“You don’t have to know a man’s exact weight to know that he’s fat.” – Ben Graham

I was reading through some notes from the 2008 Berkshire Hathaway Annual Meeting and one of the questions grabbed my attention. The question was pertaining to Warren Buffett’s decision to purchase stock in PetroChina back in 2002. Basically, the questioner was surprised that Buffett made such a sizable investment after a seemingly small amount of due diligence saying “all you did was read the annual report… Wouldn’t you want to do more research?”

Here is the question along with Buffett’s response:

Buffett PTR Response 1

I think think this displays one of the keys to Buffett’s success in the public equity markets that he has used throughout his career… namely, waiting to notice a huge gap between the value of a business and the price that you can buy the stock for.

Also, I think it’s interesting to note how he simply read the report, came up with a value, and only then checked the price. This is something that removes a lot of bias that comes when you know the price of the stock before trying to value it. Most investors will subconsciously anchor everything toward the current stock price. It would be hard to value PetroChina at $100 billion if you knew going in that the market was valuing it at $35 billion.

(Note: this is one of the reasons I enjoy valuing every spinoff situation. Normally, you don’t know the market valuation until the spinoff begins to trade, which allows you to come up with an intrinsic value ahead of time without any reference to the stock price. It can be a useful exercise.)

This appears to be what Buffett did with PetroChina. He loves reading reports, and you get the impression that he picked up the report one day in the spring of 2002, read through it, came up with a rough value of the business, then noticed that he could buy the stock for roughly a third of his estimated value of the business.

Of course, he was able to make this simple, seemingly quick decision to buy PetroChina stock because of his enormous foundation that came from the countless hours of reading and accumulating a bank of knowledge. This informational bank allows him to quickly compute the probabilities of various outcomes for each investment. But the takeaway is that the decision should be based on a few simple variables, and it should be a relatively easy decision. It’s easy to know that a $100 billion company that is currently priced at $35 billion is a bargain.

Indeed, a bargain it was back in 2002:

PTR Chart

Buffett purchased a stake in PTR between 2002 and 2003 at a cost of $488 million. He sold this stake in 2007 for $4 billion, netting Berkshire a gain of 8 times its initial investment. The capital Buffett put to work in PetroChina compounded at about 55% annually between 2002 and 2007.

The quote that I referenced at the top of this post from Graham is one that I always enjoy keeping in mind when valuing businesses. The idea is not to obsess over the details, but to understand the big picture.

Buffett finished his answer to the question with another example:

Buffett PTR Response 2

It’s interesting to hear him say “I never made an investment that would have been avoided due to conventional due diligence.”

To Sum It Up

I recall Joel Greenblatt saying something similar when asked about diving deep into footnotes in annual reports. He basically said that he reads the footnotes also, but he likes to keep the big picture in mind. Things like how good is the business (what returns on capital does it generate?) and how cheap is it (what is the earnings yield?).

Each investor has different ways of analyzing and evaluating investment opportunities, but I definitely think that keeping things simple, and keeping the big picture in mind is crucial to maintaining a margin of safety and establishing superior results over time.

Perhaps the best way to sum up this post is to quote the 18th century German poet Christoph Martin Wieland who once said:

“Too much light often blinds gentlemen of this sort. They cannot see the forest for the trees.”

I’m not sure if Wieland was referring to investment managers, but his words are certainly applicable to our chosen trade.

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16 Responses to Buffett’s PetroChina Investment: Finding Large Gaps Between Price & Value

  1. Henry says:

    Great article! I think Buffett’s key advantage is his ability to analyze and trust management. You would want to hire someone who is smarter and more hard working than you are. And Buffett likes to surround himself with management who is honest and able. That’s why he doesn’t have to perform such due diligence. He trust what management has to say in their annual reports. There’s no point in reading the footnotes and such if that’s the case. That’s my take anyways.

    Cheers and happy investing!

    • John Huber says:

      Hi Henry… thanks for the comment.

      I should make a clarification… Buffett definitely reads footnotes. He reads everything. However, the decision often comes down to just a few factors that are broad, simple, and logical. I think the footnotes can provide some details, but as Buffett says–much of it is just meaningless trivia. I think the point is not to abandon reading footnotes, but to simply keep in mind the big picture. And the big picture is trying to come up with an estimated range of value, and then comparing it to price–with the objective of locating wide gaps between price and value. I think what Buffett is suggesting is that if you’re sweating over footnotes to determine if you’re going to make the investment, you probably don’t understand the business well enough or you don’t have a large enough gap between price and value. It should be an easy decision–like Buffett’s was when he bought PTR for $35 billion when it was worth $100 billion.

  2. Craytheon says:

    We had added PetroChina to our database. See if you think it was fundamentally good company in 2002 or not.

    http://craytheon.info/articles/petrochina/warren_buffett_petrochina_financial_performance_ratios.php

  3. S says:

    Your articles are the best John!

    I remember reading from Gannon that one of the biggest reasons Buffett bought PetroChina was because they devoted a significant amount of their earnings to dividends.

  4. His reasoning makes sense to me except in many cases Chinese companies have accounting fraud. So I don’t know how he figured out that there wasn’t accounting fraud at PetroChina. Any thoughts John?

    • Chris Burke says:

      The company is majority owned by the Chinese government which in my opinion would have a lower risk of massive fraud. Regardless, there was such a disparity between value and price that the risk was worth the potential reward. Also, they were paying a dividend at the time.

  5. Alam says:

    How did Mr Buffett arrive at the $100 Billion valuation?

    • Chris Burke says:

      If I remember correctly he just put a comparable multiple on PetroChina taken from the other oil majors at the time. Back of the envelope type stuff.

  6. This post isn’t directly related to the post but to a philosophical question I’ve often had of “why do so many people use speculation in markets?” That is, if Buffett’s punch card approach works so well, like in this PetroChina case, why then do people use other approaches? It’s a bit of a psychological mystery to me. I figured it might be on topic since this blog is fairly philosophical.

    The common answer to “why do people speculate?” is excess greed, fear, jealousy. People get jealous of a neighbor with a bigger house, and they try their hand at gambling with some leveraged day trading on momentum plays. It’s negative expected value, but like Las Vegas, maybe they can make 50x if they’re lucky.

    I found an unconventional and interesting answer recently in the experiments of John Calhoun on social breakdown in mice. You can watch this video or read his biography on Wikipedia:

    https://www.youtube.com/watch?v=0Z760XNy4VM
    http://en.wikipedia.org/wiki/John_B._Calhoun

    The problem in his Mouse Utopia experiments is that the “social space” gets overcrowded. There is a breakdown in social roles due to natural mouse behavior no longer being productive. This results in deviant behavior, and eventually population collapse due to mice not fulfilling their nature-intended roles. We can see such behavior in human societies such as the grasseater men in Japan or recently in criminality in Detroit.

    In investing one could argue that economic value is added due to interfacing with the primary market. A startup wants to grow and has good prospects, so an investor provides it with capital. If a company grew too much for the market size, then it could return capital through corporate actions. But the secondary stock market where people trade companies does not provide any profit in aggregate (although it does provide convenience).

    The analogy with the Calhoun mouse utopia is that if the supply of investment capital is so great, and the number of investors who understand their social role is so small, then the natural role of the investor breaks down. Consequently, most capital is devoted to speculation in the secondary market. Technical analysis, momentum plays, stock newsletters about “explosive growth potential,” 50x leverage, etc.

    Wall Street people seek employment, but there isn’t always sufficient social space for productive behavior. And speculative clients who supply “overcrowded” capital are suffering from aggressive behavior due to not having any socially productive uses for their capital (or at least they haven’t found any such use). Thus constant “fighting” in the secondary market results, with disastrous social outcome similar to the “mouse utopia.”

    We see such asocial behavior increasing as the supply of capital grows very high such as the Dot com bubble, where there were famously high amounts of day trading. Conversely in market crashes such as 2008, the supply of capital dwindles. The remaining investors have ample “social space” and revert to their natural and socially useful behavior.

    Currently we see bubble-ish comments, like: “the Fed is forcing US investors to buy at irrationally high valuations.” This seems like a peculiar statement indeed given that valuations are moderate in many developed countries, and cheap in Russia and China. But it makes perfect sense if you view people as having predetermined social roles that they insist on following. Overcrowding may have resulted in the US market simply because too many people have decided that they choose to play the social role of “Buyers of US stocks,” rather than performing the service that adds economic value.

  7. Munger Fan says:

    I wrote this for fun after reading John’s article and he suggested that I put it up here. Enjoy!

    I shall attempt to demonstrate why PetroChina (PTR) in 2001 was actually a unique, once in a lifetime investment opportunity and why the same results cannot be easily replicated with companies such as Rosneft and Gazprom at the current moment.
    I will mainly be discussing information available prior to 2002 as my goal is to attempt to analyze the thought process of Warren Buffett.
    There isn’t a lot of insight to be gained from merely looking at the financial statement numbers. It does provide us with a starting point though. The results show that the company is making a fair attempt at generating profits. The annual report talks about goals in reducing costs and improving efficiency in operations. Considering the fact that this is a state owned enterprise under a communist regime, the valuation then, at around 7x P/E could have been considered quite rich depending on who was looking at this company. Therefore, to claim that the company was intrinsically worth $100 billion rather than the then current price of $35 billion would seem absurd given the legal, political environment and the financial statements taken at face value alone. Indeed, I believe many accounting numbers were heavily distorted in PTR’s financial statements not because of differences in accounting policy but because of the nature of state owned enterprise under a semi-command economy and how those conditions are reflected in the financial statements. A simple example would be that in a market-driven economy, companies must acquire assets at a market price since many other companies are competing for the same assets. This is not the case for PTR. Due to the lack of a mature oil industry and governmental protection from foreign competition, PTR accessed significant oil exploration rights at a nominal cost compared to any American oil company.
    Oil exploration rights are somewhat ignored by the financial community as they generally don’t make much of an impact on financial statements within a one year period. However, these rights basically represent a company’s access to oil and matter tremendously to the oil company in the long run. Since Buffett’s timeline for investment is potentially forever, it also matters greatly to him. When evaluating an oil company, two things matter most; the company’s capacity and ability to produce crude oil in the short to medium term and their ability to replace reserves in the long run.
    PTR’s exploration rights covered 1.4 million km2 in China in 2001. To give you the scale of things, China’s total area is roughly 9.6 million km2. Therefore, PTR had exclusive access to explore more than 1/7th of China’s total geography for oil. This 1.4 million km2 of land is not just random land, but land which has a high probability of discovering large oil reserves. What we have then, is the remnants of a state-owned monopoly thrown into an environment that is clearly becoming more market-driven.
    The proven reserves are also significant at about 11 billion barrels of crude oil. At a $35 billion price tag for the company, you’re paying around $3.20 per barrel of crude. I think it’s not an unfair valuation given the political environment. We all know about the potential drag on earnings as a result of government subsidization from neo-mercantilism. It was a potential risk at the time and it is reasonable to demand a very conservative valuation for the oil in hand for future drags on earnings.
    I think so far, we have determined that PTR was indeed a fat man (recall Buffett’s metaphor). But can we get any idea as to whether this particular fat man is at the right place and the right time?
    According to the IEA (International Energy Agency), China’s demand for oil overtook their production in the mid-1990s. Demand has been on the upward projection since the late 80s and far exceeded production by the early 2000s. In fact, China’s demand for oil increased from 3.29 million barrels per day in 1995 to 4.63 million per day in 2000. Domestic production in the same period only increased from 3.01 to 3.27 million barrels per day. Undoubtedly, most people recognized the industrialization process taking place in China in the early 2000s. Its massive labor capital provided tremendous potential for further industrialization and the life blood for an industrializing nation is of course, oil. It would have been difficult to predict the fact that China’s emergence would impact global commodity and especially oil prices to such a degree. But what was not difficult to see was the fact that any new domestic production would have a cost advantage in terms of transportation as well as a growing domestic market where demand far exceeded supply to absorb any such production. These are significant advantages and potential catalysts that the current Rosneft and Gazprom do not have. PTR could cook its food and find the hungry mouths in its own home. Rosneft and Gazprom must go out knocking on the doors of neighbors to find hungry mouths. Many of these neighbors have been historically hostile or are closely working with Russia’s enemies, some of whom are very influential. Furthermore, the operational inefficiency actually represents an opportunity for investors. Oil drilling and refining techniques are not very difficult to learn and to improve upon when you begin at a low base and are faced with high demand for your products. Furthermore, efficiency within a company generally does not reverse itself. Therefore, you can count on the current level of efficiency to be a base line. It also helps that PTR’s Daqing reserves represent some of the least expensive reserves in China to access. PTR’s earnings are the result of operations from a low technical base. The earnings multiples were not expensive at this point. Therefore, any improvements in productivity will expand earnings as well as the price to earnings multiples given by investors. The 2002 annual report heavily emphasized increasing efficiency as a top priority. When the price is right and the conditions are friendly, beginning with low efficiency can actually add value to your investment over time.
    In 2000, an incentive scheme was introduced for managers to receive cash payment from what would be the equivalent long term share options. Although the Chinese managers cannot hold actual shares, this new incentive scheme can be a positive aspect for operations going forward.
    The combination of all these factors can generate wonderful results when they act together. Buffett exited the investment when speculative fervor began to take place. A good investment is also a good speculation. In this case, the exit came from speculative pricing. Had Buffett held till now, his return would still have been good, but not quite as spectacular.

  8. Jin Dong says:

    Hey John,

    First of all, this is a great site and I have learned so much from here. Thank you for being so generous to share your knowledge, experience, wisdom, and thoughts.

    My question is about intrinsic value. I have read The Intelligent Investor, The Essays of Warren Buffett, and half way through Security Analysis. From my understanding, Buffett puts a lot of emphasis on intrinsic value, where he would only invest in a company only if the market price is much lower than intrinsic value (i.e. under valued stocks). However, neither Graham nor Buffett explains how they calculate their intrinsic value. Where can I learn more about intrinsic value, more importantly, the method to compute intrinsic value?

    • John Huber says:

      Jin, it’s a great question, and I’ve had a few emails on this lately. I’ll put up a post or two within the next few weeks on this topic. But in short, Intrinsic Value (IV) is a very simple concept. I think most people are searching for a specific formula or a specific number for each business. It doesn’t really work this way. Valuation is an art form. IV is usually defined as the price that a knowledgeable private buyer would pay for the entire business (and all of its future cash flows). The way I think about IV is the earning power. Specifically, what does this business produce in normal cash earnings after paying for capital expenditures required to maintain the competitive position of the business? So what is the normal “owner earning” power of the business?

      In short: what does the business earn? And how much is that worth to me?

      I’ll post some more thoughts in a 1-2 part post, along with some quotes from Security Analysis and Buffett. Check out his owner’s manual for more details.

      Of course, each business is different, and each valuation is different. Buffett and Munger would come up with slightly different IV’s for Berkshire if each were asked to write down a number (this is according to Buffett himself). Each business needs to be analyzed based on its track record, profitability, competitive position, management, etc…

      But in the end, it’s really: what is the normal (and future) earning power of this business and how much is that earning power worth to me?

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  10. […] Warren Buffet zapytany przy okazji inwestycji w Petro China (na której zarobi? ponad 3,5 mld. dolarów) o strategi? inwestycyjn? odpowiedzia?, ?e na pocz?tku nigdy nie patrzy na cen? akcji przedsi?biorstwa, lecz okre?la warto?? ca?ego biznesu i dopiero wtedy sprawdza na jakim poziomie dana spó?ka jest wyceniana przez rynek. Buffett wyliczy? warto?? Petro China na ok. 100 mld dolarów, a jej warto?? rynkowa stanowi?a w tamtym okresie 35 mld dolarów, dokona? wi?c klasycznej inwestycji w swoim stylu1  […]

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