Friday, April 26, 2013

Worldwide Daily Beverage Consumption

Back in the year 2000, the worldwide daily beverage consumption totaled roughly 48 billion servings.

At that time, Coca-Cola's (KO) shares of this consumption was a bit over 2 percent.

Roughly 1 billion servings each day.

These days, the worldwide number of servings consumed per day has increased to 57 billion with Coca-Cola's share now at 3.2 percent.

So, via what is the world's largest beverage distribution system, Coca-Cola now accounts for roughly 1.8 billion servings each day and the company now reaches consumers in 200 plus countries.

Some simple math shows that Coca-Cola picked up 8.9 percent of the 9 billion servings of incremental daily beverage consumption since the year 2000.*
(The .8 billion increase in Coca-Cola's volume -- from 1 billion to 1.8 billion -- divided by the difference between the estimated worldwide daily beverage consumption in 2012 compared to 2000.)

More than its fair share of the increased consumption. If it continues, Coca-Cola will naturally get an increasing share of worldwide daily beverage consumption over time. We'll see if it does but, considering the company's advantages, it seems not a stretch to expect them to continue doing just fine in this regard.

The bad news is that carbonated beverage sales in the U.S. remains challenging. The good news is a bunch of the company's profits come from elsewhere with no shortage of opportunity in the emerging markets.

Carbonated beverage sales are also a challenge in Europe but the region still remains a nice source of profits.

See page 34 of the latest 10-Q or page 57 of the latest 10-K for more details on the company's operating income and margins in different parts of the world.

This Fortune article points out that the average American consumes 400 servings of Coca-Cola products each year. That number includes non-soda beverages, of course. The American beverage market seems rather saturated to say the least.

Global average consumption of Coca-Cola products is more like roughly 90 servings each year.

Over time no doubt that gap should be an opportunity though it likely closes rather slowly over time.

Coca-Cola will certainly -- like any business -- have its ups and downs but the company currently has very attractive core business economics.

High and durable return on capital.

Chances are, the company will continue to have very sound economics even if possibly somewhat less so than in the past.

Durable advantages make more than solid increases to intrinsic value over time quite likely.

So it remains quite a business with plenty of prospects but, unfortunately, the stock seems awfully expensive these days.

"Risk is not inherent in an investment; it is always relative to the price paid." - Seth Klarman in his 2010 Annual Letter

The initial price paid relative to current value matters even for the highest quality businesses.

Adam

Long position in KO established at much lower than recent prices. No intention to buy or sell near current prices.
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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 24, 2013

Modern Portfolio Theory, Efficient Markets, and the Flat Earth Revisited

"...Berkshire's whole record has been achieved without paying one ounce of attention to the efficient market theory in its hard form. And not one ounce of attention to the descendants of that idea, which came out of academic economics and went into corporate finance and morphed into such obscenities as the capital asset pricing model, which we also paid no attention to." - Charlie Munger at UC Santa Barbara back in 2003

With this year's Berkshire Hathaway (BRKa) annual shareholder meeting coming up soon, I decided to take a little time to browse some of the notes taken at past meetings.

As always, lots of useful stuff that's well worth reading (and, I guess in my case, re-reading). Well, one exchange that caught my attention comes from the 2006 meeting. At that meeting, Warren Buffett and Charlie Munger covered the subject of efficient market hypothesis (EMH) and modern portfolio theory (MPT) a bit.

Here's what they had to say about EMH and MPT at the 2006 meeting according the notes taken by The Motley Fool:*

Warren Buffett: The teaching of finance has improved over the past 20 years, but from a very low base. The flat-Earth orthodoxy of 20 years ago, of modern portfolio theory and the efficient market hypothesis, is breaking down. [The universities] of Kansas, Missouri, Florida, Columbia, and Stanford, among others, have good programs. Twenty-five years ago, you couldn't get a job or advance if you didn't go along with the EMH [Efficient Market Hypothesis] and MPT [Modern Portfolio Theory] orthodoxy.

Nowadays, students all think they'll get rich doing what Charlie and I do. The amount of brainpower going into money management is somewhat distressing, but it's a great time to be 20 or 25 years old and be getting out of school. A lot of students who come to visit say that they want to go into private equity or hedge funds. I'm not sure what the economy is going to do for basics like food and clothes.

Charlie Munger: Half of the business school graduates at the elite Eastern schools say that they want to go into private equity or hedge funds. Their goal seems to be to keep up with their cohorts at Goldman Sachs (NYSE: GS). This can't possibly end well.

At that same meeting they later had the following to say:

Charlie Munger: Finding a single investment that will return 20% per year for 40 years tends to happen only in dreamland. In the real world, you uncover an opportunity, and then you compare other opportunities with that. And you only invest in the most attractive opportunities. That's your opportunity cost. That's what you learn in freshman economics. The game hasn't changed at all. That's why Modern Portfolio Theory is so asinine.

Warren Buffett: It really is, folks.

Charlie Munger: If Warren were starting today, he'd put together a concentrated portfolio. Your one or two best ideas are way better than the rest. So when you act, you're thinking about how the alternatives compare with your best idea. But you don't want to own your 10th-best idea when you can use that cash to invest in your best idea.

Warren Buffett also brought the same subject up in the 2006 letter, using the record of Walter Schloss as an example:**

"I first publicly discussed Walter's remarkable record in 1984. At that time 'efficient market theory' (EMT) was the centerpiece of investment instruction at most major business schools. This theory, as then most commonly taught, held that the price of any stock at any moment is not demonstrably mispriced, which means that no investor can be expected to overperform the stock market averages using only publicly-available information (though some will do so by luck). When I talked about Walter 23 years ago, his record forcefully contradicted this dogma.

And what did members of the academic community do when they were exposed to this new and important evidence? Unfortunately, they reacted in all-too-human fashion: Rather than opening their minds, they closed their eyes. To my knowledge no business school teaching EMT made any attempt to study Walter's performance and what it meant for the school's cherished theory.

Instead, the faculties of the schools went merrily on their way presenting EMT as having the certainty of scripture. Typically, a finance instructor who had the nerve to question EMT had about as much chance of major promotion as Galileo had of being named Pope.

Tens of thousands of students were therefore sent out into life believing that on every day the price of every stock was 'right' (or, more accurately, not demonstrably wrong) and that attempts to evaluate businesses – that is, stocks – were useless. Walter meanwhile went on overperforming, his job made easier by the misguided instructions that had been given to those young minds. After all, if you are in the shipping business, it's helpful to have all of your potential competitors be taught that the earth is flat."

At least there seems to be some progress, however painfully slow it has unfortunately been, in academia and elsewhere on this front.

For quite a while it seemed like that would never happen.

These days, fewer buy into this stuff but there is still, remarkably, no shortage of adherents. I think Marty Whitman has it about right when he said the following about modern portfolio theory in this Barron's interview:

"...as far as value investing, control investing, distress investing and credit analysis is concerned, that stuff is absolute garbage."

Here's what Buffett said more recently about efficient markets in the 2010 Berkshire Hathaway shareholder letter:

"John Kenneth Galbraith once slyly observed that economists were most economical with ideas: They made the ones learned in graduate school last a lifetime. University finance departments often behave similarly. Witness the tenacity with which almost all clung to the theory of efficient markets throughout the 1970s and 1980s, dismissively calling powerful facts that refuted it 'anomalies.' (I always love explanations of that kind: The Flat Earth Society probably views a ship's circling of the globe as an annoying, but inconsequential, anomaly.)"

To me, whether the criticism happens to be delivered politely, sarcastically or-- in the case of Charlie Munger or Marty Whitman -- maybe a bit more harshly, it seems just as valid. These ideas aren't necessarily just useless, they're actually capable of doing real economic damage over time.

With this example in mind, I'll never again be surprised by how long certain extremely flawed ideas persist when, on merit, they should not.

Adam

Long position in BRKb established at much lower than recent market prices

Related posts:
-Buffett on Risk and Reward
-Buffett: Why Stocks Beat Bonds
-Beta, Risk, & the Inconvenient Real World Special Case
-Howard Marks: The Two Main Risks in the Investment World
-Black-Scholes and the Flat Earth Society
-Buffett: Indebted to Academics
-Grantham on "The Greatest-Ever Failure of Economic Theory"
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind

* Since these are notes it's not possible to know if the quotes are exact, of course.
** From the 2006 letter: "Following a strategy that involved no real risk – defined as permanent loss of capital – Walter produced results over his 47 partnership years that dramatically surpassed those of the S&P 500."

Buffett then added...


"There is simply no possibility that what Walter achieved over 47 years was due to chance."
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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.

Friday, April 19, 2013

Berkshire's Manufacturing, Service and Retailing Operations

Berkshire Hathaway's (BRKa) Manufacturing, Service and Retailing Operations covers, as Warren Buffett points out, everything from "lollipops to jet airplanes". These businesses earned $ 3.7 billion combined in 2012.

Buffett wrote the following about the group of wide-ranging businesses in his latest Berkshire 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 Candies, 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 focus on what happens to be easily measurable while de-emphasizing what's 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 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.
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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 17, 2013

Coca-Cola's 1st Quarter 2013 Results

From Coca-Cola's (KO) latest earnings release:

The Coca-Cola Company reported worldwide volume growth of 4% for the first quarter, with 3% growth in Coca-Cola Americas and 5% growth in Coca-Cola International. The Company reported solid volume growth in key developed markets, including Germany (+3%), North America (+1%) and Japan (+1%). Europe volume was even for the first quarter and a sequential improvement from fourth quarter 2012, despite ongoing uncertain macroeconomic conditions and unseasonably cold weather. The Company also delivered strong volume growth during the quarter in key emerging markets, including Thailand (+18%), India (+8%), Russia (+8%), Mexico (+3%) and Brazil (+3%).

On the surface, it was not exactly a spectacular quarter.

Net revenues and operating income were actually down 1% and 4% respectively.

Oh, and the already at least seemingly somewhat pricey stock -- roughly 20x current earnings -- has traded even higher since these results were released.

I'll let others try to figure out or justify why this is.*

Let's step back a bit from these near-term results.

In prior posts, I've looked at how the earnings of certain companies (including KO) were impacted by the financial crisis. A business that can do okay during the tougher times seems likely to do just fine when some of the storms have passed over the longer haul (i.e. not quarter-to-quarter or even year-over-year). To me, understanding a company's economic resilience is at least as important, if not more important, than understanding the potential upside. The gains usually takes care of themselves if an appropriate price is paid in the first place, the core economics are attractive, durable, and, of course, were judged reasonably well.

Before the financial crisis, Coca-Cola had peak earnings of $ 1.28 per share. Those earnings dropped somewhat to $ 1.24 per share in 2008 -- its worst year during the crisis. That was followed by earnings of $ 1.46 per share in 2009.

If nothing else quite persistent even if explosive growth is just about never in the cards for a business like Coca-Cola.

Five years later or so, the company seems likely to earn $ 2.10-2.20 per share.

So roughly 65-70% higher in five years.

Coca-Cola has, in recent years, delivered solid increases to its per share intrinsic value with little drama. Who knows if the company will do quite as well going forward, but it has certainly become a lot tougher to buy at a discount to its current approximate value. The same thing happens to be true for many other high quality businesses. They're still good businesses but price paid relative to value, as always, is all-important:

"Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments." - Seth Klarman in his 2010 Annual Letter

I think it is fair to say that the idea that more risk must be taken to achieve greater rewards is a rather widespread one. It certainly gets stated often enough without challenge as if a given. Well, it's not necessarily wrong, it's just an incomplete view of the world. As Warren Buffett explains further here, risk and reward does not have to be positively correlated (and the reason isn't at all complicated or tough to understand).

So some might choose to assume risk and reward are always positively correlated. In many instances they are, of course. Just not always. A lower price both reduces risk and increases potential reward. A simple insight, yes, but not at all unimportant.

Negative correlation.

Occasionally, simple but useful insights get overlooked because an assumption is made that there's more to it.

This seems a good candidate for that sort of thing.

It's not difficult -- especially during a chaotic time like a financial crisis -- to find reasons NOT to buy something. Scary headlines, dire forecasts, loss aversion, and raw emotions (among other things) provide plenty of distractions away from simply comparing prevailing prices to conservatively estimated value then, when a discount is plain, acting accordingly.

The time buy shares of a good business at a nice discount to value is rarely going to be when it feels safe. Usually it's when confidence is low and it seems the most uncertain that attractive prices become available.

I say seems because the world is always uncertain. It just seems more uncertain at different times.

"The world's always uncertain. The world was uncertain on December 6th, 1941, we just didn't know it. The world was uncertain on October 18th, 1987, you know, we just didn't know it. The world was uncertain on September 10th, 2001, we just didn't know it." - Warren Buffett on CNBC

It's impossible to know when the window of opportunity to buy a meaningful amount something sensible at a discount will close.

"We try to avoid buying a little of this or that when we are only lukewarm about the business or its price. When we are convinced as to attractiveness, we believe in buying worthwhile amounts." - From the 1978 Berkshire Hathaway Shareholder Letter

It was comparably easier to buy shares of the higher quality businesses not too long ago but it wasn't when it felt comfortable. It was when the macro environment felt pretty awful and at least temporary paper losses -- and maybe even permanent losses if value were to get misjudged -- were very likely.

Mistakes are easy to make in chaotic environment.

When it didn't feel good is when the big discounts were available (fewer opportunities now but naturally not none). That's likely to be true in the future. The problem isn't necessarily knowing what's selling cheap and should be bought. The problem is more temperamental; it's aspects of human nature itself.

In contrast to several years back (and even more recently), the window of opportunity to buy at truly bargain prices has mostly closed for the highest quality businesses.**

At least it has for now.

Naturally, there's always something that's individually mispriced but only so many things can be well enough understood. Those buying now instead of buying when confidence was lower and uncertainty seemed greater are taking far more risk and likely to get far worse long-term results.

More risk for less reward. Also, lacking an appropriate margin of safety, greater likelihood of permanent capital loss.

Buying the best assets cheap is easier (though not easy) during a rough patch. Many good assets are far harder to buy right now at a price that minimizes the risk of permanent losses. It might feel safer but, at least somewhat paradoxically, that's the reason it is likely not.

Others can try to speculate on price action but, as far as true investment goes, it's an inherently tougher environment simply because prices are higher.

Adam

Long position in KO established at much lower than recent prices

* All I know is, as a long-term owner, I'd prefer that the shares get cheaper in the near-term or even longer. When prices drop further below intrinsic value, the buybacks are more effective and more shares can be accumulated at a discount over time. As always, I never have an opinion or any idea what the near-term price action of individual stocks or the markets in general might be. The good news it is not a required skill in investment (though for those involved in speculation on price action, I suppose it is). Instead, I'm interested in how price compares to per share intrinsic value -- or, at least, a likely range of intrinsic values; I'm interested in how intrinsic value is likely to change over time; I'm also interested in getting better, over time, at judging intrinsic value in the first place. Those things are all difficult enough to do consistently well without -- at least in my case -- lots of work. 

Any attempt at picking bottoms or guessing what prices might do short-term would be a waste of energy for me. I suspect it is for many others but no doubt someone does that sort of thing well.
** That doesn't mean I'll sell the shares of high quality businesses because they're fully valued or maybe even somewhat more than fully valued. Once a good business that's understood well is owned at a discount, my view is it's better to hold on unless price relative valuation gets extreme, something fundamentally has damaged the business economics, intrinsic value was misjudged in the first place, or the opportunity costs are high. The merits of this approach are not insignificant but I understand why few utilize it.
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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, April 12, 2013

Buffett on Risk and Reward

One investor that Warren Buffett highlights in The Superinvestors of Graham-and-Doddsvilleis Rick Guerin.

Buffett describes Guerin as "another non-business school type -- who was a math major at USC."

From the article:

"Rick, from 1965 to 1983, against a compounded gain of 316 percent for the S&P, came off with 22,200 percent, which probably because he lacks a business school education, he regards as statistically significant.

One sidelight here: it is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately to people or it doesn't take at all. It's like an inoculation. If it doesn't grab a person right away, I find that you can talk to him for years and show him records, and it doesn't make any difference. They just don't seem able to grasp the concept, simple as it is. A fellow like Rick Guerin, who had no formal education in business, understands immediately the value approach to investing and he's applying it five minutes later. I've never seen anyone who became a gradual convert over a ten-year period to this approach. It doesn't seem to be a matter of IQ or academic training. It's instant recognition, or it is nothing."

Then, later in the article, Warren Buffett said the following about risk and reward:

"I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, 'I have here a six-shooter and I have slipped one cartridge into it. Why don't you just spin it and pull it once? If you survive, I will give you $1 million.' I would decline -- perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice -- now that would be a positive correlation between risk and reward!

The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it's riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is."

The idea that more risk is required to increase returns seems, at least for some, an article of faith. Yet, at least in the context of value-oriented investing, it need not be the case. The insight may be an extremely simple one but that doesn't make it any less significant. Not all useful insights or expertise require extreme complexity.*

It's a mistake to assume that risk and reward must be positively correlated.

Clearly, sometimes risk and reward is positively correlated; other times, it is not.

A useful and, yes, simple idea that's always been there for the taking (yet still seems to get little respect or attention).

If value is judged reasonably well, a lower price doesn't just increase the potential return -- all else equal -- it also can reduce risk.

Though, for some assets, no price is low enough (and no discount rate is high enough).**

No doubt some who've read Buffett's thinking on risk and reward find it to be of just passing interest. That's understandable but, I think, unfortunate.

I just happen to believe those who choose to not think about risk and reward this way are likely underestimating the benefits of doing so. Of course, that gets back to Buffett's comment above that it's usually "instant recognition, or it is nothing."

More risk being necessary for greater reward is more than just embedded in much of academia (CAPM being a good example), it also seems fairly well embedded in culture more generally.

Adam

Related posts:
-Buffett: Why Stocks Beat Bonds
-Beta, Risk, & the Inconvenient Real World Special Case
-Howard Marks: The Two Main Risks in the Investment World
-Black-Scholes and the Flat Earth Society
-Buffett: Indebted to Academics
-Grantham on "The Greatest-Ever Failure of Economic Theory"
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind

* Charlie Munger on why Berkshire's model isn't copied more: "...our model is too simple. Most people believe you can't be an expert if it's too simple."
** Warren Buffett once said the following about discount rates:"Don't worry about risk the way it is taught at Wharton. Risk is a go/no go signal for us—if it has risk, we just don't go ahead. We don't discount the future cash flows at 9% or 10%; we use the U.S. Treasury rate. We try to deal with things about which we are quite certain. You can't compensate for risk by using a high discount rate."
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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.

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 Warren Buffett's latest Berkshire 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, 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 enti
re 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.
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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, April 5, 2013

Big Cap Tech: 10-Year Changes to Share Count

Below is a quick summary of how shares outstanding have changed for the largest technology companies over the past decade:

Apple (AAPL)
Fiscal Year 2003: 723 million
Fiscal Year 2012: 945 million
Share count increased by 31 percent

Google (GOOG)
FY 2003: 257 million
FY 2012: 332 million
Share count increased by 29 percent

Microsoft (MSFT)
FY 2003: 10.9 billion
FY 2012: 8.5 billion
Share count reduced by 22 percent

IBM (IBM)
FY 2003: 1.76 billion
FY 2012: 1.16 billion
Share count reduced by 34 percent

Oracle (ORCL)*
FY 2003: 5.4 billion
FY 2012: 5.1 billion
Share count reduced by 6 percent

Some thoughts:

Whether the share count was reduced in an economically sound manner (i.e. shares were bought when selling comfortably below intrinsic value) should be taken into account. Obviously, if a company overpaid for shares during the past decade it can't be undone but, if nothing else, it's an indication of how wisely capital might be allocated in the future.

How capital will get allocated naturally has a big impact on how intrinsic value will change over time.

The two stocks with meaningful dilution is related primarily to stock-based compensation**, Google and Apple, each had extremely good decades in terms of business (and stock) performance to say the least.

Even if they continue to do just fine business-wise, any sound judgment of their per share intrinsic value will require appropriate consideration of additional future share dilution. Coming up with a reasonable assumption for the future per-share economic impact (not just the accounting impact) of stock-based compensation isn't exactly the easiest thing to do.

At least not for those companies that happen to rely heavily on stock-based compensation.

Those who do decide to ignore stock-based compensation -- and some seem willing to do just that -- along with the dilution that results from it are more likely misjudge per-share value. Stock-based compensation can surely become very meaningful and expensive for shareholders over the long run.
(That the ultimate true cost is difficult to quantify beforehand makes it no less real.)

The dilution that results -- or, alternatively, the company's net cash that must be used to buyback enough shares to offset that dilution -- impacts per share value in a very real way.

Investors who think otherwise are kidding themselves.

Adam

Long positions in AAPL, GOOG, and MSFT established at lower than recent market prices

Related posts:
Technology Stocks
Time for Dividends in Techland

* Oracle's last full fiscal year ended almost a year ago. The company's share count has dropped to 4.8 billion since then.
** For both Apple and Google, increases to share count has been relatively slower in more recent years (when compared to the earlier part of the past ten years). Much of the dilution is related to stock-based compensation but not all of it. For example, Google also raised some capital that increased shares outstanding not only during their 2004 initial public offering, but also via follow-on common stock offerings in 2005 and 2006. The follow-on offerings resulted in more than 14 million additional shares in 2005, then more than 5 million additional shares in 2006. 
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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 3, 2013

The Dell Buyout

This Barron's article provides a good summary of the battle that has emerged over Dell (DELL):

Barron's: Michael Dell's Folly

From the article:

It doesn't look like Michael Dell, founder, chairman, and CEO of Dell, will be able to steal his company from public shareholders for just $13.65 a share now that superior preliminary offers for Dell have been submitted...

Both competing proposals from Blackstone and Icahn are essentially a leveraged recapitalization that appear to allow some Dell shareholders -- though more details are needed -- to at least an extent remain invested if they choose to do so. If that's the case, investors should be able to cash out at whatever the final price agreed upon or have the option to remain invested.

Well, at least based upon what is known today. These deals could fall through and there's plenty of time for the terms to morph into something else altogether.

When it comes to allowing Dell shareholders to remain invested after the deal is done, it's the Icahn offer that seems to be the most straightforward. The Blackstone offer also seems to allow investors to remain invested, but apparently there will be some kind of "cap".

Need to see the fine print to know what that really means.

The original proposal from Michael Dell and Silver Lake would force all investors to sell but that, of course, could change in a possible counter offer.

In this CNBC video, Leon Cooperman makes a moral argument against forcing investors to sell.
(Some of Cooperman's comments can also be found in this New York Times article.)

More from the Barron's article:

"Having the choice of cashing out or staying in is hugely superior to what Michael Dell had to offer," says Richard Pzena, co-chief investment officer at Pzena Investment Management, which owns about 1% of the company.

Those that decide to remain shareholders will own a company with far fewer shares outstanding but also quite a lot more debt.

When it's all said and done who knows whether some Dell shares remain publicly traded. There's likely a long way to go in this process and more than a  few twists and turns.

The article suggest shares outstanding would likely fall from around 1.8 billion shares outstanding to one billion or maybe less.

That should boost earnings per share since borrowing costs are likely quite a bit less than the company's earnings yield.

Of course, the trajectory of earnings is at least somewhat difficult to gauge.

In any case, the additional debt involved in all the proposed deals (including the original buyout offer from Dell and Silver Lake) certainly adds additional risk if things business-wise were to more rapidly deteriorate.

Added leverage naturally amplifies the not only the upside but also the downside.

Barron's has covered the developments of this Dell deal well. Early on, while many seemed to expect the original Dell buyout offer to go through relatively unchallenged, they did not.

Barron's from the start was suggesting otherwise. They even brought up the idea of a leveraged recapitalization and that an activist investor might get involved not long after the initial offer was announced. Barron's also contrasted the way that Berkshire Hathaway (BRK.A) operates with this proposed deal that seemed to be at the expense of shareholders:

Some founder-CEOs like Warren Buffett of Berkshire Hathaway (BRK.A) enjoy getting rich along with their shareholders.

In this separate Barron's article, they added this about the valuation:

No major company has ever gone private so cheaply. Most leveraged buyouts are done for double the Dell transaction valuation.

It's worth noting that one of Dell's larger shareholders, Southeastern Asset Management, thinks Dell is worth far more per share than any of these offers and advocates "a public 'stub,' which would allow public shareholders to remain investors in Dell’s future."

Here's Southeastern's valuation summary from the letter* that was sent to Dell's Board of Directors:

Valuation Summary
(per share)
Net cash (1)
$3.64
DFS (2)
1.72
Acquisitions since 2008 (3)
7.58
Server Business (4)
4.44
Support and Deployment (5)
3.89
PC Business (6)
2.78
Software and Peripherals (7)
1.67
Unallocated Expenses (8)
-1.00
DFS value embedded in segments (9)
-1.00
Total
$23.72

Obtaining the necessary financing at that kind of price, to say the least, would be a tall order. Still, Southeastern certainly seem unlikely to be cashing out unless the price were to be raised materially.

Icahn's valuation isn't much lower at $ 22 per share. It's understandable that these investors are coming up with pinpoint numbers since it's part of an ongoing negotiation. Yet, in reality, judging per share intrinsic value can never be that precise. It's necessarily more of a range of values.

Seems rather unlikely this will be resolved anytime soon.

Adam

Some related articles:
Barron's - Dell Deal: The Same as Insider Trading
Fortune - Who is Dell's board working for?
New York Times - 2 Rivals Complicate Deal for Dell
WSJ - Everything You Need to Know About the Dell Offers

Very small long position in DELL established at lower than recent market prices

* See Schedule III of their SEC filing.
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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.
 
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