“Indeed, who has ever benefited during the past 238 years by betting against America? If you compare our country’s present condition to that existing in 1776, you have to rub your eyes in wonder. In my lifetime alone, real per-capita U.S. output has sextupled. My parents could not have dreamed in 1930 of the world their son would see. Though the preachers of pessimism prattle endlessly about America’s problems, I’ve never seen one who wishes to emigrate (though I can think of a few for whom I would happily buy a one-way ticket). The dynamism embedded in our market economy will continue to work its magic. Gains won’t come in a smooth or uninterrupted manner; they never have. And we will regularly grumble about our government. But, most assuredly, America’s best days lie ahead.”
In classic Warren Buffett fashion, it’s hard to disagree with him. The Great Recession was the worst our generation has ever witnessed, and it saw the toppling of firms from Lehman Brothers to General Motors (GM). Yet, the stock market is making new highs again. The resiliency of America is truly amazing. The one nugget of wisdom, however, is that prior to the housing crisis of the last decade, investors thought housing prices could only go up. Is America truly a riskless investment as Warren Buffett says it is? I’m not so sure, but the country’s track record is fantastic.
“As much as Charlie and I talk about intrinsic business value, we cannot tell you precisely what that number is for Berkshire shares (nor, in fact, for any other stock).”
There’s not much more we can say about this. The Valuentum process reflects this truism of equity investing. A stock’s intrinsic value is based on the future free cash flows of the company, and the future has yet to be written (it’s uncertain). Therefore, intrinsic value represents a probability weighting of all of a company’s expected future free cash flow streams under various reasonable scenarios. By extension, a reasonable valuation of a company can best be expressed as a fair value range (as we outline in the 16-page reports of every company). Value will never be a precise estimate. It will always be a range of fair value outcomes. A company is truly undervalued only when its share price falls below a reasonable range of fair value outcomes. To register a high rating on the Valuentum Buying Index, a company must meet this valuation criteria.
“Since 1970, our per-share investments have increased at a rate of 19% compounded annually, and our earnings figure has grown at a 20.6% clip. It is no coincidence that the price of Berkshire stock over the ensuing 44 years has increased at a rate very similar to that of our two measures of value. Charlie and I like to see gains in both sectors, but our main focus is to build operating earnings. That’s why we were pleased to exchange our Phillips 66 and Graham Holdings stock for operating businesses last year and to contract with Procter and Gamble to acquire Duracell by means of a similar exchange set to close in 2015.”
Warren Buffett is quite savvy.
Exchanging stock for operating earnings ensures that the tax bill is minimized and that Berkshire Hathaway capitalizes on the cash-flow generation of the acquired tangible businesses that are less volatile than their underlying equity prices (which are impacted by a large variety of factors that are not firm-specific). In many cases, the cash flows of the business are more resilient during economic troughs than equity prices themselves, and said cash flows can then be reinvested to buy other companies on the cheap during difficult times. In pure equity investing, on the other hand, many companies that do not pay dividends do not provide explicit cash flows to investors for reinvestment. As a result, tangible operating earnings are the preferred choice for most investors in most cases.
The quoted paragraph also reveals why Warren Buffett may be less concerned about stock price moves. The link between future operating earnings, or earnings before interest (EBI), and intrinsic value estimation has been well-documented. In situations where the share price of a company falls below its intrinsic value, for example, investors like Warren Buffett, who are flush with cash, can buy the entire company outright, and exploit the value differential–the difference between the present value of a company’s future free cash flows (and balance sheet considerations) and its share price. The tangible cash-flow link is in part why share prices are anchored to intrinsic value over time. If the deviation between a company’s share price and its intrinsic value becomes too large, large investors (or activist investors) will step in and buy the company outright, exploiting the differential.
For stock-market-only investors, the opportunity to buy a company outright is usually not feasible. From our perspective, stock-market-only investors care more about stock prices than Warren Buffett, and they should. Unlike Berkshire Hathaway, stock-market-only investors cannot exploit the aforementioned value differential (between public share prices and the value accrued by taking a firm private), should it occur. The very presence of large investors that are scouring for new ideas, however, keeps share prices relatively close to intrinsic value. When discrepancies between share prices and intrinsic values do occur, they are usually resolved in time; such is the theory behind value investing.
Stock prices will always be anchored to intrinsic value.
“One reason we were attracted to the property-casualty business (in 1967) was its financial characteristics: P/C insurers receive premiums upfront and pay claims later. In extreme cases, such as those arising from certain workers’ compensation accidents, payments can stretch over many decades. This collect-now, pay-later model leaves P/C companies holding large sums – money we call “float” – that will eventually go to others. Meanwhile, insurers get to invest this float for their benefit. Though individual policies and claims come and go, the amount of float an insurer holds usually remains fairly stable in relation to premium volume. Consequently, as our business grows, so does our float.”
Warren Buffett has built most of the wealth of Berkshire Hathaway from investing insurance premiums and the accumulated float. It is not because of the insurance business itself that Warren Buffett has been successful, however. On the contrary, it is because of the timing mismatch of cash flows in the insurance business (between float and claims) that has given Warren Buffett the opportunity to invest the float to achieve above average returns. In the insurance business, over the very long run, premiums received should equal eventual losses (emphasis on very long run), where net underwriting profit is close to zero. Buffett says as much in subsequent paragraghs:
If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit is earned, we enjoy the use of free money–and, better yet, get paid for holding it. Unfortunately, the wish of all insurers to achieve this happy result creates intense competition, so vigorous indeed that it frequently causes the P/C industry as a whole to operate at a significant underwriting loss.
This loss, in effect, is what the industry pays to hold its float. Competitive dynamics almost guarantee that the insurance industry, despite the float income all its companies enjoy, will continue its dismal record of earning subnormal returns on tangible net worth as compared to other American businesses. The prolonged period of low interest rates our country is now dealing with causes earnings on float to decrease, thereby exacerbating the profit problems of the industry.
This is partly why we’re not fans of the insurance business, in general. The other part rests in the commodity-type nature of insurance products. As Buffett outlines, insurers “simply can’t turn their back on business that is being eagerly written by their competitors. That old line, ‘The other guy is doing it, so we must as well,’ spells trouble in any business, but in none more so than insurance.”
We see no reason to own an insurer. Berkshire Hathaway is no such thing, however – it is a conglomerate with diversified sources of free cash flows.
Enjoying the commentary thus far? Continue to Part III>>
Referenced Tickers: PSX, PG, GHC