I’ve talked a lot about the importance of the concept of return on invested capital (ROIC), and how it is a key driver of value in a business. Feel free to go back and read some of those posts here. In this particular post, the discussion is continued. This post is something new for BHI: it’s a guest post written by my good friend Connor Leonard (see his brief bio at the end of the post).

Connor and I live in the same area (Raleigh, North Carolina), and we get together on a regular basis to discuss businesses we follow as well as investment strategy. He and I think very similarly when it comes to investing in high quality businesses that can create significant value over the long-run. Connor is a smart investor, and I appreciate his willingness to be a sounding board for me at times.

This post contains his own thoughts (unedited by me) regarding the importance of a company being able to retain and reinvest its cash flow at high rates of return. I think he articulates the concept very well.

Here is Connor’s post:

The Reinvestment Moat

Outstanding companies are often described as having a “moat”, a term popularized by Warren Buffett where a durable competitive advantage enables a business to earn high returns on capital for many years[1]. These businesses are rare and form a small group, however I bifurcate the group further into what I classify as “Legacy Moats” and “Reinvestment Moats”. I find that most businesses with a durable competitive advantage belong in the Legacy Moat bucket, meaning the companies earn strong returns on capital but do not have compelling opportunities to deploy incremental capital at similar rates.

There is an even more elite category of quality businesses that I classify as having a Reinvestment Moat. These businesses have all of the advantages of a Legacy Moat, but also have opportunities to deploy incremental capital at high rates. Businesses with long runways of high-return investment opportunities can compound capital for long stretches, and a portfolio of these exceptional businesses is likely to produce years of strong returns. It will take some work and a lot of discipline to filter down to the true compounding machines, however I will outline what factors to look for and how many of the “bargains” hide in plain sight.

The “Legacy Moat”:

Businesses with a Legacy Moat possess a solid competitive position that results in healthy profits and strong returns on invested capital. In exceptional cases, a company with a Legacy Moat employs no tangible capital and can modestly grow without requiring additional capital. However because there are no reinvestment opportunities offering those same high returns, whatever cash the business generates needs to be deployed elsewhere or shipped back to the owners.

Think of a self-storage facility in a rural town with a high occupancy rate and little competition. This location may be generating $200,000 of annual free cash flow, a solid yield on the $1,000,000 of capital used to build the facility. As long as they run a tight operation, and a competing storage facility doesn’t open across the street, the owner can be reasonably assured that the earnings power will persist or modestly grow over time.

But what does the owner do with the $200,000 that the operation generates each year? The town can’t really support another location, and nearby towns are already serving the storage demand adequately. So maybe the owner invests it in another private business, or puts it towards savings, or maybe buys a lake house. But wherever that capital goes, it likely won’t be at the same 20% return earned on the initial facility.

This same dilemma applies to many larger businesses such as Hershey’s, Coca-Cola, McDonald’s or Proctor & Gamble. These four companies on average distributed 82.4% of their 2015 net income out to shareholders as dividends. For these companies that decision makes sense, they do not have enough attractive reinvestment opportunities to justify retaining the capital.

Even though these Legacy Moat businesses demonstrate high returns on invested capital (ROIC), if you purchase their stock today and own it for ten years it is unlikely you as an investor will achieve exceptional returns. This is because their high ROIC reflects returns on prior invested capital rather than incremental invested capital. In other words, a 20% reported ROIC today is not worth as much to an investor if there are no more 20% ROIC opportunities available to direct the profits.

Equity ownership in these businesses ends up resembling a high-yield bond with a coupon that should increase over time. There is absolutely nothing wrong with this, businesses like Proctor & Gamble and Hershey’s provide a steady yield and are excellent at preserving capital but not necessarily for creating wealth. If you are looking to compound your capital at unusually high rates, the focus needs to shift to identifying businesses that also possess a “Reinvestment Moat”.

The “Reinvestment Moat”:

There is a second group of companies that have all the benefits of a Legacy Moat, but also have opportunities to deploy incremental capital at high rates because they have a Reinvestment Moat. These companies have their current profits protected by a Legacy Moat, so the core earnings power should be maintained. But instead of shipping the earnings back to the owner at the end of each year, the vast majority of the capital will be retained and deployed into opportunities that stand a high likelihood of producing high returns.

Think of Wal-Mart in 1972. There were 51 locations open at the time and the overall business generated a 52% pre-tax return on net tangible assets. Clearly their early stores were working, they dominated small towns with a differentiated format and a fanatical devotion to low prices. Within the 51 towns, I would bet that each store had a moat and Sam Walton could be reasonably assured the earnings power would hold steady or grow over time. Mr. Walton also had a pretty simple job when it came to deploying the cash those stores generated each year. The clear path was to reinvest the earnings right back into opening more Wal-Marts for as long as possible. Today there are over 11,000 Wal-Mart locations throughout the world and both sales and net income are up over 5,000x from 1972 levels.

How To Identify a Reinvestment Moat:

When searching for a Reinvestment Moat, I’m essentially looking for a business that defies capitalism. Isolated profits in a small market is one thing, but continuing to achieve high returns on incremental dollars for years should in theory not be attainable. As a business gets bigger, and the profits become more meaningful, it will attract more and more competition and returns should eventually compress. Instead I’m looking for a business that actually becomes stronger as it gets bigger. In my opinion there are two models that lend itself to this kind of positive reinforcement cycle over time: companies with low cost production or scale advantages and companies with a two-sided network effect.

Low Cost / Scale:

Going back to the early Wal-Mart example, the stores were so big compared to traditional five and dimes that Mr. Walton could sell each item at a lower margin than competitors and still operate profitably due to the large volume of shoppers. The more people that shopped at a given Wal-Mart, or the more Wal-Marts that were built, only furthered this cost advantage and widened the moat. The lower prices enticed more shoppers, and the cycle continues to reinforce itself. So by the time there were 1,000 Wal-Marts in existence, the moat was significantly wider than when there were 51. Other businesses such as Costco, GEICO, and Amazon have followed a similar playbook, creating a “flywheel” that accelerates as the business grows[2].

Example: Sketch of the Amazon Flywheel

Connor-Amazon Flywheel

Two-Sided Network:

Creating a two-sided network such as an auction or marketplace business requires both buyers and sellers, and each group is only going to show up if they believe the other side will also be present. Once the network is established however, it actually becomes stronger as more participants from either side engage. This is because the network is stronger for the “n + 1,000th” participant compared to the “n” participant directly as a function of adding 1,000 participants to the market[3].  Another way of describing this: as more buyers show up it will attract more sellers, and that in turn will attract more buyers. Once this positive cycle is in place, it becomes nearly impossible to convince either buyer or seller to leave and join a new platform. Businesses such as Copart, eBay, and Airbnb have built up strong two-sided networks over time.

Andreesen Horowitz’s example of Airbnb’s two-sided network:
Connor-Horowitz

Judging the “Runway” to Reinvest:

Many investors focus purely on growth rates, driving up the valuation of a company growing at high rates even if the growth does not carry positive economics. The key to Reinvestment Moats is not the specific growth rate forecasted for next year, but instead having conviction that there is a very long runway and the competitive advantages that produce those high returns will remain or strengthen over time. Instead of focusing on next quarter or next year, the key is to step back and envision if this company can be 5x or 10x today’s size in a decade or two? My guess is for 99% of businesses you will find that it is almost impossible to have that kind of conviction. That’s fine, be patient and focus your energy on identifying the 1%.

Admittedly this is the most difficult step of the process, with many variables and uncertainties. Each situation will be different, but below are items I look for as positive indicators of a long runway and also red flags that the runway is concluding:

Positive Indicators:

If a two-sided network is consistently increasing key metrics like users or gross transactions but is still a small percentage of the overall market:

  • Focus on companies with a high “flow through” margin on an incremental user or transaction, which will help the company expand margins as the network grows.

If a company has a structural advantage that leads to a lower cost model than competitors:

  • This could be a differentiated business model such as selling direct rather than through agents. Or it could be an advantage developed over time such as technology that results in greater automation. The structural advantage has to be difficult for larger incumbents to duplicate.

If a multi-unit retailer currently has less than 100 locations but foresees an end market of over 1,000:

  • Focus on companies with a consistent, profitable, and replicable model. The company should primarily be “stamping out” the same prototype over and over while producing consistent unit economics.

Red Flags:

If a company that claims to have a long runway begins shifting into new or different markets:

  • If the future is so bright, then why deviate from the plan? The management may already know the runway is limited and is making a pivot.

If management’s definition of the total addressable market (TAM) is suspect:

  • Some management teams like to throw out a massive TAM number in a slide deck for investors to focus on. Check the underlying source of that number, if their definition is overly broad they may be trying to mislead investors.

If the recent vintages of growth investments are producing lower returns:

  • If the most recent stores opened are producing lower sales and margins, but cost just as much, the runway is showing some cracks. Many multi-unit businesses begin to show lower unit returns once outside of core markets.

Why Value Investors Often “Miss” the Reinvestment Moats:

I believe identifying these businesses with Reinvestment Moats is possible with some work, but many value investors struggle with identifying a “reasonable” price. My theory is that these Reinvestment Moats tend to “hide in plain sight” because most investors underappreciate the impact of compounding.

When assessing a quality business, value investors will often point to a P/E ratio over 20x or the EV/EBITDA multiple of 10x+ to show that Ben Graham would surely shake his head in disgust over such a purchase[4]. However let’s consider two investments and determine which will yield better results over a ten year horizon. The first business, Reinvestment Corp., has the ability to deploy all retained earnings at a high rate because of the strong Reinvestment Moat it possesses. Of course investors acknowledge this likelihood, meaning the entry price is fairly high at 20x earnings, leading most bargain hunters to pass. On the other hand, Undervalued Corp. has all of Graham and Doddsville in a buzz because it’s a steady business with a nice dividend selling for a bargain of only 10x earnings! Assume that over time both companies will be valued in-line with the market at 15x:

Connor-Reinvestment vs Legacy 1
*Assumes all earnings not reinvested are distributed as dividends                                                                                            
**Pre-tax IRR, factoring in tax rates will only further the advantage of Reinvestment Corp.               

This example illustrates a concept Charlie Munger outlined in “The Art of Stockpicking”:

“If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.”

To create an even more extreme example, if you find a business that you believe is capable of earning strong returns over a decade, look at how much you can “overpay” and still earn a return equal to a typical business:

Connor-Reinvestment vs Legacy 2
*Assumes all earnings not reinvested are distributed as dividends       
                                                                                     **Pre-tax IRR           

Time is certainly the friend of a great business. But does this mean that only businesses with a Reinvestment Moat should be considered for a long-term investment?

Earning High Returns Investing in Legacy Moats:

A solid Legacy Moat paired with the right management team and strategy can be a wealth creator for shareholders over many years. In order to accomplish this, the playbook has to change into one more focused on capital allocation, specifically a systematic focus on acquisitions and managing the capital structure. In a sense the management team’s capital allocation prowess must become the Reinvestment Moat.

While the research on the negative consequences of M&A for corporations is extensive, I think there are a select group of management teams that can actually reinvest the company’s capital better than individual shareholders could do on their own. They tend to operate solely within their circle of competence, which is typically the sector where the underlying business resides. With deep industry knowledge, access to deal flow, and the ability to achieve operational synergies, these companies can operate like a private equity fund with permanent capital (and without the fee structure). Notable examples include TransDigm Group, Danaher Corporation, and Constellation Software.

Typically the management team consists of at least one “Operator” and a sole “Allocator”. The Operator is tightly managing the existing businesses to maintain their competitive positions. The Allocator functions more as an investor than a CEO, seeking out opportunities to deploy capital at high rates while also optimizing the capital structure. For the Allocator the capital structure is another means of creating shareholder value, and it is common to see special dividends, strategic use of leverage, and lumpy share buybacks that only occur when the stock is undervalued. William Thorndike’s book “The Outsiders” does a fantastic job of detailing these unique management teams with a talent for capital allocation.

I’ve found that the best way to find these companies is by reading annual shareholder letters and picking up on certain qualitative patterns.  First, a thoughtful and informative annual letter is key because it shows the managers view the shareholders more as business partners and co-owners rather than a pesky group they have to deal with each quarter. While I prefer to do further research, typically the letter is so insightful to a potential owner that they could make an informed investment decision simply by reading it each year. The letters typically contain terms like “intrinsic value”, “return on capital employed”, and “free cash flow per share” rather than simply discussing sales growth. These businesses tend to view frugality as a source of pride, with the home office setting the tone that each dollar is valuable because it ultimately belongs to the shareholder. If you happen to come across one of these companies, and you think the management team has a number of years remaining with plenty of attractive M&A targets, my advice is to buy the shares and let them take care of the compounding for you.

Summary:

Most of the companies that are identified as having a “moat” tend to be Legacy Moats that produce consistent, protected earnings and strong returns on prior invested capital. These are perfectly good businesses and can produce nice returns for investors in a comfortable fashion.

However if you aiming to compound capital at high rates, I believe you should spend time focusing on businesses possessing a Reinvestment Moat with a very long runway. These businesses exhibit strong economics today, but more importantly possess a long runway of opportunities to deploy capital at high incremental rates. If these are hard to come by, the next best alternative is a business with the combination of a Legacy Moat and an exceptionally strong capital allocator. It will take some work and a lot of discipline to filter down to the true compounding machines, however a portfolio of these exceptional businesses acquired sensibly is likely to produce years of strong returns.

[1] If you are new to the concept of “moats”, this video of Buffett speaking to MBA students at the University of Florida does as far better job of describing the concept than I can: https://youtu.be/r7m7ifUz7r0?t=108  

[2] The concept of a flywheel is popularized by Jim Collins, you can read more about it here: http://www.inc.com/jeff-haden/the-best-from-the-brightest-jim-collins-flywheel.html

[3] This description of the strength of a network business is taken from venture capitalist Bill Gurley

[4] According to the postscript to the revised edition of the Intelligent Investor, Ben Graham made more money off his stake in GEICO (a true Reinvestment Moat with lost-cost advantages) than he did from every other investment in his partnership over twenty years combined. At the time of the GEICO purchase, Graham allocated about 25% of the partnership’s funds towards the investment.

John’s Comment: Thanks again to Connor for putting this guest post together. I think it is a good extension of some of the investment concepts we’ve talked about here before. For related posts on this topic, please review the ROIC label as well as a recent post I did summarizing the talk that Connor referenced where Buffett does a particularly great job summarizing some of his investment tenets, including the concepts discussed in this post.


Connor Leonard is the Public Securities Manager at Investors Management Corporation (IMC) where he runs a concentrated portfolio utilizing a value investing philosophy. IMC is a privately-held holding company based in Raleigh, NC and modeled after Berkshire Hathaway. IMC looks to partner with exceptional management teams and is focused on being a long-term owner of a family of companies. For more information visit www.investorsmanagement.com or reach Connor at cleonard@investorsmanagement.com, or on Twitter at @CataumetCap.


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

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

John can be reached at john@sabercapitalmgt.com

I read an article last week by Scott Fearon, who wrote the excellent book Dead Companies Walking (a good book about shorting stocks, which can benefit investors even if they don’t short stocks). The article basically posed a hypothetical question on whether Apple was a better investment than Exxon Mobil. Fearon goes on to explain why he thinks XOM is a better bet than AAPL over the long-term.

His points:

  • Apple is a consumer products company with the majority of revenues coming from one product class—the iPhone
  • Consumer products can be very difficult to predict and can go in and out of demand very quickly
  • Exxon is a more predictable company that sells products that are essential to the world’s economy
  • He implies that Exxon has a stronger balance sheet than Apple

While I often agree with many of Scott’s opinions in his posts, I’ll make just a few counterarguments to his opinion that Exxon is a better business than Apple. This isn’t a write-up on why I like Apple, or why I don’t like Exxon (I actually don’t have much of an opinion of Exxon either way). These are just a few comments on the two. At some point, I’ll discuss more details on why I do actually like Apple as a business.

Exxon Sells a Commodity Product

Scott mentions that he was concerned that once the iPhone sales started falling that the stock would fall with it. That has in fact happened just as Scott predicted. Apple’s revenue fell 13% and profit fell 22% in the recent quarter. That said, Exxon’s revenue fell 28% and its profit fell 63% due to the brutal conditions in the energy industry. 

The problem I see with Exxon is that while it is the largest integrated (diversified) oil company, it still sells a commodity product. The problem inherent to a business that sells a commodity product is that they have no control over the price of the main product they sell. Not only does a commodity producer have no control over the price of their product, but they have no idea what the spot price of that product will be in any given year. It could be 100% higher one year, and 60% lower the next year. It’s generally a difficult business when you have no control over the price of the product that you sell, especially when a good amount of your input costs are fixed (i.e. if oil goes from 100 to 40, there are certain operating expenses that don’t drop with it—some costs do fall, but not necessarily by 60%).

A lot of people are worried about Apple’s ASP (average selling price) falling as they face competitive pressures as well as a possible shift toward smaller phones. But the “ASP” of one of Exxon’s main products (a barrel of oil) has dropped from around 110 to 45 in the past 18 months. Exxon is certainly strong enough to survive this, but that’s a difficult business to be in.

Exxon is More Predictable

I do agree that it is easier to look out 10 or 20 years and visualize what Exxon will be doing. They’ll still be drilling and pulling oil out of the ground 10 or 20 years from now (yes, the developed world will still be using fossil fuels as a primary energy source a decade or two from now). But just understanding what a business will likely be doing 10 years from now doesn’t necessarily make it a great investment. The company might struggle to create incremental value for shareholders during that time.

Take US Steel for example. It’s quite predictable that US Steel will still be producing steel 10 years from now, but that doesn’t mean that the stock will end up being a great buy and hold investment. In fact, it doesn’t even necessarily guarantee that the equity will survive—but US Steel will still be making steel in a decade or two. But 25 years ago, X traded around 26 and today it trades around 16.

As Charlie Munger warned in his discussion on cattle at the Berkshire AGM, it’s probably best to avoid commodity businesses that don’t produce decent returns on capital.

US Steel

Just because you can visualize what a company will be doing in a decade doesn’t mean that the intrinsic value of the business will grow or that the equity is a good investment.

To be clear, Exxon Mobil is a much better business than US Steel. I’m not suggesting the two are similar (except that they are both commodity producers). My point is simply that predictability doesn’t necessarily lead to value creation. As Buffett rightly points out, being able to understand what a business will look like in 10 years is an important prerequisite for an investment, but being able to see what products and services a business will sell in 10 years doesn’t necessarily mean that there is a high level of predictability around the company’s earning power.

Apple’s Balance Sheet

Apple has a cash hoard of roughly $233 billion, and after subtracting all debt, Apple has a net cash position of $161 billion, or roughly $29 per share. Scott mentioned that Apple will need to use much of this to invest in research and development projects in order to continue producing innovative products.

Let’s take a look at Apple’s R&D spending the last five years:

  • 2011: $2.4 billion spent on R&D
  • 2012: $3.5 billion
  • 2013: $4.5 billion
  • 2014: $6.0 billion
  • 2015: $8.1 billion

To put these numbers in perspective, the R&D spending ranges between roughly 2.0% and 3.5% of Apple’s revenue. In the past 5 years, Apple has produced a combined $283.1 billion in operating cash flow (and this is after deducting the R&D expenses which run through the income statement). Apple’s total capital expenditures over that five year period were $47.3 billion—much of which would be categorized as “growth capex”. So even after deducting all capex, Apple has produced a combined $235.8 billion in cumulative free cash flow (FCF) over the past 5 years, or an average of roughly $47 billion FCF per year.

It’s hard to suggest—even assuming worse than expected sales declines—that Apple’s business model is going to require it to wind up using most of the cash hoard to finance capital investments and research projects when the operating business produces FCF that is 6 times larger than the R&D budget.

In other words, Apple could double or triple its R&D spending and still–even with worse than expected sales declines–add significant amounts of cash to its balance sheet.

Another way to look at the size of the cash is this: if Apple could somehow take its cash hoard and find a place to get 3% after-tax returns, it would produce $8 billion of interest from its cash, enough to finance the entire R&D budget from 2015 without even tapping principal. This doesn’t include the $40 billion or so of FCF that Apple will have this year to either pay out as dividends, buyback stock, or add to its growing pile of cash. I’m not suggesting Apple will or should invest in low-earning income securities, but this should help illustrate how much earning potential Apple has from its balance sheet to finance its spending.

Exxon’s Balance Sheet

On the other hand, let’s briefly glance at Exxon’s balance sheet. There is $4.8 billion of cash and roughly $43 billion of debt. Exxon has also produced a huge amount of cash flow over the past 5 years, and has historically produced a sizable amount of free cash flow as well. Over the past 5 years, the company has averaged $14.7 billion annually in FCF.

The problem is that over the past 5 years, Exxon has spent an average of $15.2 billion per year on stock buybacks and an additional $11.0 billion per year on dividends. So a business with around $15 billion of free cash flow is not producing enough cash to finance its $26 billion of average capital returns (buybacks and dividends). Obviously, buybacks can easily be cut as earnings decline, but in recent quarters, the free cash flow (the amount of money the business generates to pay for things like buybacks and dividends) is not enough to even support the dividend. This is largely the reason Exxon’s debt has gone from $15 billion to $42 billion over the past 5 years. In 2015, Exxon’s free cash flow was just $3.9 billion, which was significantly less than the $12.3 billion that Exxon spent just on the dividend.

Buybacks have dropped from $22 billion at the peak to just $4 billion last year, but if conditions in the energy industry continue, Exxon could be forced to either continuing taking on large amounts of incremental debt each year to finance the dividend, or cut the dividend down to a level that can be financed out of the company’s free cash flow.

I am not making a prediction or casting judgment on the future of Exxon’s business (or its dividend), but I certainly view it in a much more precarious situation than Apple (which will most likely do somewhere between $40 billion and $50 billion of free cash flow this year—plenty to pay for its $13 billion dividend payment and still have much left over to buy back shares or add to its massive cash position).

To Sum It Up

The two businesses are like comparing apples (no pun intended) and oranges, but the articles Scott wrote got me thinking about the two last week. 

I recommend his book, which is a good read regardless of whether you short stocks or not. Thinking like a short seller is a very important skill to develop for any investor, as it helps you poke holes in your own potential investment ideas with a more discerning eye.

As far as this comparison between Exxon and Apple, it is more of just a random thought experiment without much relevance (since the two are unrelated businesses). But still it was interesting to consider the respective futures of the two since they are two of the largest companies in the market. In the near future, I’ll probably put up a post on why I like Apple as a business and an investment, which might be contrarian in the value community given the current view that the company is just another consumer electronics business. I currently own shares of Apple. 

——

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

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

I can be reached at john@sabercapitalmgt.com.

I spent some time traveling in the car last week. Whenever I am driving by myself, I always listen to something—usually related to business or investing. I keep a long list of videos of interviews or talks that I can pick from whenever I am in the car. On this particular short trip, I had got through two different videos. I listened to this talk from 2012 where Jeff Bezos talks about Amazon Web Services—the cloud computing services business that Amazon has built into a juggernaut. It’s a pretty good talk that outlines much of how Bezos thinks about not just AWS, but his retail business in general.

The second video was a talk that Buffett gave to a group of students at the University of Florida back in 1998. I’ve listened to this video numerous times over the years, but it is one that I have on my favorites list and is worth listening to every year or two.

After Omaha last week, I heard someone say that Buffett and Munger “never say anything new”. This comment was probably out of frustration that Buffett and Munger didn’t unveil some secret formula for success in investing.

The fact that these guys have been so successful by sticking to the same gameplan—in terms of general investment principles—should actually be a lesson in itself. Never wavering on their basic philosophy has brought them a long way. Tactics have changed over time as they’ve grown, but the concepts they implemented very early on have remained the same.

The University of Florida talk from 1998 is one of the best when it comes to articulating very clearly these investment principles that have served Buffett and Munger so well for so long. There is nothing “new”, but sometimes just going back to the basics is beneficial.

Here are some highlights from the talk (along with the time in the video of the comments):

On the Economics of Good Businesses (11 minute mark)

In response to a question about Japan, Buffett mentions how most Japanese businesses produce low returns on equity, and how time works against you when you own low return businesses:

“Japanese companies earn very low returns on equity. They have a bunch of businesses that earn 4%, 5%, or 6% returns on equity. It’s very hard to earn a lot as an investor when the business you’re in doesn’t earn very much money.”

Buffett goes on to explain that some people can invest profitably in such businesses, and he talks about how he used this method in the early years. He also references Walter Schloss, who made a career out of owning such businesses. Schloss would buy low earning (or sometimes money-losing) businesses that were trading below the value of the net tangible assets the company owned. It’s an approach that can work well, but I’ve found that it’s an uncomfortable way to invest—it often means owning bad businesses, and I prefer avoiding bad businesses. I’ve found that when I’ve owned bad businesses because I was attracted to the valuation, I become much more influenced and concerned with the behavior of the stock price, or even the general economy. Many bad businesses trade cheaply, but won’t survive the next recession. Glenn Greenberg once said that he wanted his portfolio filled with stocks that he would feel comfortable owning if a 1987-style stock market crash occurred (when the market plummeted over 20% in one day). I won’t comment on his largest current position or any other stocks in his portfolio, but I do think there is a lot of merit in that concept. If you own good businesses with strong earning power, you’re less concerned (or hopefully not concerned at all) about the stock market or the near term prospects for the economy.

The other problem with a Schloss-type approach is it requires a plethora of ideas that have to be continually replaced. Because the businesses are of low quality in some cases, you need plenty of diversification. Also, since you have to sell these stocks as soon as the price gets a modest bump, you need to be constantly looking for the next idea.

I think Schloss’ asset-based approach worked well in part because the US economy was much more manufacturing-oriented in the 1950’s, 60’s and 70’s. Manufacturing was responsible for just 12% of US GDP in 2015, down from 24% in 1970. Service producing businesses have taken share from goods producing businesses, and now make up a much greater piece of the overall economic pie, and these service businesses tend to operate with much lower amounts of tangible capital. Trying to find service businesses trading below book value is a mostly irrelevant and futile exercise—the ones that do tend to be going out of business, and rarely do these make attractive investments.

But the concept of buying cheap “cigar butt” stocks vs buying good businesses is a debate that still goes on, and both approaches can work, but the tactics involved are very different.

As I’ve talked about before, I think Buffett grasped the power of owning good businesses at a much earlier age than many people realize.

Buffett caps off this question by saying:

“If you’re in a lousy business for a long time, you’re going to get a lousy result even if you buy it cheap.”

Long-Term Capital Management (13 minute mark)

Buffett talks about the background of LTCM, which is a fascinating story in general. One of my favorite books on the topic is When Genius Failed by Roger Lowenstein. This book is a must read for all investors in my opinion.

He uses the story as a teaching moment, and discusses the dangers in leverage, overconfidence, and numerous other biases/mistakes that were made by incredibly smart people.

The takeaway here is that formulas and mathematics only take you so far. You need to apply logic and reason to risk management, not just computer-driven models:

“Those guys would tell me back when I was at Solomon that a six-sigma event wouldn’t touch us. But they were wrong. History does not tell you the probabilities of future financial things happening.”  

How do you decide how much to pay for a business? (32 minute mark)

This is an interesting question because Buffett—despite producing incredible returns in his partnership and the early Berkshire years—says he was never trying to go for home-run type returns. He was more focused on finding the sure bets—investments where he was fairly certain to make money without taking much risk:

“I don’t want to buy into any business that I’m not terribly sure of. So if I’m terribly sure of it, it probably isn’t going to offer incredible returns. Why should something that is essentially a cinch to do well offer you 40% a year or something like that? So we don’t have huge returns in mind. But we do have in mind never losing anything.”

He uses Sees Candy as a case study for how he thinks about what to pay for a business. They bought Sees in 1972 for $25 million. It was selling 16 million pounds of candy at $1.95 per pound, and making $4 million pretax. He said that he and Munger basically had to decide if there was some untapped pricing power. If they could sell candy at $2.25 a pound, then $0.30 per pound on 16 million pounds was another $4.8 million of pretax profit on the same volume, which would have doubled the then-current earning power of the business. Even raising prices by a nickel per pound would have produced a 20% gain in pretax earnings.

What I find interesting is that the purchase price itself was quite cheap—just 6 times pretax earnings, the equivalent of an after-tax P/E of about 10. But Buffett never even mentions the valuation in answering the question—almost as if it was an afterthought. Notice how this was very similar even in his early two writeups of GEICO and Western Insurance–much more focused on the business, with barely a mention of valuation.

With Sees, he talked about the pricing power, references the return on capital (in this case Sees basically needed no capital), and talked about the attractiveness of the product. In the end, the decision to buy the business was made not based on whether the “multiple” was cheap enough, but because he and Munger decided the product had plenty of untapped pricing power—in other words, the product itself was very undervalued from the customer’s point of view. They surmised they could raise prices and still maintain or grow volumes.

Buffett and Munger were correct in their view that the product was undervalued, and through pricing power and unit growth, Sees has produced over $1.9 billion in pretax profits to Berkshire from an incremental investment of just $40 million and a purchase price of $25 million.

Sees is an extreme example to be sure, but one that exemplifies why it’s more important to be right on the business than right on the exact price to pay.

Qualitative vs. Quantitative (39 minute mark)

“The best buys have been when the numbers almost tell you not to.”

On Thinking Long-Term (45 minute mark)

“Coke went public in 1919. Stock sold for $40 per share. One year later it’s selling for $19—down 50% in one year. Now you might think that’s some kind of disaster, and you might think that sugar prices increased or the bottlers were rebellious… you could always find a few reasons why that wasn’t the ideal moment to buy it. Years later you would have seen the great depression, World War II, sugar rationing, thermonuclear weapons… there is always a reason. But in the end, if you would have bought one share for $40 and reinvested dividends, it would be worth about $5 million now.”

Coke is obviously another rare example of a business that has survived and prospered for many decades, but Buffett’s main point is the thing to focus on:

“If you’re right about the business, you’ll make a lot of money.”

Focusing on the “what” is more important than focusing on the “when”.

On Mistakes (49 minute mark)

Berkshire Hathaway itself is a mistake he often talks about (when it was a cigar-butt business that consumed a lot of cash and never really made any money).

He also brings up an interesting point: buying attractive securities of a business that he didn’t really like. He mentions two examples: buying preferred stock in both Solomon and US Air. In both situations, Buffett ended up okay, but he came very close to losing a significant amount of his principal in both of these investments. He sums up the lesson:

“We bought an attractive security in a business I wouldn’t have bought the equity in. You could say that’s one form of mistake—buying something when you like the terms but you don’t like the business that well.”

I think this could be extended to buying stocks when you like the terms (i.e. the valuation) but not necessarily the business.

Macro (54 minute mark)

“I don’t think about the macro stuff. What you really want to do in investments is figure out what’s important and knowable.”

He says macroeconomics (interest rates, economic trends, etc…) are important, but unpredictable.

He mentions what a mistake it would have been to not buy Sees Candy for $25 million (a business that was producing $60 million pretax in 1998 at the time of this lecture) because of some fear of interest rates or the near term economy (the US did in fact enter a significant recession and bear market in 1973-1974).

General Portfolio Management (60 minute mark)

“We never buy a stock with a price target in mind. We never buy something at 30 and say ‘if it goes to 40 we’ll sell it.’… That’s just not the right way to look at a business.”

Buffett obviously does buy and sell stocks—and did much more of that in his early years—but the concept is to focus on stocks not as trading vehicles with price targets, but as businesses that produce cash flow for owners. Mr. Market will always be there offering prices that can be taken advantage of, but the mindset should be firmly focused on the fundamentals of the business and its future earning power, not on where the stock will go or when it will get there.

Diversification (66 minute mark)

Buffett says that for most individuals, owning an index fund is the appropriate investment for stocks. But for those who desire to treat investing as a business and have an ability to analyze companies, diversification is a mistake:

“If you really know businesses, you probably shouldn’t own more than 6 of them. If you can identify six wonderful businesses, that is all the diversification you need and you’re going to make a lot of money, and I will guarantee you that going into a seventh one rather than putting more money in your first one is a terrible mistake.”

This is interesting because Berkshire obviously owns more than 6 businesses, but it’s probably more useful to look back at how Buffett ran money when he had small sums. His personal account was very concentrated (he did 50% returns by owning just a few stocks at a time in the 1950’s), and his partnership—according to the details laid out in Snowball—often had 3 or 4 stocks representing over half the portfolio—sometimes his best idea represented 25-40% of capital.

To Sum It Up

There are other valuable passages that I didn’t highlight, but the entire video is worth spending 90 minutes to watch. There is nothing new in it, just as the shareholder meeting this past weekend had nothing “new”, but sometimes it’s worth listening to the best investor in the world articulate his own philosophy in his own words—even if that philosophy is already seared into your mind.

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

– George Soros, Alchemy of Finance

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

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

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

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

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

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

SUNE TERP Flow Chart

It Tends to Work, Until it Doesn’t

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

BRK Buffett quote on share issuances

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

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

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

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

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

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

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

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

Incentives

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

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

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

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

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

Growth at Any Cost

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

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

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

Parallels Between SUNE and VRX

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

Investing is a Negative Art

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

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

General takeaways:

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

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

——

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

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

I can be reached at john@sabercapitalmgt.com.

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

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

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

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

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

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

———

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

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

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

I can be reached at john@sabercapitalmgt.com.

 

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

AMZN Bezos Letter 2015

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

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

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

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

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

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

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

“Moonshot” Strategy is Aided by Recurring Cash Flow

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

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

Employees, Ideas, and Human Capital

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

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

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

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

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

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

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

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

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

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

———

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

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

I can be reached at john@sabercapitalmgt.com.

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

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

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

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

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

How much diversification is necessary?

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

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

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

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

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

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

Focusing on a Few Good Businesses

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

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

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

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

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

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

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

Predictable Businesses

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

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

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

Owning carefully selected high quality businesses is a different approach.

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

To Sum It Up

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

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

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

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

———

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

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

I can be reached at john@sabercapitalmgt.com.

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

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

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

Berkshire is attractive for four general reasons:

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

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

Cash-rich Balance Sheet

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

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

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

Strong and Diversified Earning Power

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

Insurance Businesses

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

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

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

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

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

Operating Businesses

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

Earning Power per Share

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

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

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

Attractive Current Valuation

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

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

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

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

Book Value

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

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

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

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

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

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

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

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

Buffett’s Reputational Value

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

Buffett invested a total of:

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

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

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

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

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

To Sum It Up

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

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

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

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

I can be reached at john@sabercapitalmgt.com.

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

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

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

BRK 1964

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

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

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

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

Liquidation vs. Leveraged Buyout

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

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

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

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

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

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

Two Mistakes to Avoid

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

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

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

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

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

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

Have a great week,

John

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

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

I can be reached at john@sabercapitalmgt.com

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

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

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

Focusing on Stock Price vs. Running the Business

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

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

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

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

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

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

Wall Street’s Obsession with Buybacks

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

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

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

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

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

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

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

Tying this All Together With Outerwall

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

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

OUTR-Outerwall Dividend 1

OUTR-Outerwall Dividend 2

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

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

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

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

Three General Takeaways

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

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

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

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

Disclosure: Long AAPL, BRK-B

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

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

I can be reached at john@sabercapitalmgt.com