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Examining Benjamin Graham’s Record: Skill Or Luck?

Posted in About, Behavioral economics, Quantitative investment, Quantitative Value Book, Strategy, Value Investment, tagged , , , on January 9, 2013| 23 Comments »

Two recent articles, Was Benjamin Graham Skillful or Lucky? (WSJ), and Ben Graham’s 60-Year-Old Strategy Still Winning Big (Forbes), have thrown the spotlight back on Benjamin Graham’s investment strategy and his record. In the context of Michael Mauboussin’s new book The Success Equation, Jason Zweig asks in his WSJ Total Return column whether Graham was lucky or skillful, noting that Graham admitted he had his fair share of luck:

We tend to think of the greatest investors – say, Peter Lynch, George Soros, John Templeton, Warren Buffett, Benjamin Graham – as being mostly or entirely skillful.

Graham, of course, was the founder of security analysis as a profession, Buffett’s professor and first boss, and the author of the classic book The Intelligent Investor. He is universally regarded as one of the best investors of the 20th century.

But Graham, who outperformed the stock market by an annual average of at least 2.5 percentage points for more than two decades, coyly admitted that much of his remarkable track record may have been due to luck.

John Reese, in his Forbes’ Intelligent Investing column, notes that Graham’s Defensive Investor strategy has continued to outpace the market over the last decade:

Known as the “Father of Value Investing”—and the mentor of Warren Buffett—Graham’s investment firm posted annualized returns of about 20% from 1936 to 1956, far outpacing the 12.2% average return for the broader market over that time.

But the success of Graham’s approach goes far beyond even that lengthy period. For nearly a decade, I have been tracking a portfolio of stocks picked using my Graham-inspired Guru Strategy, which is based on the “Defensive Investor” criteria that Graham laid out in his 1949 classic, The Intelligent Investor. And, since its inception, the portfolio has returned 224.3% (13.3% annualized) vs. 43.0% (3.9% annualized) for the S&P 500.

Even with all of the fiscal cliff and European debt drama in 2012, the Graham-based portfolio has had a particularly good year. While the S&P 500 has notched a solid 13.7% gain (all performance figures through Dec. 17), the Graham portfolio is up more than twice that, gaining 28.5%.

Reese’s experiment might suggest that Graham is more skillful than lucky.

In our recently released book, Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, Wes and I examine one of Graham’s simple strategies in the period after he described it to the present day. Graham gave an interview to the Financial Analysts Journal in 1976, some 40 year after the publication of Security Analysis. He was asked whether he still selected stocks by carefully studying individual issues, and responded:

I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook “Graham and Dodd” was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I’m on the side of the “efficient market” school of thought now generally accepted by the professors.

Instead, Graham proposed a highly simplified approach that relied for its results on the performance of the portfolio as a whole rather than on the selection of individual issues. Graham believed that such an approach “[combined] the three virtues of sound logic, simplicity of application, and an extraordinarily good performance record.”

Graham said of his simplified value investment strategy:

What’s needed is, first, a definite rule for purchasing which indicates a priori that you’re acquiring stocks for less than they’re worth. Second, you have to operate with a large enough number of stocks to make the approach effective. And finally you need a very definite guideline for selling.

What did Graham believe was the simplest way to select value stocks? He recommended that an investor create a portfolio of a minimum of 30 stocks meeting specific price-to-earnings criteria (below 10) and specific debt-to-equity criteria (below 50 percent) to give the “best odds statistically,” and then hold those stocks until they had returned 50 percent, or, if a stock hadn’t met that return objective by the “end of the second calendar year from the time of purchase, sell it regardless of price.”

Graham said that his research suggested that this formula returned approximately 15 percent per year over the preceding 50 years. He cautioned, however, that an investor should not expect 15 percent every year. The minimum period of time to determine the likely performance of the strategy was five years.

Graham’s simple strategy sounds almost too good to be true. Sure, this approach worked in the 50 years prior to 1976, but how has it performed in the age of the personal computer and the Internet, where computing power is a commodity, and access to comprehensive financial information is as close as the browser? We decided to find out. Like Graham, Wes and I used a price-to-earnings ratio cutoff of 10, and we included only stocks with a debt-to-equity ratio of less than 50 percent. We also apply his trading rules, selling a stock if it returned 50 percent or had been held in the portfolio for two years.

Figure 1.2 below taken from our book shows the cumulative performance of Graham’s simple value strategy plotted against the performance of the S&P 500 for the period 1976 to 2011:

Graham Strategy

Amazingly, Graham’s simple value strategy has continued to outperform.

Table 1.2 presents the results from our study of the simple Graham value strategy:

Graham Chart

Graham’s strategy turns $100 invested on January 1, 1976, into $36,354 by December 31, 2011, which represents an average yearly compound rate of return of 17.80 percent—outperforming even Graham’s estimate of approximately 15 percent per year. This compares favorably with the performance of the S&P 500 over the same period, which would have turned $100 invested on January 1, 1976, into $4,351 by December 31, 2011, an average yearly compound rate of return of 11.05 percent. The performance of the Graham strategy is attended by very high volatility, 23.92 percent versus 15.40 percent for the total return on the S&P 500.

The evidence suggests that Graham’s simplified approach to value investment continues to outperform the market. I think it’s a reasonable argument for skill on the part of Graham.

It’s useful to consider why Graham’s simple strategy continues to outperform. At a superficial level, it’s clear that some proxy for price—like a P/E ratio below 10—combined with some proxy for quality—like a debt-to-equity ratio below 50 percent—is predictive of future returns. But is something else at work here that might provide us with a deeper understanding of the reasons for the strategy’s success? Is there some other reason for its outperformance beyond simple awareness of the strategy? We think so.

Graham’s simple value strategy has concrete rules that have been applied consistently in our study. Even through the years when the strategy underperformed the market  our study assumed that we continued to apply it, regardless of how discouraged or scared we might have felt had we actually used it during the periods when it underperformed the market. Is it possible that the very consistency of the strategy is an important reason for its success? We believe so. A value investment strategy might provide an edge, but some other element is required to fully exploit that advantage.

Warren Buffett and Charlie Munger believe that the missing ingredient is temperament. Says Buffett, “Success in investing doesn’t correlate with IQ once you’re above the level of 125. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”

Was Graham skillful or lucky? Yes. Does the fact that he was lucky detract from his extraordinary skill? No because he purposefully concentrated on the undervalued tranch of stocks that provide asymmetric outcomes: good luck in the fortunes of his holdings helped his portfolio disproportionately on the upside, and bad luck didn’t hurt his portfolio much on the downside. That, in my opinion, is strong evidence of skill.

Buy my book The Acquirer’s Multiple: How the Billionaire Contrarians of Deep Value Beat the Market from on Kindle, paperback, and Audible.

Here’s your book for the fall if you’re on global Wall Street. Tobias Carlisle has hit a home run deep over left field. It’s an incredibly smart, dense, 213 pages on how to not lose money in the market. It’s your Autumn smart read. –Tom Keene, Bloomberg’s Editor-At-Large, Bloomberg Surveillance, September 9, 2014.

Click here if you’d like to read more on The Acquirer’s Multiple, or connect with me on Twitter, LinkedIn or Facebook. Check out the best deep value stocks in the largest 1000 names for free on the deep value stock screener at The Acquirer’s Multiple®.

 

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Eight investment maxims to generate extraordinary returns investing in the unknown and unknowable

Posted in About, Behavioral economics, Strategy, tagged on December 18, 2012| 2 Comments »

Richard Zeckhauser’s Investing in the Unknown and Unknowable (.pdf) is a fantastic 2006 paper about investing in “unknown and unknowable” (UU) situations in which “traditional finance theory does not apply” because each is unique, so past data are non-existent, and therefore an obviously poor guide to evaluating the investment.

Zeckhauser gives as an example David Ricardo’s purchase of British government bonds on the eve of the Battle of Waterloo:

David Ricardo made a fortune buying bonds from the British government four days in advance of the Battle of Waterloo. He was not a military analyst, and even if he were, he had no basis to compute the odds of Napoleon’s defeat or victory, or hard-to-identify ambiguous outcomes. Thus, he was investing in the unknown and the unknowable. Still, he knew that competition was thin, that the seller was eager, and that his windfall pounds should Napoleon lose would be worth much more than the pounds he’d lose should Napoleon win. Ricardo knew a good bet when he saw it.

…

The financing of 36 million pounds was floated on the London Stock Exchange. Ricardo took a substantial share. His frequent correspondent Thomas Malthus took 5,000 pounds on Ricardo’s recommendation, but sold out shortly before news of the Waterloo outcome was received. The evidence is clear that Ricardo, in his words, understood the “dismal forebodings” of the situation, including “its consequences, on our [England’s] finances.”

Zeckhauser’s Table 1 below shows the UU world:

UU Table

Zeckhauser says that many great investors, from David Ricardo to Warren Buffett, have made most of their fortunes by betting on “UUU” or unique UU situations:

Ricardo allegedly made 1 million pounds (over $50 million today) – roughly half of his fortune at death – on his Waterloo bonds.5 Buffett has made dozens of equivalent investments. Though he is best known for the Nebraska Furniture Mart and See’s Candies, or for long-term investments in companies like the Washington Post and Coca Cola, insurance has been Berkshire Hathaway’s firehose of wealth over the years. And insurance often requires UUU thinking.

Not all UU situations are unique:

Some UU situations that appear to be unique are not, and thus fall into categories that lend themselves to traditional speculation. Corporate takeover bids are such situations. When one company makes a bid for another, it is often impossible to determine what is going on or what will happen, suggesting uniqueness. But since dozens of such situations have been seen over the years, speculators are willing to take positions in them. From the standpoint of investment, uniqueness is lost, just as the uniqueness of each child matters not to those who manufacture sneakers.

These strategies are distilled into eight investment maxims:

  • Maxim A: Individuals with complementary skills enjoy great positive excess returns from UU investments. Make a sidecar investment alongside them when given the opportunity.

  • Maxim B: The greater is your expected return on an investment, that is the larger is your advantage, the greater the percentage of your capital you should put at risk.

  • Maxim C: When information asymmetries may lead your counterpart to be concerned about trading with you, identify for her important areas where you have an absolute advantage from trading. You can also identify her absolute advantages, but she is more likely to know those already.

  • Maxim D: In a situation where probabilities may be hard for either side to assess, it may be sufficient to assess your knowledge relative to the party on the other side (perhaps the market).

  • Maxim E: A significant absolute advantage offers some protection against potential selection. You should invest in a UU world if your advantage multiple is great, unless the probability is high the other side is informed and if, in addition, the expected selection factor is severe.

  • Maxim F: In UU situations, even sophisticated investors tend to underweight how strongly the value of assets varies. The goal should be to get good payoffs when the value of assets is high.

  • Maxim G: Discounting for ambiguity is a natural tendency that should be overcome, just as should be overeating.

  • Maxim H: Do not engage in the heuristic reasoning that just because you do not know the risk, others do. Think carefully, and assess whether they are likely to know more than you. When the odds are extremely favorable, sometimes it pays to gamble on the unknown, even though there is some chance that people on the other side may know more than you.

The essay is brilliant. Zeckhauser acknowledges in the conclusion that it offers “more speculations than conclusions,” and its theory is “often tentative and implicit” in seeking to answer the question, “How can one invest rationally in UU situations?” but, if anything, it’s the better for it. Thinking as Zeckhauser proposes about UU situations may vastly improve investment decisions where UU events are involved, and should yield substantial benefits because “competition may be limited and prices well out of line.”

Read Investing in the Unknown and Unknowable (.pdf).

h/t @trengriffin via @mjmauboussin

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Do confidential hedge fund portfolio holdings generate superior performance?

Posted in About, Activist Investors, Catalysts, Stocks, Strategy, Value Investment, tagged , , on November 27, 2012| Leave a Comment »

What do requests for confidentiality reveal about hedge fund portfolio holdings? In Uncovering Hedge Fund Skill from the Portfolio Holdings They Hide, a paper to be published in the upcoming Journal of Finance (or see a February 2012 version on the SSRN), authors Vikas Agarwal, Wei Jiang, Yuehua Tang, and Baozhong Yang ask whether confidential holdings exhibit superior performance to holdings disclosed on a 13F in the ordinary course.

Institutional investment managers must disclose their quarterly portfolio holdings in a Form 13F. The 13(f) rule allows the SEC to delay disclosure that is “necessary or appropriate in the public interest or for the protection of investors.” When filers request confidential treatment for certain holdings, they may omit those holdings off their Form 13F. After the confidentiality period expires, the filer must reveal the holdings by filing an amendment to the original Form 13F.

Confidential treatment allows hedge funds to accumulate larger positions in stocks, and to spread the trades over a longer period of time. Funds request confidentiality where timely disclosure of portfolio holdings may reveal information about proprietary investment strategies that other investors can free-ride on without incurring the costs of research. The Form 13F filings of investors with the best track records are followed by many investors. Warren Buffett’s new holdings are so closely followed that he regularly requests confidential treatment on his larger investments.

Hedge funds seek confidentiality more frequently than other institutional investors. They constitute about 30 percent of all institutions, but account for 56 percent of all the confidential filings. Hedge funds on average relegate about one-third of their total portfolio values into confidentiality, while the same figure is one-fifth for investment companies/advisors and one-tenth for banks and insurance companies.

The authors make three important findings:

  1. Hedge funds with characteristics associated with more active portfolio management, such as those managing large and concentrated portfolios, and adopting non-standard investment strategies (i.e., higher idiosyncratic risk), are more likely to request confidentiality.
  2. The confidential holdings are more likely to consist of stocks associated with information-sensitive events such as mergers and acquisitions, and stocks subject to greater information asymmetry, i.e., those with smaller market capitalization and fewer analysts following.
  3. Confidential holdings of hedge funds exhibit significantly higher abnormal performance compared to their original holdings for different horizons ranging from 2 months to 12 months. For example, the difference over the 12-month horizon ranges from 5.2% to 7.5% on an annualized basis.

Read a February 2012 version on the SSRN.

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Buffett buys newspaper division of Media General $MEG

Posted in Activist Investors, Warren Buffett, tagged , on May 29, 2012| Leave a Comment »

I’ve been closely following on Greenbackd the Kinnaras stoush with the board of Media General Inc (NYSE:MEG) over the last few months.

Kinnaras has been pushing the Board to “take advantage of the robust M&A market for both newspaper and broadcast television and to sell all operating units of MEG in order to retire existing corporate and pension debt and achieve a share price shareholders have rarely seen in recent years.”

It looks like Kinnaras has succeeded, with the board announcing recently that it had reached an agreement to sell its newspaper division, excluding the Tampa Tribune, to Warren Buffett’s BH Media Group for $142 million. In addition, Buffett would also provide MEG with a new Term Loan and revolver in exchange for roughly 20 percent of additional equity.

MEG is a provider of local news in small and mid-size communities throughout the Southeastern United States. It owns three metropolitan and 20 community newspapers and 18 network-affiliated broadcast television stations Virginia/Tennessee, Florida, Mid-South, North Carolina, and Ohio/Rhode Island.

Kinnaras’s Managing Member Amit Chokshi has a new post analyzing the sale and the valuation of the remaining rump of $MEG. Chokshi sees the valuation as follows (against a prevailing share price of $3.50):

A 6.8x multiple would imply a valuation of about $8.50/share when using my estimates for how MEG’s capitalization will look post the BH Media transaction and accounting for BH Media’s warrants. By year-end, it is possible that another $10-20MM in debt is reduced which would bring share value up close to $1. The reason the jump is so significant is because each dollar of cash flow erases some very expensive debt. In addition, pure-play broadcasters are valued from 6-9x EV/EBITDA and one could argue that MEG deserves a valuation closer towards the mid point or higher for its peers when factoring the disposal of newspapers and accounting for the high quality locations of its key stations.

…

Lastly, as I’ve repeated in each prior post, another potential value creation event would be selling off the entire company. BH Media will now occupy a Board seat and I don’t expect the blind subservience other Board members have. Management has demonstrated a clear lack of competence in every facet of managing MEG. The only thing they have done thus far is get lucky in terms of finding a buyer for their assets and providing them financing. As an owner of MEG, BH Media will get an up close look at the type of management this team brings and I suspect will compare the value management adds or detracts. To any sane observer, management is just pitiful and MEG’s value suffers for it.

Read the full post here.

No position.

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The Superinvestors of Graham-and-Doddsville Revisited: Value Trounces Growth in Mutual Funds

Posted in About, Stocks, Strategy, Value Investment, Warren Buffett, tagged , on May 24, 2012| 1 Comment »

The Superinvestors of Graham-and-Doddsville is a well-known article (see the original Hermes article here.pdf) by Warren Buffett defending value investing against the efficient market hypothesis. The article is an edited transcript of a talk Buffett gave at Columbia University in 1984 commemorating the fiftieth anniversary of Security Analysis, written by Benjamin Graham and David L. Dodd.

In a 2006 talk, “Journey Into the Whirlwind: Graham-and-Doddsville Revisited,” Louis Lowenstein*, then a professor at the Columbia Law School, compared the performance of a group of “true-blue, walk-the-walk value investors” (the “Goldfarb Ten”) and “a group of large cap growth funds” (the “Group of Fifteen”).

Here are Lowenstein’s findings:

For the five years ended this past August 31, the Group of Fifteen experienced on average negative returns of 8.89% per year, vs. a negative 2.71% for the S&P 500.4 The group of ten value funds I had studied in the “Searching for Rational Investors” article had been suggested by Bob Goldfarb of the Sequoia Fund.5 Over those same five years, the Goldfarb Ten enjoyed positive average annual returns of 9.83%. This audience is no doubt quick with numbers, but let me help. Those fifteen large growth funds underperformed the Goldfarb Ten during those five years by an average of over 18 percentage points per year. Hey, pretty soon you have real money. Only one of the fifteen had even modestly positive returns. Now if you go back ten years, a period that includes the bubble, the Group of Fifteen did better, averaging a positive 8.13% per year.Even for that ten year period, however, they underperformed the value group, on average, by more than 5% per year.6 With a good tailwind, those large cap funds were not great – underperforming the index by almost 2% per year – and in stormy weather their boats leaked badly.

Lowenstein takes a close look at one of the Group of Fifteen (a growth fund):

The first was the Massachusetts Investors Growth Stock Fund, chosen because of its long history. Founded in 1932, as the Massachusetts Investors Second Fund, it was, like its older sibling, Massachusetts Investors Trust, truly a mutual fund, in the sense that it was managed internally, supplemented by an advisory board of six prominent Boston businessmen.7 In 1969, when management was shifted to an external company, now known as MFS Investment Management, the total expense ratio was a modest 0.32%.

I am confident that the founders of the Massachusetts Investors Trust would no longer recognize their second fund, which has become a caricature of the “do something” culture. The expense ratio, though still below its peer group, has tripled. But it’s the turbulent pace of trading that would have puzzled and distressed them. At year-end 1999, having turned the portfolio over 174%, the manager said they had moved away from “stable growth companies” such as supermarket and financial companies, and into tech and leisure stocks, singling out in the year- end report Cisco and Sun Microsystems – each selling at the time at about 100 X earnings – for their “reasonable stock valuation.” The following year, while citing a bottom-up, “value sensitive approach,” the fund’s turnover soared to 261%. And in 2001, with the fund continuing to remark on its “fundamental . . .bottom-up investment process,” turnover reached the stratospheric level of 305%. It is difficult to conceive how, even in 2003, well after the market as a whole had stabilized, the managers of this $10 billion portfolio had sold $28 billion of stock and then reinvested that $28 billion in other stocks.

For the five years ended in 2003, turnover in the fund averaged 250%. All that senseless trading took a toll. For the five years ended this past August, average annual returns were a negative 9-1/2%. Over the past ten years, which included the glory days of the New Economy, the fund did better, almost matching the index, though still trailing our value funds by 4% a year. Net assets which had been a modest $1.9 billion at Don Phillips’ kickoff date in 1997, and had risen to $17 billion in 2000, are now about $8 billion.

If you’re feeling some sympathy for the passengers in this financial vehicle, hold on. Investors – and I’m using the term loosely – in the Mass. Inv. Growth Stock Fund were for several years running spinning their holdings in and out of the fund at rates approximating the total assets of the fund. In 2001, for example, investors cashed out of $17-1/2 billion in Class A shares, and bought $16 billion in new shares, leaving the fund at year end with net assets of about $14 billion. Having attracted, not investors, but speculators trying to catch the next new thing, management got the shareholders they deserved.

And the value investors?

Having updated my data through August of this year, I am happy to report that the Goldfarb Ten still look true blue – actually better than at year-end 2003. The portfolio turnover rates have dropped on average to 16% – translation, an average holding period of six years. Honey, what did you do today? Nothing, dear.The average cash holding is 14% of the portfolio, and five of the funds are closed to new investors.f Currently, however, two of the still open funds, Mutual Beacon and Clipper, are losing their managers. The company managing the Clipper Fund has been sold twice over and Jim Gipson and two colleagues recently announced they’re moving on. At Mutual Beacon, which is part of the Franklin Templeton family, David Winters has left to create a mutual fund, ah yes, the Wintergreen Fund. It will be interesting to see whether Mutual Beacon and Clipper will maintain their discipline.

Speaking of discipline, you may remember that after Buffett published “The Superinvestors,” someone calculated that while they were indeed superinvestors, on average they had trailed the market one year in three.20 Tom Russo, of the Semper Vic Partners fund, took a similar look at the Goldfarb Ten and found, for example, that four of them had each underperformed the S&P 500 for four consecutive years, 1996-1999, and in some cases by huge amounts. For the full ten years, of course, that underperformance was sharply reversed, and then some. Value investing thus requires not just patient managers but also patient investors, those with the temperament as well as intelligence to feel comfortable even when sorely out of step with the crowd. If you’re fretting that the CBOE Market Volatility Index may be signaling fear this week, value investing is not for you.

* Louis was father to Roger Lowenstein of Buffett: The Making of an American Capitalist.

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The dumbest net net stock Warren Buffett ever bought

Posted in About, Greenbackd, Net Current Asset Value, Net Net Stocks, Net Quick Stocks, Net Quick Value, Warren Buffett, tagged , on October 19, 2010| 1 Comment »

This is an oldie, but a goodie (via CNN). The travails of buying net nets, as told by the master’s apprentice:

Warren Buffett says Berkshire Hathaway is the “dumbest” stock he ever bought.

He calls his 1964 decision to buy the textile company a $200 billion dollar blunder, sparked by a spiteful urge to retaliate against the CEO who tried to “chisel” Buffett out of an eighth of a point on a tender deal.

Buffett tells the story in response to a question from CNBC’s Becky Quick for a Squawk Box series on the biggest self-admitted mistakes by some of the world’s most successful investors.

Buffett tells Becky that his holding company (presumably with a different name) would be “worth twice as much as it is now” — another $200 billion — if he had bought a good insurance company instead of dumping so much money into the dying textile business.

Here’s his story:

BUFFETT:  The— the dumbest stock I ever bought— was— drum roll here— Berkshire Hathaway.  And— that may require a bit of explanation.  It was early in— 1962, and I was running a small partnership, about seven million.  They call it a hedge fund now.

And here was this cheap stock, cheap by working capital standards or so.  But it was a stock in a— in a textile company that had been going downhill for years.  So it was a huge company originally, and they kept closing one mill after another.  And every time they would close a mill, they would— take the proceeds and they would buy in their stock.  And I figured they were gonna close, they only had a few mills left, but that they would close another one.  I’d buy the stock.  I’d tender it to them and make a small profit.

So I started buying the stock.  And in 1964, we had quite a bit of stock.  And I went back and visited the management,  Mr. (Seabury) Stanton.  And he looked at me and he said, ‘Mr. Buffett.  We’ve just sold some mills.  We got some excess money.  We’re gonna have a tender offer.  And at what price will you tender your stock?’

And I said, ‘11.50.’  And he said, ‘Do you promise me that you’ll tender it 11.50?’  And I said, ‘Mr. Stanton, you have my word that if you do it here in the near future, that I will sell my stock to— at 11.50.’  I went back to Omaha.  And a few weeks later, I opened the mail—

BECKY:  Oh, you have this?

BUFFETT:   And here it is:  a tender offer from Berkshire Hathaway— that’s from 1964.  And if you look carefully, you’ll see the price is—

BECKY:  11 and—

BUFFETT:   —11 and three-eighths.  He chiseled me for an eighth.  And if that letter had come through with 11 and a half, I would have tendered my stock.  But this made me mad.  So I went out and started buying the stock, and I bought control of the company, and fired Mr. Stanton.  (LAUGHTER)

Now, that sounds like a great little morality table— tale at this point.  But the truth is I had now committed a major amount of money to a terrible business.  And Berkshire Hathaway became the base for everything pretty much that I’ve done since.  So in 1967, when a good insurance company came along, I bought it for Berkshire Hathaway.  I really should— should have bought it for a new entity.

Because Berkshire Hathaway was carrying this anchor, all these textile assets.  So initially, it was all textile assets that weren’t any good.  And then, gradually, we built more things on to it.  But always, we were carrying this anchor.  And for 20 years, I fought the textile business before I gave up.  As instead of putting that money into the textile business originally, we just started out with the insurance company, Berkshire would be worth twice as much as it is now.  So—

BECKY:  Twice as much?

BUFFETT:  Yeah.  This is $200 billion.  You can— you can figure that— comes about.  Because the genius here thought he could run a textile business. (LAUGHTER)

BECKY:  Why $200 billion?

BUFFETT:  Well, because if you look at taking that same money that I put into the textile business and just putting it into the insurance business, and starting from there, we would have had a company that— because all of this money was a drag.  I mean, we had to— a net worth of $20 million.  And Berkshire Hathaway was earning nothing, year after year after year after year.  And— so there you have it, the story of— a $200 billion— incidentally, if you come back in ten years, I may have one that’s even worse.  (LAUGHTER)

Hat tip SD and David Lau.

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Warren Buffett on the economy: “No double dip”

Posted in About, Austrian Economics, Value Investment, Warren Buffett, tagged on September 14, 2010| 2 Comments »

Warren Buffett has long eschewed any ability to foresee the path of the markets or the economy, but according to this BusinessWeek article, he’s resolute that the economy will not slide back into recession:

Warren Buffett ruled out a second recession in the U.S. and said businesses owned by his Berkshire Hathaway Inc. are growing.

“I am a huge bull on this country,” Buffett, Berkshire’s chief executive officer, said today in remarks to the Montana Economic Development Summit. “We will not have a double-dip recession at all. I see our businesses coming back almost across the board.”

Berkshire bought railroad Burlington Northern Santa Fe Corp. for $27 billion in February in a deal that Buffett, 80, called a bet on the U.S. economy. The billionaire’s outlook contrasts with the views of economists such as New York University Professor Nouriel Roubini and Harvard University Professor Martin Feldstein, who have said the odds of another recession may be one in three or higher.

Now that the great man has prognosticated on the state of the economy, I have to ask, “Are we all macro investors now?”

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Fortune on David Sokol

Posted in About, Warren Buffett, tagged , , , on August 3, 2010| 1 Comment »

Fortune magazine has a great profile on David Sokol, Warren Buffett’s Mr. Fix-It:

Buffett first met Sokol in 1999 when Berkshire was buying MidAmerican, the Iowa utility. With longtime Buffett friend Walter Scott, Sokol had bought a small, $28-million-a-year geothermal business in 1991 and built it into that utility powerhouse. MidAmerican, headquartered in Des Moines, now represents an $11.4 billion slice of Berkshire’s revenue (about 10%), and Sokol is its chairman. In 2007, Buffett asked Sokol to get Johns Manville, an underperforming roofing and insulation company, on track, and he did; he is now its chairman. In 2008, Charlie Munger, Buffett’s vice chairman, asked Sokol to fly to China to conduct due diligence on BYD, a battery and electric car maker. Sokol liked what he saw, and Berkshire invested $230 million for 10% of the company. That stake is now worth around $1.5 billion. In April, when Buffett had concerns about a provision in the Senate financial regulation bill that would have required Berkshire and other companies to post billions of collateral on their existing derivatives, it was Sokol he sent to argue his case. Buffett’s side of the argument won.

Last summer Buffett handed Sokol perhaps the biggest assignment of his career: turning around NetJets. The fractional-ownership jet company last year lost $711 million before taxes — not the kind of performance that warms Buffett’s heart. Today the company is profitable, and Fortune got a rare, exclusive view of how Sokol did it

This story about Berkshire’s attempted acquisition of Constellation Energy is superb:

The day after Lehman collapsed in September 2008, David Sokol noticed that the stock of Constellation Energy, a Baltimore utility, was plummeting. He called his boss, Warren Buffett, and said, “I see an opportunity here.” Buffett, who had noticed the same thing, replied after a brief discussion: “Let’s go after it.”

Constellation (CEG, Fortune 500) held vast amounts of energy futures contracts that had gone sour, and the company appeared to be on the verge of bankruptcy. Sokol, as chairman of the Berkshire subsidiary MidAmerican Energy Holdings, knew the utility industry and saw a chance to buy solid assets at a bargain price. The deal, however, had to be done within 48 hours or the company would have to file for bankruptcy.

Sokol phoned the office of Constellation CEO Mayo Shattuck III, who was in an emergency board meeting. When his assistant answered, Sokol told her he’d like to speak to him. The secretary replied that if she interrupted the meeting, she might lose her job. Sokol replied, “If you don’t interrupt the meeting, you might lose your job.”

Sokol boarded a Falcon 50EX and sped to Baltimore. He met with Shattuck and struck a deal that evening to buy the company for $4.7 billion, staving off bankruptcy.

Within weeks, before the acquisition was completed, Constellation’s board received a competing bid from Électricité de France for about a 30% premium. The board liked the offer, and so did Sokol — who walked away with a $1.2 billion breakup fee for Berkshire.

Read the article.

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WSJ profile of Li Lu

Posted in About, Stocks, Warren Buffett, tagged , , , , on August 2, 2010| 2 Comments »

The WSJ has a more full profile of Li Lu (subscription required), the Chinese-born hedge-fund manager in line to become a successor to Warren Buffett at Berkshire Hathaway Inc.:

Mr. Li, 44 years old, has emerged as a leading candidate to run a chunk of Berkshire’s $100 billion portfolio, stemming from a close friendship with Charlie Munger, Berkshire’s 86-year-old vice chairman. In an interview, Mr. Munger revealed that Mr. Li was likely to become one of the top Berkshire investment officials. “In my mind, it’s a foregone conclusion,” Mr. Munger said.

The profile discusses Li Lu’s investment in BYD:

The Chinese-American investor already has made money for Berkshire: He introduced Mr. Munger to BYD Co., a Chinese battery and auto maker, and Berkshire invested. Since 2008, Berkshire’s BYD stake has surged more than six-fold, generating profit of about $1.2 billion, Mr. Buffett says. Mr. Li’s hedge funds have garnered an annualized compound return of 26.4% since 1998, compared to 2.25% for the Standard & Poor’s 500 stock index during the same period.

…

Mr. Li’s big hit began in 2002 when he first invested in BYD, then a fledgling Chinese battery company. Its founder came from humble beginnings and started the company in 1995 with $300,000 of borrowed money.

Mr. Li made an initial investment in BYD soon after its initial public offering on the Hong Kong stock exchange. (BYD trades in the U.S. on the Pink Sheets and was recently quoted at $6.90 a share.)

When he opened the fund, he loaded up again on BYD shares, eventually investing a significant share of the $150 million fund with Mr. Munger in BYD, which already was growing quickly and had bought a bankrupt Chinese automaker. “He bought a little early and more later when the stock fell, which is his nature,” Mr. Munger says.

In 2008, Mr. Munger persuaded Mr. Sokol to investigate BYD for Berkshire as well. Mr. Sokol went to China and when he returned, he and Mr. Munger convinced Mr. Buffett to load up on BYD. In September, Berkshire invested $230 million in BYD for a 10% stake in the company.

BYD’s business has been on fire. It now has close to one-third of the global market for lithium-ion batteries, used in cell phones. Its bigger plans involve the electric and hybrid-vehicle business.

The test for BYD, one of the largest Chinese car makers, will be whether it can deliver on plans to develop the most effective lithium battery on the market that could become an even bigger source of power in the future. Even more promising is the potential to use the lithium battery to store power from other energy sources like solar and wind.

Says Mr. Munger: “The big lithium battery is a game-changer.”

BYD is a big roll of the dice for Mr. Li. He is an informal adviser to the company and owns about 2.5% of the company.

Mr. Li’s fund’s $40 million investment in BYD is now worth about $400 million. Berkshire’s $230 million investment in 2008 now is worth about $1.5 billion. Messrs. Buffett, Munger, Sokol, Li and Microsoft founder and Berkshire Director Bill Gates plan to visit China and BYD in September.

As impressive as that investment is, the WSJ says that Lu’s record is unremarkable without the investment in BYD:

But hiring Mr. Li could be risky. His big bet on BYD is his only large-scale investing home run. Without the BYD profits, his performance as a hedge-fund manager is unremarkable.

It’s unclear whether he could rack up such profits if managing a large portfolio of Berkshire’s.

What’s more, his strategy of “backing up the truck,” to make large investments and not wavering when the markets turn down could backfire in a prolonged bear market. Despite a 200% return in 2009, he was down 13% at the end of June this year, nearly double the 6.6% drop in the S&P-500 during the period.

…

Mr. Li declined to name his fund’s other holdings. Despite this year’s losses, the $600 million fund is up 338% since its late 2004 launch, an annualized return of around 30%, compared to less than 1% for the S&P 500 index.

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The long and short of Berkshire Hathaway Inc. (NYSE:BRK.A BRK.B)

Posted in Stocks, Warren Buffett, tagged , , on July 12, 2010| 4 Comments »

Berkshire Hathaway Inc. (NYSE:BRK.A BRK.B) has been in the news recently as Goldman Sachs initiated coverage on the stock with a “Buy” rating and then Stifel Nicolaus & Co. followed with a “Sell.” It’s not often that the street gets so polarized about a stock, tending to the more tepid “Hold,” so I thought I’d set out the long and short arguments below.

Long

Goldman Sachs’s view is summarized as follows:

Valuation disconnect at a multi-decade high

We initiate coverage of Berkshire Hathaway (BRK.A/BRK.B) with a Buy rating, as the disconnect between the market value of the stock and the intrinsic value of the business is close to a multi-decade high. With the recent inclusion of Berkshire in the S&P 500 and Russell indices and increased investor focus, we attempt to provide a framework for how to invest in the stock. In our view, the company is a unique collection of assets that over time earns a return on those assets – and as such should be valued accordingly.

Transformation: Key shifts in value mix

Post the acquisition of Burlington Northern, we estimate close to half of Berkshire’s intrinsic value will be derived from “operating” entities (as opposed to “securities investments”). This accomplishes two key things, in our view: (a) it reduces the long-term reliance on senior management’s equity investing decisions, and (b) provides greater clarity into the source of future value for the company as a whole.

Structural growth in largest segments

Structurally, Berkshire’s earnings will benefit from the ongoing shift in consumers’ auto insurance buying habits (via the direct-to-consumer GEICO subsidiary), the continuing change in the way goods are transported across the country (via the large intermodal operations at Burlington Northern), and the enduring growth in energy and power demand (via MidAmerican).

Levered to cyclical economic recovery

Cyclically, the non-insurance entities are tied to GDP growth and to a lesser extent, industrial production. Thus, as the economy continues to emerge from its cyclical downturn, we would expect earnings to grow at a faster rate than what appears to be currently discounted in the stock.

Price targets and risks

Our 12-month intrinsic value-based price target is $152,000 for BRK.A and $101 for BRK.B, implying over 25% upside. Key risks include an economic downturn, insured catastrophes, and management succession.

The Goldman report also sets out Goldman’s rationale for calculating BRK intrinsic value with a very interesting back-test of the reasoning:

(1) Intrinsic Value

While Berkshire is a unique set of assets, we believe intrinsic value can be calculated in a manner similar to other companies. In our view the company is a collection of assets which earns a return on those assets over time – and thus the present value of such returns should equal the intrinsic value. Using historical drivers of returns (i.e. historical operating profits, market value of investments, interest rates, etc.) we can assess how Berkshire’s stock has tracked a derived intrinsic value over time. Importantly, however, the company has a long track record of producing significantly above-average returns on its assets and thus – while previous investment returns are no guarantee of future performance – we believe it is appropriate to factor above-average yields into intrinsic value. Specifically, we assess the intrinsic value as comprised of three main components:

1. The value of the investment portfolio (minus the insurance liabilities). This would be akin to a “book value” metric for other financial institutions. In other words, after liquidating the assets and having repaid all of the insurance obligations, the remainder would be the value left for shareholders.

2. The value of the float within the insurance operations. Float is the amount of funds an insurance company holds for future obligations and which can be invested for its own account. We ascribe a value to the float based on estimated future returns and growth. We will describe this analysis in more detail within the Insurance section below, however we would note this is the most unique component to the value of Berkshire, as there are few, if any, financial institutions with a track record of generating similar levels of consistent returns (see Exhibits 11-14 below).

3. The value of the non-insurance operating businesses. Outside of insurance, Berkshire owns majority stakes in a wide array of businesses. While the underlying operations are very diverse (i.e. railroads, utilities, carpet manufacturers, and even Dairy Queen), the businesses tend to share a common characteristic in that almost all maintain leading market share for either their industry or their geography. This is important when ascribing an intrinsic or long-term value to the operations, as the risk of obsolescence for the majority of the operations is considerably lower than other individual companies within the market. The idea of a real competitive advantage – or “moat” – suggests that at worst the companies will grow with the economy and at best will continue to compound returns at a rate higher than their peers. When valuing the non-insurance operations of Berkshire, we utilize a discounted cash flow model by aggregating expected earnings and applying a modest (and declining) 3-year growth rate and then a terminal growth rate of 2.5%.

Other key points to note:

  • Historically, the majority of the value derived from Berkshire has been sourced from the insurance operations – i.e. components one and two above. However, post the Burlington Northern acquisition, the contribution from non-insurance earnings will be larger than at any previous time in BRK’s history. We believe this is likely a concerted effort by current management over the past few years to allow for the “investing” component of BRK’s value to become less of a variable in the future – and thereby reducing the risk of lower investment returns impacting the value of Berkshire in the future (see Exhibits 5 and 6 below).
  • When we back-test our intrinsic value (as seen in Exhibit 4 above), we can show that comments or actions (as highlighted in the exhibit) made by Berkshire are consistent with the relationship depicted between intrinsic value and the market value ascribed to Berkshire stock. For example, in 1998, when Berkshire purchased General Re with stock, our analysis clearly shows the market value of the stock exceeded the intrinsic value of the company – thus, making the acquisition with “share currency” a significant value addition to the overall shares (ignoring however the future liability problems that General Re wound up disclosing).
  • When we back-test our intrinsic value model, we use a market cost of equity – i.e. the 10-year risk free rate and an applied equity risk premium for the US stock market. Not surprisingly, the general declining cost of capital over the past 30 years has helped to raise the value of Berkshire as well as the market.
  • While Berkshire can be shown to be largely impacted by cyclical industrial forces within the US, we note that the dual nature of the operations (i.e. insurance and non-insurance) allows for uncorrelated value creation opportunities. In other words, despite the recent recession’s negative impact on the future cash flows of the noninsurance businesses, the continued increase in insurance float (and the corresponding high-yielding investments made with that float) helped to mute the negative impact on the overall value of Berkshire.

Here’s Goldman’s calculation of intrinsic value:

The best part of the Goldman analysis is their comparison of BRK market price to Goldman’s calculation of intrinsic value since 1981:

Click here to see Goldman Sachs’s BRK report.

Short

The short argument for BRK is described by Meyer Shields of Stifel Nicolaus & Co.. Shields’s view, from the WSJ’s Market Beat column, is as follows:

Q: Meyer, thanks a lot for taking the time to parry a few of our questions. First things first, does it feel strange to hit the sell button on Buffett?

A: It does, because it sounds like I’m saying that I know more about investing or markets than Buffett does, which is nuts. All I’m saying is that I think the share price underperforms in the near-term.

Q: And from the looks of your note, you’re not saying that the Buffmeister has lost his edge. A lot of your analysis is about your outlook for the economy right? So, put simply: The slower the economy, the slower the results at all the multivarious businesses Berkshire owns?

A: With the exception of insurance, which is pretty well-insulated from the economy, yes. Berkshire’s more exposed to homebuilding and less exposed to technology than the overall economy, but the bottom line is that if unemployment stays high, spending stays low, both for the U.S. in general and Berkshire in particular.

Q: So, if a weak economy is bad for both Berkshire and the U.S. in general. Why would Berkshire underperform in the near-term?

A: On top of its own businesses’ exposure to the economy, Berkshire sold some equity index put options that are marked to market every quarter, so its book value gets hit twice.

Q: Ahah! So Berkshire sold puts — options that make money when the underlying falls in price. That means essentially Berkshire is on the hook to pay-up for the falloff we saw during the correction. Right?

A: Yes, except that it would only be on the hook for that sort of falloff if there’s no recovery until 2018 and beyond. In the meanwhile, the only issue is the mark-to-market, but in March 2009, that was enough to spook investors.

Q: Ah, ok. So, Berkshire is going to have to take a paper loss this quarter on those puts it sold. Got it. You note that Berkshire has been outperforming the S&P 500 by about 26% year-to-date. I’m wondering how much of that may have to do with the Baby Berks being added to the S&P 500? (A lot of index funds had to buy.) Wondering if you have any other thoughts on what Berkshire’s addition to the index might mean for the shares?

A: I think there were three implications of the addition to the S&P. First, a lot of funds had to buy the stock. Second, the resulting share price appreciation meant that it cost Buffett fewer Berkshire shares to purchase Burlington Northern. Third (and this is less positive), with widespread professional ownership, the “cult-stock” aspect (some investors use valuation methods for Berkshire that don’t work for any other name) will weaken, making the shares more “normal.”

Q: Interesting. You mean “cult,” like, less of the long-term loyalists that stick with the stock through thick and thin?

A: Exactly. I think we’ll see bigger reactions to good and bad quarters than we’ve seen in the past.

Q: Good stuff. Thanks a lot for taking the time. We’ll be watching to see how the call pans out. We’d wish you good luck, but then some of Buffett’s cult following might attack us in the comments section, and accuse us of anti-Buffett bias. So, we’ll just wish you a generalized, not-specific-to-this-call, good luck.

A: I love Warren Buffett, and I look forward to the stock trading down to a point where I can rate it a Buy.

[Full Disclosure:  No positions. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. Do your own research before investing in any security.]

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