I recently watched a video lecture at Columbia from 2010 with Glenn Greenberg of Brave Warrior Advisors, and thought I’d share some thoughts.

Greenberg is one of the best investors of the past 3 decades. His track record over that period is excellent. From 1984 to 2009, he and his partner Jon Shapiro ran a firm called Chieftain Capital, where they produced annual returns in the mid-20′s until 2008, when Chieftain lost 25%. The next year, Greenberg and his partner split the firm up into two smaller firms, with Shapiro retaining the Cheiftain name and Greenberg now running his own firm called Brave Warrior.

Greenberg has stated that he has returned to his roots of simplicity. He uses no computer models to arrive at valuation, preferring to simply rely on his own analysis and judgment. He has gone back to his original method of jotting down notes on a yellow legal pad, and using very simple, common sense methods to value his businesses.

Greenberg is an interesting investor to study because he runs a very focused fund, choosing to concentrate his capital on his best ideas. He likes to own high quality businesses that he would feel very comfortable owning in the event of a “1987 style market crash”.

Here is what Greenberg’s portfolio looks like as of 12/31/13 (including the amount of his stock portfolio that each security represents):

  • Valeant Pharmaceuticals (29.4%)
  • Express Scripts (11.4%)
  • Oracle (11.1%)
  • Halliburton (9.9%)
  • Charles Schwab (8.5%)
  • Vistaprint (7.4%)
  • Microsoft (6.1%)
  • Primerica (6.0%)
  • Kinder Morgan (5.6%)
  • Comcast (3.7%)

Note: the position sizes do not include the level of cash that Greenberg holds, which would slightly lower the percentages.

He also has new positions in Tidewater, Bank of America, and Motorola Solutions. These three are very small—collectively just a fraction (less than 1%) of his portfolio, although they might become larger as Greenberg has stated that he generally doesn’t want to own a stock unless he is willing to put at least 5% of his capital into the idea.

Large Caps: Not Always Fairly Priced

You might notice that most of the positions are large cap stocks. Greenberg runs a large fund with over $2 billion of assets, and because he likes his stocks to represent meaningful portions of his portfolio (5-10%+), this means he needs to allocate $200-$400 million or more to each idea. If he wanted to limit his firm’s ownership of any given company to around 10%, he would primarily only be able to invest in companies with a minimum market cap of around $2-$4 billion.

He does say that just because a company is large, doesn’t mean it’s well understood or fairly valued. He discussed Google, mentioning that even though it’s a huge company, it is still not well understood. The vast majority of the analysts are all focused on short-term things such as cost per click next quarter, or EPS this year, etc… but very few people are thinking more broadly about the quality of the business. Analysts are paid to think in short terms increments—quarters, one year at the most. Very few are thinking about the value of the franchise, and what the business will look like in five years.

This “gap” is what creates opportunity—even in large caps.

Greenberg has stated that with a smaller firm, he would certainly look at both small caps and large caps. In fact, Greenberg’s firm produced 28% annual returns in its first five years of operations, and many investments were small caps. Here is a great compilation of some old Barron’s articles from the late 1980’s that discuss some of Greenberg’s early investments.

So Greenberg is worth studying, as his 3-decade long track record is outstanding. The Columbia lecture from 2010 had some interesting topics. Greenberg discussed a few of his current investments that he owned at that time, including his thoughts on Google, Comcast, and some health care ideas.

Takeaways From the Lecture

But I found his comments in the last 15 minutes of the lecture to be most interesting, as they pertained to a more general topic of how he thinks about investments as well as his process. Here are a few highlights:

Strategy

  • He prefers to own great businesses with growing intrinsic value.
  • He wants to feel comfortable in the event of a severe market crash (i.e. 1987), knowing that his companies will survive, and that the stock price drop is only temporary.
  • He places a strong emphasis on the combination of free cash flow generation and growth.

Portfolio Management

  • Over time he has learned that his best investments have come from ideas he has researched thoroughly, and he feels more comfortable owning a smaller basket of stocks that he understands well.
  • He prefers to not have positions smaller than 5%, as he feels that they contribute very little to results relative to the maintenance work required to keep them.
  • Other than his 5% minimum rule of thumb, he doesn’t have any specific formula that tells him how big of a position to take. His portfolio management style seems more art form, and less science.
  • The biggest positions are the stocks he feels have the highest combination of low risk and return potential.

Valuation

  • Although he values a business based on its future cash flow, he chooses to rely on simple methods of analysis instead of complicated computer models and spreadsheets
  • He prefers to jot notes on the back of a yellow pad, and his analysis consists of simple methods
  • He says the important thing is to have a very clear view on what makes the business a great business, and have a good idea of what the business will likely look like in 3-5 years
  • His preferred valuation method: adding the current free cash flow yield to his conservative estimate of the growth rate—anything over 15% is a hurdle rate that gets him interested
  • In his early days, he used to be even simpler: asking himself if the stock he was looking at could be worth 50% more in the next 2 years (not factoring in multiple expansion).

To Sum It Up:

So Greenberg has always been interested in investing in high quality businesses, but after his recent split with his partner, he has returned to his more simplistic methods:

  • Buy great businesses
  • Buy at low prices that allow for high compounding over time
  • Have a clear understanding of the business—why is it a good business (not what the EPS will be this year)
  • Use simple, common sense methods of analysis—prefer notes on a yellow pad over a complicated computer model.

Check out the full video for more of Greenberg’s ideas: 2010 Columbia Lecture

Here are a few other sources with info on Greenberg:

Our financial goals are to earn consistent underwriting profits and superior investment returns to build shareholder value” – Markel 2013 Annual Report

Markel is an outstanding business currently in its 85th year of operations. It is an excellent insurance company with a history of underwriting profits. It is also a superb investment company with a history of above average investment returns. Markel had an outstanding year in 2013, basically doubling the size of its insurance business and investment portfolio in an acquisition that the market hasn’t seemed to fully value yet. I think the shares are priced not just fairly—but cheaply—at a valuation level where investors have the chance to partner with one of the great long term compounding machines of the past 3 decades and achieve investment results for a long period of time that will at least equal—and possibly exceed the comprehensive returns on equity and growth in book value that the business achieves.

I’ll discuss my opinions on Markel, but first a quick overview of the fundamentals inherent to the Property and Casualty insurance industry, for those who need a quick primer. For those that don’t, feel free to skip ahead…

Insurance—Desirable Business Model Leads to Subpar Returns

Insurance companies have a unique feature that most businesses lack. Most businesses have one main source of capital to invest—namely the capital that the shareholders invested into the business. But Markel—and other insurance companies—have two:

  • Shareholder Equity
  • Reserves from Policyholders

Insurance companies have the added benefit of being able to accept money from customers (premiums) long in advance of the requirement to pay for the losses associated with that revenue (claims).

Of course, this concept is referred to as float—or the policyholders’ money that an insurance company gets to invest after receiving the premiums but before paying the claims.

Buffett made this concept famous, and he describes it often in his letters—here is his quick explanation in the most recent annual report:

“Property casualty insurers receive premiums upfront and pay claims later… This collect-now, pay-later model leaves P/C companies holding large sums—money we call “float”—that will eventually go to others. Meanwhile, insurers get to invest this float for their benefit. Though individual policies and claims come and go, the amount of float an insurer holds usually remains fairly stable in relation to premium volume.”  

Although technically a liability, float is really an incredibly valuable asset—so much so that the industry at large is willing to lose money on underwriting in exchange for the access to this float. The concept is somewhat similar to a bank that collects deposits at a cost of say 3% and invests or lends those deposits out at say 6%–profiting from the 3% spread. Unlike banking however, it is possible for insurance companies to reduce their cost of float down to zero—or in rare cases even below zero cost. In other words, instead of having to pay 3% to gather funds, some insurance companies actually breakeven on their underwriting, meaning that this float is effectively “free”—like a bank that has no costs associated with gathering deposits.

Breaking even on the underwriting might not sound like a terrific situation, but it actually is quite valuable in the insurance business, as it effectively allows the business to use other peoples’ money to invest for its sole benefit. It’s effectively like taking on a partner who supplies your business with capital but asks for no equity stake nor charges you any interest—effectively this breakeven result creates an interest free loan for the insurance company.

In some rare situations, an insurance company not only breaks even on the underwriting, but actually makes consistent profits. This pleasant situation results in two possible streams of income:

  • Underwriting profits
  • Investment profits

The company in this rare situation actually gets paid to hold and invest their policyholders’ funds—like a bank that somehow charged depositors interest for the privilege of keeping their money at the bank.

Insurance—Competition Creates Mediocre Returns

Unfortunately for insurance companies, the nature of capitalism is such that this valuable business model combined with relatively low barriers-to-entry creates intense competition in the industry. Each insurance company understands how valuable this float is, and so they fiercely compete for a piece of the industry’s premium volume and the float that accompanies it.

This intense competition leads to companies being very willing to write business at a loss just to access this valuable float. These factors have led to very mediocre returns on equity over time for the industry as a whole.

Buffett again:

“Unfortunately, the wish of all insurers to achieve this happy result creates intense competition, so vigorous in most years that it causes the P/C industry as a whole to operate a significant underwriting loss. This loss, in effect, is what the industry pays to hold its float. For example, State Farm, by far the country’s largest insurer and a well-managed company besides, incurred an underwriting loss in nine of the twelve years ending in 2012… Competitive dynamics almost guarantee that the insurance industry—despite the float income all companies enjoy—will continue its dismal record of earning subnormal returns as compared to other businesses.”

The P&C insurance industry has long operated at a combined ratio well over 100—meaning collectively insurance companies lose money on their underwriting. The combined ratio measures the total insurance costs (expenses and claims) as a percentage of premiums. A combined ratio of 100 is breakeven—meaning that the total expenses equaled premiums. Over 100 is an underwriting loss, below 100 signals an underwriting profit. 

Moats in a No-Moat Industry

But some businesses—Berkshire certainly being one—have carved out competitive advantages in this cyclical industry with commodity-like economics. Some businesses are able to consistently operate at an underwriting profit, which creates enormous value for shareholders over time. When combined with good investment skills, this combination can create an incredible compounding effect.

How do insurance companies create this advantage?

There are a few answers to that question, but one major factor is the willingness to walk away from business that will not result in profits. This is harder than it sounds, because it involves willingly lowering current revenue—something that most executives and almost all Wall Street analysts don’t like. But companies that are able to actually reduce their underwriting volume during soft markets are able to preserve their capital and their profitability. Every insurance company understands this, but few are willing to walk away from business. It is difficult for executives of insurance companies to willingly shrink their revenues when their competitors are growing theirs. It is also difficult for insurance employees—who are paid on commission in some cases—to willingly walk away from current business—even if it is the best thing to do for the long term interests of shareholders and employees.

However, a select few businesses have created incentive structures and an owners’ minded culture that allows them to be able to operate in such a profitable manner.

Berkshire obviously is one example of this—compounding shareholder value at 20% annually for half a century.

Markel is another example.

Introduction to Markel—A Value Compounding Machine

Markel was founded in 1930 and initially focused on insuring taxi cabs in Norfolk, Virgina. It was a family owned and operated business for decades until it went public in 1986, but even to this day it has largely maintained its culture as a family run business.

Markel is a compounding machine. It has grown book value by 20.1% per year since its IPO in 1986, thanks to three main ingredients:

  • Consistent Underwriting Profits
  • Superior Investment Results
  • Excellent Long-term Owner/Managers

The three pronged approach has resulted in enormous shareholder value creation over time, even when compared to better-known compounders such as Berkshire Hathaway.

Here are the results of Markel’s per share book value compound annual returns vs those of Berkshire and the S&P 500:

MKL vs. BRK and SP 500

As the compounding of book value goes, so goes intrinsic value and so goes the stock price. MKL’s stock price has compounded at 17.1% over 27 years since the IPO, turning a $10,000 investment in 1986 into $705,596 in 2013:

MKL Long Term Chart

I like to think about Markel as a holding company with three distinct business lines:

  • Insurance
  • Investments
  • Operating Businesses (Markel Ventures)

Markel is a very disciplined underwriter with a history of underwriting profits (Markel’s 28 year average combined ratio is an incredible 96%). This profitability is as rare as it is valuable in the insurance business. It provides Markel with cash flow from insurance operations, but more importantly, it means that the float—the money that belongs to policyholders from premiums that are reserved for future claims—is effectively free money for Markel to invest for the sole benefit of shareholders. It’s like a massive loan that bears no interest and doesn’t have to be paid back!

As long as Markel remains a profitable underwriter over time, it will have two main buckets of permanent capital to invest:

  1. Float
  2. Shareholders’ Equity

The former is conservatively allocated to mostly short duration fixed income securities—bonds. The latter is invested in long term securities—namely stocks. Markel invests a much larger portion of its equity into stocks relative to most P/C insurance companies. This means higher returns for the investment portfolio over time, and it means above average book value compounding, which correlates over time with the intrinsic growth in value of the enterprise.

It also means slightly more volatility—which is probably why most insurance companies prefer not to own equities. But Markel’s logic is the same as Buffett’s and most value investors—volatility is not risk. Risk is the uncertainty of losing permanent capital—not the temporary fluctuation in the quoted value of that capital.

I’m surprised that after 49 years of 20% annual returns at Berkshire Hathaway that more companies don’t follow this relatively simple model.

Not Just Stocks & Bonds, but Businesses—Markel Ventures

In addition to stocks and bonds, Markel also allocates capital to privately owned businesses. The company recently established an entity called Markel Ventures, which is the vehicle that holds wholly-owned and partially-owned operating businesses.

Markel Ventures is only a very small piece of the overall Markel pie, but it is rapidly expanding—revenues grew 40% last year as new businesses were acquired. I believe this will be a significant source of value for Markel in years to come as the vehicle begins to throw off greater and greater free cash flow for Markel to reinvest.

Markel invests in businesses using the same principles it uses to buy stocks—similar to how Buffett thinks about investing in public and private businesses.

So how does an insurance company—a business in an industry known for subpar returns—create above average returns on equity and high book value compounding over three decades?

Competitive Advantages at Markel

Markel is unique—an insurance company with various competitive advantages. A few of these advantages are:

  • Long-term Owner-Minded Management—Markel’s managers are experienced, disciplined, and very conservative in their underwriting, investing, and reserve policies.
  • Culture—management has established and maintained a culture that promotes long term oriented thinking in every aspect of their business that benefits shareholders, customers, and employees.
  • Niche Insurance Markets—it has specialized expertise in markets where many other insurance companies don’t write
  • Size—it is one of the largest players in its markets with a long term history—which gives it scale advantages as well as customer loyalty (customers in these hard-to-place risk categories know Markel is one of the largest and most secure counterparties in their markets)
  • Disciplined and Profitable Underwriting—willing to shrink premium volume in soft markets
  • Superior Investment Skills—Tom Gayner is a high quality value investor and Markel allocates a larger percentage of its shareholder equity (i.e. permanent capital) to equities than most other insurance companies

Let’s explore a few of these advantages that have carved out Markel’s ever widening moat over the years…

Competitive Advantage #1: Management and the Markel Culture

“One of the primary reasons for (our) success is that we have a large group with a long tenure… Another important fact is that all Markel associates own stock in the Company, and many have very significant investments.” –1997 Shareholder Letter

Markel’s history goes back to the 1930’s when the company was founded. For most of its history, the business was family owned and controlled. It went public in 1986 to provide liquidity for some of the cousins and other relatives who were not interested in owning an insurance company, but the principles of the Markel family are very much intact today.

These principles—honesty, integrity, customer service, and work ethic among others—can be evidenced by listening to management and observing their behavior over long periods of time. I’ve gone through every shareholder letter since the IPO in 1986, and it is very clear that they put a top priority on maintaining the culture that the founding family established decades ago.

This type of qualitative analysis is often deemphasized, and this type of rhetoric is common at almost every company. But at Markel, this isn’t just rhetoric—it is how they actually run their business. And this culture creates a competitive advantage for a few reasons, but one is that employees think like owners—and they operate with the long term in mind.

Many of the letters from the 1980’s are written by executives that still are at the company playing a major role today. Employee turnover is very low. This means that executives are given the freedom to think beyond quarterly, yearly, or even 2-3 year results. They are thinking 5, 10, even 20 years down the road. They own stock in their company, and their compensation is highly tied to long term incentives such as 5-year CAGR of book value. Employees at lower levels are also incentivized this way—underwriters are not incentivized to write business at any price—they are incentivized to write profitable business.

This creates a culture of owners working together to build value.

Competitive Advantage #2:  Niche Markets

“By focusing on market niches where we have underwriting expertise, we seek to earn consistent underwriting profits, which are a key component of our strategy. We believe that the ability to achieve consistent underwriting profits demonstrates knowledge and expertise, commitment to superior customer service, and the ability to manage insurance risk.” –2013 Annual Report

Warren Buffett mentioned at a recent shareholder meeting that one of Berkshire’s huge competitive advantages is that they have no competitors in certain activities they engage in. Markel’s insurance business is founded on hard-to-place risks, which by definition are lines of insurance that relatively few insurance companies participate in.

This means they insure things that other insurance companies don’t. Throughout its history, Markel has indeed insured such unusual risks such as classic cars, boats, event cancellations, children’s summer camps, horses, vacant properties, new medical devices, and even things such as the red slippers Judy Garland wore in the Wizard of Oz.

Markel has specialized in these niche markets for decades, and has built up both experience and a brand name among customers and prospective customers as one of the largest players in these specialty markets. Their size, their expertise, and their capacity to insure these risks that others won’t have given Markel a sizeable advantage over competitors. Most don’t want to compete in these lines. Those that do try to enter these lines often lack have the specialized knowledge that Markel has built up over time.

Competitive Advantage #3: Disciplined Underwriting

 “In tough markets, we will need to be extremely disciplined and willing to walk away from underpriced business” –2013 Shareholder Letter

This has been the philosophy at Markel for three quarters of a century. And it’s not just ubiquitous rhetoric that you hear from most P&C management teams—the results show Markel management “walks the walk” as well, producing remarkable results relative to the overall P&C insurance industry:

MKL-Underwriting

These are incredible underwriting results, especially when taking into account the enormous growth in premiums that Markel has achieved over the years. Growth in premiums often do not equate to growth in per share intrinsic value, but as management said in the 2013 Shareholder Letter:

“Our compensation as senior managers, and our wealth as shareholders of the company, depends on profitable revenues, not just revenues. That said, when it comes to profitable revenues, more is better.”

Competitive Advantage #4: Equity Investing

“We have a larger portion of our portfolio allocated to common equities than many property/casualty insurance companies. Although we recognize the short term impact (of higher volatility), we are confident our strategy will enhance shareholder value in the long term.” –1992 Shareholder Letter                                                                                   

Like value investors, Markel believes that equating volatility with risk is nonsensical. They look at their shareholders’ equity as permanent capital, which implies that they can invest that capital with a long term view, and their philosophy is that stocks—specifically quality companies at fair prices—will outperform bonds over long periods of time.

This strategy has worked. Here is a look at the average annual returns that the investment portfolio has produced—with a side by side comparison of the steadily rising increasing value as shown in the per share book value and stock price:

MKL-20 Year Key Data

MKL-Key 20 Year Numbers

Tom Gayner, Markel’s CIO, runs the investment portfolio, and is a well-known student of value investing and the principles of Warren Buffett. Gayner’s equity results would put him in the top 10% of just about any mutual fund category.

Gayner invests in equities using a simple four point filtering process that is rooted in the principles of value investing. He likes to look for:

  1. Profitable companies that produce high returns on capital
  2. Management that is both talented and honest
  3. Businesses that have sizable reinvestment opportunities (compounding machines)
  4. A fair price

Although the level of performance might not seem to rank him among other superinvestors, it certainly adds enormous value when combined with the structural advantage of negative cost float (“better-than-free” leverage) that Markel uses.

Superior Investments Results + Zero-Cost Leverage (Float) =  Outstanding ROE

For example, at the end of 2013, Markel had investments $1,259 per share, and net investments (after subtracting all debt) of $1,098 per share. They also had leverage (investment assets/equity) of 2.6—which happens to be well below Markel’s historical leverage level.

This leverage means that if Markel’s overall portfolio averages 5.0% after tax, the portfolio will gain $63 per share, which represents 13.2% of book value. If leverage increases to a level of 3.0 invested assets to equity (historical average is 3.5), then the contribution to ROE from the investment portfolio gets to 15%. Because of Markel’s consistent ability to produce underwriting profits as well as a growing revenue stream from Markel Ventures, these investment results can be thought of as a “back of the envelope” conservative proxy for comprehensive ROE and book value growth.

Another “back of the envelope” way to look at it: if Markel can produce breakeven underwriting results (including interest charges) and can produce 5% after-tax investment returns, then Markel is priced at around 9 times comprehensive earnings ($595/$63 comprehensive EPS: basically the change in equity which includes income as well as unrealized gains on investments that bypass the income statement).

Of course, leverage works in both directions, but thanks to Markel’s underwriting practice and long-term orientation, their lumpier than normal earnings will likely lead to far superior value creation over time.

When discussing this “leverage”, remember—As long as Markel underwrites profitably over time, this “leverage” provides capital that is both free and permanent. Markel’s overall balance sheet is very conservatively capitalized, with a debt to equity ratio of around 34%.

Over the past 20 years, Markel has produced pretax average annual investment returns—in both stocks (13.1%) and its overall portfolio (7.0%)—that far exceed the investment returns that most P&C companies achieved over that period of time. Much of this has to do with outstanding stock investing.

As Gayner said in the recent shareholder letter:

“Our equity portfolio has added immense value to our total returns over many years and we think our long standing and consistent commitment to disciplined equity investing is a unique and valuable feature.”

Alterra Acquisition and Equity Allocation

Markel acquired Alterra on May 1st, 2013. The company is referring to this merger as “transformational” as it not only nearly doubled the insurance business, but also increased the size of the investment portfolio from $9.3 billion to $17.6 billion.

The acquisition not only increased the size of the investment portfolio, but also significantly altered the allocation profile between stocks and bonds. At year end, Markel had just 17% of its portfolio in stocks, vs. around 25% a year ago.

Put differently, Markel had just 49% of its shareholder equity invested in stocks, compared to a management stated target of around 80%.

As Gayner said on the 2nd Quarter 2013 Conference Call:

“The addition of the Alterra portfolio was a sluggish (reallocation of investments), and it is appropriate for you to assume that we will methodically and opportunistically guide the equity investment percentage back up to the historical levels over time.”

This reallocation will be a catalyst for sizable increases in Markel’s investment returns, ROE, and book value over time.

Bringing It Together—Great Company, Great Price

“At Markel, underwriting and investing are working from the same blueprint. The principles that support profitable underwriting are the same ones that lead us to superior investment returns and, in turn, help us build shareholder value. These important principles are: maintaining a long-term time horizon, discipline, and continuous learning.” –2006 Shareholder Letter

The thesis really boils down to the fact that we have a great business that has compounded book value at 20% annually since its IPO thanks to the following key attributes:

  • Long term owner friendly managers
  • Profitable, conservative insurance operations
  • Superior investing results

Markel is a compounding machine and should be able to continue to replicate this formula for years into the future.

And to add a cherry on top, the stock is actually priced cheaply relative to normalized earnings and Markel’s own historical price to book ratio:

  • Markel’s current P/B Ratio: 1.24
  • Markel’s long-term average P/B Ratio: 1.73

The low price is surprising considering how well the company is positioned to grow its insurance operations, investment portfolio, and private business holdings via Markel Ventures.

The price to book (P/B) ratio is at the very low end of the 28-year range:

MKL Long Term Price to Book Ratio

So the current valuation is just 71% of the long term average valuation and don’t forget, the denominator in this multiple has grown at 20.1% per year since 1986!

I believe Markel is an outstanding opportunity—with or without multiple expansion. So I think the long term business prospects are much more important to consider than short term catalysts, but I do think that the reallocation of Alterra’s portfolio along with Markel’s strength to take advantage of the inevitable return to a hard insurance market will provide a tailwind to the current valuation.

To illustrate the power of compounding, let’s assume book value grows at rates between 10-14% annually over the next 5-10 years (significantly lower than Markel’s long term historical range). Let’s also assume a valuation multiple between 1.5 (also conservative vs. long term average of 1.73 P/B ratio):

  • Book Value Grows at 10%
    • Book Value in 5-10 Years = $768 to $1,237
    • Stock Price at P/B of 1.5 = $1,152 to $1,856
    • Stock Price CAGR in 5-10 Years: 12.0% to 14.1%
  • Book Value Grows at 14%
    • Book Value in 5-10 Years = $918 to $1,768
    • Stock Price at P/B of 1.5 = $1,452 to $2,652
    • Stock Price CAGR in 5-10 Years: 16.1% to 19.5%

I think there are arguments to be made for higher compounding as well as higher valuations, but I think these are reasonable possibilities.

To Sum It Up

With Markel, we get:

  • Consistently profitable insurance company
  • Superior investment holding company
  • Shareholder friendly long term management
  • Cheap Price

On 3/31/13, MKL trades at $595 per share. The stock is trading at the very low end of the historical valuation range at 1.2 times book. This seems far too cheap for a company of this quality—one that has compounded book value per share at 20.1% since its IPO in 1986.

So we have a great business—and an opportunistic investment. A compounding machine that is growing intrinsic value at greater than 15% annually—available at a price that allows investors to experience an investment result that should equal—or possibly exceed—the internal business returns over the next 5-10 years.

Disclosure: John Huber owns shares of MKL in his own account and in accounts he manages for clients.

“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”

–Warren Buffett, 2011 (Financial Crisis Inquiry Commission)

I wrote a post about Amazon a couple weeks ago. I don’t own it, and I don’t really know enough about the business at this point to determine if it’s cheap or not (it appears to be expensive, but then again… appearances can be deceptive).

I do think that Amazon is a great business, and regardless of the price of the stock, I think it’s a business worth studying. I may not own it in the near future—and I may never own it—but there is a lot to learn from studying Bezos, Amazon, and their model.

One aspect of Amazon’s model that is worth ruminating on is their potential real pricing power. I won’t comment much more on Amazon’s untapped pricing power for now, as I thought I’d post some general thoughts on this topic for now. These thoughts stemmed from some things I read a few weeks back by Josh Tarasoff, a value investor who has some interesting things to say regarding pricing power, and he thinks about this important subject differently than most investors.

Basically, as value investors, we are all conditioned to think linearly when it comes to pricing power. How often have we heard Buffett talk about See’s Candies and how every December 26th they raise prices? This is a very attractive business to own. In other words, a business that can raise prices each year in a nice, steady upward trend is ideal. This is a business that we say has pricing power, as it can increase the cost of its product or service to reflect the general increase in prices (inflation).

But Tarasoff brings up three really good points regarding pricing power:

  1. Nominal vs Real Pricing Power: A business that can increase prices at a rate that only offsets inflation is good, but not exceptional (if it can’t raise nominal prices at a level that meets the inflation rate, it’s a bad situation). Ideally what we’d like is a business that can raise prices in excess of inflation (real pricing power).
  2. Real pricing power actually indicates an inefficiently priced product or service. In other words, just as stock prices occasionally get priced below fair value, sometimes a business’s products or services get priced below fair value to a customer. This undervalued product is a source of potential value as a business begins to price their product more efficiently (raise prices in real terms).
  3. Real pricing power is finite. Just like a stock that reaches fair value and is no longer mispriced, at some point, a businesses’ ability to increase real prices without impacting unit volume comes to an end. This means that a long history of real price increases doesn’t necessarily indicate future real price increases.

Let’s discuss the first point…

Nominal vs. Real Pricing Power

If you are a business owner, the minimum amount of pricing power that you would demand is to be able to price your goods or services in a way that keeps up with inflation. If you can’t offset inflation, you don’t have a very good situation. So nominal pricing power is really just a necessary, but not sufficient condition of business quality. A better situation for a business owner would be the ability to raise the prices of his product or service in excess of inflation. This type of real pricing power can create significant value for owners.

This is rare. It is also inefficient. And it leads us to the second bullet point…

Real Pricing Power = Undervalued (Mispriced) Products

If a business can raise prices in excess of inflation, it actually means that it is not actually maximizing its current pricing. In other words, if a business can actually raise prices in excess of inflation without negatively impacting unit volume, it was not charging as much as it could have prior to the real price increase.

Tarasoff likens this “inefficiency” to a stock that is “inefficiently priced” in the market. Just like there are undervalued stocks, there are also undervalued products and services. This means that customers are getting a bargain. They collectively would be willing to pay more in real terms for the same product or service. In this situation, businesses can raise their prices in real terms without affecting unit volume, creating an enormous amount of value for their shareholders.

All Good Things Must End—Point 3

Now, although some companies can experience very long periods of real price increases, it is true that real pricing power is finite.  There is only a certain amount of real pricing power that a business has before it reaches the maximum price per unit that it can operate at without negatively impacting volume.

The contrarian aspect of Tarasoff’s thinking is that while it’s nice to see a business that has consistently raised its prices, it might actually be better to find a business that has not raised its prices in a long time for one reason or another, thus causing its product or service to become underpriced—and undervalued to customers. This situation creates a sort of pent-up pricing power that can be released in the form of future real price increases for a certain amount of time.

Look For Undervalued Products/Services

Tarasoff references the railroad industry as a general example of this type of thinking… real prices declined for decades until 2004, creating an underpriced service and pent-up pricing power for a consolidated industry.

Railroad Real Rates

Some were surprised when Buffett made a massive acquisition of a major railroad in 2009, as these capital intensive businesses are typically not what Buffett finds attractive. But as the quote at the top of this post suggests, Buffett has pricing power at the top of his investment wish list, and Burlington Northern Santa Fe certainly has the potential to grant this wish.

There are other examples of general situations that can lead to potential real pricing power—one is the situation that occurs when a not-for-profit organization converts into a for-profit business. This change in structure can lead to more efficient prices, as management and owners are incentivized differently in for-profit enterprises.

And occasionally it is not an industry trend or a structural change, but simply an individual business case where for some reason, management has not priced its products or services correctly, leading to pent-up pricing power. Occasionally a management team discovers that their business possesses the ability to raise real prices—a pleasant finding that they may not have been aware of previously.

To Sum It Up

The main idea here—which I think is quite contrary to what most investors do—is that in order to find real pricing power, it might be helpful to locate businesses that have NOT raised prices for a long period of time for some reason. It’s an interesting take…

I still love finding the See’s type businesses with a history of price increases, but I can understand Tarasoff’s logic that real pricing power can only exist for a finite period of time, and so a business with a history of raising real prices might be nearing the end of its run (as its product becomes more fairly priced), which might cause investors to overvalue this real pricing power, and thus place too much emphasis on the business’ margin expansion and future earning power.

Like a stock that has gone up faster than its value, a long history of real pricing power and margin expansion may mean that the business’ products/services are now much more “fully valued” than they once were.

To summarize these thoughts on real pricing power:

  • Pricing power is good
  • Real pricing power (as opposed to just nominal pricing power) is what we really want as business owners
  • Nominal pricing power (ability to offset inflation) is really the minimum pricing power we would demand as a business owner
  • Just like we search for undervalued, or “mispriced” stocks, we should also be on the lookout for undervalued, or “mispriced” products or services (or “untapped pricing power”), as both situations eventually tend to correct themselves creating future value for shareholders.

“I found that the entire fund industry worked a certain way, and that their results reflected the mediocre way in which they operated.”

- Mohnish Pabrai, recalling an important discovery he made at the outset of his investment career

I’ve mentioned before that I keep a list of investors who I’ve studied that have achieved long term returns (over a decade or preferably longer) of 20-30%+ annual returns. It’s a relatively small list, but it is larger than you might think. My logic here is simple: Try to seek out the ideas and commentary from those who have achieve results that I would like to achieve over the course of my career, and try to ignore all of the other things that might be traditional and accepted, but haven’t proven to add value.

I mention this often, but the big outperformers in the investment field truly think differently than the majority of fund managers. Mohnish Pabrai gave a talk at Columbia last year where he mentioned that his goal from the beginning of his career (when he was admittedly quite naive) was to “do what Buffett did”, which was double money every three years. Doubling money every three years is exactly 26.0% per year.  A feat most fund managers would (accurately) say is improbable, if not impossible. Laughable, in fact, for someone like a 30 year old Pabrai with no experience and no track record to even suggest such a feat.

Of course, 18 years later, Pabrai (according to his presentation at Columbia) has made 25.7% per year over the last 18 years, just a few basis points off of his goal, and over half the way through his “30 year game”.

Results like these beg the question: How does one compound at 26% annually? Pabrai provides a few answers in that presentation that can be summed up by saying:

  • Don’t try to beat the market (focus on absolute returns)
  • Don’t buy something unless you feel it is worth 2-3x in 2-3 years

This last point is one that I believe gets largely ignored by most fund managers. It’s too difficult to sit by with excess cash and wait for opportunities that clearly present 2-3x potential. It’s much easier to fill the portfolio with decent looking ideas that appear to be cheap based on standard metrics. These “average ideas at 10x earnings” are what Charlie479 said filled the pages at Value Investors Club: Ideas that might work out okay, but when many of them fill a portfolio, they are almost certain to dilute returns down to the averages. 

I have some related thoughts on this topic, which I’ll save for another time. But one thing I think is important is the necessity to think differently. And it’s one thing I’ve noticed with every one of the investors on my list who have achieved these types of returns over long periods of time. I notice this either through the public interviews they’ve given, or sometimes simply by just studying their investments and their overall portfolios over the years.

Ted Weschler is on this list.

Ted Weschler and DaVita

Weschler has achieved outstanding results (mid-20′s) in the decade+ that he ran his own fund. And he rarely appears in public, which is why I was very interested to see him, along with Todd Combs and Tracy Britt Cool (Buffett’s “3 T’s”) on CNBC last week.

I thought I’d put up a quick post with the video clip of Weschler talking about his largest (I believe) holding: DaVita Healthcare Partners (DVA). DaVita is a very interesting business, and one that I’ve begun studying in more detail. At some point, I might post on DaVita itself. I don’t own it currently, but I’m learning more about it. They are one of the nation’s largest operators of dialysis centers, and the business has some very interesting competitive advantages, which deserve more commentary. They also have a manager, Ken Thiry, who is worth studying. I highly recommend watching this video lecture with Thiry to get an idea of what I mean.

Thiry took over the nearly bankrupt business in the fall of 1999 (then called Total Renal Care Holdings). He completely changed the culture of the business, set new goals, and has transformed DaVita into an incredible operation. The results:

DaVita Thiry

Interestingly, DaVita’s stock has compounded at 25.7% per year since the time Thiry took over.

Why Does Weschler Like It?

Again, that might be the topic of another post. But we know that DaVita has scale, they have customer captivity, and they have a few other large operational advantages worth discussing. And the business produces a lot of free cash flow, much larger than the GAAP earnings imply.

The clip of Weschler answering this question is short, but he did provide this interesting checklist… basically, he said he’s studied this industry for a long time, and said he uses these broad filters for health care stocks:

  1. Does the company deliver better quality care than someone can get anywhere else?
  2. Does the company deliver a net savings to the overall health care system?
  3. Does the business produce high returns on capital, have growth potential, and have shareholder friendly management?

Weschler says DaVita passes all of these filters. The last thing he says is often stated, but I think rarely believed by the talking head who is saying it: Basically Weschler said he doesn’t know (and probably doesn’t care) what the stock price will do over the next couple years, but he believes very strongly that in 5 years or so it will be a more valuable franchise than it is today.

DVA is a Large Holding for Weschler

Weschler seems convicted. Not only is it his biggest position in the Berkshire funds he manages (we can roughly estimate that DVA makes up around 30% of Weschler’s portfolio at Berkshire), but he has been gobbling up shares for himself and his family members in his personal accounts, now owning in excess of $150 million worth of DVA personally.

So this post is not necessarily to endorse the stock, although I think it’s an interesting company. I really wanted to point out that there is a big advantage to thinking differently. Weschler does this, and his results have shown it over time.

As I’ve mentioned before, as I scan down the list of investors that have achieved these types of outstanding long term returns, I noticed two general ways that they’ve achieved this performance:

  • Focus Investing (Concentrating on 5-15 quality ideas that are significantly undervalued)
  • Extreme Cheap (Buying a more diversified basket of stocks that are hated, forgotten, or just plain cheap)

Weschler, Pabrai, and most of the others on the list fall into the first category. They are very patient, and they will not allocate capital to ideas just to fill a portfolio. They truly are looking for the most undervalued ideas, and they tend to focus more on quality. These investors focus on partnering with compounders, or businesses that can create enormous wealth for shareholders over time through the internal results of the business. The returns to shareholders come not through multiple expansion, but through internal compounding.

I’ve had a few questions lately on the investment philosophy itself, and I’ll share some thoughts on compounders, specifically how to value them and how to think about them in the context of the overall portfolio and how they compare to other ideas such as special situations, cheap/hidden assets, etc… I also have some thoughts on pricing power, which is a topic I’ve been spending time thinking about lately.

For now, check out the short clip of Weschler talking about DaVita.

Have a Great Weekend!

“Investment is most intelligent when it is most businesslike”. – Ben Graham, The Intelligent Investor

This is the time of year that I always look forward to for a variety of reasons. Spring is near in my area of the United States, college basketball tournaments will be captivating audiences around the country, the azaleas will soon be in full bloom at Augusta National Golf Club (the site of my favorite golf major), and my personal favorite: the slew of annual reports and shareholder letters that begin making their way across my desk and into my email box.

Annual Report Time

I receive a lot of reports, but there are a few that I really look forward to reading each year. Last week, I mentioned the Eddie Lampert letter, which is always interesting. Here are a few others that would be #1 or #2 seeds if I were to assemble my own “bracket” of quality shareholder letters:

It’s hard to single out just a few, but the above “Big 4″ are certainly four of my favorites. I love the business model that Berkshire, Markel, and Fairfax use–as float can be an incredibly significant source of value creation when used by quality managers with sound business and investing principles. It’s hard not to get excited about quality underwriting that creates permanent low/no cost capital to be invested by quality investment managers. And aside from those three firms, M&T is a bank with a history of top-tier returns on equity–and one of the highest quality banks around. There are many others I anticipate as well: some quite small (here is an excellent series of letters from a tiny, high quality bank), and some quite large (Jamie Dimon’s letters to JP Morgan shareholders are always great).

But the Markel, Fairfax, M&T, and Berkshire letters are always at the top of my list. As an aside, those four firms have managed to compound shareholder value at extremely high rates (15-20% annually) over multi-decade periods, so it’s worth reading about how management thinks.

Of course, Buffett’s letter is most famous, and for good reason–despite the ubiquity of Warren Buffett, he still continues to impart incredibly valuable wisdom every time he speaks/writes to the business and investing community.

There are lots of posts summarizing Buffett’s letter. I won’t bother to add my two cents–as I think the letter itself should be read in full. But I did want to comment on one aspect of the letter I found interesting…

How Buffett Thinks About Stocks

Shortly before the letter was released, Fortune released a “sneak peak” of the letter that contained the section where Buffett describes two personal real estate investments. I often get emailed questions from novice investors who have a desire to learn more about investing and want to understand the conceptual aspects of value investing better. I though that this part of the letter did an excellent job at exemplifying the importance of the some of the key fundamentals of stock investing. Interestingly, Buffett did this by discussing two real estate investments that he did with personal (non-Berkshire) money.

I really recommend reading the full letter, but for beginners interested in developing your own investment philosophy, read the Fortune piece, as it will help you understand the importance of having a long term time horizon as well as the importance of viewing stocks as businesses, and not pieces of paper to be traded back and forth. I actually sent this letter in a note to my own investors, as I think it’s an excellent summary of how I think about the stock market. If you manage your own capital, this is how you should think, and if you hire outside advisers to manage your investments, this is how they should think.

Some (Buffett) Thoughts on Investing

Here are a few snippets of this part of the letter:

The Farm

  • Buffett purchased a Nebraska farm in 1986 for $280,000
  • The earnings from the farm provided him with a 10% annual cash flow return
  • Buffett estimates the farm is now worth 5 times what he paid for it (5.9% CAGR)
  • Earnings have tripled
  • So the estimated 6% annualized appreciation, plus a solid (and growing) annual earnings yield adds up to a superb 28 year investment

The Manhattan Building

  • Buffett (with a few partners) bought a foreclosed retail building in New York near NYU from the Resolution Trust Corp in 1993
  • The property improved occupancy rates as the market recovered and earnings increased, allowing Buffett and his partners to refinance the building, drawing out roughly 150% of what they invested (so they got their initial investment back–and then some–and kept the cash flowing asset)
  • The property now provides annual earnings dividends equaling about 35% of the initial equity investment

From these two relatively simple real estate investments, Buffett made the following points:

Buffett Point 1

Buffett Point 2No advanced spreadsheets, no macro forecasting, no earnings models, just some sound principles, common sense, and conservative analysis. Buffett mentions his philosophy–which is probably oversimplified because of the point he’s trying to drive home, but still worth remembering:

“When Charlie Munger and I buy stocks — which we think of as small portions of businesses — our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings — which is usually the case — we simply move on to other prospects. In the 54 years we have worked together, we have never forgone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions.”

Buffett ends this portion of the letter by paying tribute to Graham, and mentioning an interesting example that Graham used in the 1949 edition of the Intelligent Investor. That year, Northern Pacific, a railroad stock, earned $10 per share and traded at $17 (a P/E of 1.7). This company had a market cap of $40 million, and is now part of BNSF (a Berkshire owned railroad, which earns $40 million every 4 days, according to Buffett).

I thought this part of Buffett’s letter was excellent, and I hope you enjoy it and take the time to read it. I’ll leave you with a chart that I never get sick of looking at… Have a great week:

Buffett Results 1

Buffett Results 2

“Messer Hubbard and Bell want to install one of their “telephone devices” in every city. The idea is idiotic on the face of it. Furthermore, why would any person want to use this ungainly and impractical device when he can send a messenger to the telegraph office and have a clear written message sent to any large city in the United States?” 

Excerpt from a Western Union internal report in response to an offer from Alexander Graham Bell (inventor of the telephone) to sell his invention to Western Union to $100,000

I have tremendous respect for Eddie Lampert as an investor—an incredible track record for sure (one of the best ever)—but also the way he handles his business in the face of significant criticism. I like following Sears Holdings—like many investors, the assets pique my interest.

Sears Transformation

Lampert has been pounding the table on how he believes Sears is ahead of the curve when it comes to the tectonic shift taking place in the brick and mortar retail business model. Basically, Lampert claims that Sears is making headway in their “transformation” from a traditional retail store to an “integrated” retailer that interacts and serves customers through online channels, social media, and also in the physical stores.

Late last week, Sears posted Lampert’s annual letter to shareholders, where he again cites data that he feels provides further evidence that Sears is making progress on this transformation front, despite the ever present operating losses.

I’m not sure about the efficacy of this type of business strategy, and like many value investors, I’m much more interested in the assets. But one thing I think too many people are doing is closing their minds to this story, and following the consensus view that Sears is dead. Now, I have an ironic opinion on general consensus views—the popular belief is that the consensus is usually wrong… that’s actually not true. It is my observation that more often than not, the majority is actually right. So it’s important to keep that in mind. I don’t necessarily disagree with the naysayers regarding the future of Sears’ retail operations. It looks bleak to me as well, and they have a significant mountain to climb to reach consistent profitability.

But I think many have closed their minds on the future prospects of Sears as a retailer. The assets have been discussed ad nauseam to be sure, but I think Lampert has some interesting viewpoints, and given the investor’s record, I think it doesn’t hurt to try to reverse engineer his logic.

As an aside, I read through the press release that contained Sears’ year end results, and noticed that Lands’ End (which is the next asset that Lampert plans to spin off later this year) increased its profitability from the previous year, earning $79 million in profits:

Lands End Results

For those who are interested in learning more about how Lampert thinks as an investor and a businessman, I would really recommend the shareholder letters. Lampert rarely makes public appearances, so there won’t be many other places to get his views on investing, but he does actually write a blog. He rarely posts, but he has a couple interesting comments there, and the quote at the top of this post came from an interesting piece he linked to.

For those interested in Sears, or just gaining more insight into how Lampert thinks as an investor, capital allocator, and chief executive, here are some other links to check out:

I came across an excellent presentation that I wanted to share because it sparked some thoughts. It is not about a current—or even prospective—investment, but one that exemplifies the art of thinking differently.

I spend a fair amount of time reading annual reports about businesses that I have no intention of owning. Typically, these businesses are high quality companies that—although maybe too expensive to offer attractive investor returns—are great entities to study and learn about. Studying businesses that have a history of compounding their value (and their owner’s equity) over time can help you develop a blueprint of sorts—things to look for in an effort to find such businesses when they are more attractively priced, smaller, or otherwise more unknown.

Quality Business Characteristics

A friend and I were discussing some of the ideal things we like in businesses. Valuations aside, we all like high ROIC, ample reinvestment opportunities, great management, etc… When thinking about what I like in a business, I always start with simple business models. I like toll bridges. I like parking garages in attractive downtown locations. I just was reading about a business I like that is the largest provider of ATM machines and other point-of-sale products (and the recurring revenue associated with many of these products) for restaurants, retailers, and convenient stores. I like simple models. It’s easy to understand why these businesses are profitable, sustainable, and predictable.

Those are nice businesses to own. The owner of a strategically located parking garage will do quite well over time. One thing I want to mention in more detail—maybe the next post—is pricing power, something Buffett called “the single most important” aspect of a business. Even though the parking garage owner might have limited reinvestment options for his sizable cash flow, he does possess pricing power.

At the top of the post, I mentioned I like to read about great businesses and great business models—even if they are stocks that I really have no intention of owning. Amazon is one of these businesses. (Don’t leave, keep reading).

Much to Learn from AMZN’s Model

It is now 13-f time, and I always enjoy reading through what other respected value investors are doing. About this time last quarter when I was reading through my 13-f list, I was quite surprised to see Amazon listed as one of Tom Gayner’s stocks that he was buying. He actually began buying it about a year ago, and has purchased very small amounts each quarter since. It’s a tiny position, but regardless of the size, I was surprised to see AMZN enter his portfolio. So I casually began thinking about it here and there, perusing through annual reports. I actually really enjoy reading the AMZN reports, and would encourage investors to check them out.

The stock isn’t cheap, but the business model can teach us a lot about the importance of scale, efficiency, pricing power, capital allocation, and great management with ownership mentalities and long term horizons.

Of course, it is with great trepidation that I reference Amazon on these pages here at BHI, as it perennially trades at ungodly prices when using traditional value metrics that most of us look at. But fear not, I don’t own Amazon, and I don’t necessarily intend to—although I’m always aware of one of Ben Graham’s famous quotes which I’ll paraphrase: “For almost every business, there is a price at which it could be purchased, and a completely different price at which it should be sold.”

Good, if Not Cheap

So certainly at some price, I’d love to own Amazon, as it is—in my opinion—one of the greatest companies in existence. But the purpose today is to share some brief thoughts on a specific aspect of Amazon’s quality that is important—namely an owner operator that thinks and acts for the long term benefit of owners. My thoughts on AMZN today were sparked by an excellent presentation I came across over the weekend by Josh Tarasoff of Greenlea Lane, a value investor who happens to own this forbidden fruit.

My reaction to seeing a recommendation for AMZN at a value investing conference is similar to when I noticed it in Gayner’s portfolio. I was surprised. But nevertheless, it rekindled my energy to begin paging through some of the old AMZN annual reports again.

Every value investor knows Amazon’s P/E is in the stratosphere. Some investors have made the case that their high P/E is actually inflated due to the massive amounts of expenses they incur–all in the name of “future revenue”. My very general interpretation is that Amazon is basically advancing expenses—paid for with current cash flow—that would normally be reserved for next year, or 2016, or beyond. They are incurring these “future” expenses today in an effort to expedite their already incredible revenue growth, building out massive infrastructure that will support even greater sales volumes.

At some point, this will stop and the expenses will slow down to match revenues, and the real (i.e. normal) cash flow will rear its pleasant head, and the multiples will come crashing down (or maybe the stock will continue rising). I really have no idea when this occurs, but reading through the 10-K’s, and studying this business, I do believe this is part of what’s happening there. Amazon is actually understating their true earning power—which is the opposite of what often occurs in the more common situation among the more GAAP-conscious, Wall Street pleasing managers.

The Importance of Long Term Oriented Managers

As I said, I really enjoy reading the reports. Bezos makes it clear that he is an owner minded manager with a long term horizon. He has no interest in what Wall Street says or thinks, and he is completely focused on generating long term shareholder value. To borrow a quote from the presenation, which can also be found in Bezos’ 1997 shareholder 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.”

This is one of my favorite new quotes, and it would behoove shareholders of every company if their managers would post this quote on their office wall, internalize it, and implement the corresponding behavior. It’s kind of the anti-activist style of “profit now, ask questions later”.

By the way, despite the fact that many of these noisy activist investors are successful in driving stock prices higher in the short term through massive cost cuts and buybacks, I’m very unconvinced of how much true value they are adding for long term owners.

Bezos runs AMZN like it’s his family business that he intends to own for generations, without a care toward what outside judges think of his short term performance.

Regardless of whether AMZN is ridiculously expensive or not, I think studying the business and reading the annual reports really help create a blueprint for what kind of manager we’d ideally like to partner with as shareholders.

Long Term Orientation Plus Favorable Economics Means Growing Owner’s Value

Of course, long term thinking on its own means nothing if not combined with advantageous economics. And Amazon also has plenty of those. They basically beat every other retailer because they can afford to operate with the lowest markups and the slimmest of margins. Basically, their incredible economies of scale means they can spread their costs across an ever growing number of customers, which translates into lower prices, which begets more customers, creating even greater scale, and the cycle continues, etc…

Their business model is interesting, and I might write another post or two on some things I’ve picked up from reading through the old reports. I was recently inspired this weekend after reading Josh’s presentation, which was excellent. Josh also has some absolutely brilliant things to say regarding pricing power, which got me thinking, and might make a nice summary post on its own.

Beware of Your Biases 

As an aside: Consider your internal reaction when you first saw that I was talking about Amazon. Maybe you had no reaction… but lots of value investors have an immediate negative reaction because of the high valuation. I used to have this same reaction whenever I came across something on Amazon. But seeing Gayner buying it made me open up my mind and begin to approach it with curiosity, which is a much better mindset for learning. The closed-mindedness that many exhibit with AMZN prevents the brain from being able to consider facts in an unbiased way, and thus stunts the development that can take place by studying a model as successful as Amazon’s.

Again, I really have no opinion on the stock, and like many value investors, I also find that even after adjusting expenses to try and estimate normal earning power, it still seems that a lot of future growth is built into the current price. I am unsure if this future has been properly discounted or not, but regardless of AMZN’s value or lack thereof, I’ve enjoyed occasionally reading about the company and I thought Josh’s presentation did a great job at succinctly summarizing most of AMZN’s strengths.

I may or may not ever own the stock, but I’m happy to continue reading the reports as they come out each year if nothing else.

Here’s some relevant links:

I am in the midst of writing a few posts on the importance of Return on Invested Capital (ROIC). I wrote two posts last week discussing Greenblatt’s formula and some thoughts on the topic (Here and Here). I’ll have one or two more posts next week discussing a few brief examples of compounders (companies that exhibit unusually high returns on capital over extended periods of time, allowing them to grow–or “compound”–shareholder value over long periods of time).

There always seems to be a strong divide between “value and growth“, deep value (aka cigar butts) and quality value, etc… I too have mentioned these differences numerous times. And it’s true that many investors can do well simply buying great businesses at fair prices and holding them for long periods of time, while other investors prefer to slowly and steadily buy cheap stocks of average quality and sell them as they appreciate to fair value, repeating the process over time as they cycle through endless new opportunities.

The styles are different, but not as different as most people describe them to be. The tactics used are different, but the objective is exactly the same: trying to buy something for less than what its really worth. Both strategies rely on Graham’s famous “margin of safety” concept, which is probably the most important concept in the investing discipline.

Both Quality and Valuation Impact Margin of Safety

The margin of safety can be derived from the gap between price and value, and it can also be derived from the quality of the business. The latter point is really part of the former… For example, a business that can steadily grow intrinsic value at a rate of say 12% annually is worth much more than a business that is growing its value at say 4% annually–all other things being equal. And since the higher quality compounder is worth more than the lower quality business, the quality compounder offers a larger margin of safety.

Of course, in the real world, it’s not that easy. The lower quality business might offer an extremely attractive discount between current price and value, which is significant enough to make the investment opportunity preferable to the compounder. This is often the case in real life–compounders are rarely are offered cheaply.

But too often, value investors get enticed by cheap metrics and seemingly large discounts between price and value in businesses with shrinking intrinsic value. The problem in these types of cigar butts is that the margin of safety (gap between purchase price and value) is largest the day of the investment. Every day thereafter the business value slowly erodes further, making the investment a race against time.

Now, not all cheap stocks have eroding intrinsic value. On the contrary, many high quality, or average quality businesses are occasionally offered quite cheap. But in my opinion, it’s always much more reassuring to be invested in businesses that have intrinsic values that are growing over time, as it allows for larger margins of error in the event that you’re wrong, and better returns in the event that you’re right. A couple days ago I read a quote somewhere that I believe Allan Mecham said that I’ll paraphrase: If investors focused on reducing unforced errors as opposed to hitting the next home run, their returns would improve dramatically.

So it’s like the amateur tennis champion that wins because they had the fewest mistakes, not necessarily the most forehand winners.

Reducing Unforced Errors and Buffett’s 1987 Roster

One way to reduce unforced errors in investing is to carefully choose the businesses that you decide to own. The gap between price and value will ultimately determine your returns, but picking the right business is one important step in reducing errors.

One way to reduce errors is to focus on studying high quality businesses with high returns on capital. In the last post, I mentioned an article that Buffett referenced in the 1987 Berkshire shareholder letter. In this letter, Buffett mentions that Berkshire’s seven largest non-financial subsidiary companies made $180 million of operating earnings and $100 million after tax earnings. But, he says “by itself, this figure says nothing about economic performance. To evaluate that, we must know how much total capital – debt and equity – was needed to produce these earnings.

So Buffett was interested in return on invested capital. However, he goes on to state that these seven business units used virtually no debt, incurring just $2 million of total combined interest charges in 1987, so virtually all capital employed to produce those earnings was equity capital. And these 7 businesses had a combined equity of only $175 million.

So Berkshire had seven businesses that combined to produce the following numbers:

  • $178 million pretax earnings
  • $100 million after tax earnings
  • $175 equity capital
  • 57% ROE
  • 102% Pretax ROE

So Buffett’s top 7 non-financial businesses produced fabulously high returns on equity with very little use of debt. In short, they were outstanding businesses. Buffett proudly goes on to say that “You’ll seldom see such a percentage anywhere, let alone at large, diversified companies with nominal leverage.” Of course, investor returns depend on price paid in relation to value received, and we are only discussing the value received part of the equation here.

Buffett then voices his opinion on the importance of predictability and stability in business models:

Buffett Shareholder Letter 1987 Clip

He then references an interesting study by Fortune that backs up his empirical observation. In this study, Fortune looked at 1000 of the largest stocks in the US. Here are some interesting facts:

  • Only 6 of the 1000 companies averaged over 30% ROE over the previous decade (1977-1986)
  • Only 25 of the 1000 companies averaged over 20% ROE and had no single year lower than 15% ROE
  • These 25 “business superstars were also stock market superstars” as 24 out of 25 outperformed the S&P 500 during the 1977-1986 period.

The last statistic is remarkable. Even in the really high performing value baskets such as low P/B or low P/E groups, you’ll typically see a ratio of around one-half to two-thirds of the stocks that outperform the market. Sometimes you’ll even have a majority of underperformers that are paid for by a few large winners in these basket situations. But in this case, even with a small sample space, it’s pretty telling that 96% of the group outperformed over a period of meaningful length (10 years).

Of course, this begs a question along the following lines: “Great, by looking in the rear view mirror, it’s easy to determine great businesses… how do we know what the next 10 years will look like?”.

Buffett again provides some ideas:

Buffett Shareholder Letter 1987 Clip 2

The idea is to locate quality businesses in an effort to reduce unforced errors. Again, one way to do this is to focus on valuation alone. I think Schloss implemented this method the best. Another way is to study compounders and be disciplined to only invest when the valuation aligns with your hurdle rate.

And in terms of percentages, there will likely be fewer errors made (fewer permanent capital losses) in the compounder category than there will be in the cigar butt category. It doesn’t mean one will do better than the other, as higher winning percentage doesn’t necessarily mean higher returns. But if you want to reduce unforced errors (reduce losing investments), it helps to get familiar with stable, predictable businesses with long histories of producing above average returns on invested capital. 

So circling back to the compounders… and the question of: “Yeah the last 10 years are great, but how do we find the winners for the next 10 years?” One possible place to look would be to glance at the same list that Fortune put together. I attempted to recreat the Fortune list in Morningstar based on the last 10 years (2004-2013). As I’ve mentioned before, I keep a few quality lists at Morningstar including:

  • Non-financial stocks that have grown revenues and maintained positive earnings for 10 consecutive years (81 stocks, less than 1% of the database)
  • Non-financial stocks that have produced positive free cash flow in each of the last 10 years (596 stocks, 6% of the database)
  • Stocks that have produced returns on equity of 15% or more in each of the last 10 years (143 stocks, or just over 1% of the database)

My attempt to recreate Fortune’s list will fall short, because I can’t easily determine the average ROE of these 143 businesses, but this list would be a good place to start looking. Many of these stocks have performed very well in the past 10 years, just from glancing at the list.

And it’s worth noting that this list is the previous 10 years, it doesn’t mean that these stocks will maintain their strong returns on equity over the next 10, although research shows that most strong businesses tend to remain strong over time (mean reversion plays much less a role than is commonly assumed).

So it might be worth checking out this list, and keeping it as a watchlist for quality companies that might become available at low prices at some time or another. Or use it as a list to go through one by one, learning about successful business models in the process.

Here is a look at the list of consistent ROE stocks sorted by lowest 25 P/E ratios:

High ROE Low PE

Here is a look at the same list of 143 stocks that have produced 15% ROE in each of the past 10 years, this time sorted by highest Returns on Assets:

High ROE High ROA

Remember, all of these firms have achieved at least 15% ROE in each of the past 10 years, something 99% of public companies failed to do. This list certainly contains stocks that aren’t undervalued (many are quite expensive), but it’s probably a good list to keep an eye on from time to time, as it certainly contains a healthy amount of businesses with compounding intrinsic values.

In part 1 of this post, I mentioned I caught a video interview with Joel Greenblatt at Morningstar. In the video, Greenblatt talks about indexing, and things that are not necessarily interesting to me and my investment strategy, but he also had some brief comments on Return on Capital. In the last post, I discussed the basic method that Joel Greenblatt uses to define Return on Capital. I also discuss some of the fundamentals and the importance of this key business metric, so check out that post first, if you haven’t yet.

The interesting thing was when Greenblatt specifically said he looks to fill his portfolio with businesses that have historically produced 50% returns on capital.

Greenblatt uses the often repeated example from his Magic Formula book:

  • Suppose you have a gum shop that costs you $400,000 to buy the land, build the store, stock the shelves, etc…
  • Suppose this $400,000 investment gets you a pretax earnings of $200,000

So even though I’ve probably heard him reference this example 10 times or more (and I’ve also read the Magic Formula book, which is basic—not nearly as good as his Genius book, but still quite good), his comment where he actually quantified the amount of return that he looks for (50% ROIC) was something I hadn’t heard him say previously. This really isn’t groundbreaking… we all know that high ROIC is better than low ROIC, valuation and everything else being equal… but it got me thinking about the example from a business perspective.

That hypothetical gum shop is a very good business (50% return on capital). It takes $400k to build out a store that produces $200k in pretax earnings. In fact, it’s a business that we’d all probably enjoy owning. And over time, if the business can be scaled and replicated into more locations that produce similar returns, the owner of that gum shop business will likely become quite wealthy over time.

Pretty logical, right?

It’s just interesting because we often lose sight of what we are looking for as value investors… we are owners of businesses, and all else equal, we want good businesses over bad businesses (i.e Greenblatt says 50% ROIC is obviously much better than say 10% ROIC).

The 50% comment also got me thinking about a Munger comment I heard once where he basically said that over time, the owner of a business will likely see investment results that (over very long periods of time) begin to approximate the internal returns that the business produces. Now, it’s absolutely crucial to understand this in the context of valuation.  Much of the early shareholder returns depend on valuation (the price paid), but over time, this “gap” between valuation and quality closes.

Munger used an example: a shareholder of a business that produces 6% returns on capital over time cannot expect to see investment results much better than 6%. Conversely, a shareholder of a business that makes 18% returns on capital over time will likely see superb investment results that begin to approximate this result as time goes on.

Of course, the hard part is determining durability, competitive positioning, etc… and that’s why valuation (paying a low price) gives us an all important safety net that Graham taught us about. But the math is easy to follow, over time, a stable 18% ROIC over a multidecade period will dominate a stable 6% ROIC in terms of shareholder returns.

I once looked at numerous examples of this in real life, and it’s certainly true over very long periods (15-20 years+), but valuation is the most important factor (in my opinion) in the early years and even the first decade. So valuation must not be forgotten. And of course Greenblatt factors in valuation into his investment decisions. But over time, Munger is right… imagine buying Walmart in the 70’s, Fastenal in the 80′s, etc… You could have paid 50 times earnings, and your long term results (if you held from then until now) would likely come close to the returns on capital that those businesses have produced over time (near 20% over time).

Now I’m not interested in predicting the next Walmart (well I guess I’d be interested in predicting the next Walmart, but I don’t think I have the foresight to do that on a consistent basis), so I choose to place a heavy Ben Graham emphasis (valuation) on my investment ideas.

But within that context, it is interesting to think about looking for businesses that produce 50% or more returns on capital. Those are basically the “Gum shop” businesses that Greenblatt likes. They produce $200K or more of earnings for every $400K of capital invested… and for whatever reason, they are cheap at the moment. I took a look at Greenblatt’s latest 13-F, and indeed, there are a lot of businesses that are producing very high returns on capital (but note: his new investment approach is not very helpful to follow, because he owns so many businesses, but it would be interesting to use it as a list to read annual reports from).

Another idea is to build a very simple screen that looks for businesses with high returns on capital, or alternatively high ROA or high ROE without much leverage. I wrote a post that summarizes one such screen I like to occasionally glance at from time to time. 

My hunch is that one could do better by using these concepts and studying the businesses, focusing on the more predictable businesses that can be easily understood. But it’s worth noting and respecting the results of the Magic Formula over time:

  • 23.8% annualized returns from 1988-2009 (according to the book)

Last year, I started tracking two “mock” magic formula portfolios (both have 30 stocks that I take from Greenblatt’s Magic Formula on 1/1/13—one is composed of stocks with market caps over $250 million, and the other has market caps over $2 billion) and both have done incredibly well, although one year isn’t really a good indicator in my mind.

So who wouldn’t want to use this formula to invest? Well, although I think over time the results will be difficult to beat, I feel that risk management (i.e. understanding what I own and quantifying the downside with each stock) is the most important aspect of my investment philosophy. I find it hard to do that with a computer screen telling me what to buy, so I don’t personally invest using this method. This is despite the fact I agree with the system’s concept (cheap and good). I just don’t feel comfortable allocating capital to businesses that I don’t understand and haven’t researched.

But to each his own, and hopefully for Greenblatt, he’ll be able to do very well using his mechanical stock picking system over time.

For me, I’ll take his concepts (basically Graham, Buffett, and many other value investors) and keep plugging along looking for low risk 50 cent dollars.

By the way, in the last post I mentioned an  interesting study that Buffett discussed in the 1980′s about high return on capital businesses, and I’ll have to delay that for a post some other time since this post is getting long (what else is new?)

In media, they call that a teaser. I’m sure the anticipation is unbearable…

I recently watched a video of Joel Greenblatt with Morningstar. Most of the video discusses the index approach to investing using a value weight (as opposed to equal weight or market weight, which most indexes use).

I’m not that interested in indexing, although for individuals who want completely passive exposure to stocks, value weighting certainly makes much more sense to me than market weighting (because market weighting systematically buys more of a stock as it goes up, thus forcing you to buy more of a stock as it becomes more overvalued, and less of a stock as it becomes undervalued… equal weighting makes these errors random, and value weighting essentially reverses the errors, thus allowing you to own more of a stock as it becomes cheaper, and less of it as it becomes more expensive).

Anyhow, it’s an interesting concept that Greenblatt has been discussing for a few years and it is the topic of a book he recently wrote called the Big Secret for the Small Investor.

It’s a good book, but indexing is not what we do here, so it’s less interesting to me than his previous work on bottom up stock picking.

Cheap is Good, Cheap and Good is Better

But in this short interview, he made some interesting remarks on specific metrics he wants… first, he recapped the same basic things he likes to look for in stocks. Greenblatt likes stocks that are “cheap and good” as he often puts it. This means he likes stocks that are cheap relative to earnings in the Ben Graham tradition, but he strives to own stocks that are not just cheap, but also good.

The “good” part comes from what Warren Buffett talked about in his shareholder letter in 1992… basically he wanted businesses that could invest large amounts of incremental capital at very high rates of return. Good businesses earn high returns on capital, great businesses can reinvest large amounts of capital at similarly high rates. Greenblatt uses historical financial statements as a guidepost for identifying businesses that could potentially meet this critiera.

So Greenblatt attempts to combine Graham and Buffett… he wants stocks cheap (low price to earnings) and good (high returns on capital).

The Importance of Return on Capital

Now, for some inside baseball stuff… To determine valuation, Greenblatt doesn’t use P/E, but rather EV/EBIT, which is a better measure that removes the effect of leverage and tax rates which makes for easier apples to apples comparisons across capital structures and across time. For quality, he uses return on capital.

I might do a more detailed post on return on capital at some point, as it seems each investor calculates it slightly differently.

Return on Capital is a general concept that is extremely important for investors to understand. Some investors prefer to buy cheap assets (Graham bargains, net-nets, etc…), but even in these businesses, return on capital is important to understand as it will impact your margin of safety, i.e. the window of time you have to sell those cheap assets before their intrinsic value begins to decline over time (as inevitably occurs with poor earning assets). Cheap assets and special situation investments can work out wonderfully over time, and they can be very simple investments, but ideally we’d prefer owning businesses that produce high returns on assets at those same cheap prices. That’s what Greenblatt endeavors to do with his magic formula. He wants to have his cake and eat it too…

This broad measure is usually referred to as “return on capital”, “return on capital employed”, “return on invested capital”, among other terms, and they can have slightly varying definitions, but the main objective—regardless of how it’s labeled or the nuances involved in calculating it—is to determine how good a business is at using its capital to generate earnings.

As investors (part business owners), we are interested to know—among other things—these basic things when it comes to Return on Capital:

  • How much capital has the business invested?
  • What kind of rates of return has it historically earned on that investment?
  • How much capital will it need to invest going forward (or better yet, how much can it invest going forward?) and what can we expect to earn on that future investment?

The first two things we can determine by looking at the financial statements. The invested capital is listed on the balance sheet. The third thing is really what we want to find out (how much money can we earn going forward, and what kind of capital will we need to invest to achieve those earnings?). Ideally, we want a business that can produce high returns on capital and can also invest large amounts of additional capital at similar rates of return in the future. There are methods to approximate returns on the incremental capital that a business employs, which we can discuss a different time, but we’ll discuss Greenblatt’s method now…

Greenblatt’s Definition of Return on Capital

Greenblatt defines “capital employed” as net working capital plus net fixed assets (PP&E) less excess cash. In other words, he uses total assets less non-interest bearing current liabilities (a more common calculation), but then he subtracts goodwill and intangibles as well as excess cash.

His objective is to determine the tangible capital that a business needs to operate. A business needs to lay out money to stock shelves with inventory, equipment to produce goods, buildings to house employees and products, etc… but it doesn’t have to lay out money for goodwill, intangibles, or accounts payable (which are essentially an interest free short term loan reducing the amount of required capital). Also, the excess cash is not needed to operate the business either, so that gets subtracted from the total assets as well.

He also uses EBIT in the numerator as opposed to net income, which allows for a better apples to apples comparison of earning power as it allows us to compare earnings across capital structures and across time (varying tax rates).

So the two main components of value that he uses for his “magic formula” are:

  • Valuation: EV/EBIT
  • Return on Capital: EBIT/(Net Working Capital + Net PPE – Excess Cash)

To use an oversimplified example, think of it like this… if you buy a duplex for $100,000 in cash, and it gives you $6,000 per year in net operating income (rent less all expenses before taxes), your duplex provides you with a 6% return on invested capital. Since there is no debt, your return on equity (ROE) is also 6%.

Return on capital accounts for the total capital that your business uses, whether it’s equity (all cash) or equity and debt (cash plus a mortgage). In this example, if you used $20,000 of cash for a downpayment (equity) and took out an $80,000 mortgage at 5% interest (debt), then your Return on Equity changes, but your Return on Capital is still 6%. In this case, you now have a $4,000 interest payment each year, which gets subtracted from the $6,000 net operating income, leaving you with $2,000 pretax income, meaning that your pretax ROE is 10% ($2,000 pretax earnings divided by $20,000 equity). In this case, using debt increased your return on equity, but the business itself (the duplex) didn’t become better. The duplex is the same duplex, and the monthly rent checks didn’t change. The capital structure changed, but the earning power of the duplex didn’t change.

Greenblatt was interested in determining and comparing the raw earning power of each business, and so he didn’t want results skewed due to the effects of leverage and tax rates, which is why he preferred to use pretax operating earnings, or more specifically–Earnings before Interest and Taxes (EBIT).

I introduce these terms here to provide a brief backdrop, but here is what I found interesting in the video. Greenblatt said he prefers companies that produce 50% or better returns on capital, and most of the stocks he owns are businesses that produce 50% returns on capital or better.

He points out that he specifically looks for businesses with these types of returns on capital. I have a few more thoughts on this topic, which I’ll post in a “part 2” in a day or two, as this post is getting lengthy. I also will provide a link to the video (couldn’t find it in my bookmarks at the moment), as well as a link to one of Buffett’s letters where he did a general study of these types of high quality businesses in the 1980’s.