Hi all,
It has taken me a few weeks to get a chance to read the annual newsletter of Warren Buffett’s Berkshire Hathaway (BRK.A, BRK.B), and this year’s installment was not a disappointment. For me personally, there’s not a lot of incremental insights that are gleaned, but I like reviewing the newsletter because the annual installment is invaluable for new investors, especially those looking to learn about the markets and how to think about them.
What I’ll do below and in future parts is pull out a sentence or paragraph from the annual report and add to it or comment on it in order to provide further perspective. It should make for some great conversation. I’m not sure how many parts there will be, but this is the first one. Hope you enjoy the series.
“Market prices, let me stress, have their limitations in the short term. Monthly or yearly movements of stocks are often erratic and not indicative of changes in intrinsic value. Over time, however, stock prices and intrinsic value almost invariably converge.”
It is no surprise that stock prices are very difficult to predict in the short term. We know that they are driven by the buy and sell decisions of investors, and these buy and sell decisions do not have to be based on a company’s fundamentals at all. For example, a long-term investor who has held shares for 40 or more years may have to sell to pay for his/her medical bills. Or a CEO, who is a majority owner in the company, is selling shares under a designated plan to diversify his wealth. Or a company is removed from an index, and those that are tracking the index have to sell.
There are a variety of reasons why stock prices are unpredictable in the near term. We’d have to know the risk tolerances and behaviors of all major investors within each company to know what they will do, buy or sell, and when, in order to be able to predict with precision the market price movements of equities. This is an insurmountable task, and not worth one’s time. Even if such information could be aggregated, it would absorb considerable resources such that the payoff may not be worth the effort.
There is one thing we can count on, however. Over time, stock prices and intrinsic value converge due to the presence of value investors in the market who buy undervalued stocks and sell overvalued stocks. In most cases, these two different concepts (price versus value) may not converge completely (because value is a range not a point estimate), but stock prices tend to be attracted to intrinsic value over time, much like a magnet is attracted to steel or iron, for example. Stock prices have a natural tendency to be attracted to their intrinsic value. Value investors make this happen.
Within our 16-page reports, we arbitrarily choose 3 years as the price-to-convergence period, but there’s really no hard-and-fast rule. A stock’s price can converge to its intrinsic value in the next trading session or it could take 10 years or longer. In some value traps, the true intrinsic value is $0, even if the company has tangible net assets. Investing will never be precise. In many cases, investing is about having the odds stacked in your favor – or owning a stock that is trading at a significant discount to intrinsic value and is going up. This leads to outperformance. Owning good companies at intrinsic value leads to the market return, or the cost of capital less the dividend yield.
It is partly because of the uncertainty of both timing and intrinsic value estimation that the Valuentum process waits for an undervalued stock’s price to turn higher before adding it to the newsletter portfolio. If we like the stock’s valuation and business model anyway, what’s the harm in waiting until the market starts to agree? We won’t miss much. In fact, we’d only miss further declines, making the potential entry point even more attractive. That’s why we like undervalued stocks that are in the process of converging to intrinsic value. It takes a lot of risk out of the equation, and it optimizes time-weighted returns. We won’t be holding a stock, for example, that goes down for years before it turns higher. A 25% return in one year is much better than a 25% return in 20 years. A lot of what we do is common sense.
The increase in Berkshire’s per-share intrinsic value over the past half-century has been roughly equal to the ~1,800% gain in the market price of its shares. Remember, stock prices are attracted to intrinsic value. That’s why intrinsic value estimation is so important.
“BNSF is, by far, Berkshire’s most important non-insurance subsidiary and, to improve its performance, we will spend $6 billion on plant and equipment in 2015. That sum is nearly 50% more than any other railroad has spent in a single year and is a truly extraordinary amount, whether compared to revenues, earnings or depreciation charges.”
BNSF is one of the largest railroads in the US. The reason why we’ve pulled this quote is to illustrate the capital intensity of the railroad industry. A company’s intrinsic value is based on the future enterprise free cash flows of the organization, where net investment (capital spending less maintenance expense) is subtracted from earnings before interest, going forward. Net cash is added or net debt is subtracted from the present value of a company’s enterprise free cash flows when arriving at its equity value.
Though railroads have fantastic monopolistic positions due in part to the private ownership of track networks, their business models are heavily dependent on spending a large portion of cash flow from operations to maintain these track networks. By definition, the less a company has to reinvest in the business in the form of capital spending to maintain cash flow from operations, the better the free cash flow generation of the entity. Railroads are very capital intensive operations.
Berkshire Hathaway owns BNSF because it is a fantastic business that won’t go away anytime soon, the quintessential investment of Warren Buffett. In market parlance, we’d say that railroads have economic moats, but their economic castles aren’t highly rated. The very best types of businesses are the ones that throw off tons of cash without having to invest much of that cash to maintain a growing free cash flow stream. Asset light companies that generate lots of cash are the best businesses. Think like a business owner.
Railroads: ARII, CNI, CSX, GWR, KSU, NSC, UNP
“Charlie and I encourage bolt-ons, if they are sensibly-priced. (Most deals offered us aren’t.)”
This is an important point and why sometimes we’re not fans of a merger or acquisition, even if we may like the deal from a strategic standpoint. Remember, you can like a company to the moon, but if it engages in a merger or acquisition where the target’s takeout price cannot be reasonably justified with merger accounting via a discounted cash-flow process (including synergies), it doesn’t matter how much you like the company — its capital allocation decisions are destroying value. You can still like the company, but the deal is not in your best interest.
In the case where a suitor pays too much for a target, the suitor’s intrinsic value falls, while the target’s shareholders are paid more than they should. When the takeout premium is unjustified, value is transferred from the acquirer’s shareholders to the target’s shareholders. In today’s overheated market, some of the transaction multiples that we’ve seen have been astronomical. Siemens (SIEGY), for example, continues to take flak for its buyout of Dresser-Rand, where it paid 14 times this year’s EBITDA for the company, far greater than comparable multiples and the company’s own one. Some management teams are engaging in something called “empire building” under the guise of “strategy.” The discounted cash-flow model does not lie.
“Berkshire increased its ownership interest last year in each of its ‘Big Four’ investments – American Express, Coca-Cola, IBM and Wells Fargo. We purchased additional shares of IBM (increasing our ownership to 7.8% versus 6.3% at year-end 2013).” The earnings these investees retain are often used for repurchases of their own stock – a move that enhances Berkshire’s share of future earnings without requiring us to lay out a dime. Their retained earnings also fund business opportunities that usually turn out to be advantageous. All that leads us to expect that the per-share earnings of these four investees, in aggregate, will grow substantially over time (though 2015 will be a tough year for the group, in part because of the strong dollar).
This paragraph needs clarifying because there are a lot of moving parts. For starters, Warren Buffett thinks American Express (AXP), Coca-Cola (KO), IBM (IBM) and Wells Fargo (WFC) are undervalued. It’s important to make this distinction because not all share buybacks are a good thing. Buybacks completed on company stock that is overvalued are value-destroying, regardless of whether earnings-per-share is enhanced. Remember, in repurchasing overvalued stock, net cash on the balance sheet is reduced by a factor that is greater than the net benefit generated from dividing equity value by a lower share count. You wouldn’t want to buy overvalued stock, right? So why would you want management to?
“I’ve mentioned in the past that my experience in business helps me as an investor and that my investment experience has made me a better businessman. Each pursuit teaches lessons that are applicable to the other. And some truths can only be fully learned through experience.”
How true. Continue to Part II >>