Last weekend I spent a couple hours reading through Buffett’s old partnership letters (again). I was looking for something specific that I remembered him talking about, but then as I was flipping through them trying to find this comment, I just decided to read them again. I’ve always found it extremely valuable to read Buffett’s letters. Although I’ve read both the partnership letters and the Berkshire letters multiple times, I feel like I pick up something new each time I read them, or maybe I notice something helpful or relevant to a particular investment situation I’m currently working on.

I think the best way to learn and improve as an investor is by doing it—just invest. You learn a lot by reading about companies and researching situations. The second best thing you can do outside of investing itself is by reading and reverse engineering case studies. There aren’t many in the Buffett letters, but there are a few. (I found it interesting that he lists an oil stock arbitrage in an appendix to the 1963 letter, and discusses how it was very profitable to invest in merger arbitrage deals during that time—Buffett would buy stocks of smaller oil producers that were selling out to the larger integrated oil majors, with the objective of making 20% annualized returns on the investment operations).

Anyhow, maybe I’ll review a case study or two some other time. For now, I wanted to write a post with a few comments that Buffett made in those early letters that were thought provoking. Another thing for me personally, I think the partnership letters are interesting because Buffett was operating with a much smaller sum of capital, and was engaging in investment operations that were much different than he engaged in even a decade or two later at Berkshire.

For instance, he was managing $4 million in 1961, which was a small sum even then (however, it was large enough for Buffett to engage in activist investment operations even back then).

A good friend and I have considered writing a series of posts, or some sort of compilation at some point discussing these letters, but for now, here are just a few clips that made me think while flipping through them over the weekend.

1962 Letter

Buffett talks about his strategy here. I’ve always liked his approach to categorizing investment ideas. Although I’ve said before that I don’t seek out investments in any specific category, I do think it helps to know which investment idea belongs in which category—but the horse has to come before the cart (seek out value first, not categories of investments). As far as Buffett is concerned, he described his approach in the 1961 letter. I might summarize his portfolio strategy in a separate post, because I think it is generally misunderstood by the casual investing public, especially in the early years.

In the 1962 letter (and most letters thereafter), he briefly summarizes his portfolio strategy:

“Our avenues of investment break down into three categories. These categories have different behavior characteristics, and the way our money is divided among them will have an important effect on our results, relative to the Dow in any given year. The actual percentage division among categories is to some degree planned, but to a great extent, accidental, based upon available factors.”

I’ll go into more detail in another post, but he lists his three categories of investments as:

  • Generals—plain vanilla investments in stocks that are undervalued without any specific catalyst
  • Workouts—special situations such as merger arbitrage, spinoffs, etc…
  • Controls—investments where Buffett became the largest or majority shareholder and pushed for change (a category that would now be referred to as activism).

Buffett and the Activist Put

Since the title of this post is “Things You Didn’t Know About Buffett”, here is the first comment I jotted down that I hadn’t noticed before (the title is presumptuous… maybe you did know!). Buffett, when discussing the general investment category said this:

“Many times generals represent a form of “coattail riding” where we feel the dominating stockholder group has plans for the conversion of unprofitable or under-utilized assets to a better use. We have done that ourselves in Sanborn and Dempster, but everything else equal, we would rather let others do the work. Obviously, not only do the values have to be ample in a case like this, but we also have to be careful whose coat we are holding.”

This sounds like what has recently been referred to as the “activist put”. Basically, a large shareholder takes a stake in a company and announces the “changes” they’d like to see (usually, it’s something really creative like loading the company with debt to buy back stock in the name of “unlocking shareholder value”). Investors who believe in the merit of this “activist put” will then invest in this company under the assumption that if things get better and operations improve or the stock price rises, great… if the stock price falls, then the activist will buy more and continue rattling the cage until things do improve. The theory is that this creates a floor (or “put”) under the price.

I’ve never been a big fan of such a strategy, and I wouldn’t make an investment decision that is founded on this type of theory. But I do understand that in reality this type of situation exists. Heck, there was even talk of a “Buffett put” a year or two ago when Buffett announced he would buy back stock at 1.1 (later increased to 1.2) times book value.

So the activist put can be real—I just wouldn’t make it a primary reason for being interested in an investment. And as Buffett says, value has to be present, and probably most importantly when evaluating the activist put is to “be careful whose coat we are holding”.

Using Borrowed Money

The second thing that some people might not have known is that Buffett used borrowed money in his partnerships. He didn’t borrow a lot, and he didn’t borrow against the “general” investments, but he did use leverage when investing in special situations, or “workouts” as he called them.

Buffett describes workouts as “securities whose financial results depend on corporate action rather than supply and demand factors created by buyers and sellers of securities… Corporate situations such as mergers, liquidations, reorganizations, spin-offs, etc… lead to workouts.”

He describes the benefits of investing in these special situations:

“This category will produce reasonably stable earnings from year to year, to a large extent irrespective of the course of the Dow. Obviously, if we operate throughout the year with a large portion of our portfolio in workouts, we will look extremely good if it turns out to be a declining year for the Dow or quite bad if it is a strongly advancing year.”

So the workouts provide, as the portfolio academics would say, uncorrelated and attractive risk-adjusted returns. While any one deal could go sour, a basket of these investments over a period of time would provide quite predictable results.

This is why Buffett decided to add leverage:

“Over the years, workouts have provided our second largest category. At any given time, we may be in five to ten of these; some just beginning and others in the late stage of their development. I believe in using borrowed money to offset a portion of our workout portfolio, since there is a high degree of safety in this category in terms of both eventual results and intermediate market behavior.”

Buffett goes on to say that these situations typically provide 10-20% annualized returns (before the benefits of leverage), and that he limits the leverage to 25% of the partnership’s assets.

Quick Comment on Buffett’s Evolution as an Investor

Obviously, Buffett uses leverage at Berkshire, but it’s interesting to read about how opportunistic he was during his partnership days as well. His plan was certainly not to buy and hold Coke for decades in the 1950’s and 60’s.

His thoughts on investing evolved, but I think the reason for the evolution was much more due to the rising asset base than for the more commonly attributed reason—Charlie Munger’s influence (and this is not a slight to Munger at all-he’ll tell you the same thing). The latter was certainly a big factor, but the former was (and still is) the driving reason behind Buffett’s continual evolution as an investor. We may be entering a new phase of Buffett’s career in present years as he gets more involved with 3G and their hands-on approach to the operational side of businesses.

Buffett has always taken what the defense has given him. I think deep down, he probably longs for the days of the cigar butts, the oil stock arbitrage deals, and the quantitative bargains. But that’s a moot point—Buffett has always been opportunistic, and has maximized his returns with a minimum of risk by investing in the opportunity set that was in front of him at any given time.

There are a number of other things I’d like to discuss, but we’ll save them for another post. The letters are good reads, and I think there are beneficial discussions on investment philosophy, portfolio strategy, and also some interesting case studies.

Have a great weekend!

I wrote a post recently on intrinsic value, and I received some comments and questions that made me think a lot of readers are still looking for a formula to calculate a stock’s value precisely. I really don’t think this is the case. I think the best result that an investor can hope to achieve when it comes to appraising business values is to come up with a fairly sizable range of values, and then wait for the market to offer you a price that is significantly below the lower end of the range—which gives you both a margin of safety in the event your analysis is wrong and high returns on your investment if you’re right.

Investing should be simple. The concept of intrinsic value is simple. The value of a business is simply the present value of the cash that you can pull out of it over time. Graham and Buffett both agreed that this is the intrinsic value of a security—either a bond or a stock. But it’s hard to determine the precise level of future cash flows of a business. I think both Graham and Buffett would agree that instead of trying to crunch numbers into a spreadsheet and using DCF’s to value businesses, they thought of intrinsic value in terms of private owner value. Essentially, what is the normal future earning power of this business and what is that earning power worth to a rational private buyer? This is just a more practical way to think about what something is worth. What will a rational buyer pay for this business?

This, to me, is the simplest way to think about value and it’s how I think about intrinsic value.

I like to think of each investment as a separate business that I am about to buy. And with each business, I want to consider the sum of cash flows that I’ll be able to take from the business each year on average in the future. Then, given all of the other qualitative/quantitative factors that go with each individual business, I will decide how much I’m willing to pay to acquire that stream of earnings.

Each business is different. $10 of earnings from Costco is obviously worth more to me than $10 of earnings from Sears. So you have to look at each business’ earning power along with the future prospects of the business to decide how much you’re willing to pay to acquire that business’s future cash flows.

So keep in mind the two questions I referenced in a previous post:

  • How much does the business earn?
  • What is that worth to me?

Remember, you want “normal” earning power of a business. You’re not looking at the P/E ratio or the EPS from the last twelve months. You’re trying to understand the business to make a judgment on what their earning power will look like over the long term (over the next 3-5 years, or even longer perhaps). This is an art. You’re not trying to predict down to the penny what EPS will be in 2017. You’re just trying to understand the business to make an informed estimate on what the cash earnings will look like in a normal year going forward.

I sometimes use a simple real estate investment as an example, and I referenced this example in the last post. Imagine you own a duplex that rents for $900 on each side ($1800 per month of gross rent). This duplex has a gross potential rent of $21,600 per year. Of course, in any given year, a smart duplex owner understands that he might sustain a vacancy in one of the units, so maybe you’d take 8% off of that potential rent to arrive at a gross effective rent of just under $20,000. Then you have taxes, insurance, utilities, property management fees, and routine maintenance. Let’s say after paying all of these expenses, you’re left with $12,000 of annual net operating income from your duplex (NOI is a real estate term, but this is technically a pretax number, as we aren’t factoring in personal income taxes that you’ll owe on your duplex earnings, and we’ll assume for simplicity that there is no mortgage).

In this example, the duplex earns about $12,000 per year of pretax cash flow before depreciation, but since you’re a smart duplex owner, you’ll set aside around $2,000 per year for maintenance capital expenditures (larger outlays of capital for non-recurring items such as a new roof or a new air conditioner, etc…). These are maintenance capital expenditures—real expenses that are required of an owner of a duplex to maintain the current competitive position of this duplex (i.e. without a functioning roof, it will be hard to attract tenants).

So let’s say the pretax owner earnings are around $10,000 per year.

Once you know this, you can then decide how much that is worth to you. If this duplex is in a slow growth, average neighborhood that hasn’t changed much over time and won’t likely experience any abnormal appreciation, maybe you’d be willing to pay $80,000 to $90,000 for the property. If the duplex is newer and is located in a great part of town that is growing rapidly, you might be willing to pay $110,000 to $120,000. If the duplex sits in town on a half-acre lot across the street from a piece of land that is getting developed into luxury condominiums and land is trading at $300,000 per acre, maybe you’d be willing to pay more still to get this same $10,000 of earning power.

And to make a different point, it’s pretty safe to assume that the duplex has earning power of $10,000. This is a “business” that is pretty easy to understand—it’s easy to estimate the future earning power of this asset. Even if in one year you had to make some renovations and sustained an abnormally high level of vacancy and your duplex only earned $5,000 in the last 12 months, you’d still consider the “normal earning power” of the duplex to be around $10,000.

But in each case, you’d decide on the earning power of the duplex (how much does the business earn?), and then you’d weight the other factors such as age, location, neighborhood, population growth, job market, etc… and you would decide how much you’d be willing to pay to acquire that duplex’s earning power.

So just like the duplex, when you’re looking at the earnings from Costco, you’re going to capitalize that earning power differently than you would for the earnings from Sears.

Like the Concert Pianist, Practice Makes Perfect

Start with the businesses you know how to value. For practice, read a book called Analyzing and Investing in Community Banks and then go out and read a few annual reports of tiny community banks–which are fairly transparent and relatively easy to value. Or pick an industry that you have some expertise in and begin reading some annual reports of businesses in those industries. Pick simple things–I recently read a 10-K on a business that sells hot dogs and has a nice competitive position in that niche. It’s easier to understand–and value–a business that has been selling hot dogs for the past 100 years than it is to value a business that sells pharmaceuticals (at least for me–others might have an advantage with drug companies, or software, or oil and gas, etc…).

So if you’re going to value individual businesses, you have to understand that business. As Joel Greenblatt says, if you don’t understand it, move on to the next one. There are 10,000 stocks in the US, and probably over 50,000 worldwide in developed markets. You only need to find a minuscule percentage of them to fully allocate a portfolio.

Also, value investing comes in many different shapes and sizes, and if you choose not to value individual businesses, there are alternative measures such as quantitative investing in the Graham or Schloss tradition, or even Greenblatt’s “formula”. This quantitative approach values the basket as whole, removing the need to value each individual business. It relies on the law of large numbers, similar to the insurance underwriting business. I personally enjoy reading about those types of strategies, and the results from Schloss are absolutely phenomenal, but I prefer to think of the stocks in my portfolio as fractions of businesses, and thus I endeavor to understand them and value them individually.

Anyhow, valuation is an art form, and it takes practice. Just like practicing the piano, you’ll get better the more you practice. And the best way to practice is to just start reading reports. Over time, you’ll begin to understand the different metrics that are important for each business, and you’ll be less inclined to use hard and fast rules (ROIC above X, P/E below X, etc…) and more inclined to think inquisitively about the business and its operations.

The last thing I’ll mention: over time, as business owners our results are tied to the internal results of the businesses we own. A business that is growing intrinsic value over time will reward us as owners. Over the longer term, quality is the most important determinant of our results as equity owners. A business that can compound value over time at 12-15% annually will create fabulous amounts of wealth for the owners of that business.

So quality is crucial for long term owners. BUT, valuation is the most important determinant (or at least as important) over the shorter term (say 1-3 years). If you overpay–even for great businesses–you’ll have to wait a long time for your investment returns to “catch up” to the internal compounding returns of the business. Conversely, if you buy a great business that compounds value at 12% per year–if you can buy it at a discount to its fair value, then your returns will generally exceed the business’s results in the early years of the investment.

The market is a weighing machine, and over 3-5 years, it tends to weigh things properly. So valuation is an absolutely crucial factor over the near term.

Have a great week!

A while back I wrote a post about how the gap between 52 week high and low prices presents an opportunity for investors in public markets.

I mentioned that this simple observation (the huge gap between yearly highs and lows) is all the evidence you need to debunk the theory that markets are efficiently priced all the time. I think the market generally does a good job at valuing companies within a range of reasonableness, but there is absolutely no way that the intrinsic values of these multibillion dollar organizations fluctuate by 50%, 80%, 120%, 150% or more during the span of just 52 weeks.

The market is constantly serving up opportunities. I just checked a screener and there are 375 stocks in the US that are 50% higher than they were 1 year ago today.

This leads me to a thought that I think, for some reason, is not really discussed in investing circles—at least not in value investing circles: and that is the concept of portfolio “turnover”.

To think about portfolio turnover, let’s first take a look at a concept that security analysts and value investors think about more often: asset turnover.

Asset turnover basically measures how efficient a company is at using the resources it has to generate revenue. It’s simply a company’s revenue in a given period divided by its assets. Generally speaking, asset turnover is a good thing—the higher the better. If two companies have the same asset base, the company with the higher level of sales is doing a better job at employing those assets.

Coke and Pepsi

Coke and Pepsi are somewhat similar businesses, but it isn’t necessary to compare their business models when it comes to understanding the math of turnover. Just look at how Coke’s profit margins are almost double the margins at Pepsi, but Pepsi is about equally profitable (produces similar returns on assets) because Pepsi is more efficient than Coke is at using the assets it has.

Let’s glance at two homebuilders:

NVR and Lennar

NVR has a different business model than Lennar as it uses less capital (it employs a smaller asset base). This allows NVR to be almost three times more efficient with its resources than Lennar, and although Lennar has a higher profit margin, NVR produced a much better return on assets.

We can compare two businesses in different industries to see how their business models and operating results affect their profitability:

Coke and Whole Foods

Coke and Whole Foods produce roughly the same ROA, but got there in very different ways… Coke has very high profit margins but takes nearly 2 years to produce $1 of revenue for every $1 of assets. Meanwhile, Whole Foods’ profit margin is less than 1/4th the size of Coke’s, but it turns over its asset base nearly 5 times faster, yielding roughly the same return on the resources it has to deploy.

These examples aren’t to say one business or one measurement is better than the other–it’s really just to point out the importance of turnover.

Inventory turnover is a similar ratio. A grocery store is a very low margin business, but in some cases grocers can produce adequate (or sometimes better than adequate) returns on capital if they are able to turn their inventory (merchandise on the shelves) faster than competitors. Two competitors with identically low profit margins might have vastly different profitability because one grocer might be producing much higher ROA due to its ability to turn its inventory over faster.

So in business, it is clear that asset turnover (and inventory turnover) is a good thing. The higher the turnover, the higher the returns.

Portfolio Turnover

I once mentioned I have put together notes on investors who have achieved exceptional (20-30% annual returns or better) over a long period of time (say 10-15 years minimum). There are a variety of strategies and tactics employed, but there are a few common denominators. In addition to the expected commonalities (most are value investors), there is one common denominator that isn’t talked about much: portfolio turnover.

Portfolio turnover is a phrase that I’m using—I don’t like using phrases and words that you might find in a CFA textbook, but this is the easiest way to refer to the concept. Basically, think of portfolio turnover as asset turnover.

The capital you have in your account might consists of stocks, bonds, cash, etc… these are your assets. The faster you turn these assets over (at any given level of profit), the better.

It’s simple math. I think a lot of value investors get hung up on the Buffett 3.0 version. Let Seth Klarman explain this… Klarman once said that Buffett’s career has evolved a few different times and can be categorized generally as follows:

  • Stage 1: Classic Graham and Dodd deep value and arbitrage (special situations)
  • Stage 2: Great businesses at really cheap prices (think American Express after Salad Oil Scandal, Washington Post, Disney—the first time at 10 times earnings in the 60’s)
  • Stage 3: Great businesses at so-so prices

Now, if we look at Buffett’s results, even lately, some might take issue with Klarman calling them “so-so” prices. But nevertheless, I think Klarman is basically correct in his assessment of Buffett’s career, and I actually think Buffett himself would agree with this. As Buffett’s capital base expanded, he had to begin to begrudgingly adjust the investment hurdle rate that he required. He mentions this in his 1992 letter to shareholders, replacing his demand for “a very attractive price” with simply “an attractive price”.

This description by Klarman took place during an interview with Charlie Rose, and Klarman jokes that he (Klarman) is still in Stage 1, scavenging for bargains. What’s interesting about this comment, is Klarman has been able to produce really solid returns on a very large amount of capital, and I think it’s in large part because of the simple math of asset turnover—Klarman buys bargains, waits for them to be valued at a more reasonable level, sells them, and repeats.

Walter Schloss was another master at turning over his portfolio that was filled with bargains. Schloss actually ran his portfolio like a grocery store. I’d say on balance, his stocks produced relative small profits (I’d venture Schloss had many 20-50% gainers, but very few 5-10 baggers), but collectively, he produced 20% annual returns for nearly 50 years because he was able to adequately turn over his “inventory” (i.e. his stocks) fast enough. This isn’t to say that you have to look for activity, or actively trade—Schloss said he kept his stocks an average of  3-4 years. But it just means that he would not have produced anywhere near the results he did if he held his stocks “forever”, or for 10 years instead of 4, etc…

Walter Schloss was akin to the low margin grocery store that didn’t produce exciting margins on any one product, but collectively across the store it was able to effectively turn over the merchandise fast enough to make exceptional returns on the assets it employed.

Some other investors might be more akin to the higher margin, lower turnover businesses that might produce much lower asset and inventory turns, but still generates very attractive returns on capital because of its very high return on sales (profit margin). These investors hold stocks for longer periods of time, but find big winners that rise 3, 5, 10 times in value over many years. A business can produce incredible profitability on lower asset turnover if it can wring out a large amount of bottom line earning power from its top line revenue.

The Two Drivers of Profitability

Some people might be familiar with the simple math of this situation, but it might help to briefly illustrate this to show what ROA (Return on Assets) consists of:

The Return on Assets (ROA) is one measure of profitability and it is calculated simply by dividing net income into total assets. A lemonade stand that produces $20 of earnings and has $100 worth of assets (the stand, the small square of front lawn, the inventory of lemonade, etc…) is producing a 20% return on assets.

The two functions that determine ROA are:

  • Profit Margin (some accountants refer to this as “Return on Sales”). Profit margin is calculated as follows:
    • Profit Margin = Net Income/Sales
  • Asset Turnover (the measure of how efficiently a business uses its assets—i.e. how much revenue can be generated from each $1 of assets). Asset turnover is calculated as follows:
    • Asset Turnover = Sales/Assets

So I hear a lot of people talking about the profit margins (big winners) but few investors talk much about asset turnover (how quickly you go from one investment to the next). And worse yet, when they do discuss turnover, it’s usually negative (most investors say lower turnover is better, which is not true—more on this shortly).

Higher Turnover Isn’t Necessary—But It Does Influence Returns

Now, it’s important to keep in mind the above equation—there are two drivers of profitability of a business:

  • Efficiency—how much revenue you can produce from your available resources (assets)
  • Profitability—how much profit you earn for each $1 of sales

So, turnover (whether we’re talking about asset turnover in the context of a business, or portfolio turnover in the context of an investment account) is just one driver of the returns that the business (or portfolio) generates.

The other driver is how much money you make on each $1 of sale (or each $1 invested).

If your business begins to turn over its assets more slowly (i.e. it begins to generate less revenue per $1 of assets), then you’ll need to make up for that by earning a higher profit margin on each $1 of revenue if you are to maintain the same ROA.

Similarly, as an investor, if your portfolio turnover decreases (which is often the result of a longer time horizon), your profit margin (in the context of investing, the amount of money you make on each $1 invested) must increase if you are to maintain the same level of annual returns on your overall portfolio.

I think this is where there is somewhat of a disconnect in the value investing community—which often considers portfolio turnover to be a negative thing. In and of itself, turnover is not bad. In fact, generally speaking, the math tells us that it is one of two main drivers of investment performance. So it’s actually necessary!

Why Do Investors Think Portfolio Turnover is Bad?

I think the reason for this negative connotation is that portfolio turnover is often associated with excess, or inappropriately high levels of trading, which is often done for emotional reasons without regard for the fundamentals of the business.

But let’s assume you are a rational, disciplined value investor. If that’s you, then you should try to turn your portfolio (your assets) over as fast (as efficiently) as possible. The faster you can buy and sell 50 cent dollars, the higher your returns.

Again, simple math (this might be painfully obvious, but I’m still going to demonstrate):

Let’s say you buy a stock at $10 and you sell it at $20:

  • If it takes 5 years to get from $10 to $20, you’ll earn a 15% CAGR on that invested capital
  • If it takes 2 years to get from $10 to $20, you’ll earn a 41% CAGR on that invested capital
  • If it takes 1 year to get from $10 to $20, you’ll earn 100% CAGR on that invested capital

In this case, your “profit margin” is the same in each case: it’s 100% in all three examples (the stock doubled in all three cases). However, your CAGR increases as your asset turnover increases—in other words, the more opportunities like this you can find and the faster they play out, the higher your portfolio returns will be.

So that demonstrates the various CAGR’s on the same level of profit margin. This is the same basic math that you’d see if you compare two companies with a 10% net margin, but Company A turns over its assets twice as fast as company B, then Company A’s ROA will be twice as high.

Now let’s quickly look at the same level of asset turnover on different levels of profitability:

Let’s say each year on January 1st, you buy one stock, and each year on December 31st, you sell it to buy something else:

  • If the stock you bought goes up 15% over the course of the 1 year, obviously your CAGR is 15% on this 1 year investment
  • If your stock goes up 25%, your CAGR is 25%, etc…

In this example, your asset turnover is exactly the same (you turn over your assets once per year in this case), but your profit margins are different.

Obvious stuff, right?

I think so, but I consistently read a lot of people referring to portfolio turnover as a bad thing, which runs counter to the math behind these examples.

Buffett’s Returns and Peter Lynch’s Famous 10-Baggers

It’s clear to see with these simple examples that portfolio returns (ROA) is dependent on two drivers:

  • How much you make on each investment (profit margin)
  • How quickly you can turn over your assets (asset turnover)

Buffett’s transition that Klarman referred to above is one where he transitioned over the course of his career from a lower profit margin, higher turnover investor to a higher margin, lower turnover investor. In the 50’s and 60’s, Buffett made many more investments, and made much smaller profits on average (in other words, he bought stocks, sold them when they appreciated to buy still more undervalued stocks). In the 80’s and 90’s, he began making fewer investments (due to increasing capital levels), but his profit margins grew (he went from making 20%-50% gains in shorter time periods to making 1000%+ gains over many years).

Interestingly, Buffett’s results (on a percentage return basis) were much better when he had higher turnover (and lower average profit per investment) in the early years than they are now. In fact, Buffett said his best decade of returns was the 1950’s, when he was making 50% annual returns, and investing in a variety of bargains and special situation events.

This wasn’t necessarily intended or by design, it was simply that Buffett was “taking what the defense gave him”. As his capital grew, he had to look for larger investments and had to extend his time horizon.

If he were investing again with $1 million or so, he’d be making many more investments and his asset turnover would be much, much higher—there is absolutely no doubt about this.

He may have a few investments that become big winners, but there would be very few 10 baggers, and many, many smaller, faster gains.

One other point that runs counterintuitive to what most people think: Peter Lynch is famous for the term “10-baggers”—investment that rise 10 times in value. But in fact, when Lynch started running the Magellan fund and was producing incredible 50%+ returns in the early years, his turnover exceeded 300% every year for the first 4 years (in other words, the average length of time he held a stock was only 4 months). I think in reality, his fantastic track record is much more because of higher portfolio turnover and much less because of the famous “10-baggers” that he cites in One Up on Wall Street.

Certainly profit margins are just as important a driver to profitability (portfolio returns), but I think turnover is vastly misunderstood.

I think it’s important when listening to the great investors–even Buffett–to keep in mind this math when you hear ubiquitous investment advice and generally accepted wisdom regarding turnover, investment time frames and holding periods.

I was catching up on some links and articles this weekend. Sometimes, things that are interesting but not time sensitive get pushed to the back burner. In these cases, I sometimes create a file filled with things that I’d like to read and the early morning Saturday hours are sometimes a good time to catch up on these things.

Anyhow, here are some things I’ve read recently that I read that I thought readers might be interested in taking a look at.

The Advantage of Cheapness

This is a piece from 1997 on the then-CEO of Fastenal (now Chairman) Bob Kierlin. The article discusses his incredible appetite for low costs at all costs, and how his cheapness helped foster the culture at Fastenal, and helped it become lean, profitable, and sustainably competitive.

Some Ivy League MBA professors will say cost cutting is not a “sustainable competitive advantage”. In other words, these skeptics will say: yeah, a frugal management team is great, but if keeping a lid on costs is the only advantage one company has over competitors, soon those competitors will cut their costs also and erase this edge.

Once again, I think this calls for the great Yogi Berra quote: “In theory, there is no difference between practice and theory. In practice, there is.”

There aren’t many CEO’s worth a quarter of a billion who are renting vans to drive themselves on business trips, eating fast food, staying in motels, and eschewing the stationary store’s scratch pads in favor of homemade notepads made from used paper and glue. Maybe this passage takes the cake:

“And then there are his suits. At a discount store, they’d probably go for $200 apiece. But Kierlin didn’t buy them there. He got them from the manager of a men’s clothing store. Not from the manager’s store. From the manager. The suits are used. “Luckily, we’re the same size,” says Kierlin, a triumphant smile crossing his face. “I picked up six of those suits for 60 bucks each.”

Cheapness might be a personality trait, but there are some who can use this to foster a culture that leads to increased profitability. And the reason this is sustainable is simply because being cheap often means not taking the easy route (i.e. the company paying for your private jet is much more comfortable than driving yourself for 5 and a half hours in a rented van). In practice, most CEO’s aren’t willing to do what in theory they would.

Read the full article here.

Munger Complilation

For you Charlie Munger fans, here is a document I came across a few weeks ago that is a nice compilation of the Wesco annual meeting notes as well as a number of other transcripts and articles written by or about Munger.

The title of the compilation is “Best of Charlie Munger” or something to that effect. But any compilation of Munger isn’t complete without this one: The Art of Stock Picking. I might highlight a passage or two from this piece some other time: it’s a great discussion on behavior, mindset and investment philosophy.

Jeff Bezos Interview

This was a great discussion with Jeff Bezos. The Amazon.com CEO rarely gives these types of at-length interviews, and it’s worth watching if you have some time. I’ve never invested in Amazon, but I really admire Bezos’ ability to stay focused on the long term mission of building value at his company with complete disinterest for what short term traders, analysts, and observers think about him or his strategy. Time will tell if Bezos’ strategy of investing “profits” back into the business is successful, but it is refreshing to listen to a CEO who really doesn’t care about short term results and pays more than just lip service to “thinking for the long term”.

Other Odds and Ends

Here are a few other interesting articles that I came across recently…

I hope a few of these are interesting. Have a great week!

A few weeks back I came across an article that someone had posted on Sears. It is a fascinating read for a few different reasons. One, I think Sears is an excellent case study of the retail industry and the difficulties of investing and allocating capital in that type of business, and two, the article was written in the summer of 1988.

This post is not a prediction of the demise of Sears, or an indictment against those who find value in the stock, it’s just my own commentary on the case study and some observations I had while reading the interesting piece.

Some Clips From 1988

First the title of the piece itself is telling:

Sears: Why the last big store must transform itself, or die“.

Sounds like a headline for a piece from 2014, doesn’t it?

Here are some other “deja vu all over again” type quotes from this 1988 article on Sears (emphasis mine):

First, the article depicts the scene at an analyst conference where Sears’ executives pleaded their case that progress at the firm–while elusive so far–was imminent:

“(The CEO of Sears pledged that the retailer) stood poised for a long-awaited turnaround… Despite past, unsuccessful counterattacks against specialty and discount merchants, there would be no more false starts. Success lay just around the corner. But (the CEO and his top executive) soon found themselves in familiar waters: Sears was selling a bill of goods that nobody wanted to buy.”

I found the following interesting solely because of the reference to market value:

“With a market capitalization of $14 billion, Sears is too big, and too powerful, to fall to a raider.” 

Sears current market cap: $3.5 billion. (Note: Of course, this isn’t completely apples to apples because of the many different asset sales, spinoffs, restructurings, and other corporate events that split off some value for shareholders. However, the 1988 Sears Roebuck value didn’t include Kmart either, which paid $11 billion or so to buy Sears in 2004. Anyway you slice it, the last 27 years hasn’t been kind to shareholders…)

How about this comment on the value of Sears’ real estate assets:

“Certainly, the profit potential of a Sears bust-up is tempting. Despite hidden assets, especially a coveted real estate portfolio valued as high as $11 billion, Sears’ shares are selling at about $36.50 each–slightly above book value and a whopping 160% less than Sears’ estimated break-up value.”

Wow… this is from 1988! Insert whatever the current estimates for those numbers are, and you have an investment thesis that has been repeated–including by some really high quality investors–for the past decade or so.

This brings me to a quick aside: One thing that I think often gets left out of liquidation valuations, break-up analyses, asset sales, etc… is the general concept of the time value of money. Key factors such as absorption rates or inventory levels often get left out of the argument–i.e. how long is it going to take to sell these properties? Even if the current values of the assets are accurate–which is a big “if” if you’ve visited a vacant Sears-anchored mall lately–if it takes 10 years to sell off a massive portfolio of illiquid real estate assets, then the net present value of those assets is much lower. You can’t dump all of the assets into a real estate sector like retail all at once. Well I guess you could, but not without enormous price consequences.

There are some really high quality write-ups I’ve read regarding the value of Sears’ assets, but many others that I’ve read forget the all-important concept of time value of money. Are those two birds in the bush really worth the one in the hand? The answer depends on many things, but specifically two come to mind: your level of conviction that there are in fact two birds in the bush, and your estimate of the time it will take to get those birds out of the bush.

Back to the article… this clip generally summarizes how difficult and competitive the business is:

“Montgomery Ward & Co. has transformed itself into a tight network of value-driven specialty stores; J.C. Penney Co. has exited most hard-goods lines to concentrate on fashion-oriented soft goods. And other general merchants, such as Kmart Corp and Wal-mart Stores Inc. have made razor-sharp discount pricing a specialty unto itself.

“Sears drifts between the role of no-frills discounter and full-service department store. It sells everything from dishwashers to dresses, but not as well as specialty stores, nor as cheaply as discounters and outlet stores.” 

It’s a tough business… The fate of Sears is perhaps summed up by this last clip from the article:

“‘Sears, in its present form, is not where America wants to shop‘, declares Louis Stern, a professor at (Northwestern University) and a retailing expert.”

7-Foot Hurdles

Retail is a difficult business to be in. Reading Buffett’s letters and studying his previous investments have left me with a couple broad (and possibly contradictory) conclusions. One, you don’t have to be a Buffett clone to do well in investing—I think it’s wise to think independently, do your own analysis, and come to your own conclusions. Two, it’s almost always a wise thing to follow Buffett’s general advice on investing and business.

Lampert once referenced Buffett’s quote “I don’t try to jump over 7-foot hurdles: I look for 1-foot hurdles that I can step over“. Lampert said that he loves 1 foot hurdles also, but he can’t find any… I was surprised to hear him say this because he was basically admitting that Sears was a 7 foot hurdle—in other words, a less than ideal investment, but he justified the investment simply because there were no other 1 foot hurdles that he could find.

This always struck me as strange because Lampert was regarded by many as “the next Warren Buffett”. I’m not a fan of referring to anyone as “the next” anyone, but Lampert certainly had a skillset and a temperament that was conducive to producing long-term results in the stock market. A young Lampert once reverse engineered Buffett’s past investments and in one particular case while still in his 20’s, flew out to Omaha and somehow got Warren to meet with him for an hour and a half so the younger investor could pepper the master with questions.

The results for Lampert were absolutely outstanding, and the Buffett comparisons, which started early, continued to grow as his fund and his track record grew. Even today, many liken the asset-heavy Sears Holdings to the original Berkshire Hathaway—the dying textile business that consumed more cash than it spit out for Buffett. Many Sears investors are hoping Lampert turns it into “the next Berkshire Hathaway”—another “the next” comparison that may end up being relevant but probably gets thrown around too frivolously.

Anyhow, there are a lot of lessons with Sears, and I suppose that the story isn’t finished yet for Lampert nor SHLD, but I think the story probably is finished for Sears as a retailer. It was probably finished a long time ago—probably well before Eddie even began producing 30% annual returns in his investment partnership. There still might be value there somewhere in the holding company, and I would not be betting against Lampert. Again, this is not a knock on the guy—I think he’s incredible, and I think his investment record (outside of Sears) is probably one of the best records of the last few decades. If there is any way to squeeze value out of Sears, I believe Lampert will do it. But again, there certainly were far lower hurdles for him to step over than tackling this monster.

Anyway you slice it, it’s a fascinating case study, and one that is worth reading about. Here is the link to the full article referenced above from 1988.

Have a great week!

“The newer approach to security analysis attempts to value a common stock independently of its market price. If the value found is substantially above or below the current price, the analyst concludes that the issue should be bought or disposed of. This independent value has a variety of names, the most familiar of which is “intrinsic value”.

- Ben Graham, Security Analysis (1951 Edition)

Graham went on to say this about the definition of intrinsic value:

“A general definition of intrinsic value would be that value which is justified by the facts—e.g. assets, earnings, dividends, definite prospects. In the usual case, the most important single factor determining value is now held to be the indicated average future earning power. Intrinsic value would then be found by first estimating this earning power, and then multiplying that estimate by an appropriate ‘capitalization factor’”.

Graham was a very eloquent speaker and writer, but Joel Greenblatt I think does a great job at summarizing the crux of the issue when he says:

“Value investing is figuring out what something is worth and paying a lot less for it.”

When I’ve referenced intrinsic value in the past, I’ve received questions like: yes, but how do you figure out what something is worth? In other words, how do you determine intrinsic value?

This post will just have some of my comments that I’ve compiled on the topic of intrinsic value. For those hoping for a spreadsheet or a formula, you will be disappointed. But hopefully this post will provide some general ideas you might find helpful with understanding and grasping the concept of intrinsic value, which at the core is very simple.

Determining Intrinsic Value is an Art Form

The process of determining the intrinsic value of a business is an art form. There are no rigid rules that you can use to plug data into a spreadsheet and hope that it spits out the value for you. I’ve looked at a lot of different models over the years, including many DCF’s, and I’m usually skeptical of most of these types of models. On page 4 of his owner’s manual, Buffett simply defines intrinsic value:

“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”  

This implies that a DCF model is the proper method of determining value. However, he goes on to say on page 5 that:

“The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure… two people looking at the same set of facts… will almost inevitably come up with at least slightly different intrinsic value figures.”

Buffett implies that valuation is an art form. Determining the present value of all the future cash flows of a business involves looking at all different aspects of a business’s DNA including its historical financials, its profitability, the stability of its operating history, its balance sheet, evaluating its competitive position, critically thinking about its future prospects, and evaluating its management team, among other factors–all weighted and compared to the current price.

So it’s an art form, and it takes practice.

Buffett was asked about intrinsic value at the annual meeting, and he basically said that it’s really the concept of private owner value. What is the price that a private buyer would pay for the entire business and its future stream of cash?

This is a simple concept, and it makes sense… the question I’ve been getting is how can we determine that?

What is the Earning Power, and What is that Worth?

To me, the concept of a business’ intrinsic value is very simple. It’s based on earning power. Take a look at that Graham quote above one more time… it’s interesting to note that Graham is saying that future earning power is the “most important single factor determining value”.

I can boil down Graham’s words into my own simple definition of intrinsic value by asking two questions:

  1. How much does the business earn in a normal year?
  2. What is that earnings stream worth to me?

So the real question you’re trying to answer is what is the business’s normal earning power? In other words, if I am a private buyer, how much cash will this business put in my pocket each year after paying for capital expenditures required to maintain my competitive position? (What are the normal owner earnings that I can expect from this business)?

In Security Analysis, Graham—contrary to popular belief—actually spends a lot of time discussing future earnings, as that is really what we’re after…. Not what the business earned in the past, but what we can expect the business to earn each year on average in the future.

So think of earning power when you’re thinking about a business’s intrinsic value. Try to determine the stream of cash that you could expect to get from the business over time in the future. If you think a business can earn $3 per share, how much is that $3 worth to you? If you think the business, by retaining and reinvesting a portion of its earnings, can grow its earning power at 10% per year, maybe that $3 is worth more to you than a business that earns a consistent $3 that pays it all out in dividends but can’t retain and reinvest anything (i.e. it’s not growing).

Focus on Predictable Businesses

It’s important to note that not all securities can be valued by everyone. Each investor has a circle of competence. You can’t possibly know everything about everything all the time. You just need to know a little bit about something some of the time.

It helps to also know that some businesses are just easier to value than other businesses. Predictability of cash flows is a very important thing to consider. Graham talked about this as well when he said that the security analyst must:

use good judgment in distinguishing between securities and situations that are better suited and those that are worse suited to value analysis. Its working assumption is that the past record affords at least a rough guide to the future. The more questionable this assumption, the less valuable is the analysis.”

In other words, it’s easier to value a business with stable operations and cash flows than one with a wide variation in cash flows from year to year.

Don’t Overcomplicate Things

Investing is simple. Weigh things against each other, and think in simple terms. Simple decision trees… How much is the cash flow, what will the cash flow look like in normal times going forward, and what is that worth to me?

If you can’t figure out what the normal earnings will look like 5 years down the road, don’t buy the stock and move onto something where the earning power is more predictable. Most business won’t be able to be valued with any sort of accuracy. If you can’t figure out normal earning power, it will be difficult to figure out what the business is worth.

People tend to make things far too complicated. Intrinsic value is simply what the future stream of cash flow is worth. I think a lot of new investors are searching for a formula or some specific number, and it doesn’t really work that way. As Buffett says, he and Charlie would come up with two different intrinsic values for Berkshire Hathaway if they were forced to write down what they thought it was worth (it would be close, but it wouldn’t be exactly the same).

You don’t have to be precise either. Remember, you don’t need a scale to know that a 350 pound man is fat. Don’t try to sweat over whether the business will earn $3 or $3.25. Just try to focus on finding the big gaps between the current price and the value you’ve placed on future earning power. Remember, Buffett thought PetroChina was worth $100 billion and he could buy it at $35 billion. You could do all sorts of elaborate analysis, but Buffett basically boils down everything to what will the business look like in 5 to 10 years (i.e. what will the business, and all of its assets, be able to produce in owner earnings over time, and how much are those owner earnings worth to a rational buyer).

Simple Logic of Intrinsic Value

If I’m looking at a duplex that I think can earn $10,000 per year, how much am I willing to pay for that duplex? Each situation is different. If the duplex sits in a stable neighborhood with very modest growth and development, I might be willing to pay $80,000 or $90,000. If the duplex sits in a growing part of town with a rapidly developing landscape, maybe those earnings will grow and are worth more to me. If the duplex has a plot of land in the back that can be developed into two more units that will double the cash flow, the overall investment has significantly more future earning power and I might be willing to pay more still.

The level of capitalization I put on those earnings depends on my overall analysis of the situation including what I expect the future earnings to be, but the basic two questions I’m always asking myself when it comes to the concept of intrinsic value are:

  • What can the business earn? And,
  • How much is that worth to me?

Keep things simple. I’ve never bought a stock because of numbers that a spreadsheet gave me based on specific future projections for growth, cost of capital, etc… I spend most of my time reading and thinking, and I try to keep the math very simple. And I try to give myself a large margin of safety in case my assessment of the situation is wrong. But I don’t want to invest in a situation where heroics are needed to reach a certain earnings level or a complicated model is needed to justify a purchase price.

I don’t think Graham ever used a model, and I don’t think Buffett ever did either. I’m not saying models are completely useless, I just prefer not to use them. I think more often than not they provide a false sense of precision, and the real world just isn’t that precise. The world is a dynamic, ever changing landscape, and investing and valuation are—in large part—art forms.

I hope this discussion is somewhat useful, and Happy New Year to all!

This weekend I came across a link to an excellent Manual of Ideas interview with Allan Mecham that I’ve read before, but I decided to read through it again. There are a few key points that Mecham brings up that I think are really worth repeating, so I thought I’d highlight them here. Investing is not easy, but it should be simplistic. Here are some points worth keeping in mind:

Understand What You Are Buying

The first is the concept of understanding a business like an owner.

Mecham said something interesting when asked how he generates ideas:

“Mainly by reading a lot. I don’t have a scientific model to generate ideas. I’m weary of most screens. The one screen I’ve done in the past was by market cap, then I started alphabetically… Over the past 13+ years, I’ve built up a base of companies that I understand well and would like to own at the right price. We tend to stay within this small circle of companies, owning the same names multiple times. It’s rare for us to buy a company we haven’t researched and followed for a number of years—we like to stick to what we know.”

A friend and I have jokingly talked about the concept of a “Grandma Watchlist”, or a list of businesses that your grandma would feel comfortable owning. These are the great businesses. Unfortunately, they are also stocks that aren’t often cheap. However, I think building a list of great businesses is extremely valuable for two reasons:

  1. Studying a great business is never a bad idea. It helps you develop pattern recognition skills, and might help you identify successful characteristics of other businesses over time.
  2. More directly, studying a high quality business that you understand will allow you to act aggressively if that business ever is offered up by Mr. Market at a price that represents significant value

So this exercise of reading, researching, and building a database can be beneficial over time, and this process compounds over time. You might start with 1 business you understand well, which won’t leave you with much opportunity. But as the list grows to 3, then 5, then 10, etc… it begins to increase your opportunity set as well as your knowledge base.

My own investment strategy involves a two-fold approach of looking for the undervalued compounders that are building value (good businesses at bargain prices) as well as special situations (workout investments that possess significant value that might get realized through some corporate event or other catalyst). But I don’t think categorizing investments is that important—the key is finding bargains that you understand. While I’m focused first and foremost on locating bargains (gaps between price and value), I do spend a considerable amount of time reading and contemplating aspects of businesses.

So what I’m really after is quite simple: Good businesses that I can understand—at bargain prices. I think an underrated principle of investing is focusing on what you know. I think this will reduce unforced errors, which—like the amateur tennis player—is the best way to win.

In my hunt for bargains, I always keep an eye on a list of businesses that I know well, so that I’m prepared to act if and when they fall to a price that I know represents a sizable gap between price and value.

Be like the plumber in Bemidji, who keeps carving out his niche and stays focused on his small, but effective circle of competence.

Focus On Downside

Speaking of unforced errors, Mecham references the importance of reducing them when answering a question on mistakes investors tend to make:

“Patience, discipline, and intellectual honest are the main factors in my opinion. Most investors are their own worst enemies—buying and selling too often, ignorning the boundaries of their mental horsepower. I think if investors adopted an ethos of not fooling themselves, and focused on reducing unforced errors as opposed to hitting the next home run, returns would improve dramatically. This is where the individual investor has a huge advantage over the professional; most fund managers don’t have the leeway to patiently wait for the exceptional opportunity.”

Everyone talks about the importance of focusing on downside (just like everyone talks about understanding what you own). But I still think these concepts get implemented much less frequently than the “air time” they receive would have you believe.

Beware the Lottery Ticket Investments

The concept of focusing on the downside brings me to a tangential topic that I’d like to briefly talk about, and that is the allure of the “lottery ticket” investment. This is the type of investment that has long odds of paying off but could result in a huge payday if it works. For example, let’s say investment has a 40% chance of making 5 times your money, and a 60% chance of going to 0. In theory, this investment has a high expected value, and should be taken (if you could make this investment 10 times, 4 times out of 10 you’ll make 5 times your money, which far more than compensates for the 6 times your investment went to 0). In other words, if you bet $1 on a situation like this 10 times, you’d end up with $20 on a $10 total investment.

I’ve read many investment write-ups that are very similar to the example I just described. The investor acknowledges the risk, but then points out that in the event that the situation works out favorably, it will be a big winner. Again, in theory, this makes sense. But as Yogi Berra wisely said once: “In theory there is no difference between theory and practice. In practice there is.”

One thing I’ve observed over time is that market participants tend to overestimate the probability of the favorable outcome. It’s very easy to do this for a number of reasons: one, we are generally optimistic beings. Two, we naturally want to find a situation with high expected value like the one described above.

But since weighting the various outcomes is a very subjective exercise without a precisely calculable set of probabilities, it makes it very easy to skew these probabilities in our favor. Our desire to locate such an investment only makes this skewed analysis more likely. This makes it possible to justify an investment that in theory looks like a great bet, but in reality is just a risky bet.

Some investors have done very well making a living off of these types of situations, but if you are going to invest in these types of binary type events with two widely different potential outcomes, I think you need to be well aware of the biases described above, and be very careful when estimating the probabilities of the various outcomes.

I think in general, it’s much better to simply focus on simple situations that you understand very well—good businesses at bargain prices—and patiently keep building out your circle of competence while waiting for the proverbial fat pitch. Home runs will help increase long term returns, but they don’t need to come from swinging at really difficult pitches that are outside the strike zone.

The interview touches on these points, as well as a few other aspects of investing that are interesting. You can also read the 400% Man article from a few years back to get a better idea of how Mecham thinks about investing, which I think is a very prudent way to allocate capital.

Merry Christmas and Happy Holidays to everyone. I hope you get to spend time with family, and enjoy the week.

Long time readers of the blog know that I’m a big sports fan, and occasionally I’ll use analogies from the sports world to make a point on investing. There are many flaws in the efficient market hypothesis. And no, I don’t think that stocks are always mispriced. I think that much of the time stocks fluctuate in a range that could be considered a fair estimate of intrinsic value. But just not all the time, and this creates opportunity.

There are certain rules of thumb that I keep in mind when thinking about the public markets. There are certain principles, which are rooted in human psychology, that are almost guaranteed to create opportunities for rational minded investors over time. I keep a small list of “stock market truisms” as I call them—or recurring situations that present themselves over and over again in the markets, providing investors with opportunities to find mispriced merchandise.

One of these truisms is simply that stocks fluctuate (sometimes significantly) above and below their fair value at times. This is evident by looking at the 52 week high and low list. I read somewhere the average NYSE stock has an 80% gap between its yearly high and low price. The average NYSE company’s intrinsic value doesn’t change nearly this much in one year.

Similar to that principle, here is another one that I’ve always found very helpful to keep in mind:

  • Markets tend to overemphasize the importance of events that just occurred. In other words, markets tend to overestimate the prospects of companies who have done well recently, and conversely tend to underestimate the prospects of companies that have done poorly recently.

So there will often be opportunities to find bargains among companies that missed quarterly expectations, or reported guidance that portrays a bleak picture for the coming quarter or even the coming year. Most of the investment community (analysts, bankers, portfolio managers)—despite what they might tell you—are very concerned with short term results and where the company (the stock) will go in the next few quarters. Even if a company will likely overcome its near term struggles, and will likely have earning power normalize in a couple years, portfolio managers will not feel compelled to own the stock if they think it will be “dead money” for the next 18 months.

Investors’ Reactions to Short Term Results Cause Dramatic Gaps Between Price and Value

It’s not hard to find a list of stocks that have appreciated 100% or more over the past 12 months. I just pulled up a simple screen for US stocks that have appreciated 100% or more YTD in 2014, and there are 99 stocks that passed this “2x test”. I quickly perused the list to see how many of the stocks I recognized, and—to my surprise—I found one stock that I owned earlier this year. Somewhat unfortunately but not unusually, the stock continued to rise after I sold it (luckily for me though, my valuation skills aren’t as deficient as my timing skills… in other words, it’s always easier spotting a bargain than it is knowing when to sell that bargain after it appreciates).

Regardless, Strayer Education is a good example because I know the company well. The stock is up 110% YTD, yet the business is basically the same business it was a year ago. The market values Strayer at close to $800 million—significantly higher than the $375 million price tag that Strayer had just 11 months ago. Strayer is a well-managed company. It’s a good business in a bad industry, and because of negative industry perceptions, the stock has historically traded far above and below fair value. It’s possible that the intrinsic value of the business is modestly higher than it was a year ago, but I know the business well, and I know that the value is not twice what it was in January.

The point here is not to try and locate a stock that you think will double next year (although that’s a nice result when you get it), it’s to realize that the market is continually serving up opportunities. I extended the list and found 315 stocks that were up 50% YTD, and at the opposite end of the spectrum, there are 477 stocks that are down 50%. That’s roughly 800 stocks that trade on US exchanges that saw their market values either rise or fall by 50% in less than one year. I would venture a guess that out of those 800 stocks, probably 95% or more of them did not see their intrinsic value rise or fall by that much in 2014.

Large Caps Get Mispriced As Well

Also, it’s important to note that this market truism applies to companies of all sizes. Some people acknowledge that small caps can get mispriced, but believe large caps are much more efficiently priced. That large caps are more efficiently priced might be true in general, but there are still glaring mispricings among even the largest stocks. Charlie Munger once mentioned that even though Coca Cola was one of the largest stocks in the S&P when Berkshire spent a billion dollars in the late 80’s to take a big position in the stock, it was still quite undervalued. It subsequently rose 10-fold over the following decade, netting Berkshire 26% annual returns on that investment over that time.

The largest stock in the market by market capitalization is Apple at roughly $650 billion. It just so happens that AAPL is up 42% in 2014, which means the market believes that Apple is worth nearly $200 billion more than it was on January 1st. 488 companies in the S&P 500 have valuations less than $200 billion—and that’s just the value that Apple has added to its market cap in 2014 alone. It’s unlikely the business is intrinsically worth $200 billion more than it was a year ago.

If we go back another 6 months to the middle of 2013, we see that Apple was valued closer to $325 billion. I’m not arguing whether Apple is overvalued now, undervalued now, undervalued 18 months ago, etc… I’m just saying that a year and a half ago it was valued around $325 billion, and now it is valued around $650 billion, and both of those valuations can’t be right. One of them is wrong—and likely wrong by a lot.

This is obvious to most of us—especially those of us familiar with Ben Graham’s simple foundation for value investing. Nevertheless, it’s always fun to point out the variance with which the market values its merchandise—and this is in a year that has not been very volatile at all (not one 10% correction in the S&P). These gaps between price and value get all the more prevalent in years where the overall market experiences volatility—which is one reason why as value investors, we root for volatility—it provides us with opportunity.

I mentioned earlier one reason that might explain this. Portfolio managers don’t want to own companies that they think will struggle for the next few quarters—even if they believe that the company will recover a year or two down the road. They can’t afford the career risk that comes with short term underperformance, and the perception is that a company with a negative near term outlook will be “dead money” for the next 18 months or so.

What I’ve learned through observation is that the 18 month “dead money” period for a lot of these stocks is often not nearly as long. But as a patient minded investor, you have to be willing to wait this long, or sometimes longer. Few investors have the ability to wait this long. The institutional imperative is quite strong—portfolio managers are judged based on quarterly and yearly results. Many of the greatest investors of all time have had periods of time (sometimes even a few years) of underperformance. This type of period is almost always followed by periods of significant outperformance, but few investors are willing to wait for the end result. And this leads to constant activity, and constant movement, which creates buying and selling decisions that are not based on the long term earning power and the long term value of the company and security in question.

Mispricings Occur When Human Reactions Are Involved

The reason that these market mispricing situations continue to occur is simply because of human nature. That’s the reason I’m confident that there will always be opportunities for patient minded value investors. It’s hard to fight human nature. One glaring example in the sports world currently is the New England Patriots. As much as it pains me to say this (being a fan of a different AFC East team), the Patriots are one of the best run franchises in sports from the front office to the coaching staff to the quality and work ethic of the players themselves. And of course, they have one of the greatest quarterbacks of all-time leading the way for them.

But all of this was forgotten just a couple months ago when New England was blown out by Kansas City and fell to 2-2 on the season. The talk that week in the NFL was that the Patriots’ time in the sun had come to an end. Belichick no longer had his “genius” touch, Brady was a shadow of his former self as a QB, the team lacked cohesiveness at various positions, etc… Basically, the Pats were getting written off completely, just 4 weeks into the season.

I found this post-game exchange (or lack thereof) between Belichick and a reporter comical. Brady played terrible against the Chiefs, and since the game was out of hand, the Pats decided to give their backup QB some playing time. Somehow, this apparently was taken by some as a possible harbinger of what might come (quarterback controversy in New England). The picture below says it all. It’s the look Belichick gave the reporter who asked whether it might be time to “evaluate the quarterback position”:

Will the QB position be evaluated

Since this interview, the Pats have gone 8-1 (losing only to the hottest team in the NFC—the Green Bay Packers), and everything from week four has been forgotten.

As a side note, this same human nature phenomenon was exemplified with the Packers, who also got off to a slow start which caused unrest among Packer fans, and prompted QB Aaron Rodgers now famous quip “I’ve got five letters for Packer fans: R-E-L-A-X… Relax”.

If only the New England Patriots were publicly traded as an MLP, like the Boston Celtics used to be!

The stock in both the Packers and Patriots would almost certainly have been marked down in late September, only to have soared right back two months later when the fears subsided.

Football fans and sports media members—just like stock market participants—tend to overemphasize the relevance of short term results. And this causes inaccurate assumptions and valuations, and leads to irrational decision making.

The reason is that football fans, media members, and stock market participants are humans. And humans are prone to behaving in a particular way. Although our reactions are unpredictable in the short term, there are certain patterns that we are destined to repeat over and over again.

I just read the book “The Great Crash: 1929” and it’s a great book that highlights some of these behavioral traits that occurred in 1929—and again in virtually every other bubble since.

But while very occasionally these behaviors spread to the entire public at large causing market wide mispricings of epic proportions (bubbles and crashes), they occur far more frequently on a smaller, more specific case at the individual stock level.

I think it helps to keep an eye out for the media member who is asking about whether it’s time to think about starting Jimmy Garoppolo over Tom Brady. When these types of questions are getting asked, there is often a mispricing and a subsequent opportunity.

I thought I’d write a post with some quick thoughts on Markel’s value. I recently had a few conversations with a friend regarding how to think about the return on equity that Markel produces relative to the investment return that you will receive as a shareholder. For example, I’ve had a couple questions from clients similar to this: “It’s great that Markel can produce 15% ROE over time, but will we receive 15% if we’re paying above book value?” The current price of Markel is somewhere around 1.3 times book, so this is a relevant question.

First off, I wrote a much more detailed post with my thoughts on Markel earlier this year, so I won’t rehash why I think Markel is a great business here. If you’re interested in what I think about Markel as a business, please check out that post.

But back to the question: If Markel produces X% ROE, will I get X% on my investment if I’m paying above book value?

To answer the question, I need to explain how I think about Markel. Although I’ve referenced Markel’s book value growth over the past few decades, I don’t really value Markel relative to book value. In fact, I don’t usually value anything relative to book value. I’m interested in earning power.

Buffett once made the following comment regarding Wells Fargo:

“You don’t make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on.”

Buffett was talking about banks, but the same concept applies here. Unless Markel gets liquidated, book value is not really relevant. What is relevant is how much value Markel can wring from that equity capital.

So I think about Markel like I think about most other businesses: using a price relative to earning power, not book value. And one way to think about it is this: As long as you are paying a fair price for Markel—one that is equal or below intrinsic value—and Markel can grow intrinsic value at 12-14% per year, then you should expect 12-14% shareholder returns over a long period of time.

And you could look at the P/B ratio of 1.3 to determine valuation, but what I do is compare the P/B ratio to the ROE, which essentially values the business using a price to earnings ratio rather than price to book.

Think about it this way… Markel is priced at 1.3 times book. If Markel produces 13% ROE over time, then you’re paying 10 times earnings at the current price (At the risk of stating the obvious, let’s review simple math and invert our P/B thinking with a quick example of Stock XYZ. Let’s say XYZ has:

  • Book value of $100 per share
  • P/B ratio of 1.3
  • ROE of 13%

In this case, XYZ is priced at $130 per share (P/B of 1.3 times $100 book value), and is producing $13 per share in earnings (13% ROE on $100 book value). So the stock (at $130 per share) has a P/E ratio of 10.

So, if Markel’s ROE averages 13% over time, then at 1.3 times book (roughly the current valuation), Markel currently has a P/E ratio of just 10. If Markel produces 15% ROE over time, then you’re getting the stock at just 8.7 times earnings at the current price. Again, this is probably obvious, but I thought some explanation might be necessary since everyone always likes to talk about P/B ratios when it comes to financial companies. This makes some sense since financial companies’ earning power is somewhat tethered to the amount of capital they have, but what really matters is earning power, not book value.

So I think about the value in terms of price relative to earning power, not directly in terms of price relative to net worth on the books. Markel earns much more on its net worth than most other insurance companies, so I think price to earning power is much more relevant way of thinking about valuation.

Note: Please keep in mind that Markel is priced around 10 times earnings (normal earning power) at the current level, but these are comprehensive earnings, not GAAP earnings, as some of the earnings come from unrealized gains that don’t flow through the income statement.

A Simple Way to Think About Markel

So I’ll lay out a very simple way that I think about Markel (update numbers):

  • $17.6 billion investments
  • $2.3 billion debt
  • $1250 investments per share
  • $510 equity per share
  • 5% after tax investment return = $63 per share in investment earnings

Markel over time has been a consistently profitable insurance business. I’m assuming they will make enough money to pay the relatively small interest charges on the debt along with all other expenses associated with the insurance company.

So in this example, we have a business that produces 12.3% returns on equity, and $63 per share in earnings.

So here is what we have if Markel produces the numbers above:

  • $63 per share earning power
  • P/E of 10.8

Instead of thinking about the return on Markel’s investment portfolio, you could also think about Markel in terms of book value compounding or return on equity. Basically, over time Markel has compounded book value at better than 15% annually, which means that their comprehensive return on equity (including unrealized gains) has been in the neighborhood of 15%.

Also, it’s worth noting what Markel said in the 2013 annual report:

“We believe that the five year change in book value is now just as important a measurement to consider when thinking about the value of your company as the book value itself.”

Basically, they don’t really view book value as a relevant proxy for intrinsic value, but they do view the growth of book value over time as a decent proxy for the growth of intrinsic value over time.

And growing book value (producing high returns on equity over time) is something that Markel has excelled at:

MKL vs. BRK and SP 500

In other words, don’t look at the static value on the books—look at the growth of that value over a long term time period (5 years or more). This will give you a better view on how Markel is doing at growing intrinsic value.

So all of this boils down to a few questions:

  • How fast is Markel compounding intrinsic value?

I would say that if they can produce 12% ROE, they’ll be able to grow intrinsic value at around 12% over time. It’s a back of the envelope way to think about it, but it’s been true over decades, and I think it will be true going forward. One can argue about what their ROE will be going forward. I predict it will be better than 12%. But for now, let’s say the insurance company just breaks even after paying interest and we get 12% ROE, and thus 12% growth in intrinsic value going forward.

The next question is naturally:

  • What price do we have to pay in order to ensure that our investment returns match the intrinsic value compounding?

The answer here is quite simple: In order for our investment returns to match the 12% compounding of intrinsic value, we need to just make sure we pay a price that is at or below the current intrinsic value.

How do we determine this? My method is simple. I think about what a rational private owner would be willing to pay for a business that has compounded intrinsic value at between 15-20% annually for decades, and will likely compound intrinsic value at a rate of 12% for a period of time going forward. And while this answer could have a wide range of values, my guess is that this private buyer would be willing to pay more than 10.8 times earnings, which is where Markel is currently priced.

So to me, it’s that simple. It’s not scientific, and there are no spreadsheet models. I like to keep Ben Graham’s comment in mind that you don’t need to know the exact weight of a 350 lb man to know that he’s fat.

To me, a business that produces 12% (my guess is this is quite conservative) returns going forward and is currently available at 10 or 11 times earnings is a bargain.

My guess is someone would probably pay at least 12-15 times earnings for this type of business.

So to sum it up, Markel has historically compounded its book value at 20%. I think the growth of book value, not the current point in time value, is what’s relevant in thinking about the intrinsic value. As for the current price, Markel is priced around 1.3 times book value, but the way I think about this is simply that 1.3 times book at 12% ROE is simply 11 times earnings.

I think Markel is worth much more than 11 times earnings, and even if I’m wrong, I’m getting a business that is compounding at 12%.

Not bad. Although this would be a satisfactory result, my guess is that we’ll get:

  • Slightly better than 12% returns because of profitable underwriting over time
  • Higher valuation at some point in the future

I don’t need those two things to happen, but if they do, the results from owning Markel at this level should be quite good.

If not, we will be satisfied owning a business that is prudently managed, safe, cheap, and compounding value at a good clip.

Disclosure: John Huber owns Markel for his own account and for accounts he manages for clients. 

I’ve been spending the vast majority of my time working on a number of new investment ideas, but I do find time to catch up on reading the paper. Earlier this week I came across a post on one of the Wall Street Journal blogs that posted a copy of an old letter that Warren Buffett sent to George Young at National Indemnity (a Berkshire owned insurance subsidiary) regarding his thoughts on GEICO.

I’ve written a few posts on Buffett and GEICO, and his history with the company goes back to 1951 when he put 65% of his net worth (at the time around $13,000) into GEICO stock. At that time, a 21 year old Buffett saw the enormous growth potential GEICO had because of the large market it operated in and the fact that GEICO could provide car insurance at a lower cost than any of its competitors.

The two most important factors:

  1. Low cost provider of a product that competes mainly on price
  2. Huge addressable market

These two things—combined with good management—contributed to GEICO’s fabulous growth in earning power in the subsequent decades, and its stock price went up over 100 times.

As I’ve stated before, despite the frequent comparisons between Buffett and Graham in his early years, Buffett was in fact much different than Graham. Although Graham bought a controlling stake in GEICO, he rarely made investment decisions based on the factors that Buffett used to put a majority of his capital into GEICO—factors such as management, market share, cost structure, and future growth prospects. As Buffett wrote about in his 1951 writeup of the stock, these qualitative considerations were much more significant to Buffett than price (which although not a Graham asset based bargain, was still attractive at around 8 times earnings).

So the fact that he bought it at 8 times earnings certainly contributed to Buffett doubling his money in the stock in the next year and a half, but the qualitative factors Buffett pointed out were the reasons that the stock was a 100 bagger over the coming decades.

Regarding his early 1950’s purchase, Buffett wrote that he was able to “develop a depth of conviction which I have felt few times since about any security”.

“At the time I felt that GEICO possessed an extraordinary business advantage in a very large industry that was going to continue to grow. Since that time they never have lost that advantage—the ability to give the policyholder back in losses a greater percentage of the premium dollar than any other auto insurance company in the country, while still providing a profit to the company.”

But fast forward a couple decades—despite its core low cost advantage still intact—the company was struggling because of factors that often ail many insurance operations—focusing on growth more than prudent underwriting. GEICO’s management had been doing a poor job of pricing its product and they were accepting inadequately priced risk.

Buffett often talks about the dubious prospects of investing in turnarounds, but GEICO was one that he thought could in fact turn. Buffett felt that GEICO was the rare exception to his rule because it had a low cost advantage that was still intact, it was just being mitigated because of poor management.

Buffett felt that this could be corrected, and with the right manager—Jack Byrne—this proved to be true. Buffett bought a significant amount of stock in the 70’s, and then bought the rest of the company entirely in the mid 90’s.

Here is one clip from the letter I thought was worth highlighting, as it is a key advantage to consider with other businesses and investment opportunities:

“I have always been attracted to the low cost operator in any business and, when you can find a combination of i) an extremely large business, (ii) a more or less homogenous product, and (iii) a very large gap in operating costs between the low cost operator and all of the other companies in the industry, you have a really attractive investment situation. That situation prevailed twenty five years ago when I first became interested in the company, and it still prevails.”

Here is the link to the entire letter that Buffett sent to National Indemnity concerning his thoughts on GEICO.