About Our Name
But how, you will ask, does one decide what [stocks are] “attractive”? Most analysts feel they must choose between two approaches customarily thought to be in opposition: “value” and “growth,”…We view that as fuzzy thinking…Growth is always a component of value [and] the very term “value investing” is redundant.
– Warren Buffett, Berkshire Hathaway annual report, 1993
At Valuentum, we take Buffett’s thoughts one step further. We think the best opportunities arise from a complete understanding of all investing disciplines in order to identify the most attractive stocks at any given time. Valuentum therefore analyzes each stock across a wide spectrum of philosophies, from deep value to momentum investing. And a combination of the two approaches found on each side of the spectrum (value/momentum) in a name couldn’t be more representative of what our analysts do here; hence, we’re called Valuentum.
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By Brian Nelson, CFA
“If you want to guarantee yourself a lifetime of misery, be sure to marry someone with the intent of changing their behavior.” – a “Mungerism” explaining the importance of identifying good managers when pursuing a hands-off ownership style.
We covered quite a bit of ground in the first part of the evaluation of Berkshire Hathaway’s 2015 annual report here, and we’ll cover even more ground in this second installment. We left off with a good conversation about the insurance business, and how part of Berkshire Hathaway’s business strength emanates from its fortress balance sheet and credit rating, rather than any commoditized insurance policy it may be able to write. Let’s keep going through the Oracle of Omaha’s writings in similar format as the first installment, picking select excerpts to highlight and then comment on: Mr. Buffett’s words in italics, mine in standard type. Berkshire’s full “2015 Letter to Shareholders” can be downloaded here. Let’s proceed.
While Charlie and I search for new businesses to buy, our many subsidiaries are regularly making bolt-on acquisitions. Last year we contracted for 29 bolt-ons, scheduled to cost $634 million in aggregate. The cost of these purchases ranged from $300,000 to $143 million.
Charlie and I encourage bolt-ons, if they are sensibly-priced. (Most deals offered us most definitely aren’t.) These purchases deploy capital in operations that fit with our existing businesses and that will be managed by our corps of expert managers. That means no additional work for us, yet more earnings for Berkshire, a combination we find highly appealing. We will make many dozens of bolt-on deals in future years.
Though perhaps an observation more than anything else, I find it interesting that Berkshire Hathaway completed a bolt-on acquisition to the tune of $300,000 in 2015. That company must have been a great fit, and it’s more than likely that Berkshire underpaid for those assets, if only because any assets that would be worth acquiring by Berkshire are likely worth more than that nominal value. That’s neither here nor there, however, and the real focus of the two paragraphs above should be on the importance of recognizing that “price” matters.
Mr. Buffett notes that, while he and Charlie encourage bolt-ons, he does so only if they are sensibly-priced. The Oracle of Omaha is well-known for helping investors understand that the price of something is what you pay for it, and the value of something is based on the net cash position on the books, the present value of future enterprise free cash flows, and the value of non-operating assets (or “what you get”). Folding into the portfolio cheap assets that fit well with existing operations is simply a no-brainer and explains why nearly 30 bolt-on deals were completed at Berkshire during the year.
Savvy investors approach the art of investing in a similar capacity. Remember: price and value are two different concepts, and estimating intrinsic worth for any asset is par for the course before purchasing it. Only when a price can be had at a level on par (for a fantastic enterprise) or preferably materially lower than the fair value of those assets does an investment become intriguing. Bargain-basement opportunities don’t come up that often, as Mr. Buffett outlines when he says most deals presented to him come with price tags that are too high.
Our Heinz partnership with Jorge Paulo Lemann, Alex Behring and Bernardo Hees more than doubled its size last year by merging with Kraft…
Jorge Paulo and his associates could not be better partners. We share with them a passion to buy, build and hold large businesses that satisfy basic needs and desires. We follow different paths, however, in pursuing this goal.
Their method, at which they have been extraordinarily successful, is to buy companies that offer an opportunity for eliminating many unnecessary costs and then – very promptly – to make the moves that will get the job done. Their actions significantly boost productivity, the all-important factor in America’s economic growth over the past 240 years. Without more output of desired goods and services per working hour – that’s the measure of productivity gains – an economy inevitably stagnates. At much of corporate America, truly major gains in productivity are possible, a fact offering opportunities to Jorge Paulo and his associates.
The passages above reiterate the importance of productivity to the pace of economic growth. From the development of the assembly line to the invention of the personal computer, America has sourced the ingenuity to make things better and more efficient, seemingly without fail. What Mr. Buffett is talking about in the above amounts to the cost-cutting variety of enhancing efficiency rather than of the “invention” or “discovery” method, but productivity in any form remains the lifeblood of economic growth.
By logical extension, the biggest question on any investor’s mind is what will be the next ‘assembly line’ or ‘personal computer’ over the next 30 years to drive even more productivity. We say as much not in the sprit of uncovering the coming decades’ Ford (F) or Microsoft (MSFT), per se, but to help build the case (and better understand) why investors should be optimistic about future economic growth in America, as Mr. Buffett outlines at the bottom of this piece. Eternal optimists and/or perma bulls may like the future “just because,” but we think it’s important to think about what may be the “next big thing” because without it, as Mr. Buffett states, “an economy inevitably stagnates.”
Unfortunately, neither the Oracle nor I know with absolutely certainty what will be the source of the next giant leap in productivity, but the future not only holds this promise, it may also come with significant challenges. After all, how can we forget that the federal funds rate in 1980 was a staggering 20% and now its near-0%? Markets benefitted from the ongoing loosening of monetary policy over the past 30+ years, and the coming contractionary monetary policy will have the opposite impact, increasing discount rates across equity valuations and making the lending environment all the more stringent to achieve consistent expansion. One must be cognizant of the obstacles to future economic growth, and how the tailwinds of the past may very well soon turn into the stiff headwinds of the future.
At Berkshire, we, too, crave efficiency and detest bureaucracy. To achieve our goals, however, we follow an approach emphasizing avoidance of bloat, buying businesses such as PCC that have long been run by cost-conscious and efficient managers. After the purchase, our role is simply to create an environment in which these CEOs – and their eventual successors, who typically are like-minded – can maximize both their managerial effectiveness and the pleasure they derive from their jobs. (With this hands-off style, I am heeding a well-known Mungerism: “If you want to guarantee yourself a lifetime of misery, be sure to marry someone with the intent of changing their behavior.”)
Investors love Warren Buffett’s letters to shareholders not only because they are full of wisdom, but also because they are full of quips, the treasure in the above from his partner Charlie Munger, which we also reproduced at the top of this article. Mr. Buffett and the Berkshire team are owners, not managers, so they rely on their proficiency in selecting the best managers, in part because they don’t have the skill set to change them.
In the passage above, Mr. Buffett makes another reference to the managerial prowess of the team at Precision Castparts (PCC), a company that we have been quite fond of for many years and in part is a large reason why we are considering adding Berkshire Hathaway to the portfolio of the Best Ideas Newsletter. Precision’s CEO Mark Donegan may be one of the best executives to head up any organization across any industry.
Berkshire increased its ownership interest last year in each of its “Big Four” investments – American Express (AXP), Coca-Cola (KO), IBM (IBM) and Wells Fargo (WFC). We purchased additional shares of IBM (increasing our ownership to 8.4% versus 7.8% at yearend 2014) and Wells Fargo (going to 9.8% from 9.4%). At the other two companies, Coca-Cola and American Express, stock repurchases raised our percentage ownership. Our equity in Coca-Cola grew from 9.2% to 9.3%, and our interest in American Express increased from 14.8% to 15.6%. In case you think these seemingly small changes aren’t important, consider this math: For the four companies in aggregate, each increase of one percentage point in our ownership raises Berkshire’s portion of their annual earnings by about $500 million.
These four investees possess excellent businesses and are run by managers who are both talented and shareholder-oriented. Their returns on tangible equity range from excellent to staggering. At Berkshire, we much prefer owning a non-controlling but substantial portion of a wonderful company to owning 100% of a so-so business. It’s better to have a partial interest in the Hope Diamond than to own all of a rhinestone.
If Berkshire’s yearend holdings are used as the marker, our portion of the “Big Four’s” 2015 earnings amounted to $4.7 billion. In the earnings we report to you, however, we include only the dividends they pay us – about $1.8 billion last year. But make no mistake: The nearly $3 billion of these companies’ earnings we don’t report are every bit as valuable to us as the portion Berkshire records.
The earnings our investees retain are often used for repurchases of their own stock – a move that increases Berkshire’s share of future earnings without requiring us to lay out a dime. The retained earnings of these companies also fund business opportunities that usually turn out to be advantageous. All that leads us to expect that the per-share earnings of these four investees, in aggregate, will grow substantially over time. If gains do indeed materialize, dividends to Berkshire will increase and so, too, will our unrealized capital gains.
There is a lot to digest in the passages above, but we’d like to make just a couple observations, and let Mr. Buffett’s words speak for themselves, for the most part.
First, we’re surprised that, for as much as Uncle Warren talks about the pitfalls of accounting within Berkshire’s own reporting that he is relying on return on tangible equity (ROTE) as an evaluation of the “Big Four.” Though ROTE may be appropriate for financial entities such as American Express and Wells Fargo, we don’t think it makes much sense for operating entities such as Coca-Cola and IBM, and we think its use is in part why the Oracle made one of his few mistakes in loading up on the latter. Return on invested capital will always trump accounting measures of return on tangible equity, and he knows this.
The other reason Berkshire may have made a compounding error with IBM rests on the tech giant’s aggressive repurchase program, and Mr. Buffett’s perception of it. It sounds like the Berkshire team had been focusing on increasing its share of the IBM earnings over time as shares were retired, instead of a focus on whether the buybacks are actually creating value for shareholders – i.e. whether the company is repurchasing stock below an estimate of intrinsic value. We’re shocked to say this but Warren Buffett fell into the “earnings-per-share” trap at IBM, and it could be a long time before Berkshire makes good on the trade, if at all. Remember: focus on return on invested capital and economic value creation, not on return on equity, which can be augmented by more-risky leverage (debt), or buybacks, which can be value-destructive if executed at the wrong price (above fair value).
For the conclusion of this second installment, let’s reproduce the Oracle’s optimistic views on America. It’s a great read, if only because the nationalistic, optimistic bent may offer some calm in an otherwise hectic world. Be sure to tune in for Part III as we wrap up this year’s review. Enjoy! The following is Warren Buffett at his finest.
It’s an election year, and candidates can’t stop speaking about our country’s problems (which, of course, only they can solve). As a result of this negative drumbeat, many Americans now believe that their children will not live as well as they themselves do.
That view is dead wrong: The babies being born in America today are the luckiest crop in history.
American GDP per capita is now about $56,000. As I mentioned last year that – in real terms – is a staggering six times the amount in 1930, the year I was born, a leap far beyond the wildest dreams of my parents or their contemporaries. U.S. citizens are not intrinsically more intelligent today, nor do they work harder than did Americans in 1930. Rather, they work far more efficiently and thereby produce far more. This all-powerful trend is certain to continue: America’s economic magic remains alive and well.
Some commentators bemoan our current 2% per year growth in real GDP – and, yes, we would all like to see a higher rate. But let’s do some simple math using the much-lamented 2% figure. That rate, we will see, delivers astounding gains.
America’s population is growing about .8% per year (.5% from births minus deaths and .3% from net migration). Thus 2% of overall growth produces about 1.2% of per capita growth. That may not sound impressive. But in a single generation of, say, 25 years, that rate of growth leads to a gain of 34.4% in real GDP per capita. (Compounding’s effects produce the excess over the percentage that would result by simply multiplying 25 x 1.2%.) In turn, that 34.4% gain will produce a staggering $19,000 increase in real GDP per capita for the next generation. Were that to be distributed equally, the gain would be $76,000 annually for a family of four. Today’s politicians need not shed tears for tomorrow’s children.
Indeed, most of today’s children are doing well. All families in my upper middle-class neighborhood regularly enjoy a living standard better than that achieved by John D. Rockefeller Sr. at the time of my birth. His unparalleled fortune couldn’t buy what we now take for granted, whether the field is – to name just a few – transportation, entertainment, communication or medical services. Rockefeller certainly had power and fame; he could not, however, live as well as my neighbors now do.
Though the pie to be shared by the next generation will be far larger than today’s, how it will be divided will remain fiercely contentious. Just as is now the case, there will be struggles for the increased output of goods and services between those people in their productive years and retirees, between the healthy and the infirm, between the inheritors and the Horatio Algers, between investors and workers and, in particular, between those with talents that are valued highly by the marketplace and the equally decent hard-working Americans who lack the skills the market prizes. Clashes of that sort have forever been with us – and will forever continue. Congress will be the battlefield; money and votes will be the weapons. Lobbying will remain a growth industry.
The good news, however, is that even members of the “losing” sides will almost certainly enjoy – as they should – far more goods and services in the future than they have in the past. The quality of their increased bounty will also dramatically improve. Nothing rivals the market system in producing what people want – nor, even more so, in delivering what people don’t yet know they want. My parents, when young, could not envision a television set, nor did I, in my 50s, think I needed a personal computer. Both products, once people saw what they could do, quickly revolutionized their lives. I now spend ten hours a week playing bridge online. And, as I write this letter, “search” is invaluable to me. (I’m not ready for Tinder, however.)
For 240 years it’s been a terrible mistake to bet against America, and now is no time to start. America’s golden goose of commerce and innovation will continue to lay more and larger eggs. America’s social security promises will be honored and perhaps made more generous. And, yes, America’s kids will live far better than their parents did.
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