billion shows up on Berkshire's income statement. That doesn't make them any less real from a business economics point of view:
"In the earnings we report to you, however, we include only the dividends we receive – about $1.1 billion. But make no mistake: The $2.8 billion of earnings we do not report is every bit as valuable to us as what we record.
The earnings that the four companies retain are often used for repurchases – which enhance our share of future earnings – and also for funding business opportunities that are usually advantageous. Over time we expect substantially greater earnings from these four investees. If we are correct, dividends to Berkshire will increase and, even more important, so will our unrealized capital gains (which, for the four, totaled $26.7 billion at yearend)."
Buffett later points out that, since 1970, Berkshire has increased per-share investments 19.4% annually while increasing per-share earnings 20.8% annually. In the letter Buffett points out:
"It is no coincidence that the price of Berkshire stock over the 42-year period has increased at a rate very similar to that of our two measures of value. Charlie and I like to see gains in both areas, but our strong emphasis will always be on building operating earnings."
An important part of Berkshire's advantage, of course, is the generally costless (in fact, often better-than-costless) and enduring float they get from the insurance businesses. As mentioned above, what ends up essentially being free money if they can just breakeven on underwriting.
Well, for the tenth consecutive year they had an underwriting gain. More on that in a follow-up.
Adam
* Initially this was covered in the 2010 Annual Report (pages 6 and 7 of the letter).
Berkshire's "Powerhouse Five" Businesses
Berkshire's five most profitable non-insurance businesses are BNSF, Iscar, Lubrizol, Marmon Group and MidAmerican Energy.
Of these five, Berkshire only owned MidAmerican Energy as of eight years ago. At that time, MidAmerican earned just under $ 400 million pre-tax.
In acquiring the other four businesses since, Berkshire has used mostly cash to do so.
In fact, the company added just 6.1% to shares outstanding as a result of the BNSF deal. Otherwise, the deals were done with cash.
Well, those five businesses earned $ 10.1 billion pre-tax in 2012. Last year, Buffett had said he expected this to happen and, well, it did.
So a rather substantial $ 9.7 billion increase in pre-tax earnings while adding few shares outstanding. More from the letter:
"...the $9.7 billion gain in annual earnings delivered Berkshire by the five companies has been accompanied by only minor dilution.That satisfies our goal of not simply growing, but rather increasing per-share results."
Not all dilution is equal.
Dilution can make sense if it increases per-share value.
Dilution can make sense if investors get at least sufficient value per-share relative to what's being given up in value per-share.
Buffett covers this in the 1982 letter:
"...we will not issue shares unless we receive as much intrinsic business value as we give. Such a policy might seem axiomatic. Why, you might ask, would anyone issue dollar bills in exchange for fifty-cent pieces? Unfortunately, many corporate managers have been willing to do just that."
The above acquisitions, at least in combination, clearly worked out just fine on a per-share basis for investors.
Still, as Buffett explained in the 1997 letter, it's not often going to make sense to use Berkshire's stock as a currency in acquisitions:
"For a baseball team, acquiring a player who can be expected to bat .350 is almost always a wonderful event -- except when the team must trade a .380 hitter to make the deal.
Because our roster is filled with .380 hitters, we have tried to pay cash for acquisitions..."
In all too many deals, getting sufficient value in return is hardly the norm. A particular acquisition may result in a larger entity overall, but ends up not necessarily making sense on a per-share intrinsic value basis. In fact, per-share value too often gets destroyed in pursuit of an expanded domain.
Naturally, what a transaction does to intrinsic value on a per-share basis is ultimately what matters to investors.
Page 104-105 of the 2012 Annual Report provides an explanation of the elements that Buffett thinks should go into an - even if necessarily imprecise -- estimate of Berkshire's intrinsic value.*
Two of the elements are quantitative:
- Investments in stocks, bonds, and cash. These investments are funded by retained earnings and "float". If Berkshire ends up breakeven on insurance underwriting that float is free. Of course, over their history they've generated underwriting profits so those funds have actually been better than free. (That means they've, in fact, been paid to hold the money.) Well, if Berkshire is just breakeven going forward on their insurance underwriting results, then the investments can be considered an element of value. Key measure: per-share value of investments.
- Earnings that come from sources other than investments and insurance underwriting. Key measure: per-share earnings from non-insurance businesses.
One element is not:
- How well will Berkshire's retained earnings be deployed over time. That's, of course, necessarily more subjective, difficult to measure, yet hardly unimportant.
Berkshire's "Big Four" Investments
American Express (AXP), Coca-Cola (KO), IBM (IBM) and Wells Fargo (WFC).
Berkshire's ownership interest in each increased during the year. That happened even though they purchased additional shares of only two of them:
"We purchased additional shares of Wells Fargo (our ownership now is 8.7% versus 7.6% at yearend 2011) and IBM (6.0% versus 5.5%). Meanwhile, stock repurchases at Coca-Cola and American Express raised our percentage ownership. Our equity in Coca-Cola grew from 8.8% to 8.9% and our interest at American Express from 13.0% to 13.7%."
Buffett then makes the following point:
"At Berkshire we much prefer owning a non-controlling but substantial portion of a wonderful business to owning 100% of a so-so business. Our flexibility in capital allocation gives us a significant advantage over companies that limit themselves only to acquisitions they can operate."
Berkshire's portion of the "Big Four's" 2012 earnings was $ 3.9 billion but a whole lot less than that $ 3.9 billion shows up on Berkshire's income statement. That doesn't make them any less real from a business economics point of view:
"In the earnings we report to you, however, we include only the dividends we receive – about $1.1 billion. But make no mistake: The $2.8 billion of earnings we do not report is every bit as valuable to us as what we record.
The earnings that the four companies retain are often used for repurchases – which enhance our share of future earnings – and also for funding business opportunities that are usually advantageous. Over time we expect substantially greater earnings from these four investees. If we are correct, dividends to Berkshire will increase and, even more important, so will our unrealized capital gains (which, for the four, totaled $26.7 billion at yearend)."
Buffett later points out that, since 1970, Berkshire has increased per-share investments 19.4% annually while increasing per-share earnings 20.8% annually. In the letter Buffett points out:
"It is no coincidence that the price of Berkshire stock over the 42-year period has increased at a rate very similar to that of our two measures of value. Charlie and I like to see gains in both areas, but our strong emphasis will always be on building operating earnings."
An important part of Berkshire's advantage, of course, is the generally costless (in fact, often better-than-costless) and enduring float they get from the insurance businesses. As mentioned above, what ends up essentially being free money if they can just breakeven on underwriting.
Well, for the tenth consecutive year they had an underwriting gain. More on that in a follow-up.
Adam
* Initially this was covered in the 2010 Annual Report (pages 6 and 7 of the letter).
Wednesday, September 12, 2012
Why Buffett Prefers Using Cash Over Stock in Acquisitions
Both stock and cash was used for the merger of Burlington Northern Santa Fe (BNSF) into a subsidiary of Berkshire Hathaway (BRKa) back in early 2010. Yet, whenever possible, Buffett has made it very clear he prefers using cash instead of stock in mergers/acquisitions.
In the 1997 letter, Buffett said the following about prior deals involving Berkshire's stock up to that point:
"If you aggregate all of our stock-only mergers (excluding those we did with two affiliated companies, Diversified Retailing and Blue Chip Stamps), you will find that our shareholders are slightly worse off than they would have been had I not done the transactions. Though it hurts me to say it, when I've issued stock, I've cost you money."
The problem wasn't that the businesses they did deals for ended up being poor performers or that they were somehow misled by the sellers. Not at all.
"Instead, our problem has been that we own a truly marvelous collection of businesses, which means that trading away a portion of them for something new almost never makes sense. When we issue shares in a merger, we reduce your ownership in all of our businesses -- partly-owned companies such as Coca-Cola, Gillette and American Express, and all of our terrific operating companies as well. An example from sports will illustrate the difficulty we face: For a baseball team, acquiring a player who can be expected to bat .350 is almost always a wonderful event -- except when the team must trade a .380 hitter to make the deal.
Because our roster is filled with .380 hitters, we have tried to pay cash for acquisitions, and here our record has been far better."
Buffett later added...
"These acquisitions have delivered Berkshire tremendous value -- indeed, far more than I anticipated when we made our purchases."
In 1998, not long after the 1997 letter was written, Berkshire would go on to use its stock to merge with General Re for roughly $ 22 billion. It was a deal that added meaningfully to Berkshire's share count (it was a more than 20 percent increase in shares outstanding).
The far more recent BNSF deal was structured to be roughly 60 percent cash and 40 percent stock. Buffett explained it this way in the 2010 Berkshire Hathaway Shareholder Letter:
"It now appears that owning this railroad will increase Berkshire's 'normal' earning power by nearly 40% pre-tax and by well over 30% after-tax. Making this purchase increased our share count by 6% and used $22 billion of cash. Since we've quickly replenished the cash, the economics of this transaction have turned out very well."
In a perfect world he'd have not used stock but this BNSF deal had a much smaller impact on shares outstanding. Buffett said this to CNBC just after the deal was announced:
"I don't like to use stock, but on this one, because of the size and because they wanted a tax-free option for shareholders..."
The deal was structured (along with the 50-1 split of the 'B' shares) to enable even those with a small number a shares of BNSF to exchange their shares tax-free for Berkshire stock.
At least compared to prior occasions, it's pretty clear that the BNSF deal was a reasonably good use of the stock. It was certainly a great use of their cash. Using some Berkshire stock to make this happen was also consistent with Buffett's preference to always have lots of cash around. Making sure Berkshire's liquidity remained ample has always been a priority for them (and, I might add, should be for any well run enterprise). After the deal was done there was more than $ 20 billion of cash on the balance sheet. From the CNBC interview:
"...after doing it we will be left with over 20 billion of consolidated cash. So, we like to have a lot of cash around and we'll have a lot of cash around straight through this."
Still, I don't doubt they'd still have rather not used stock in the deal. Yet the opportunity arose to buy a very good large business and they did the deal that made sense consistent with their principles but within real world constraints. If they waited until they could do the deal with all cash who knows if the opportunity would have been there to buy the business at an attractive valuation.
So Buffett doesn't like to use Berkshire's stock but, under the right circumstances, it happens. There was 1.23 million Class A equivalent common shares outstanding at the end of 1997. These days, there's more like 1.65 million.
That increase in share count over 15 years or so comes mostly down to the General Re and BNSF deals.
Adam
Berkshire Hathaway To Acquire Burlington Northern Santa Fe - Nov. 2009
Berkshire and BNSF Close Merger - Feb. 2010
In the 1997 letter, Buffett said the following about prior deals involving Berkshire's stock up to that point:
"If you aggregate all of our stock-only mergers (excluding those we did with two affiliated companies, Diversified Retailing and Blue Chip Stamps), you will find that our shareholders are slightly worse off than they would have been had I not done the transactions. Though it hurts me to say it, when I've issued stock, I've cost you money."
The problem wasn't that the businesses they did deals for ended up being poor performers or that they were somehow misled by the sellers. Not at all.
"Instead, our problem has been that we own a truly marvelous collection of businesses, which means that trading away a portion of them for something new almost never makes sense. When we issue shares in a merger, we reduce your ownership in all of our businesses -- partly-owned companies such as Coca-Cola, Gillette and American Express, and all of our terrific operating companies as well. An example from sports will illustrate the difficulty we face: For a baseball team, acquiring a player who can be expected to bat .350 is almost always a wonderful event -- except when the team must trade a .380 hitter to make the deal.
Because our roster is filled with .380 hitters, we have tried to pay cash for acquisitions, and here our record has been far better."
Buffett later added...
"These acquisitions have delivered Berkshire tremendous value -- indeed, far more than I anticipated when we made our purchases."
In 1998, not long after the 1997 letter was written, Berkshire would go on to use its stock to merge with General Re for roughly $ 22 billion. It was a deal that added meaningfully to Berkshire's share count (it was a more than 20 percent increase in shares outstanding).
The far more recent BNSF deal was structured to be roughly 60 percent cash and 40 percent stock. Buffett explained it this way in the 2010 Berkshire Hathaway Shareholder Letter:
In a perfect world he'd have not used stock but this BNSF deal had a much smaller impact on shares outstanding. Buffett said this to CNBC just after the deal was announced:
"I don't like to use stock, but on this one, because of the size and because they wanted a tax-free option for shareholders..."
The deal was structured (along with the 50-1 split of the 'B' shares) to enable even those with a small number a shares of BNSF to exchange their shares tax-free for Berkshire stock.
At least compared to prior occasions, it's pretty clear that the BNSF deal was a reasonably good use of the stock. It was certainly a great use of their cash. Using some Berkshire stock to make this happen was also consistent with Buffett's preference to always have lots of cash around. Making sure Berkshire's liquidity remained ample has always been a priority for them (and, I might add, should be for any well run enterprise). After the deal was done there was more than $ 20 billion of cash on the balance sheet. From the CNBC interview:
"...after doing it we will be left with over 20 billion of consolidated cash. So, we like to have a lot of cash around and we'll have a lot of cash around straight through this."
Still, I don't doubt they'd still have rather not used stock in the deal. Yet the opportunity arose to buy a very good large business and they did the deal that made sense consistent with their principles but within real world constraints. If they waited until they could do the deal with all cash who knows if the opportunity would have been there to buy the business at an attractive valuation.
So Buffett doesn't like to use Berkshire's stock but, under the right circumstances, it happens. There was 1.23 million Class A equivalent common shares outstanding at the end of 1997. These days, there's more like 1.65 million.
That increase in share count over 15 years or so comes mostly down to the General Re and BNSF deals.
Adam
Berkshire Hathaway To Acquire Burlington Northern Santa Fe - Nov. 2009
Berkshire and BNSF Close Merger - Feb. 2010
Friday, August 17, 2012
Berkshire Hathaway's Derivatives Portfolio
A follow up to this recent post on Berkshire Hathaway's (BRKa) derivatives portfolio and its impact on the company's earnings.
Buffett has said that Berkshire's derivatives now largely fall into two categories: Those tied to equity market indices and those tied to high-yield bond indices.
All these contracts provide lots of interest-free float to Berkshire.
So they are very insurance-like and crucially require that little or no collateral need to be posted. These have worked out for shareholders for the simple reason that they were priced right in the first place for the risk.
Buffett has explained, in some detail, the Berkshire derivative positions in past shareholder letters. Here's what he said in the most recent letter:
Our insurance-like derivatives contracts, whereby we pay if various issues included in high-yield bond indices default, are coming to a close. The contracts that most exposed us to losses have already expired, and the remainder will terminate soon. In 2011, we paid out $86 million on two losses, bringing our total payments to $2.6 billion. We are almost certain to realize a final "underwriting profit" on this portfolio because the premiums we received were $3.4 billion, and our future losses are apt to be minor. In addition, we will have averaged about $2 billion of float over the five-year life of these contracts. This successful result during a time of great credit stress underscores the importance of obtaining a premium that is commensurate with the risk.
Charlie and I continue to believe that our equity-put positions will produce a significant profit...
Buffett gave an example in the 2008 letter to help better understand the "equity-put" portfolio:
To illustrate, we might sell a $1 billion 15-year put contract on the S&P 500 when that index is at, say, 1300. If the index is at 1170 – down 10% – on the day of maturity, we would pay $100 million. If it is above 1300, we owe nothing. For us to lose $1 billion, the index would have to go to zero. In the meantime, the sale of the put would have delivered us a premium – perhaps $100 million to $150 million – that we would be free to invest as we wish.
Our put contracts total $37.1 billion (at current exchange rates) and are spread among four major indices: the S&P 500 in the U.S., the FTSE 100 in the U.K., the Euro Stoxx 50 in Europe, and the Nikkei 225 in Japan. Our first contract comes due on September 9, 2019 and our last on January 24, 2028. We have received premiums of $4.9 billion, money we have invested. We, meanwhile, have paid nothing, since all expiration dates are far in the future.
So it's not just that all four equity market indices would have to go to zero for Berkshire to owe the full amount.
They'd also have to do so on the specific termination date of each contract.
When it comes to Berkshire's derivatives portfolio I'm not sure this is always fully appreciated.
What Berkshire ultimately pays, if anything, will be determined by where those indices are on those specific dates. It is then and only then that Berkshire could owe anything and experience more than just a "scorekeeping" loss.
There will certainly be lots of accounting gains and losses reported between now and then for these "equity-put" contracts. There just will be no additional cash paid (other than the already collected $ 4.9 billion in premiums) to or from Berkshire as a result of these so-called gains and losses.*
Let's say all these indices went to zero tomorrow.
Berkshire would, in fact, have a big accounting loss to report but the company would still owe nothing as a result. The only way Berkshire would have to eventually write a big check is if those indices for some reason happen to still be at zero between 2019 and 2028 on the right dates (well, the wrong dates from Berkshire's point of view). During all that time Berkshire will have had the $ 4.9 billion of cash to invest as they choose.
Of course, they don't have to go to zero for Berkshire to end up owing real money. Obviously, the indices may be instead down only somewhat on those future dates and, as a result, Berkshire would owe a proportional amount at that time.
It's also true is that the indices may be higher and Berkshire would owe nothing.
What's not in doubt is that Berkshire will have all that $ 4.9 billion at their disposal to invest during this time.
It all comes down to whether the premiums collected were priced right for the risks. An investor in Berkshire Hathaway has to decide whether Buffett is likely to misprice these contracts and, if so, what are the consequences.
I still think the Derivatives section (bottom of page 16) of 2008 letter does a good job on this subject but you have to read the updates on Berkshire's derivatives portfolio in more recent letters to have a complete picture.
Here's also a post that I did a while back on Berkshire derivatives, if interested.
Buffett also wrote in the latest shareholder letter that new requirements on collateral make establishing new derivatives positions less attractive. So expect fewer of them in the future.
I won't miss trying to understand them.
Adam
Related posts:
Berkshire Hathaway: Earnings and the Derivatives Portfolio
Buffett on Derivatives: The 'Chain Reaction' Threat
Munger on Derivatives
Buffett on Derivatives
* As I mentioned in the prior post, the problem stems more from the limitations of the Black-Scholes formula when it comes to very long-term options.
Buffett has said that Berkshire's derivatives now largely fall into two categories: Those tied to equity market indices and those tied to high-yield bond indices.
All these contracts provide lots of interest-free float to Berkshire.
So they are very insurance-like and crucially require that little or no collateral need to be posted. These have worked out for shareholders for the simple reason that they were priced right in the first place for the risk.
Buffett has explained, in some detail, the Berkshire derivative positions in past shareholder letters. Here's what he said in the most recent letter:
Our insurance-like derivatives contracts, whereby we pay if various issues included in high-yield bond indices default, are coming to a close. The contracts that most exposed us to losses have already expired, and the remainder will terminate soon. In 2011, we paid out $86 million on two losses, bringing our total payments to $2.6 billion. We are almost certain to realize a final "underwriting profit" on this portfolio because the premiums we received were $3.4 billion, and our future losses are apt to be minor. In addition, we will have averaged about $2 billion of float over the five-year life of these contracts. This successful result during a time of great credit stress underscores the importance of obtaining a premium that is commensurate with the risk.
Charlie and I continue to believe that our equity-put positions will produce a significant profit...
Buffett gave an example in the 2008 letter to help better understand the "equity-put" portfolio:
To illustrate, we might sell a $1 billion 15-year put contract on the S&P 500 when that index is at, say, 1300. If the index is at 1170 – down 10% – on the day of maturity, we would pay $100 million. If it is above 1300, we owe nothing. For us to lose $1 billion, the index would have to go to zero. In the meantime, the sale of the put would have delivered us a premium – perhaps $100 million to $150 million – that we would be free to invest as we wish.
Our put contracts total $37.1 billion (at current exchange rates) and are spread among four major indices: the S&P 500 in the U.S., the FTSE 100 in the U.K., the Euro Stoxx 50 in Europe, and the Nikkei 225 in Japan. Our first contract comes due on September 9, 2019 and our last on January 24, 2028. We have received premiums of $4.9 billion, money we have invested. We, meanwhile, have paid nothing, since all expiration dates are far in the future.
So it's not just that all four equity market indices would have to go to zero for Berkshire to owe the full amount.
They'd also have to do so on the specific termination date of each contract.
When it comes to Berkshire's derivatives portfolio I'm not sure this is always fully appreciated.
What Berkshire ultimately pays, if anything, will be determined by where those indices are on those specific dates. It is then and only then that Berkshire could owe anything and experience more than just a "scorekeeping" loss.
There will certainly be lots of accounting gains and losses reported between now and then for these "equity-put" contracts. There just will be no additional cash paid (other than the already collected $ 4.9 billion in premiums) to or from Berkshire as a result of these so-called gains and losses.*
Let's say all these indices went to zero tomorrow.
Berkshire would, in fact, have a big accounting loss to report but the company would still owe nothing as a result. The only way Berkshire would have to eventually write a big check is if those indices for some reason happen to still be at zero between 2019 and 2028 on the right dates (well, the wrong dates from Berkshire's point of view). During all that time Berkshire will have had the $ 4.9 billion of cash to invest as they choose.
Of course, they don't have to go to zero for Berkshire to end up owing real money. Obviously, the indices may be instead down only somewhat on those future dates and, as a result, Berkshire would owe a proportional amount at that time.
It's also true is that the indices may be higher and Berkshire would owe nothing.
What's not in doubt is that Berkshire will have all that $ 4.9 billion at their disposal to invest during this time.
It all comes down to whether the premiums collected were priced right for the risks. An investor in Berkshire Hathaway has to decide whether Buffett is likely to misprice these contracts and, if so, what are the consequences.
I still think the Derivatives section (bottom of page 16) of 2008 letter does a good job on this subject but you have to read the updates on Berkshire's derivatives portfolio in more recent letters to have a complete picture.
Here's also a post that I did a while back on Berkshire derivatives, if interested.
Buffett also wrote in the latest shareholder letter that new requirements on collateral make establishing new derivatives positions less attractive. So expect fewer of them in the future.
I won't miss trying to understand them.
Adam
Related posts:
Berkshire Hathaway: Earnings and the Derivatives Portfolio
Buffett on Derivatives: The 'Chain Reaction' Threat
Munger on Derivatives
Buffett on Derivatives
* As I mentioned in the prior post, the problem stems more from the limitations of the Black-Scholes formula when it comes to very long-term options.
Friday, August 10, 2012
Berkshire Hathaway: Earnings and the Derivatives Portfolio
Berkshire Hathaway's (BRKa) latest quarterly results revealed that operating earnings grew to $ 3.7 billion from $ 2.7 billion in the same quarter a year ago.
On the surface looks pretty good, right?
Yet net earnings dropped to $ 3.1 billion from $ 3.4 billion.
Less impressive.
So what number better represents the economics of Berkshire?
Berkshire's operating earnings exclude gains/losses from derivatives and other investments. The generally non-cash gains/losses associated with derivatives mean little economically in the near term. It's "scorekeeping" where the "goals" are reversed time and time again. The gains and losses reveal practically nothing about the actual cash that is (or will) changing hands.
So these very lumpy, but economically pretty much meaningless, gains and losses are usually distractions at best.*
From the 2007 Berkshire Hathaway Shareholder Letter:
Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk.
Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire's balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.
The quarterly gains and losses may mean little, but the cash Berkshire is paid up front is a very useful source of "float". It's good to be aware of these contracts and understand what they may ultimately effect Berkshire economically (good or bad) a long time down the road, but otherwise is essentially worthless information.
Net earnings was reduced to $ 3.1 billion when including investment and derivative gains (losses) in the most recent quarter primarily because of a just under $ 700 million derivatives loss.
These one time gains and losses create lots of noise (on the upside and downside) that mask how Berkshire's operating businesses are really doing. So it is more useful to focus on the operating earnings while separately keeping an eye on the other stuff.
Buffett has said he believes Berkshire's derivatives position will ultimately be rather profitable (based upon recent shareholder letters it's difficult to not come to a similar conclusion). If these work out for shareholders, it will be mostly because the contracts were priced right in the first place for the risk. They will also have worked out because little or no posting of collateral was required.
From the 2011 letter:
Though our existing contracts have very minor collateral requirements, the rules have changed for new positions. Consequently, we will not be initiating any major derivatives positions. We shun contracts of any type that could require the instant posting of collateral. The possibility of some sudden and huge posting requirement – arising from an out-of-the-blue event such as a worldwide financial panic or massive terrorist attack – is inconsistent with our primary objectives of redundant liquidity and unquestioned financial strength.
A small percentage of contracts in the past have called for posting of collateral but not anywhere near enough to matter in the context of Berkshire's resources.
To better understand what the derivatives portfolio really means (or may mean) economically for shareholders (as opposed to just the accounting treatment) check out some of the recent letters.**
The Derivatives section (bottom of page 16) of the 2008 letter isn't a bad place to start.
Here's also a post that I did a while back on Berkshire derivatives, if interested.
Given the arcane nature of derivatives it might be best to save that subject for another day. Obviously, it's important to understand this stuff as a shareholder. I'm just saying that it's Friday and there must be something more fun to read going into a weekend.
Related posts:
Buffett on Derivatives: The 'Chain Reaction' Threat
Munger on Derivatives
Buffett on Derivatives
In the end, the quarterly "scorekeeping" of Berkshire's derivatives portfolio doesn't mean much.
It creates noise but offers little perspective.
The derivatives positions held by Berkshire also make understanding the company's financial results more difficult even when Buffett does his best to explain the positions.
Berkshire's financial reporting isn't actually all that complex but certainly requires a bit more work than some other companies.
Adam
* The problem here isn't so much with mark-to-market accounting. The problem stems more from the limitations of the Black-Scholes formula when it comes to very long-term options.
** Berkshire's largest derivatives positions are generally either tied to equity markets or high-yield bond indices.
On the surface looks pretty good, right?
Yet net earnings dropped to $ 3.1 billion from $ 3.4 billion.
Less impressive.
So what number better represents the economics of Berkshire?
Berkshire's operating earnings exclude gains/losses from derivatives and other investments. The generally non-cash gains/losses associated with derivatives mean little economically in the near term. It's "scorekeeping" where the "goals" are reversed time and time again. The gains and losses reveal practically nothing about the actual cash that is (or will) changing hands.
So these very lumpy, but economically pretty much meaningless, gains and losses are usually distractions at best.*
From the 2007 Berkshire Hathaway Shareholder Letter:
Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk.
Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire's balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.
The quarterly gains and losses may mean little, but the cash Berkshire is paid up front is a very useful source of "float". It's good to be aware of these contracts and understand what they may ultimately effect Berkshire economically (good or bad) a long time down the road, but otherwise is essentially worthless information.
Net earnings was reduced to $ 3.1 billion when including investment and derivative gains (losses) in the most recent quarter primarily because of a just under $ 700 million derivatives loss.
These one time gains and losses create lots of noise (on the upside and downside) that mask how Berkshire's operating businesses are really doing. So it is more useful to focus on the operating earnings while separately keeping an eye on the other stuff.
Buffett has said he believes Berkshire's derivatives position will ultimately be rather profitable (based upon recent shareholder letters it's difficult to not come to a similar conclusion). If these work out for shareholders, it will be mostly because the contracts were priced right in the first place for the risk. They will also have worked out because little or no posting of collateral was required.
From the 2011 letter:
Though our existing contracts have very minor collateral requirements, the rules have changed for new positions. Consequently, we will not be initiating any major derivatives positions. We shun contracts of any type that could require the instant posting of collateral. The possibility of some sudden and huge posting requirement – arising from an out-of-the-blue event such as a worldwide financial panic or massive terrorist attack – is inconsistent with our primary objectives of redundant liquidity and unquestioned financial strength.
A small percentage of contracts in the past have called for posting of collateral but not anywhere near enough to matter in the context of Berkshire's resources.
To better understand what the derivatives portfolio really means (or may mean) economically for shareholders (as opposed to just the accounting treatment) check out some of the recent letters.**
The Derivatives section (bottom of page 16) of the 2008 letter isn't a bad place to start.
Here's also a post that I did a while back on Berkshire derivatives, if interested.
Given the arcane nature of derivatives it might be best to save that subject for another day. Obviously, it's important to understand this stuff as a shareholder. I'm just saying that it's Friday and there must be something more fun to read going into a weekend.
Related posts:
Buffett on Derivatives: The 'Chain Reaction' Threat
Munger on Derivatives
Buffett on Derivatives
In the end, the quarterly "scorekeeping" of Berkshire's derivatives portfolio doesn't mean much.
It creates noise but offers little perspective.
The derivatives positions held by Berkshire also make understanding the company's financial results more difficult even when Buffett does his best to explain the positions.
Berkshire's financial reporting isn't actually all that complex but certainly requires a bit more work than some other companies.
Adam
* The problem here isn't so much with mark-to-market accounting. The problem stems more from the limitations of the Black-Scholes formula when it comes to very long-term options.
** Berkshire's largest derivatives positions are generally either tied to equity markets or high-yield bond indices.
Monday, June 18, 2012
Buffett on Enduring "Moats"
There's two excellent sources of a sustainable and wide economic "moat" for a business. One is by being the low cost producer in an industry, another by having solid brands and distribution that lead to pricing power.
Those with the widest "moats" have the ability to defend/expand their turf while maintaining high levels of profitability relative to the capital that's needed.
From the 2007 Berkshire Hathaway Shareholder Letter:
A truly great business must have an enduring "moat" that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business "castle" that is earning high returns. Therefore a formidable barrier such as a company's being the low cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with "Roman Candles," companies whose moats proved illusory and were soon crossed.
Our criterion of "enduring" causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism's "creative destruction" is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.
So it's about how much profit can be produced relative to the ongoing capital requirements and how well that economic equation can remain in tact over the long haul.
Notice there's no mention of growth here.
This Morningstar article explains why not all moats are created equal.
Not All Moats Are Created Equal
It also goes beyond the two sources I mentioned above and walks through five major sources of moats.
According to Morningstar, these are:
1 Cost Advantage
2 Intangible Assets
3 Switching Costs
4 Network Effect
5 Efficient Scale
Not surprisingly, return on invested capital and return on equity are two primary measures that Morningstar looks at to gauge the economic moat of an enterprise.
The article points out some businesses have more than one of the above but, among the five categories, Intangible Assets and Cost Advantage are the sources that Morningstar found to be most prevalent among "wide moat" firms.
In the letter, Buffett also makes the point that the best businesses don't require great management. Those that require a superstar to get results cannot be considered a great enterprise.
That doesn't mean a very good CEO isn't a big asset but, as an investor, you just don't want business performance to be overly dependent on it.
Adam
Those with the widest "moats" have the ability to defend/expand their turf while maintaining high levels of profitability relative to the capital that's needed.
From the 2007 Berkshire Hathaway Shareholder Letter:
A truly great business must have an enduring "moat" that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business "castle" that is earning high returns. Therefore a formidable barrier such as a company's being the low cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with "Roman Candles," companies whose moats proved illusory and were soon crossed.
Our criterion of "enduring" causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism's "creative destruction" is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.
So it's about how much profit can be produced relative to the ongoing capital requirements and how well that economic equation can remain in tact over the long haul.
Notice there's no mention of growth here.
This Morningstar article explains why not all moats are created equal.
Not All Moats Are Created Equal
It also goes beyond the two sources I mentioned above and walks through five major sources of moats.
According to Morningstar, these are:
1 Cost Advantage
2 Intangible Assets
3 Switching Costs
4 Network Effect
5 Efficient Scale
Not surprisingly, return on invested capital and return on equity are two primary measures that Morningstar looks at to gauge the economic moat of an enterprise.
The article points out some businesses have more than one of the above but, among the five categories, Intangible Assets and Cost Advantage are the sources that Morningstar found to be most prevalent among "wide moat" firms.
In the letter, Buffett also makes the point that the best businesses don't require great management. Those that require a superstar to get results cannot be considered a great enterprise.
That doesn't mean a very good CEO isn't a big asset but, as an investor, you just don't want business performance to be overly dependent on it.
Adam
Wednesday, May 2, 2012
Buffett: Intrinsic Value vs Book Value - Part II
A follow up to this recent post...
Buffett: Intrinsic Value vs Book Value
From the latest Berkshire Hathaway (BRKa) Shareholder Letter:
...we don't enjoy cashing out partners at a discount, even though our doing so may give the selling shareholders a slightly higher price than they would receive if our bid was absent. When we are buying, therefore, we want those exiting partners to be fully informed about the value of the assets they are selling.
At our limit price of 110% of book value*, repurchases clearly increase Berkshire's per-share intrinsic value. And the more and the cheaper we buy, the greater the gain for continuing shareholders. Therefore, if given the opportunity, we will likely repurchase stock aggressively at our price limit or lower. You should know, however, that we have no interest in supporting the stock and that our bids will fade in particularly weak markets. Nor will we buy shares if our cash-equivalent holdings are below $20 billion. At Berkshire, financial strength that is unquestionable takes precedence over all else.
In the Berkshire Hathaway Owner's Manual (pages 4-5), Buffett uses a college education to help explain the difference between book value and intrinsic value:
You can gain some insight into the differences between book value and intrinsic value by looking at one form of investment, a college education. Think of the education's cost as its "book value." If this cost is to be accurate, it should include the earnings that were foregone by the student because he chose college rather than a job.
For this exercise, we will ignore the important non-economic benefits of an education and focus strictly on its economic value. First, we must estimate the earnings that the graduate will receive over his lifetime and subtract from that figure an estimate of what he would have earned had he lacked his education. That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day. The dollar result equals the intrinsic economic value of the education.
Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didn't get his money's worth. In other cases, the intrinsic value of an education will far exceed its book value, a result that proves capital was wisely deployed. In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value.
Berkshire Hathaway's stock is currently selling at more than a 120% of book value. Well, at least what book value was at the end of the 4th quarter of 2012.
Book value is almost certainly higher now.
So stock repurchases at this time aren't going to happen, but it wouldn't take much of a drop in price (or increase in book value) for them to be buyers.
What Buffett specifically means when he says "we will likely repurchase stock aggressively" will be worth keeping an eye on if the stock price falls below 110% of per-share book value again.
Adam
* 110% of the book value or a 10% premium over the book value. It's been described both ways in different publications.
Buffett: Intrinsic Value vs Book Value
From the latest Berkshire Hathaway (BRKa) Shareholder Letter:
...we don't enjoy cashing out partners at a discount, even though our doing so may give the selling shareholders a slightly higher price than they would receive if our bid was absent. When we are buying, therefore, we want those exiting partners to be fully informed about the value of the assets they are selling.
At our limit price of 110% of book value*, repurchases clearly increase Berkshire's per-share intrinsic value. And the more and the cheaper we buy, the greater the gain for continuing shareholders. Therefore, if given the opportunity, we will likely repurchase stock aggressively at our price limit or lower. You should know, however, that we have no interest in supporting the stock and that our bids will fade in particularly weak markets. Nor will we buy shares if our cash-equivalent holdings are below $20 billion. At Berkshire, financial strength that is unquestionable takes precedence over all else.
In the Berkshire Hathaway Owner's Manual (pages 4-5), Buffett uses a college education to help explain the difference between book value and intrinsic value:
You can gain some insight into the differences between book value and intrinsic value by looking at one form of investment, a college education. Think of the education's cost as its "book value." If this cost is to be accurate, it should include the earnings that were foregone by the student because he chose college rather than a job.
For this exercise, we will ignore the important non-economic benefits of an education and focus strictly on its economic value. First, we must estimate the earnings that the graduate will receive over his lifetime and subtract from that figure an estimate of what he would have earned had he lacked his education. That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day. The dollar result equals the intrinsic economic value of the education.
Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didn't get his money's worth. In other cases, the intrinsic value of an education will far exceed its book value, a result that proves capital was wisely deployed. In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value.
Berkshire Hathaway's stock is currently selling at more than a 120% of book value. Well, at least what book value was at the end of the 4th quarter of 2012.
Book value is almost certainly higher now.
So stock repurchases at this time aren't going to happen, but it wouldn't take much of a drop in price (or increase in book value) for them to be buyers.
What Buffett specifically means when he says "we will likely repurchase stock aggressively" will be worth keeping an eye on if the stock price falls below 110% of per-share book value again.
Adam
* 110% of the book value or a 10% premium over the book value. It's been described both ways in different publications.
Wednesday, April 18, 2012
Buffett Reveals 'Not Life Threatening' Cancer Diagnosis
Warren Buffett disclosed that he has been diagnosed with stage I prostate cancer in this news release:
The good news is that I've been told by my doctors that my condition is not remotely life-threatening or even debilitating in any meaningful way. I received my diagnosis last Wednesday. I then had a CAT scan and a bone scan on Thursday, followed by an MRI today. These tests showed no incidence of cancer elsewhere in my body.
This CNBC article added some perspective on Buffett's health.
Buffett Moves Quickly to Disclose 'Not Life Threatening' Cancer
This inevitably will bring Berkshire's succession planning to the forefront. It is almost certain that lots of time will be dedicated to the issue at the the 2012 Berkshire Hathaway Annual Shareholder Meeting that's happening at the beginning of next month.
Who will be taking Buffett's job when he no longer can do it is obviously an important subject for Berkshire shareholders. It would be nice to know the successor (though there's plenty of downside to revealing who it is).
Having said that, the meeting need not become too narrowly focused on this one important issue. The meeting generally covers a wide range of subjects and hopefully this year will be no different.
I'd certainly like it to remain that way as long as Buffett is on the job.
In the latest Berkshire Hathaway (BRKa) Shareholder Letter, after emphasizing the Board's enthusiasm for the two new investment managers (Todd Combs and Ted Weschler), here's what Buffett said about his chosen successor:
Your Board is equally enthusiastic about my successor as CEO, an individual to whom they have had a great deal of exposure and whose managerial and human qualities they admire. (We have two superb back-up candidates as well.) When a transfer of responsibility is required, it will be seamless, and Berkshire’s prospects will remain bright. More than 98% of my net worth is in Berkshire stock, all of which will go to various philanthropies. Being so heavily concentrated in one stock defies conventional wisdom. But I’m fine with this arrangement, knowing both the quality and diversity of the businesses we own and the caliber of the people who manage them. With these assets, my successor will enjoy a running start. Do not, however, infer from this discussion that Charlie and I are going anywhere; we continue to be in excellent health, and we love what we do.
Despite his new illness, from what is known it seems there's a good chance Buffett will be in his current job for a very long time. I, like many others, wish him the best possible health.
The next shareholder meeting certainly needs to have enough time (subjective, of course) spent on succession. Yet, I'm hoping the meeting doesn't become dedicated to (or obsessed with) anticipating the inevitable transition ahead that's ultimately unknowable at this time.
There's plenty of other worthwhile ground to cover. For whatever number of years may be left where Warren Buffett and Charlie Munger take questions at the annual meeting, it would be nice if it is used to learn as much as possible from them.
Adam
The good news is that I've been told by my doctors that my condition is not remotely life-threatening or even debilitating in any meaningful way. I received my diagnosis last Wednesday. I then had a CAT scan and a bone scan on Thursday, followed by an MRI today. These tests showed no incidence of cancer elsewhere in my body.
This CNBC article added some perspective on Buffett's health.
Buffett Moves Quickly to Disclose 'Not Life Threatening' Cancer
This inevitably will bring Berkshire's succession planning to the forefront. It is almost certain that lots of time will be dedicated to the issue at the the 2012 Berkshire Hathaway Annual Shareholder Meeting that's happening at the beginning of next month.
Who will be taking Buffett's job when he no longer can do it is obviously an important subject for Berkshire shareholders. It would be nice to know the successor (though there's plenty of downside to revealing who it is).
Having said that, the meeting need not become too narrowly focused on this one important issue. The meeting generally covers a wide range of subjects and hopefully this year will be no different.
I'd certainly like it to remain that way as long as Buffett is on the job.
In the latest Berkshire Hathaway (BRKa) Shareholder Letter, after emphasizing the Board's enthusiasm for the two new investment managers (Todd Combs and Ted Weschler), here's what Buffett said about his chosen successor:
Your Board is equally enthusiastic about my successor as CEO, an individual to whom they have had a great deal of exposure and whose managerial and human qualities they admire. (We have two superb back-up candidates as well.) When a transfer of responsibility is required, it will be seamless, and Berkshire’s prospects will remain bright. More than 98% of my net worth is in Berkshire stock, all of which will go to various philanthropies. Being so heavily concentrated in one stock defies conventional wisdom. But I’m fine with this arrangement, knowing both the quality and diversity of the businesses we own and the caliber of the people who manage them. With these assets, my successor will enjoy a running start. Do not, however, infer from this discussion that Charlie and I are going anywhere; we continue to be in excellent health, and we love what we do.
Despite his new illness, from what is known it seems there's a good chance Buffett will be in his current job for a very long time. I, like many others, wish him the best possible health.
The next shareholder meeting certainly needs to have enough time (subjective, of course) spent on succession. Yet, I'm hoping the meeting doesn't become dedicated to (or obsessed with) anticipating the inevitable transition ahead that's ultimately unknowable at this time.
There's plenty of other worthwhile ground to cover. For whatever number of years may be left where Warren Buffett and Charlie Munger take questions at the annual meeting, it would be nice if it is used to learn as much as possible from them.
Adam
Thursday, April 5, 2012
Jamie Dimon's 2011 Annual Shareholder Letter
In his latest letter to the shareholders of Berkshire Hathaway (BRKa), Warren Buffett had this to say about the CEO of J.P. Morgan ((JPM), Jamie Dimon:
One CEO who always stresses the price/value factor in repurchase decisions is Jamie Dimon at J.P. Morgan; I recommend that you read his annual letter.
Recently on CNBC, he also was very complimentary of Jamie Dimon's annual letter and said he owns some J.P. Morgan shares personally.
Well, Jamie Dimon's 2011 letter to J.P. Morgan shareholders was just released and it is a very good one.
Some excerpts from Dimon's latest letter:
$ 1.8 Trillion of Capital and Credit
During 2011, the firm raised capital and provided credit of over $1.8 trillion for our commercial and consumer clients, up 18% from the prior year.
On Buybacks and Dividends
We also bought back $9 billion of stock and recently received permission to buy back an additional $15 billion of stock during the remainder of 2012 and the first quarter of 2013. We reinstated our annual dividend to $1.00 a share in April 2011 and recently announced that we are increasing it to $1.20 a share in April 2012.
J.P Morgan's Stock
Normally, we don't comment on the stock price. However, we make an exception in Section VIII of this letter because we are buying back a substantial amount of stock and because there are many concerns about investing in bank stocks.
It Could Have Been Much Better
Recently, we have begun to achieve modest economic growth around the globe, somewhat held back by certain natural disasters such as the tsunami in Japan. But I have no doubt that our own actions – from the debt ceiling fiasco to bad and uncoordinated policy, including the somewhat dramatic restraining of bank leverage in the United States and Europe at precisely the wrong time – made the recovery worse than it otherwise would have been. You cannot prove this in real time, but when economists 20 years from now write the book on the recovery, it may well be entitled, It Could Have Been Much Better.
A Stronger System
There also should be recognition that the whole system is stronger. Accounting and disclosure are better, most off-balance sheet vehicles are gone, underwriting standards are higher, there is much less leverage in the system, many of the bad actors are gone and, last but not least, each remaining bank is individually stronger.
Best and Highest Use of Capital
Our best and highest use of capital (after the dividend) is always to build our business organically – particularly where we have significant competitive advantages and good returns. We already have described many of those opportunities in this letter, and I won’t repeat them here. The second-highest use would be great acquisitions, but, as I also have indicated, it is unlikely that we will do one that requires substantial amounts of capital.
More on Buybacks
If you like our businesses, buying back stock at tangible book value is a very good deal. So you can assume that we are a buyer in size around tangible book value. Unfortunately, we were restricted from buying back more stock when it was cheap – below tangible book value – and we did not get permission to buy back stock until it was selling at $45 a share.
Our appetite for buying back stock is not as great (of course) at higher prices.
Dimon does also say that they plan to buy back the amount of stock that we issue every year for employee compensation because "we think this is just good discipline". I find that to be a bit disappointing but the statement that follows provides some reassurance they won't do that kind of thing at any price:
Rest assured, the Board will continuously reevaluate our capital plans and make changes as appropriate but will authorize a buyback of stock only when we think it is a great deal for you, our shareholders.
The statements "our appetite for buying back stock is not as great" and "will authorize a buyback of stock only when we think it is a great deal" should be the norm among CEOs but that kind of discipline is far from a given.
Adam
One CEO who always stresses the price/value factor in repurchase decisions is Jamie Dimon at J.P. Morgan; I recommend that you read his annual letter.
Recently on CNBC, he also was very complimentary of Jamie Dimon's annual letter and said he owns some J.P. Morgan shares personally.
Well, Jamie Dimon's 2011 letter to J.P. Morgan shareholders was just released and it is a very good one.
Some excerpts from Dimon's latest letter:
$ 1.8 Trillion of Capital and Credit
During 2011, the firm raised capital and provided credit of over $1.8 trillion for our commercial and consumer clients, up 18% from the prior year.
On Buybacks and Dividends
We also bought back $9 billion of stock and recently received permission to buy back an additional $15 billion of stock during the remainder of 2012 and the first quarter of 2013. We reinstated our annual dividend to $1.00 a share in April 2011 and recently announced that we are increasing it to $1.20 a share in April 2012.
J.P Morgan's Stock
Normally, we don't comment on the stock price. However, we make an exception in Section VIII of this letter because we are buying back a substantial amount of stock and because there are many concerns about investing in bank stocks.
It Could Have Been Much Better
Recently, we have begun to achieve modest economic growth around the globe, somewhat held back by certain natural disasters such as the tsunami in Japan. But I have no doubt that our own actions – from the debt ceiling fiasco to bad and uncoordinated policy, including the somewhat dramatic restraining of bank leverage in the United States and Europe at precisely the wrong time – made the recovery worse than it otherwise would have been. You cannot prove this in real time, but when economists 20 years from now write the book on the recovery, it may well be entitled, It Could Have Been Much Better.
A Stronger System
There also should be recognition that the whole system is stronger. Accounting and disclosure are better, most off-balance sheet vehicles are gone, underwriting standards are higher, there is much less leverage in the system, many of the bad actors are gone and, last but not least, each remaining bank is individually stronger.
Best and Highest Use of Capital
Our best and highest use of capital (after the dividend) is always to build our business organically – particularly where we have significant competitive advantages and good returns. We already have described many of those opportunities in this letter, and I won’t repeat them here. The second-highest use would be great acquisitions, but, as I also have indicated, it is unlikely that we will do one that requires substantial amounts of capital.
More on Buybacks
If you like our businesses, buying back stock at tangible book value is a very good deal. So you can assume that we are a buyer in size around tangible book value. Unfortunately, we were restricted from buying back more stock when it was cheap – below tangible book value – and we did not get permission to buy back stock until it was selling at $45 a share.
Our appetite for buying back stock is not as great (of course) at higher prices.
Dimon does also say that they plan to buy back the amount of stock that we issue every year for employee compensation because "we think this is just good discipline". I find that to be a bit disappointing but the statement that follows provides some reassurance they won't do that kind of thing at any price:
Rest assured, the Board will continuously reevaluate our capital plans and make changes as appropriate but will authorize a buyback of stock only when we think it is a great deal for you, our shareholders.
The statements "our appetite for buying back stock is not as great" and "will authorize a buyback of stock only when we think it is a great deal" should be the norm among CEOs but that kind of discipline is far from a given.
Adam
Monday, March 19, 2012
Apple Initiates Quarterly Dividend and Share Repurchase Program
This morning, Apple (AAPL) announced they will begin paying a quarterly dividend and initiate a share repurchase program.
The company will start paying a $ 2.65/share quarterly dividend and expects to repurchase $ 10 billion of stock over three years.
Using Friday's closing price the annual dividend yield is 1.81 %. Apple will start paying that dividend in the company's fiscal fourth quarter, which begins July 1.
With the stock now hitting all-time highs, it sure would have been nice if the share repurchases had begun much earlier.
The company said the following in their press release about the share repurchase program:
...the Company's Board of Directors has authorized a $10 billion share repurchase program commencing in the Company’s fiscal 2013, which begins on September 30, 2012. The repurchase program is expected to be executed over three years, with the primary objective of neutralizing the impact of dilution from future employee equity grants and employee stock purchase programs.
Apple's stock, even though it has run quite a bit, may not yet be overvalued but saying that the primary objective of the repurchase program is to neutralize "the impact of dilution" is revealing and seems at least poorly worded.
The purpose of a buyback should simply be to buy shares whenever they are comfortably below intrinsic value* for the benefit of long-term holders (as long as the company can easily afford it).
Consider what Apple said in the press release (that the share repurchase program has "the primary objective of neutralizing the impact of dilution") in the context of what Warren Buffett said in the most recent Berkshire Hathaway Shareholder Letter:
Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated.
We have witnessed many bouts of repurchasing that failed our second test. Sometimes, of course, infractions – even serious ones – are innocent; many CEOs never stop believing their stock is cheap. In other instances, a less benign conclusion seems warranted. It doesn't suffice to say that repurchases are being made to offset the dilution from stock issuances [emphasis added] or simply because a company has excess cash. Continuing shareholders are hurt unless shares are purchased below intrinsic value. The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another.
Apple, like any business, should buy back shares whenever both conditions are met. I think it's safe to say the company has had the first condition covered and, in recent years, it seems pretty clear they've had the second condition also covered (obviously much less so now considering the recent price action of its stock).
In the release, neutralizing share dilution is what Apple said is the primary objective but that's clearly not where the focus should be.
No share repurchase makes sense unless a clear discount to likely intrinsic value exists.
It seems obvious that true long-term investors in Apple's stock don't benefit if shares are repurchased at any cost to meet their stated primary objective. Now, make the primary objective to buy shares whenever they are selling comfortably below intrinsic value and shareholders will do just fine. To me, that's how decision-making for a share repurchase program should be guided.**
With nearly $ 100 billion of cash and investments and that pile of money growing at an extremely rapid clip, it was time for Apple to start returning cash to shareholders. The dividend seems a good start but it will be worth watching closely how their buyback decision-making plays out.
Adam
Established a long position in AAPL at much lower than recent market prices
* Obviously, intrinsic value cannot be precisely calculated. At best, it's a range that represents a company's likely value. Apple's change in intrinsic value has been unusually fast moving and hard to gauge. It continues to be difficult at best to estimate what's it's really worth and likely going to be worth down the road. The answer now seems likely to be a lot but something this dynamic by its nature has a wider range of outcomes.
** I'm guessing Apple would likely not buy back as much stock if shares became extremely expensive. It's just that the wording of their release doesn't even provide a passing mention of how price versus value impacts their decision-making. Now, if Apple's business continues to be in such good shape it will hardly be the end of the world if they don't get this exactly right. The success of their next several product launches matters a whole lot more. Yet, it is still an example of potentially less than optimal buyback decision-making and capital allocation. Something that has been prevalent with far too many public companies. Who knows, may be Apple will do a good job on this. We'll see.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
The company will start paying a $ 2.65/share quarterly dividend and expects to repurchase $ 10 billion of stock over three years.
Using Friday's closing price the annual dividend yield is 1.81 %. Apple will start paying that dividend in the company's fiscal fourth quarter, which begins July 1.
With the stock now hitting all-time highs, it sure would have been nice if the share repurchases had begun much earlier.
The company said the following in their press release about the share repurchase program:
...the Company's Board of Directors has authorized a $10 billion share repurchase program commencing in the Company’s fiscal 2013, which begins on September 30, 2012. The repurchase program is expected to be executed over three years, with the primary objective of neutralizing the impact of dilution from future employee equity grants and employee stock purchase programs.
Apple's stock, even though it has run quite a bit, may not yet be overvalued but saying that the primary objective of the repurchase program is to neutralize "the impact of dilution" is revealing and seems at least poorly worded.
The purpose of a buyback should simply be to buy shares whenever they are comfortably below intrinsic value* for the benefit of long-term holders (as long as the company can easily afford it).
Consider what Apple said in the press release (that the share repurchase program has "the primary objective of neutralizing the impact of dilution") in the context of what Warren Buffett said in the most recent Berkshire Hathaway Shareholder Letter:
Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated.
We have witnessed many bouts of repurchasing that failed our second test. Sometimes, of course, infractions – even serious ones – are innocent; many CEOs never stop believing their stock is cheap. In other instances, a less benign conclusion seems warranted. It doesn't suffice to say that repurchases are being made to offset the dilution from stock issuances [emphasis added] or simply because a company has excess cash. Continuing shareholders are hurt unless shares are purchased below intrinsic value. The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another.
Apple, like any business, should buy back shares whenever both conditions are met. I think it's safe to say the company has had the first condition covered and, in recent years, it seems pretty clear they've had the second condition also covered (obviously much less so now considering the recent price action of its stock).
In the release, neutralizing share dilution is what Apple said is the primary objective but that's clearly not where the focus should be.
No share repurchase makes sense unless a clear discount to likely intrinsic value exists.
It seems obvious that true long-term investors in Apple's stock don't benefit if shares are repurchased at any cost to meet their stated primary objective. Now, make the primary objective to buy shares whenever they are selling comfortably below intrinsic value and shareholders will do just fine. To me, that's how decision-making for a share repurchase program should be guided.**
With nearly $ 100 billion of cash and investments and that pile of money growing at an extremely rapid clip, it was time for Apple to start returning cash to shareholders. The dividend seems a good start but it will be worth watching closely how their buyback decision-making plays out.
Adam
Established a long position in AAPL at much lower than recent market prices
* Obviously, intrinsic value cannot be precisely calculated. At best, it's a range that represents a company's likely value. Apple's change in intrinsic value has been unusually fast moving and hard to gauge. It continues to be difficult at best to estimate what's it's really worth and likely going to be worth down the road. The answer now seems likely to be a lot but something this dynamic by its nature has a wider range of outcomes.
** I'm guessing Apple would likely not buy back as much stock if shares became extremely expensive. It's just that the wording of their release doesn't even provide a passing mention of how price versus value impacts their decision-making. Now, if Apple's business continues to be in such good shape it will hardly be the end of the world if they don't get this exactly right. The success of their next several product launches matters a whole lot more. Yet, it is still an example of potentially less than optimal buyback decision-making and capital allocation. Something that has been prevalent with far too many public companies. Who knows, may be Apple will do a good job on this. We'll see.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
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