“The boom is drawn out and accelerates gradually; the bust is sudden and often catastrophic.”

– George Soros, Alchemy of Finance

There was a very interesting article in the Wall Street Journal a few days ago on the story of “the swift rise and calamitous fall” of SunEdison (SUNE). Like a number of other promotional, Wall Street-fueled rise and falls, SunEdison became a victim of its own financial engineering, among other things. SUNE saw rapid growth thanks in large part through easy money provided by banks and shareholders. Low interest rates and deal hungry Wall Street investment banks helped encourage rapid expansion plans at companies like SunEdison, and provided the debt financing. Yield hungry retail investors, suffering from those same low interest rates on traditional (i.e. prudent) fixed income securities, helped provide the equity financing.

Just like MLP’s and a number of similar structures popping up in related industries, SunEdison provided itself with an unlimited source of growth funding by creating a separate business (actually a couple separate businesses) that are commonly referred to as yield companies, or “yieldco”. These yield companies are, in effect, nothing but revolving credit facilities for their “parent” business, and the credit line is always expanding (and the yield company is the one on the hook).

The scheme works as follows: a company (the “parent”) decides to grow rapidly. To finance its growth, it creates a separate company (the “yieldco”) that exists for the sole purpose of buying assets from the parent (usually at a hefty premium to the parent’s cost). To source the cash needed to buy the parent’s assets, the yieldco raises capital by selling stock to the public by promising a stable dividend yield. The yieldco uses the cash raised from the public to buy more assets from the parent, and the parent, in turn, uses these cash proceeds to buy more assets to sell (“drop down”) to the yieldco, and the cycle continues.

Thanks to a yield-deprived public, these yieldco entities often have an unlimited source of funds that it can tap whenever it wants (SUNE’s yieldco, TERP, had an IPO in 2014 that was more than 20 times oversubscribed). As long as the yieldco is paying a stable dividend, it can raise fresh capital. As long as it raises capital, it can buy assets from the parent, who gets improved asset turnover and faster revenue growth.

In Sun’s case, the yieldco is Terraform Power (TERP). (There is also TerraForm Global (GLBL) as well).

I made a very oversimplified chart to try and demonstrate the crux of this relationship:

SUNE TERP Flow Chart

It Tends to Work, Until it Doesn’t

Buffett said this recently regarding the conglomerate boom of the 1960’s, whose business models also relied on a high stock price and heavy doses of stock issuances and debt:

BRK Buffett quote on share issuances

If the assets that the yieldco is buying are good quality assets that do in fact produce distributable cash flow, (i.e. cash that actually can be paid out to shareholders without skimping on capital expenditures that are required to maintain the assets), then the chain letter can continue indefinitely. The problem I’ve noticed with many MLP’s is that the company’s definition of distributable cash flow (DCF) is much different than what the actual underlying economics of the business would suggest (i.e. a company can easily choose to not repair or properly maintain a natural gas pipeline. This gives them the ability to save cash now (and add to the DCF which supports the dividend) while not worrying about the inadequately maintained pipe that probably won’t break for another few quarters anyhow).

Another thing I’ve noticed with businesses that try to grow rapidly through acquisitions is that the financial engineering can work well when the asset base is small. When Valeant (VRX) was a $1 billion company, it had plenty of acquisition targets that might have created value for the company. When VRX became a $30 billion company, it is not only harder to move the needle, but every potential acquiree knows the acquirer’s gameplan by then. It’s hard to get a bargain at that point, but it’s also hard to abandon the lucrative and prestigious business of growth (note: lucrative depending on which stakeholder we’re talking about).

In Sun’s case, the Wall Street Journal piece sums it up:

“As SunEdison’s acquisition fever grew, standards slipped, former and current employees, advisers, and counterparties said. Deals were sometimes done with little planning or at prices observers deemed overly rich…. Some acquisitions proceeded over objections from the senior executives who would manage them, said current and former employees.”

So the game continues even when growth begins destroying value. Once growth begins to destroy value, the game has ended—although it can take time before the reality of the situation catches up to the market price.

Basically, it’s a financial engineering scheme that gives management the ability (and the incentives, especially when revenue growth or EBITDA influences their bonus) to push the envelope in terms of what would be considered acceptable accounting practices.

In some recent yieldco structures, I’ve observed that when operating cash flow from the assets isn’t enough to pay for the dividend, cash from debt or equity issuances can make up the difference—something akin to a Ponzi. Incoming cash from one shareholder is paid out to another shareholder as a dividend.

Even when fraud isn’t involved, this system can still collapse very quickly if the assets just aren’t providing enough cash flow to support the dividend.

Incentives

The incentives of this structure are out of whack. The parent company wants growth, and since it can “sell” assets to a captive buyer (the yieldco) at just about any price, it doesn’t have to worry too much about overpaying for these assets. It knows the captive buyer will be ready with cash in hand to buy these assets at a premium.

In Sun’s case, management’s incentive was certainly to get the stock price higher because, like many companies, a large amount of compensation was stock based. But their bonuses also depended on two main categories: profitability and megawatts completed.

Both categories incentivize growth at any cost—value per share is irrelevant in this compensation structure.  You might say that profitability sounds nice, until you read how management decided to measure it:

“the sum of SunEdison EBITDA and foregone margin (a measure which tracks margin foregone due to the strategic decision to hold projects on the balance sheet vs. selling them).”

Hmmm… that is one creative definition of profitability. Not surprisingly, all the executives easily met the “profitability” threshold and bonuses were paid—this is despite a company that had a GAAP loss of $1.2 billion and had a $770 million cash flow loss from operations.

Growth at Any Cost

At the root of these structures is often a very ambitious (sometimes overzealous) management team. The Wall Street Journal mentioned that Ahmad Chatila, SUNE’s CEO, said that SunEdison “would one day manage 100 gigawatts worth of electricity, enough to power 20 million homes.” Just last summer, Chatila predicted SUNE would be worth $350 billion in 6 years, and one day would be worth as much as Apple. These aggressive goals are often accompanied by a very aggressive, growth-oriented business model, which can sometimes lead to very aggressive accounting practices.

I haven’t researched SunEdison or claim to know much about the business or the renewable energy industry. I’ve followed the story in the paper, mostly because of my interest in David Einhorn, an investor I admire and have great respect for. Einhorn had a big chunk of capital invested in SUNE.

David Einhorn is a great investor. He will (and maybe already has) made up for the loss he sustained with SUNE. This is not designed to be critical of an investor, but to learn from a situation that has obviously gone awry.

Parallels Between SUNE and VRX

The SUNE story is very different from VRX, but there are some similarities. For one, well-respected investors with great track records have invested in both. But from a very general viewpoint, one thing that ties the two stories together is their focus on growth at any cost. To finance this growth, both VRX and SUNE used huge amounts of debt to pay for assets. Essentially, neither company existed a decade ago, but today the two companies together have $40 billion of debt. Wall Street was happy to provide this debt, as the banks collected sizable fees on all of the deals that the debt helped finance for both firms.

Investing is a Negative Art

A friend of mine—I’ll call him my own “west coast philosopher” (even though he doesn’t live on the west coast)—once said that investing is a negative art. I interpret this as follows: choosing what not to invest in is as important as the stocks that you actually buy.

Limiting mistakes is crucial, as I’ve talked about many times. While mistakes are inevitable, it’s always productive to study your own mistakes as well as the mistakes of others to try and glean lessons that might help you become a little closer to mastering this negative art. One general lesson from the SUNE (and VRX) saga is that business models built on the foundation of aggressive growth can be very susceptible to problems. It always looks obvious in hindsight, but a strategy that hinges on using huge amounts of debt and new stock to pay for acquisitions is probably better left alone. Sometimes profits will be missed, but avoiding a SUNE or a VRX is usually worth it.

General takeaways:

  • Be wary of overly aggressive growth plans, especially when a high stock price (and access to the capital markets) is a necessary condition for growth.
  • Be skeptical of management teams that make outlandish promises of growth, and be mindful of their incentives.
  • Be careful with debt.
  • Try to avoid companies whose only positive cash flow consistently comes from the “financing” section of the cash flow statement (and makes up for the negative cash flow from both operating and investing activities).
  • Simple investments (and simple businesses) are often better than complex ones with lots of financial engineering involved.

Here is the full article on SUNE, which is a great story to read.

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John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

I established Saber as a personal investment vehicle that would allow me to manage outside investor capital alongside my own. I also write about investing at the blog Base Hit Investing.

I can be reached at john@sabercapitalmgt.com.

I talk a lot about compounders–businesses that produce lots of cash flow and have opportunities to reinvest that cash flow at high rates of return. Such businesses that produce high returns on capital can compound their intrinsic value at above average rates over time, and the stock price follows intrinsic value over the long haul.

But while I spend time reading and researching great businesses, occasionally I come across an opportunity to buy a bargain–a stock trading for less than the value to a private owner. Sometimes these opportunities are created through special situations such as a spinoff.

Associated Capital (AC) is an example of this type of bargain. It trades for less than the net cash on its balance sheet, for about 70% of tangible book value (a portion of which is hidden due to an accounting rule), has an insider with over $500 million invested in it who wants to close this value gap, and a recently announced buyback.

AC is basically a big pile of cash worth about $40 per share that can be purchased for the current stock price of around $29. This $40 per share of tangible value gives no value to a $1 billion hedge fund that AC manages.

Given the insider incentives, future buybacks which will add to value per share at these prices, and a stock price that is trading at far less than book value, I think the stock is certainly a safe and cheap bargain.

This post is just a snapshot of the idea. I wrote a post on Seeking Alpha that covers this investment in more detail as well as my thoughts on how the situation came about.

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John Huber owns shares of AC. Clients of Saber Capital Management own shares of AC. This is not a recommendation. Please do your own research.  

John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

I established Saber as a personal investment vehicle that would allow me to manage outside investor capital alongside my own. I also write about investing at the blog Base Hit Investing.

I can be reached at john@sabercapitalmgt.com.

 

I just got done reading Jeff Bezos’ annual letter to shareholders, which is outstanding as it always it. As I finished it, I spent a few minutes thinking about it. He references Amazon’s style of “portfolio management”. He doesn’t call it that of course, but this passage got me thinking about it. Since I wrote a post earlier in the week about portfolio management, I thought using Bezos’ letter would allow me to expand on a few other random thoughts. But here is just one clip from many valuable nuggets that are in the letter:

AMZN Bezos Letter 2015

Bezos has always gone for the home run ball at Amazon, and it’s worked out tremendously for him and for shareholders. Would this type of swinging for the fences work in investing?

I’ve always preferred trying to go for the easy bets in investing. Berkshire Hathaway is an easy bet. The problem though (or maybe it’s not a problem, but the reality) is that the easy bets rarely are the bets that become massive winners. Occasionally they do—Peter Lynch talked about how Walmart’s business model was already very well-known to investors in the mid 1980’s and it had already carved out significant advantages over the dominant incumbent, Sears. You could have bought Walmart years after it had already proven itself to be a dominant retailer but also when it still had a bright future and long runway ahead of it.

So sometimes the obvious bets can be huge winners. But this is usually much easier in hindsight. After all, Buffett himself couldn’t quite pull the trigger on Walmart in the mid 1980’s, a decision he would regret for decades. At the annual meeting in 2004, he mentioned how after nibbling at a few shares, he let it go after refusing to pay up:

“We bought a little and it moved up a little and I thought maybe it will come back a bit. That thumbsucking has cost us in the current area of $10 billion.”

So sometimes obvious bets can be huge winners. But many times, the most prolific results in business come from bets that are far from sure. Jeff Bezos has always had a so-called moonshot type approach to capital allocation. The idea is simple: there will be many failures, but no single failure will put a dent in Amazon’s armor, and if one of the experiments works, it can return many, many multiples of the initial investment and become a meaningful needle-mover in terms of overall revenue.

Amazon Web Services (AWS) was one such experiment that famously became a massive winner, set to do $10 billion of business this year, and getting to that level faster than Amazon itself did. The Fire phone was the opposite–it flopped. But the beauty of the failures at a firm like Amazon is that while they are maybe a little embarrassing at times, they are a mere blip on the radar. No one notices or cares about the Amazon phone. If AWS had failed in 2005, no one today would notice, remember, or care.

So this type of low probability, high payoff approach to business has paid huge dividends for Amazon. I think many businesses exist because of the success of a moonshot idea. Mark Zuckerberg probably could not have comprehended what he was creating in his dorm room in the fall of 2004. Mohnish Pabrai has talked about how Bill Gates made a bet when he founded Microsoft that had basically no downside–something like $40,000 is the total amount of capital that ever went into the firm.

“Moonshot” Strategy is Aided by Recurring Cash Flow

One reason why I think this approach works for businesses and not necessarily in portfolio management is simply due to the risk/reward dynamic of these bets. I think a lot of these bets that Google and Amazon are making have very little downside relative to the overall enterprise. Most stocks that have 5 to 1 upside also have a significant amount of downside.

I think lost dollars are usually much more difficult to replace in investing than they are in business, partially because businesses usually produce recurring cash flow. Portfolios have a finite amount of cash that needs to be allocated to investment ideas. Portfolios can produce profits from winning investments, and then these profits can get allocated to other investment ideas, but there is no recurring cash flow coming in (other than dividends).

Employees, Ideas, and Human Capital

Not only do businesses have recurring cash flow, they also have human capital, which can produce great ideas that can become massive winners. Like Zuckerberg in his dorm room, Facebook didn’t start because of huge amounts of capital, it started because of a really good idea and the successful deployment of human capital (talented, smart, motivated people working on that good idea). Eventually, the business required some actual capital, but only after the idea combined with human capital had already catapulted the company into a valuation worth many millions of dollars.

There was essentially no financial risk to starting Facebook. If it didn’t work, Zuckerberg and his friends would have done just fine—we would have most likely never have heard of them, but they’d all be doing fine.

If AWS flopped, it’s likely we would have never noticed. There would be minor costs and human capital would be redeployed elsewhere, but for the most part, Amazon would exist as it does today—dominating the online retail world.

Google will still be making billions of dollars 10 years from now if they never make a dime from self-driving cars.

So I think this type of capital allocation approach works well with a corporate culture like Amazon’s. Bezos himself calls his company “inventive”. They like to experiment. They like to make a lot of bets. And they swing for the fences. But the cost of striking out on any of these bets is tiny. And you could argue that any human capital wasted on a bad idea wasn’t actually wasted. Amazon—like many people—probably learns a ton from failed bets. You could argue that these failures actually have a negative cost on balance—they do cost some capital, but this loss that shows up on the income statement (which again, is very small) ends up creating value somewhere else down the line due to increased knowledge and productive redeployment of human capital.

So I think there are advantages to this type of “moonshot bet” approach that works well within the confines of a business like Amazon or Google, but might not work as well within the confines of an investment portfolio. This isn’t always the case—I recently watched the Big Short (great movie, but not as good as the book) and the Cornwall Capital guys used these types of long-shot bets to great success. They used options (which inherently have this type of capped downside, unlimited upside risk/reward) and they turned $30,000 into $80 million. But I think this would be considered an exception, not the rule.

I think most investors have a tendency to arbitrarily tilt the odds of success (or the amount of the payoff) too much in their favor with these types of long-shot bets. They might think a situation has 6 to 1 upside potential when it only has 2 to 1. Or they might think that there is a 30% chance of success when there is only a 5% chance. It’s a subjective exercise—this isn’t poker or black jack where you can pinpoint probabilities based on a finite set of outcomes. So I think that many investors would be better off not trying to go for the long-shots, which in investing, unlike business, almost always carry real risk of capital destruction.

Berkshire Hathaway manages a business using a completely opposite style of capital allocation. Instead of moonshots, it goes for the sure money, the easy bets. It’s not going to create a business from scratch that can go from $0 to $10 billion in 10 years. But nor does it make many mistakes. There is no right or wrong approach. As Bezos says, it just depends on the culture of the business and the personalities involved.

I think certain businesses that possess large amounts of human capital combined with the right culture, the right leadership, and a collective mindset for the long-term can benefit from this type of moon-shot approach. They can and should use this style of capital allocation. Ironically, I think investing in such well-managed, high quality companies with great leadership and culture are often the sure bets that stock investors should be looking for.

Either way, from a portfolio management perspective, I think it’s easier to look for the low hanging fruit.

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John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

I established Saber as a personal investment vehicle that would allow me to manage outside investor capital alongside my own. I also write about investing at the blog Base Hit Investing.

I can be reached at john@sabercapitalmgt.com.

“Ship your grain across the sea; after many days you may receive a return. Invest in seven ventures, yes, in eight; you do not know what disaster may come upon the land.” –Ecclesiastes 11:1-2

Investors have always discussed and debated the merits of diversification—apparently even as far back as the days of King Solomon (although his definition of diversification—7 or 8 “ventures”—might not sit well with modern day portfolio theory and mutual fund managers who often hold 30, 50, or 100 of such ventures).

Over the weekend I happened to reread this article on Walter Schloss, which got me thinking about portfolio management a bit. Schloss is an investor I’ve talked about on the site before. He’s one of my favorite investors—not necessarily because of his strategy, but for his simplistic view of investing. To Schloss, investing was simple. It involved buying stocks that were cheap relative to easily identifiable net asset values, or low P/B stocks. He set up his business in a way that suited his personality and maximized his strengths—and it led to incredible results. His strengths were his patience, his discipline, and his ability to not be influenced by others’ opinions.

A friend and I were talking this week about portfolio management, and I thought I’d write down a few miscellaneous comments on the topic. This topic (portfolio management and how many stocks to own) is a question I get often from prospective investors, and so it seems to be of interest to many readers.

Schloss ran a very diversified portfolio. He bought many different cheap stocks. He didn’t talk to management. He relied on numbers, probability, and the concept that when taken in the aggregate, buying stocks at cheap prices relative to their book values will work out well over time.

How much diversification is necessary?

I prefer to focus my investments much more than Schloss did, but the answer is it depends on a few things—namely the type of investment approach that is being implemented. An investor buying cheap stocks of companies with little to no earning power is probably better off using a more diversified basket approach. Ben Graham—who Schloss learned from—also used this approach. Both did quite well—averaging around 20% per year for decades.

How were they able to continually achieve such great results? Because it’s not easy buying the stocks that these guys owned. As Schloss says, sometimes:

“these companies and industries get into disrepute and nobody wants them, partly because they need a lot of capital investment and partly because they don’t make much money. Since the market is aimed at earnings, who wants a company that doesn’t earn much? So, if you buy companies that are depressed because people don’t like them for various reasons, and things turn a little in your favor, you get a good deal of leverage.”

This style of investing worked for Schloss because his personality and skillset was geared for it. Although I also like cheap stocks, I find more safety in building a portfolio filled with durable businesses that can compound earning power and value. To paraphrase something Bruce Greenberg once said, I want to feel perfectly fine in the event of a 1987 style stock market crash—stock prices will go down, but the underlying businesses I own—as a group—won’t be permanently impaired.

Now, I think there can be a place in the portfolio for bargains and special situations, and not all investments fit neatly into a specific category. I’ve talked about how investors shouldn’t focus on categorizing investments, but focus on understanding them. Forget about style boxes and whether an investment fits into your pre-defined strategy—just look for great value.

As Alice Schroeder said about Buffett (paraphrasing): “If someone gave him a dollar bill and asked for two quarters for it, he’d immediately take it. He wouldn’t say, ‘Well, that dollar bill has no moat’”.

Focusing on a Few Good Businesses

The other side of the coin is to own a select few high quality businesses that do a lot of the heavy lifting for you (i.e. they compound value over time). I also think that collectively, the margin of safety is much greater in owning good companies—those well-managed, durable businesses with predictable earning power. I’ve written a few posts on the concept of return on invested capital (ROIC), and why this is an important driver of value.

Buying these businesses at a discount to their fair values provides two sources of potential return:

  1. The closing of the gap between price and value
  2. The growth in earning power over time

So if the value gap takes a year or two to correct itself, then you also benefit from the business having a higher earning power and higher intrinsic value than it did when you first bought it, giving your investment return an added kicker.

The opposite occurs with cheap stocks of mediocre or lousy businesses that have declining earning power and shrinking intrinsic values. It is possible to make money buying these companies at a discount—after all, almost every stock has some intrinsic value that is greater than $0, thus in theory it’s possible for any stock—regardless of how good or bad the business is—to become undervalued and a potentially attractive opportunity for bargain hunters. But I see two general problems with most bargain situations:

  1. You have to be very precise in your estimate of value, because the business won’t “bail you out” by growing over time
  2. There is a tricky element of timing involved—if you buy a declining business below intrinsic value, you have to sell it fairly quickly before the intrinsic value falls down to your purchase price

In other words, good businesses bought at a discount have a margin of safety that increases over time. Bad businesses bought at a discount have a margin of safety that shrinks over time. As cliché as it now is in the investment community, the following remains as true as when Buffett first said it: “Time is the friend of the wonderful business”.

Predictable Businesses

There is also the element of predictability. Many of the stocks Schloss and Graham bought had future prospects that were somewhat unpredictable:

“The thing about my companies is that they are all depressed, they all have problems and there’s no guarantee that any one will be a winner. But if you buy 15 or 20 of them…”

So you need diversification with this approach to capture the benefits of the law of large numbers—you don’t know which stocks will work, but as a group, the portfolio will do well–similar to the concept of insurance underwriting.

Owning carefully selected high quality businesses is a different approach.

I think because of the higher level of predictability in some investments means that you need fewer of them to remain adequately diversified. Berkshire Hathaway is a company I discussed recently, and this is an example of a company is very diversified. It’s also very predictable that earnings will be much higher in 5-10 years than they are now. You don’t need 10 BRK’s to have a diversified portfolio. Other stocks (most other stocks) are much less predictable and maybe you need smaller position sizes and more of them to maintain comfortable levels of diversification. But I think owning say 5-8 great businesses and in addition maybe a few special situations or bargains that occasionally pop up provides plenty of diversification without diluting your best ideas.

To Sum It Up

As I finish up my Value Line project, I’ll begin discussing some of the businesses on my watchlist. I think if you build a watchlist of 50-100 good companies, there are almost always a few opportunities at any given time for one reason or another.

To take a lesson from Schloss, I think it is imperative that each investor develop a strategy that a) works well over time (value investing generally does) and b) suits their personality and maximizes their strengths. I sleep better at night owning good businesses. I like to feel comfortable that my portfolio of businesses will do well over time regardless of what the near term outlook for the stock market is, what interest rates will do, or what’s in store for the economy in the next year. Some of these things can make or break certain companies—so I find it more comfortable to look for durable businesses that can withstand a variety of these tests. These tend not to be the cheapest P/B stocks that Graham and Schloss would have liked, but they also tend to grow value over time, which gives me a much appreciated tailwind.

These companies don’t often become undervalued, but you also don’t need that many of them to collectively create a massive margin of safety for your portfolio—and this is a margin that will grow over time.

While it’s true that life and business are often unpredictable, and sometimes disaster may strike the land, I think diversifying into a handful of high quality “ventures” ensures your twofold goal of shipping your grain safely across the sea and achieving an adequate return on your investment.

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John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

I established Saber as a personal investment vehicle that would allow me to manage outside investor capital alongside my own. I also write about investing at the blog Base Hit Investing.

I can be reached at john@sabercapitalmgt.com.

I own Berkshire Hathaway stock. In fact, it’s a stock I bought recently for the first time ever, despite following it for years. I think earlier this year it became (and to a large extent still is) far too cheap. It’s not a stock that I think has huge upside, but it is a stock that I think has no downside. (That said, I do think there is enough upside to get plenty excited). In proper investment parlance, the risk/reward of BRK is tremendous.

BRK is one of the most talked about stocks in the value investing community, and so I was hesitant to even put a post together, but as I read through the annual report and 10-K a couple weeks ago, I jotted down four main reasons why I think Berkshire is an attractive investment at these prices.

I’ll outline some comments in this post stating why I like the company and the current stock price, and then in a future post or two I might discuss in more detail a few things I noted while reading the annual report and 10-K.

Berkshire is attractive for four general reasons:

  • Cash-rich balance sheet
  • Strong earning power
  • Capital allocation (Buffett’s potential to capitalize on downturns)
  • Current stock price—Almost $100 of cash and investments per share and less than 7 times earnings for good businesses with above average ROE’s and a history of strong earnings growth

Note: everything related to per share numbers will be in B shares (which are 1/1500th of A shares).

Cash-rich Balance Sheet

Adjusting for the recent Precision Castparts acquisition which was finalized after 12/31/15, Berkshire has $98 per share in cash and investments. The balance sheet has an excess cash hoard of around $40 billion, and this cash pile grows at a rate of around $1.25 billion per month (this adds around $15 billion, or $6 per share of cash to the balance sheet each year that Buffett can reallocate or just let build).

Consider this: at the current rate that free cash is building up inside Berkshire, it will take just over 5 quarters to make back the entire amount of cash they used to fund the PCP acquisition (the largest in BRK history).

The balance sheet is one huge competitive advantage for Berkshire. Should trouble develop in the economy or if markets fall apart, Berkshire has the opportunity to create enormous value for shareholders by lending money to firms in need (and extracting a heavy toll for such funding), making acquisitions, buying stocks on the cheap, or even using a few months’ worth of free cash flow to buy back BRK stock if it trades much lower than the current quote.

Strong and Diversified Earning Power

Unlike many conglomerates, BRK has built a collection of quality compounding machines that produce copious amounts of cash flow that grows over time at a steady clip.

Insurance Businesses

Berkshire’s insurance business (with over $110 billion of stated net worth) is not only the largest insurance company in the world, but also one of the most profitable. It has produced 13 consecutive years of underwriting profits, and while this yearly streak will come to an end at some point as insurance markets continue to soften, over time these collection of assets will remain very profitable. Over this 13-year run the insurance businesses have produced a total of $26 billion of pretax profits for Berkshire and currently hold $88 billion in float—money that has been paid by policyholders and reserved by Berkshire for future claims.

This float is listed on the balance sheet as a liability, but in reality—as long as the insurance business continues to collect premiums and underwrite profitably—it is a valuable asset.

Buffett illustrates this value by calling float a revolving fund—each day Berkshire pays out millions of dollars of claims, which reduces float. But each day millions of dollars of new business is written, which adds to float. As long as policies are written profitably (premiums collectively offset claims and operating expenses), and as long as new premiums coming in replace claims going out, then float will be both interest-free and won’t have to be paid back.

As Buffett said in the recent letter: “Owing $1 that in effect will never leave the premises—because new business is almost certain to deliver a substitute—is worlds different from owing $1 that will go out the door tomorrow and not be replaced.”

So $1 of float is listed on the liabilities side of the balance sheet alongside $1 of debt—but the former is not only free but actually produces profits and will never have to be paid back. This is one reason why Buffett feels the book value (which counts this $88 billion as a full liability) understates the economic value of Berkshire.

Operating Businesses

Berkshire’s “Big Five” (BNSF, BH Energy, Marmon, Lubrizol, and Iscar) earned $13.1 billion pretax in 2015. This will soon be the “Big Six” as PCP will be included this year, and if we assume PCP’s earnings this group made over $15 billion. Buffett puts this in perspective in his letter by pointing out that a decade ago only BH Energy existed at Berkshire, and made less than $400 million. So close to $15 billion of earning power has been created in the last decade with virtually no dilution (5 of the Big 6 were purchased all-cash, and BNSF required a minor issuance of new shares).

Earning Power per Share

Including the underwriting profits (but excluding dividend and interest income) from the insurance businesses, BRK had about $8.20 per share in pretax profits in 2015. If we assume no earnings growth and include the pretax income that Berkshire will receive from PCP, we get to roughly $9 per share of pretax earnings.

Buffett has often talked about the intrinsic value of Berkshire Hathaway and how he and Charlie Munger think about it. They basically think of BRK’s value in two buckets: cash/investments per share and earnings per share. Since 1970, investments per share have compounded at 18.9% annually and earnings per share have grown at 23.4% per year. So it’s no surprise that BRK’s intrinsic value and stock price have also compounded at 20% or so for the past half century.

Of course, these rates of compounding are history, but we can still look at the two buckets and clearly see a huge margin of safety from not only a fortress balance sheet but also an earnings machine that is getting very low valuations at the current stock price.

Attractive Current Valuation

For $140 per share, we are getting $98 of cash and investments, and roughly $9 per share of pretax earning power. So backing out the investments per share, we are paying roughly 4.5 times pretax earnings for Berkshire’s businesses.

At Berkshire’s tax rate of around 30%, this is a P/E of around 6.5 for a diversified group of quality businesses that produce above average returns on equity and—as a group—are growing their earning power. Seems like a good bet.

Buffett once said he likes to pay 10 times pretax earnings for good businesses. I think this is because he thinks the businesses he buys can a) grow their earning power over time, and b) are probably worth somewhat more than 10 times pretax earnings.

At the current price, we’re getting these businesses for half of this general rule of thumb.

Book Value

“Today, the large—and growing—unrecorded gains at our “winners” make it clear that Berkshire’s intrinsic value far exceeds its book value. That’s why we would be delighted to repurchase our shares should they sell as low as 120% of book value. At that level, purchases would instantly and meaningfully increase per-share intrinsic value for Berkshire’s continuing shareholders.” –2015 Shareholder Letter (emphasis mine)

One reason why Berkshire’s book value understates the intrinsic value is that businesses that Berkshire buys never get marked higher, despite as a group growing earning power each year and becoming much more valuable as time goes on.

Another reason Berkshire’s true value far exceeds its book value is the insurance business. Earlier I mentioned the value of the float (which is listed as a liability), but we can also look at the asset side of the insurance balance sheet, where $15 billion of goodwill has been sitting since 2000 and has never been marked higher, despite float (and earning power) tripling during that time.

 “Charlie and I believe the true economic value of our insurance goodwill—what we would happily pay for float of similar quality were we to purchase an insurance operation possessing it—to be far in excess of its historic carrying value. Indeed, almost the entire $15.5 billion we carry for goodwill in our insurance business was already on our books in 2000. Yet we subsequently tripled our float. Its value today is one reason—a huge reason—why we believe Berkshire’s intrinsic business value substantially exceeds its book value.”

Berkshire’s current book value (using the current price for KHC shares) is around $105 per share. The stock price is around $140, or roughly 1.3 times book, just a touch above the 1.2x level where Buffett thinks is significantly undervalued and would buy back shares.

One thing to consider: just from cash building up throughout the year, book value will grow to around $111 per share by year end. Who knows what the $98 investment portfolio will do in the next year, but over time I would expect this to grow at rates similar to the S&P 500, or say 6-8% annually. But assuming no change in the investments per share, we still get to around $111 per share in book value just through retained earnings by year end. This puts the level Buffett would be willing to buy shares at around $133. And it continues to grow from there as earnings continuing building up. In less than 2 years the current stock price will be less (possibly much less) than 1.2 times book value even if the investment portfolio goes nowhere. Time is the friend of the wonderful business.

While it’s certainly possible for the stock price to fall below (maybe significantly below) this hypothetical buyback price over temporary short-term periods, over time I think there is very little chance of losing any money at the current price. If the S&P drops 25%, BRK will certainly fall as well. But if BRK stays much below $125 or so for very long, Buffett will likely begin buying shares, which will be very positive for earning power per share and also value per share. (Note: Don’t think of this as a “Buffett put”—he has no interest in “propping up” the stock. He’s willing to buy shares at 1.2 times book because he thinks that is a bargain price that is much below intrinsic value).

I think the current price is cheap, but the mid-120’s was a no-brainer.

Buffett’s Reputational Value

Berkshire can create value based on Buffett’s name and reputation. This is especially true during troubled times (see GE, BAC, GS deals to name a few). But even in normal times, Buffett’s name has created enormous value for shareholders, as he can partner with owner/operators like 3G at attractive terms. Consider the 3G partnership that started with Heinz and is now Kraft Heinz (KHC):

Buffett invested a total of:

  • $9.5 billion in common stock
  • $8.0 billion in preferred stock
  • $17.5 billion total

This total investment of $17.5 billion is now worth $33 billion, and has achieved an IRR of around 45%.

(Berkshire owns 325.4 million shares of KHC that is currently valued at $25.1 billion before reserving for taxes—and this resulted from a $9.5 billion initial investment).

Berkshire has also collected around $1.5 billion of dividends from the preferred stock.

By the way, this $33 billion of value is carried on BRK’s books at $23 billion, so this is an additional $10 billion gap between book value and intrinsic value.

To Sum It Up

Berkshire is a fortress that’s undervalued. It’s too big to become a home run, but one of my favorite investment situations is where I see almost no chance of permanent downside and very high chances of decent gains over the next couple years. I was buying BRK thinking there was virtually no chance of losing money and a decent chance at 50% gains in 3 years. Sometimes, the market corrects itself quickly, which has the impact of “pulling forward” two or three years’ worth of gains in a year or so.

But while we wait for the upside to occur, Berkshire is a safe and cheap stock whose value will actually increase in the event of the “black swan”, a bear market in stocks, or an economic recession.

———

John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

I established Saber as a personal investment vehicle that would allow me to manage outside investor capital alongside my own. I also write about investing at the blog Base Hit Investing.

I can be reached at john@sabercapitalmgt.com.

I was reading through the 2014 (last year’s) Berkshire Hathaway annual report and 10-K looking for a few things, and happened to reread Buffett’s letter from last year. I wrote a post a couple weeks ago concerning buybacks and Outerwall, and how a company that is buying back stock of a dying business is not a good use of capital.

I noticed a passage in last year’s letter that is relevant to the topic—Buffett himself was attracted to buybacks on a dying business—Berkshire Hathaway in the early 1960’s. Berkshire was a Ben Graham cigar butt—it was trading at around $7 and had net working capital of $10, and book value of $20. Berkshire was a classic “net net”—a stock trading for less than the value of its cash, receivables, and inventory less all liabilities. Buffett liked the fact that Berkshire was a) trading at a cheap price relative to liquidation value, and b) using proceeds from the sale of plants to buy back shares—effectively liquidating the company through share repurchases.

Here is what Buffett was looking at when he originally bought shares in this company in the early 1960’s:

BRK 1964

Like Outerwall, Berkshire’s business was in secular decline. In fact, it had been dying a long time, as the meeting notes from a 1954 Berkshire board meeting stated: “The textile industry in New England started going out of business forty years ago“.

Also like Outerwall, Berkshire was buying back stock. One difference (among many of course) between Berkshire then and Outerwall now is that Berkshire was closing plants and using proceeds to buy back shares. From the 1964 Berkshire report (which can be found on page 130):

“Our policy of closing plants which could not be operated profitabily was continued, and, as a result, the Berkshire King Philip Plants A and E in Fall River, Mass. were permanently closed during the year. The land and buildings of Plant A have been sold and those of Pant E offered for sale…. Berkshire Hathaway has maintained its strong financial positiona nd it would seem constructive to authorize the Directors, at their discretion, to purchase additional shares for retirement.”

Outerwall, on the other hand, is producing huge amounts of cash flow from its operations, not from the sale of fixed assets.

Liquidation vs. Leveraged Buyout

Another difference is that Berkshire was in liquidation mode and was buying out shareholders (through buybacks and tender offers) from cash proceeds it received from selling off plants. Outerwall hasn’t been liquidating itself through buybacks—instead it has leveraged the balance sheet by issuing large amounts of debt, using the proceeds to buy back stock, which has reduced the share count, but not the size of the balance sheet or the amount of capital employed.

Outerwall had total assets of around $1.3 billion five years ago, roughly the same as it does now (goodwill however has doubled due to acquisitions). These assets were financed in part by $400 million of debt and $400 million of equity in 2010. Today, the company’s assets are financed by roughly $900 million of debt, and shareholder equity is now negative. Outerwall has historically produced high returns on capital, and it’s a business that doesn’t need much tangible capital to produce huge amounts of cash flow (an attractive business), but it has been run similar to companies that get purchased by private equity firms—leverage up the balance sheet, issue a dividend (or buyout some shareholders), thus keeping very little equity “at risk”. It’s a gamble with other people’s money, and sometimes it results in a home run (sometimes, of course, it doesn’t).

So Berkshire in the 1960’s was more of a slow liquidation. Outerwall is basically a publicly traded leveraged buyout.

In the case of BRK, shareholders who purchased at $7 were rewarded with a tender offer of just over $11 a few years later. But that’s the nature of cigar butt investing—sometimes at the right price, there is a puff or two left that allows you to reap an outstanding IRR on your investment—in Buffett’s case, had he taken the tender offer from Seabury Stanton, his IRR on the BRK cigar butt investment would have been around 40%.

He didn’t though, and the rest is history. It’s interesting to note another mistake that he points out in last year’s letter, one that I think is rarely mentioned but was very costly. Instead of putting National Indemnity in his partnership, which would have meant it was 100% owned by Buffett and his partners, he put it into Berkshire Hathaway, which meant that he and his partners only got 61% interest in it (the size of the stake that Buffett had in BRK at the time).

I think this could have been Buffett’s way of doubling down on Berkshire (then, a dying business with terrible returns on capital). He thought he could save it (not the textile mills, but the entity itself) by adding a good business with solid cash flow and attractive returns to a bad business that was destroying capital. Obviously, as Buffett points out, he should have shut down the textile mills sooner, and just used National Indemnity to build what is now the company we know as Berkshire Hathaway.

Two Mistakes to Avoid

Two takeaways from this, which in Buffett’s own words were two of his greatest mistakes:

  • It’s usually not a good idea to buy into bad businesses, even at a price that looks attractive
  • If you are in a bad business, it probably doesn’t make sense to “double down”—for most of us, this could mean averaging down and buying more shares. In Buffett’s case, it was already a 25% position in his portfolio and he “doubled down” by throwing good money after bad (putting National Indemnity—a good business—inside a textile manufacturer instead of just a wholly owned company inside of Buffett’s partnership.

The good news—things have worked out just fine for Buffett and for Berkshire. Although the textile mills unfortunately had to finally shut down for good, National Indemnity has come a long way since Buffett purchased it for $8.6 million in 1967 (see the original 2-page purchase contract here, no big Wall Street M&A fees on this deal). National Indemnity now has over $80 billion of float, and over $110 billion of net worth, making it the most valuable insurance company in the world. The insurance business that started with National Indemnity paid dividends to Berkshire last year of $6.4 billion and holds a massive portfolio of stocks, bonds, and cash worth $193 billion at year end.

Buffett estimated his decision to put National Indemnity inside of Berkshire instead of in his partnership ended up costing Berkshire around $100 billion.

It’s refreshing when the world’s best investor humbly lays out two of his largest mistakes, his original thesis, and the thought processes he subsequently had in regards to those investments. It’s also nice to note that despite two large mistakes, things worked out okay.

I own shares in Berkshire, purchased for the first time ever just recently, and I’ll write a post with a few comments on the recent 10-K and annual report soon.

Have a great week,

John

———

John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

I established Saber as a personal investment vehicle that would allow me to manage outside investor capital alongside my own. I also write about investing at the blog Base Hit Investing.

I can be reached at john@sabercapitalmgt.com

Outerwall is a stock that has been struggling as the cash flows from Red Box are drying up much faster than investors have expected. Not only that, but Outerwall management has had the troubling habit of throwing good money after bad by “investing” in things like ecoATM–kiosks that allow you to turn in your old cell phones for cash, a concept that doesn’t seem to be gaining traction.

This spending on business lines that were unlikely to succeed was all in an effort to extend the life of the company. Extending the life of a company is not always the best way to maximize value for shareholders. One thing I’ve observed is that dying businesses (or more euphemistically, businesses in “secular decline”) almost always turn out to be bad stock market investments. I think money can certainly be made from a cash cow like Red Box (even if the cash flow eventually will be $0), but not if the cash flow stream is attached to a public company. This is because of the inherent conflict of interest between a management team and the owners of the business. The owners of the business want to see the cash. The management team wants to continue getting a salary.

Of course, this is why activists have become so interested in Outerwall, and other companies that throw off copious amounts of cash.

Focusing on Stock Price vs. Running the Business

But here is a slightly different problem I’ve observed. Activists are much more interested in driving the stock price higher in the near term than they are in improving the long term value of the enterprise. A couple years ago, an activist (who failed in his attempt to get the company to sell itself) succeeded in driving the stock price of OUTR from around 60 to 80, where he was able to unload his stock. The stock now trades around 30.

After initially failing to get the company to sell itself, this activist was able to convince the company to take on a sizable amount debt to finance a massive share buyback program. This financial engineering tactic worked in getting the stock price up, but did the owners of the company (the shareholders who were left) benefit? Absolutely not. They loaded a dying business with massive debt, which hindered the ability of the company to deliver cash back to shareholders.

To me, this tactic of loading a company with debt to finance huge buybacks (in order to allow the activist to exit the stock at a (oftentimes short-lived) higher price) is not much different than the “greenmail” strategies that the activists used in the 1980’s.

I recently came across a video from a few years ago where Buffett was talking about Apple in 2013 when a few investors were pressing for Apple to return some of its massive cash to shareholders. Tim Cook had just recently taken over the reins from Steve Jobs, who always had a habit of ignorning Wall Street and focusing on the business at hand (a wise strategy for any executive). Buffett’s advice for Tim Cook was simply: Ignore the activists.

“The best thing you can with a business is run it well. If you run it well, the stock behaves fine over time…  …I would run the business in such a manner as to create the most value over the next 5 or 10 years. You can’t run a business to try and run the stock up everyday.” 

This is obviously the way Buffett has run his own business for the past 50 years.  Despite 4 separate occasions where BRK dropped 50%, Buffett said: “We just kept focusing on building value.”

Wall Street’s Obsession with Buybacks

While I almost always think Buffett is spot on with his advice for management, it’s not necessary to always agree with his stock picks. Buffett also mentioned IBM in that interview. I noticed the share price of IBM was around $200 at that time and the share price of Apple was around $62 (split-adjusted). I looked at IBM a while back. Ironically, I felt that they were much more focused on pandering to Wall Street and the analyst community (with the previous management’s focus on share buybacks and the infamous “Road Map” that had a $20 EPS target that the current CEO finally had to walk back).

Buybacks are great in certain cases, but a management team who is trumpeting buybacks as a key business strategy is probably not entirely focused on running the business. Buybacks aren’t a business strategy, they are a capital allocation policy. Buybacks were an afterthought for Steve Jobs, and also for Warren Buffett himself. Buffett has mentioned buying back BRK stock here and there, but like Jobs, he was focused on running his business. I’m somewhat wary of CEO’s who are trumpeting buybacks and putting together glossy investor presentations that prioritize these capital allocation strategies above business strategies.

Now, I know buybacks are very popular among value investors. I too like buybacks, but buybacks don’t exist in a vacuum. Automatically and routinely using free cash flow to reduce share counts without any consideration given to price paid doesn’t automatically mean that value is being created. Like spending on R&D, marketing, capex, or any other capital allocation decision, buybacks don’t always create value. Companies often perform buybacks routinely as if it’s always value accretive. They would be much better off approaching it opportunistically, like when Jobs was considering it, or when Buffett talks about the price he would pay for Berkshire Hathaway shares. Buy it when it’s cheap, don’t just make buybacks a habit.

We obviously have the benefit of hindsight, and I am in no way making any predictions on IBM, but I will say that I think Apple was (and is) much more focused on running its business for the long-term than IBM is. Which is why I’m surprised that Buffett bought IBM.

Nevertheless, I think his general advice is—as usual—outstanding. Focus on running the business, don’t focus on the stock price.

I’d like to point out that David Einhorn was one of these activists back in 2013 calling for Apple to return cash. I respect Einhorn tremendously, and I wouldn’t put him in the category of activists who I consider modern day greenmailers. Einhorn is a much more thoughtful, much more owner-minded. He has engaged in activism, but is generally on the side of long-term shareholders (he himself has been a shareholder of Apple for a few years now).

And Apple did eventually institute a sizable buyback and dividend program, but in that case, it was probably warranted, and it didn’t come at the expense of marginalizing the balance sheet or distracting management from focusing on running the business.

Tying this All Together With Outerwall

It might be too late for Outerwall to correct its course, and because of the large debt, there are limited options to maximize the shrinking stream of cash flow. Ideally, the company would have focused solely on paying dividends to shareholders initially, running the business to maximize cash flow, keeping a clean balance sheet, and minimizing investments in long-shots. But again, management wants to keep their jobs and activists want a quick buck.

The latest activist in Outerwall (Engaged Capital) correctly points out that there is no law that says that buybacks automatically create shareholder value. They also correctly (in my opinion) point out that a business like Outerwall is much better in the hands of a private owner than in the public, because a private owner can cut costs, reduce debt, and allow the company to slowly die while siphoning off the still large (but declining) stream of cash flow. So these are good points. But then they have a few slides basically saying that if Outerwall paid a big dividend, the share price would skyrocket.

OUTR-Outerwall Dividend 1

OUTR-Outerwall Dividend 2

While I have nothing against short-term focused investors, I’d say the main objective for most activists is not improve business operations or create lasting value for shareholders, it’s to get the stock price higher as quickly as possible. As these slides point out, what could be quicker than simply declaring a massive dividend?

Maybe this works, but if it does I’m almost certain it will only accomplish what the previous activist investor did—get the stock price higher and dump the shares to another investor at a higher price (akin to greater fool theory). I personally find it to be a difficult game trying to get the timing right by jumping in and out of stocks. I’ve noticed the same arguments are being made for OUTR at $30 as were being made when OUTR was at $60. Maybe buying at $30 will allow you to sell out at $45. But those who bought at $60 using that same thesis are out of luck. So you have to a) know for sure there is a bottom, and b) time the bottom pretty accurately.

Also, one other point I would make is that dividends aren’t necessarily return on investment. Sometimes, they are return of investment (returns of principal). I understand that in this case, Outerwall is in fact generating sizable cash flows. But the cash flows are depleting. It’s not much different than an oil well that sees sizable cash flows in the first couple years followed by precipitous declines.

So a 10%, or even a 15-20% yield wouldn’t necessarily be unwarranted for a declining business. After all, if the denominator in the P/E ratio (or the numerator in the dividend yield) is declining rapidly, then the seemingly “cheap” ratios could be warranted or even not discounted enough. P/E’s of 3 aren’t necessarily cheap if multiple years’ worth of (declining) cash flow is needed to pay off debt.

Three General Takeaways

I don’t have a dog in the Outerwall fight. I have good friends (who are very smart investors) who have owned the stock in the past. Allan Mecham—an investor I respect tremendously—still owns (as far as I know) a large position. I think the best possible outcome (the only one I see resulting in profits) for shareholders is to get the company sold as quickly as possible. Let the private equity guys figure this out.

I do think watching this unfold in real time has been an excellent case study. There are specific things that could be discussed in much greater detail related specifically to the Outerwall situation, but my general takeaways:

  • Rarely have I seen intrinsic value (long-term shareholder value) increased as a result of a company taking on massive debt to buy back stock. While it might successfully drive the stock price higher in the short term, in the long-term the debt—in the best case—takes a disproportionate share of the future cash flow away from shareholders, or—in the worst case—ends up compromising the financial condition and stability of the company.
  • Shareholders are rewarded by companies with management teams who focus on running the business, rather than focusing on the stock price, or Wall Street demands, or short-term results.
  • Seemingly cheap price to free cash flow valuations on companies with depleting streams of cash flows might make attractive private equity investments, but almost always make poor stock market investments due to the inherent conflict of interest between a management team and the owners (shareholders) of the business.

There are exceptions to these of course. One exception could be if the management team themselves happen to have ownership positions that dwarf their annual salaries/bonuses. But generally speaking, I have seen these three points hold true much more often than not.

Disclosure: Long AAPL, BRK-B

———

John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

I established Saber as a personal investment vehicle that would allow me to manage outside investor capital alongside my own. I also write about investing at the blog Base Hit Investing.

I can be reached at john@sabercapitalmgt.com

I wrote a post a few months ago on Fastenal’s quarterly results. As I mentioned then, it’s one of the few companies that puts out an earnings press release that is more like a quarterly investor letter than a typical corporate press release. As I did last quarter, I thought I’d basically share some of the notes I wrote down in my FAST file as I read through the press release. This isn’t comprehensive, but I’ll probably get into the habit of sharing more “stream of consciousness” type comments as I read about companies this year. Hopefully sharing some research scratch notes will be useful for readers…

To recap what I’ve said before, Fastenal is a well-managed business that has done a great job at executing a relative simple business model. They are a distributor of nuts and bolts, among other things, and they are good at it. The company has focused on keeping costs low while making effective investments in its sales force, product lines, and store footprint over the years. The company has produced excellent returns on capital over many decades, which has led to growth and a compounding stock price in excess of 20% per year. I also admire management for their willingness to be transparent and honest about their results.

The business currently is struggling. This is likely obvious at this point, but the energy sector has a long reach and problems are arising at other manufacturing firms and service providers that do business with energy companies. Fastenal is an example of a company impacted indirectly by the commodity rout, as many of its customers do business in the oil and gas industry.

Here is the snapshot of their year:

FAST-2015 Results

Here is the month by month growth numbers:

FAST-2015 Monthly

On the surface, it doesn’t look too bad. But Fastenal’s large customers are really struggling. The company breaks its national accounts (which represent about half of Fastenal’s revenue) into two groups: top 100 companies (large firms) and smaller national accounts (companies not in the top 100 in terms of size).

  • Net sales to top 100 customers were down -4.3%
  • Net sales to all other national account customers were up 8.1%
  • Both of these growth rates slowed from Q3 2015 (which were about 1% and 13% respectively)

Growth is slowing, and in the case of the large customers, growth has turned negative. Short of a miraculous rebound in energy prices, there is almost certain to be much more “pain” this year as the companies that Fastenal distributes to are slashing capex budgets, laying off workers, and reducing capacity. Revenue declines at these commodity-dependent businesses (i.e. many of Fastenal’s large customers) are very painful because these are low margin businesses that are forced to make spending cuts in order to prevent cash from drying up.

There isn’t a lot of room for error with these heavy manufacturers. Operating expenses have to be cut and investments have to be delayed. As companies tighten their belts, Fastenal can experience volume declines and price deflation in some of its large accounts (large customers have the negotiating leverage to renegotiate contracts or force Fastenal to cut prices).

This isn’t a terrible problem for FAST, and it’s one that they’ll certainly get through, but it adds an element of cyclicality to its own results.

Fastenal’s stock price has lagged for some time now, and since many investors are worried about Fastenal’s exposure to the energy sector downturn, I thought I’d look to see how the company did during previous manufacturing slowdowns/recessions.

2008-2009 Financial Crisis and Recession

I took a look back at 2008-2009 Fastenal results, and I was quite shocked at how quickly things deteriorated for Fastenal during the recession.

Recall that the financial crisis occurred in the fall of 2008 (most people point to the Lehman bankruptcy on 9/15/08 as the main trigger event that precipitated and accelerated the crisis). The financial crisis seized up the credit markets, causing a deep recession across the broader economy (as many firms that needed access to credit couldn’t get it, causing business to grind to a halt in many industries).

You can see this in Fastenal’s numbers. This is just a snap shot from the 3rd quarter press release on October 12th, 2009:

Company “same store” sales (Sales at stores opened more than 2 years):

FAST 2009

Growth went from 10.5% in September 2008 to -3.9% by the end of the year, and by the next month (January 2009) the business was contracting by double digits. Wow… I doubt things get anywhere close to this bad, but it gives you an idea of how quickly this business can be impacted by a shut down in customer spending.

2001-2002 Recession

In addition to 08-09, I also went back and glanced at some old filings from the 2001-02 recession. Fastenal was a much smaller company at this time and was expanding its store footprint at a much faster rate, so growth slowed but did not decline during this particular economic contraction.

I read through the 10-Q from October 2002 and noticed that sales increased 10.6% in the first 9 months of 2002 vs 2001, and earnings were up 1.9%. Growth slowed from previous years, but remained positive.

However, in the 2002 10-Q I noticed that although sales grew, it was largely due to volume increases (thanks in large part to growth in the number of stores).

“The increase came primarily from higher unit sales rather than increases in prices, as the Company experienced some deflationary impact to pricing.”

During this period, as during other periods of economic contraction, sales growth was offset somewhat by price deflation, meaning that they sold more units, but the price per unit decreased.

Lower prices is a sign that customers have some leverage to negotiate pricing with Fastenal during difficult periods. This wasn’t severe in 2002, but it is evident by looking at gross margins, which contracted from 50.6% in 2001 to 49.4% in 2002. Not a big decline, but evidence that Fastenal sees some pricing pressure during tough times. Since gross margins are so high at Fastenal, even a modest 1.2% decline in gross margin meant over $8 million to the bottom line, which is why sales grew by double digits in 2002 but earnings grew just 1.9% (operating expenses were flat at 36% of sales in both years).

FAST 2002

Store Growth Is/Was the High ROIC Growth Engine

Speaking of operating expenses, I also noticed a trend in Fastenal’s business relating to its operating leverage. Fastenal has talked in recent quarters about how it is expanding its capacity (i.e. it is preparing for future growth by aggressively hiring new employees and growing its store footprint). This “investing for the future” has paid off for Fastenal, as they’ve consistently achieved double digit returns on capital invested, which has led to growth over time. In 2002 their operating expenses grew by 10.4%, basically exactly the same as sales growth. So the 2002 recession didn’t impact Fastenal significantly. They continued growing sales and investing for future sales growth—employee count increased 16.5% between 12/31/01 and 9/30/02. Net store openings grew 11.1% over the same 9 month period. Other than a temporary decline in the price of their fasteners, Fastenal kept marching through the recession.

But again, the company was smaller in 2002, and was rapidly growing its store footprint. 2014 and 2015 saw a net shrinking in this store footprint, which makes it very difficult to grow sales, especially in the current environment. Even in the 2002 period, same store sales growth was very low single digits.

The growth engine, and the beauty of the Fastenal business model, is the fact that they could replicate their model over and over by opening new stores, which produced very high returns on the capital required to open them, leading to sales growth, earnings growth, and a steadily compounding share price.

Also, in 2002 the company didn’t break out “same store” sales by month, but by looking at the trend in the 2001-2002 daily sales growth numbers, it’s clear that the business was affected by the economic downturn that occurred in the industrial sector in 2001 as sales growth slowed from 20% at the beginning of the year to 1.4% by the end of the year. And if not for the 11.1% growth in new stores, overall sales growth would almost certainly have gone negative by year end.

To Sum It Up

I think Fastenal is a good business. However, it has a cyclical nature to its results because many of its customers operate in the commodity space and have very cyclical businesses.

The historical results were much smoother than they might have appeared because Fastenal was always growing its store footprint by double digit percentages. Now that the store base is not growing (or at least not growing as fast), I think we’ll likely see more frequent declines in sales/earnings during future recessions. In short, the overall growth rate will be much slower going forward over the course of the full business cycle.

Looking at the previous two recessions as a crucible for the next one, I come to the conclusion that Fastenal will likely see sales and earnings declines that while temporary, could be significant. In the last recession, sales declines reached over 20% and stayed there for many months, affecting Fastenal’s bottom line to an even greater degree as negative operating leverage (like financial leverage) works both ways and in this case worked against the company as sales declined 22% in the third quarter of 2009 while earnings declined 35%.

In the 2002 recession, sales growth declined to almost 0%, but stayed positive thanks to double digit growth in new store openings. This tailwind is no longer available to Fastenal.

On the positive side, despite sales and earnings declines, Fastenal did remain profitable during the recession (albeit at a lower level), and subsequently recovered and sales and earnings grew to new heights during the recent recovery of the past few years.

But I think the worst of the commodity downturn has not come close to getting priced into many companies who do business in the energy sector, and I think Fastenal is probably one of them.

I recently wrote a post discussing long-term thinking, and how investors should look out 3-5 years and not make investment decisions based on the next few quarters. In this case, I would still look out 3-5 years, and I believe Fastenal will likely have slightly better earning power then than they do now, but given the current valuation level of over 20 times last year’s earnings (and given earnings have shown a susceptibility for short term declines during recessions), I’ll continue to pass on the stock at this level. I think the price relative to normal earning power—even looking 3-5 years out—continues to not have the margin of safety that I’m looking for.

I’ll continue to keep the company on my watchlist, and I’ll continue to evaluate it if it gets cheaper. For now, I think there are much more interesting opportunities, given the current market conditions. We’ll discuss some of those as well at some point…

John

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John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

I established Saber as a personal investment vehicle that would allow me to manage outside investor capital alongside my own. I also write about investing at the blog Base Hit Investing.

I can be reached at john@sabercapitalmgt.com.

When markets are tumbling, it’s time to get excited about stocks. This is often talked about, but rarely practiced. J. Paul Getty once said the key to getting rich is simple: “Buy when everyone else is selling and hold when everyone else is buying”.

For the value investing community, Buffett’s famous “Be greedy when others are fearful” basically is the same gist. Commonly referenced and preached, but far less often practiced.

I am lucky to have a great client base at Saber Capital. It is very important to have an investor base who understands how you are trying to create long term results. For individual investors, or small fund managers like myself, it’s important to capitalize on what is in my opinion the best advantage we have—the ability to look out long term. The more sophisticated people call this long-term idea “time arbitrage”. The ability to have a longer term time horizon than the vast majority of market participants is a widely talked about attribute by most fund managers, but I think it is still underrated.

Many market participants willingly admit that over time, the business in question will be making more money and the stock price will likely be much higher years down the road, but yet they are selling or avoiding the stock now because of an expected poor quarter or some other short term problem, or worse yet—for reasons that have nothing to do with the company at all but for general market or macroeconomic worries.

Regarding one well-followed company I am currently looking at, I heard one analyst downgrade the company for fears about the current quarter while admitting that the company has an extremely bright long-term future—his recommendation is to sell now as near term “pressure” will likely create a “better entry point”. Possibly, but not sure I have any edge in picking “entry points” or being able to tell when “pressure” has alleviated (other than after it’s already too late and reflected in the stock price).

As Mohnish Pabrai said in his book:

The typical hammer-wielding Wall Street analyst is fixated on the next few quarters, not the next half century when trying to figure out any given company. No Wall Street analyst’s mental model of Coke in 1988 was comprised of the latticework that Munger and Buffett fixated upon.

I’ve always felt that this is one of the reasons why large cap stocks often get significantly mispriced. The average large cap stock’s 52 week high is around 50% higher than its 52 week low. The reason for these large fluctuations in huge well-followed companies is partly due to the changing moods of the market, but also partly due to the very short-term focused views that the majority of market participants have. Every analyst talks about Google’s next quarter and has a model for earnings and other quarterly metrics. Very few analysts consider that no 22-year old engineer would rather work at Yahoo or Microsoft over Google. These intangible things matter, but they don’t show up in quarterly results. It’s why a stock like Google can trade at $500 one year and nearly $800 the next, a difference of around $200 billion of market value.

This is the time to be getting more excited, and this is the time to be taking advantage of marked down prices. Good companies are much cheaper than they were just two weeks ago. It’s like a post-Christmas sale.

The key, as Rudyard Kipling said, is keeping your head when all about you are losing theirs.

So in response to a number of readers who asked me my opinion on the market (I have no opinion by the way), I’ll list some “back to basics” things that might be helpful to review. Think of it as weekend reading list to get your frame of mind focused on thinking about businesses and valuations next week, and not economic indicators or where the S&P will find “support”.

Long-Term Thinking

Great investors talk a lot about long-term thinking. So do some of the most successful businesses of all time. Jeff Bezos doesn’t care about quarterly results now, nor did he in 1997 when he wrote the first Amazon shareholder letter:

“We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions.”

And my favorite bullet point from this letter:

“When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows.”

By the way, Amazon did $148 million in sales in 1997. This year they’ll do $100 billion.

Google

Take a look at the Google IPO Prospectus from 2004. The original shareholder letter that Page and Brin wrote contain a few great concepts:

Google Long Term View

Many people will attribute things other than “long-term view” to Google’s and Amazon’s successes. Certainly a long-term mindset wasn’t a sufficient condition for their success, but I do think it was necessary. And I think it’s interesting that these two firms were the ones who—well before they were entrenched companies with huge moats that we now know from hindsight—actually talked about this from the very beginning, before they achieved the dominance that they did. There were other search engines and other ecommerce retailers, and certainly there were many reasons why these two firms squashed the competition, but focusing on long-term results certainly helped them get there.

It behooves investors—just like it behooves corporate managers—to think past the next few quarters.

Steve Jobs—Go For a Walk

Walking helps clarify thinking. It can produce good ideas. If you don’t like to walk, sit in a room and think for a while. It worked for Buffett. It worked for Archimedes. Great ideas don’t usually come from a schedule like this one.

Steve Jobs talked a lot about “zooming out”. He would go for walks around Apple’s campus and get deep into thought about an idea.

Buffett’s 2008 NY Times Op-Ed Piece

I remember when Buffett wrote this piece, and I remember how many people laughed at him then. I also remember all the ridicule he received as the market continued lower for the next few months. A year later it was 30% higher, and five years later (the time frame he mentioned in the article) the market had tripled. I no longer hear anyone laughing at him.

“A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

“Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”

“Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.”

It’s such a simple concept, and the article was written for everyday Americans, yet the advice is really practical for all investors.

Buffett’s You Pay a Very High Price in the Stock Market for a Cheery Consensus

This piece was originally written by Buffett in Forbes in 1978.

“A second argument is made that there are just too many question marks about the near future; wouldn’t it be better to wait until things clear up a bit? You know the prose: “Maintain buying reserves until current uncertainties are resolved,” etc. Before reaching for that crutch, face up to two unpleasant facts: The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.”

Superinvestors of Graham & Doddsville

This is always an interesting piece to review once in a while. Check out the track records of some of Buffett’s friends. These guys primarily operating under the same philosophy of buying assets for less than their true value, but they used different tactics to implement their approaches (Schloss bought bargains and was diversified, Lou Simpson bought businesses that could compound over time, Munger did some of both, so did Buffett, etc…).

Here is a link to the piece.

I don’t think any of these guys paid much attention to the S&P. They didn’t beat the market every year, and they all had some bad years, but over time their focus on value and not markets paid off.

Zoom Out

Go for a walk. Turn off CNBC, stop watching “Markets in Turmoil” specials, stop reading twitter, and pick up a book or go for a walk. “Zoom out” as Jobs said. And remember that most of the great wealth was made not by using stop losses or trading in and out (granted-there are some great traders). But most of the real wealth was built by buying good assets, particularly when they are on sale.

Also, by “zooming out”, you’ll notice the market hasn’t fallen that much. 10% corrections throughout history have occurred every 18 months or so. This isn’t abnormal. 20% corrections occur about once every 4 or 5 years. Another 10% decline from here would also not be abnormal.

Regardless of what happens, low stock prices lead to opportunities, and opportunities are becoming more prevalent, which is a very exciting development.

John

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John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

I established Saber as a personal investment vehicle that would allow me to manage outside investor capital alongside my own. I also write about investing at the blog Base Hit Investing.

I can be reached at john@sabercapitalmgt.com.

 

“It is the basics. It is focusing on selection, low prices, and reliable, convenient, fast delivery. It’s the cumulative effect of having this approach for 14 years. I always tell people, if we have a good quarter it’s because of the work we did three, four, and five years ago. It’s not because we did a good job this quarter.”Jeff Bezos, 2009

The new year is always a good time to review your investment process. The other day, I read a post on Nate Tobik’s Oddball Stocks that makes a great point about “practicing”—basically stop trying to read everything under the sun and get out there and actually start investing—start valuing companies, make investments, learn, repeat, etc…

This post got me thinking because I am one who reads a lot. My favorite part of investing is the reading, thinking, and strategic aspects of portfolio management. I much prefer the strategic aspects (i.e. analysis, research, critical thinking) of the investment business over the executional aspects (i.e. making the actual trades and other administrative requirements). I prefer reading over just about any other investing activity, although I have more and more begun to appreciate the information and perspective you can get by talking to people—scuttlebutt. Anyhow, that’s a separate post. But I completely agree with Nate’s point—practice is the best way to get better.

Procedural Memory

A concert pianist gains proficiency at his or her craft by developing procedural memory—doing the same thing over and over again. You can’t learn to play Rachmaninoff by reading a book. For years, Phil Mickelson had the best short game in golf. His incredible talent was a necessary, but not a sufficient condition for his success—he got to be the best greenside player because his dad built him a green in his backyard as a kid, and Phil hit shot after shot after shot onto this green at a very young age. Mickelson’s chip shot on the 72nd hole that won him the 2005 PGA Championship was one that he said he had practiced “tens of thousands of times” as a kid.

Whether you’re playing the piano, hitting a sand wedge, shooting a jump shot, riding a bike, or even driving a car—the way you learned was through repetition. The same can be said for valuation. Reading books is fine, doing case studies is better, but actually valuing companies and making investments—practicing—is the best way to learn.

Developing a Process

As regular readers of my blog have probably gathered, I am very focused on developing processes. I’ve always felt that a process oriented approach to investing is one that will give you the best chance of being able to produce success over long periods of time. Investing is a long-term game. To produce superior results over long periods, you need a process that is replicable.

One of the centerpieces of my investment philosophy is to only invest in my very best ideas. I don’t find lots of great investment ideas on a frequent basis. Because I have a high hurdle rate and because what I am looking for is not available every day (quality businesses at cheap prices), I tend to make larger, more infrequent investments. There aren’t that many great ideas. So in order to find these good investment ideas, you need a system.

Focus on Process, Not Outcomes

I try to focus on implementing investment processes because I find it more productive to focus on processes than to focus on outcomes. I think this is especially true for investing. Your investment results in investing are due to work and effort that has been accumulating for years. Buffett was reading Bank of America reports for decades before ever buying a share. The work that I am doing today is not going to pay off tomorrow. It is going to pay off at some unknown time in the future.

Also, you rarely can attribute investment results to any one specific action. It’s usually a confluence of factors that come together over multiple investment events and multiple time periods that collectively produce results. Yesterday I read Disney’s 10-k and recorded some notes, I read the Wall Street Journal, and I talked to a few users of a product made by another company I’m researching. I have no idea if, how, or when any of these specific work activities will produce a result. I just know that if I continue to focus on my process, I give myself the best chance of achieving the long-term results I’m looking for.

Wells Fargo – Process Focused

My investment process has some similarities with the companies that I prefer investing in. My investment strategy puts an emphasis on durable companies that have predictable earning power. The stocks I buy come in all shapes and sizes, but one large well-known example is Wells Fargo. As I wrote about when I mentioned the bank warrants in a post a few weeks ago, there isn’t much more predictable than the deposit growth in the US banking system. Wells Fargo is extremely well positioned to continuously capitalize on that predictability.

They have a process—a relatively simple business strategy—that can be replicated over and over. They take in a consistent share of a steadily growing deposit base, lend out or invest these funds at higher rates, and spread operating costs over a large nationwide branch network. They try hard not to do dumb things (easier said than done in the land of big banking). Focusing on their process has led to very predictable results over the long-term for the company and its shareholders.

Get Better Each Day

As an investor, I am constantly trying to improve. One thing a cross country coach of mine used to often repeat is: “Try to get better today”. Running is a sport that I competed in at the high school and collegiate level. Long distance running has a lot of parallels with investing. You can’t wake up on race day and expect to force a great performance. The performance will depend on stringing together many months/years of daily runs—one mile after another. None of the miles will stand out much individually, but they collectively add up to produce a result.

I am using the new year as an excuse to refine and refocus my process, which I’m always trying to improve. I read the paper each day, but this year I am going to make it more routine and more deliberate. I’ll make notes and keep them in a file. I also will be focusing on writing more about individual ideas. I do a huge amount of research on companies that I end up either investing in or putting on a watchlist. I have found (and others have too I think) that writing improves comprehension and helps you retain more information. It clarifies your thinking. Basically, a short summary might help you wring more comprehension out of a given unit of effort. I keep a Word doc with hundreds of pages of notes per year on investment ideas, but they are mostly scratch notes. By organizing these notes, I hope to get a better understanding of the business and also have a file to look back on later.

Building a List of Great Businesses

Also, I am going to embark on a mini-project next week where I am going to go through all 3500 stocks in Value Line one by one to come up with a watchlist to study. I already have a watchlist of businesses I follow, but I am going to create a “best companies” file on a google sheet that will come from this project. I haven’t finalized exactly how I will do this yet, but my first idea is to go through the list and input all the companies that I think I can reasonably understand (which will narrow the list significantly). Then, I will refine it one more time by trying to pick out the best businesses from this list, as measured by the attractiveness of their economics and their historical financial results (consistent earning power, stable margins, high ROICs, growth, etc…)

My hope is to build a fresh list of maybe 50-75 durable companies that are compounding their intrinsic value at high rates. These are the horses you want to bet on over time. Some of these might be very small, others will be large. I think this will complement my current watchlist of businesses that I already follow closely. And I might even find a few bargains by turning the pages as well. I plan to report back on this effort here on the blog. Feel free to comment on your own ideas for processes…

These aren’t unique ideas. In fact, if I remember correctly, I got my the idea of building a “best companies” list by going through Value Line from something Stan Perlmeter (an original “Superinvestor”) did a long time ago. It doesn’t have to be Value Line. The point is I think that it’s a useful process to build a list of great companies. Then go through one by one and value them–determine if they are in fact great. Read about them, write down findings, and this will hopefully lay the foundation for a few great investments at some point. There is a lot of value in this process.

So none of this is original. Everyone talks about watchlists, processes, etc… And much of this I already do. I’m deliberately writing down my process this year, but I already am very process oriented. I’m just using the new year as a way to get refocused on taking these concepts and diligently implementing them in my day-to-day work.

Focusing on a process is much more important than focusing on a result. As Bezos said, a “good quarter” is the result of things they did 3-5 years ago. The same can be said for investing.

Happy New Year!

John

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John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

I established Saber as a personal investment vehicle that would allow me to manage outside investor capital alongside my own. I also write about investing at the blog Base Hit Investing.

I can be reached at john@sabercapitalmgt.com.