Friday, December 21, 2007
Earnings Are Not Alone
While profits are essential, understanding how they fit into the value creation process is critical. This is where return on equity comes into play.
An initial yet meaningful way of looking at return on equity is similar to a coupon on a bond. A bond that earns a higher coupon yield than the prevailing rate of interest will trade at a premium, or above its par issued price. A bond that is issued paying ten percent a year will be worth more in the future if future rates on interest have declined. The reason is simple economics: no investor will pay the same price for an eight percent bond if he or she can buy a ten percent bond for the same price. So the price of the existing ten percent bonds will increase until its new market price represents an approximate eight percent effective yield. So if the bond had a face value of $1000 and initially paid $100 a year, its new price would be $1250 because at an annual payment of $100, the return is 8 percent.
Similar to a bond in a fundamental sense, businesses with sustained high returns on equity are usually followed by appreciating stock prices, but not for the same specific reasons as a bond. In the real world, of course, investors in stocks don't just buy and hold.
In the long-run, the rate of return of a stock should equal its return on equity. Consider Microsoft. Microsoft continues to deliver unbelievable returns on equity of over 40 percent and has done so for decades. Yet for years, Microsoft shares have not followed suit.
The times are different. In the beginning Microsoft had lots of space in the software market to deploy its capital. So when Microsoft was generating a ROE of say 40 percent, back then it was able to continue investing that excess capital and generate a similar rate of return. What this means is that Microsoft could take a million dollars, invest it in its operations, and earn $400,000. Microsoft could then take the excess capital and still earn that same 40 percent. Microsoft was able to do this with billions of dollars and this was happening years before the Internet boom.
It is no surprise then, that Microsoft stock rocketed for many years after its IPO and why early investors, Gates, and employees got so fantastically rich off the stock. The company was compounding existing and excess capital at a phenomenal clip. Anytime you can do this for a sustained amount of time, the intrinsic value of a business mushrooms and eventually so will the stock price.
Microsoft still generates returns on equity of over 40 percent, yet the stock price sits still. Microsoft is so huge and has so much cash, that it is now only able to generate those returns only the capital needed to run he business. It can no longer take the excess capital and redeploy it at such a high rate of return. This is why it paid that huge dividend a few years back. It made more sense payout some of that excess capital to shareholders than to reinvest back in the business.
Concentrate Your Bets
Anytime you locate a company that offers the talent and ability to redeploy its existing and excess capital at above market rates of return for any sustainable period of time, odds are the stock price will follow suit. An ability to earn excess returns on equity signals that the company offers certain competitive advantages not easily reproduced by its competitors.
In the 1980's Warren Buffett bet over 20 percent of Berkshire’s book value on the Coca Cola Company. Buffett noticed, among other things, that Coke was earning excellent returns on its equity and deploy the excess capital into other infant markets. Berkshire Hathaway itself is a huge capital deployment vehicle. It takes the float from its insurance company and any excess cash from its operating subsidiaries and invests the excess capital very successfully. Berkshire has risen an amazing 7,000-fold since Buffett took control of the company in 1965.
Profits and earnings growth are vital. But what businesses are able to d0 to with those profits sets apart great businesses from good ones.
In 1978, Warren Buffett wrote an article for Fortune Magazine titled "How Inflation Swindles the Equity Investor" In it he noted that there are only five ways to improve return on equity:
1. Higher turnover, i.e. sales
2. Cheaper Leverage
3. More leverage
4. Lower taxes
5. Wider margins on sales
Companies have the least control over tax levels, although management can certainly use creative accounting to temporarily alter the tax rate. An investor is better suited to focus on the others, as the ability to spot improved sales, prudent use of leverage, or cost cutting initiatives can lead one to excellent businesses.
All else equal, sales increase should create an increase in profits. Of course the quality of sales should be carefully examined. As sales increase, accounts receivable level should naturally follow suit. However, if receivables are demonstrating a trend of growing much faster than sales future troubles may lie ahead when it’s time to collect. Additionally, inventory management is important. The application of LIFO or FIFO will affect the profit statement differently during inflationary or deflationary periods.
When used prudently and wisely the use of leverage can increase returns on equity. Similarly, if a business can lower its cost of debt, the corresponding effect is a higher return on equity. Today we are seeing exactly how the mismanagement of leverage has affected those businesses participating in the credit markets. The painful lesson is similar to buying stocks on margin. If you are levered five to one, a ten percent return on the levered portfolio equals a return on equity of 50 percent. The same corresponding loss occurs with negative returns. Unfortunately, most businesses (1) fail to use leverage appropriately and opportunistically; and (2) employ leverage at alarming multiples to equity. The results, as we can clearly see, have been disastrous.
Wider margins are created in one of two ways: increasing prices or decreasing costs. Very few companies can raise prices at will without incurring competition or meaningful declines in volume. Again, this is why Buffett bet so big on Coke. For decades Coke has been steadily increasing the price of its famous syrup with no meaningful loss in market share as a result. As Buffett once quipped, "Who's going to risk saving a nickel over a product they put in their mouth?" Wrigley's chewing gum offers a similar example.
Profits count, but it's what you can do with those profits over time that really matters.
Monday, December 3, 2007
Berkshire bought into two issues by TXU. It purchased $1.1 billion of 10.25% bonds at 95 cents on the dollar to give Buffett an effective yield of 11.2%. And Berkshire bought $1 billion of 10.5% PIK-toggle bonds (bonds whose interest can be paid out in cash or more bonds) for 93 cents on the dollar, producing an effective yield of 11.8%.
See the full article here:
Friday, November 16, 2007
The link to the entire paper is below the abstract.
We analyze the performance of Berkshire Hathaway's equity portfolio and explore potential explanations for its superior performance. Contrary to popular belief we show Berkshire's investment style is best characterized as a large-cap growth. We examine whether Berkshire's investment performance is due to luck and find that beating the market in 28 out of 31 years places it in the 99.99 percentile; however, incorporating the magnitude by which Berkshire beats the market makes the “luck” explanation unlikely even after taking into account ex-post selection bias. After adjusting for risk we find that Berkshire's performance cannot be explained by assuming high risk. From 1976 to 2006 Berkshire's stock portfolio beats the S&P 500 Index by 14.65%, the value-weighted index of all stocks by 10.91%, and the Fama and French characteristic portfolio by 8.56% per year. The market also appears to under-react to the news of a Berkshire stock investment since a hypothetical portfolio that mimics Berkshire's investments created the month after they are publicly disclosed earns positive abnormal returns of 14.26% per year. Overall, the Berkshire Hathaway triumvirates of Warren Buffett, Charles Munger, and Lou Simpson posses' investment skill consistent with a number of recent papers that argue investment skill is more prevalent than earlier papers suggest.
Sunday, November 4, 2007
Consider that from 1983 until 1999, the average annual return on the S&P 500 was 15.7%, assuming the reinvestment of dividends. A similar return like this for the Dow Jones beginning in 2008 would mean that the Dow would be trading over 139,000 in 2024!
It is in this context that I found Active Value Investing: Making Money in Range Bound Markets by author and portfolio manager Vitaliy Katsenelson an interesting and insightful read on understanding the long mood swings of Mr. Market. One should not assume that the word "Active" in the title to suggest market timing - this is the last thing Vitaliy is concerned with. In fact he readily admits that trying to time the market is a fools game. Instead his focus on using fundamental valuation techniques - discounted cash flow analysis, price to earnings models, and margin of safety - to take advantage of range bound markets.
Any serious participant in the stock markets is well aware that markets trade in in ranges some periods longer than others. During the 16 year period beginning 1966 and ending in 1982, an investment in the Dow Jones index in 1966 would have been worth about the same sixteen years later. Hovering around 1000, the Dow remained around 1000 in 1982. Whatever dividends you earned were wiped out by inflation during that time. A simple buy and hold approach during that time would have produced an annual rate of return of zero percent. Yet during that sixteen year period occurred one of the most opportunistic buying opportunities in the U.S. Beginning in 1974, as Buffett so famously quipped, "I was selling at 3 times earnings to buy stocks at two times earnings."
Active Value Investing discusses how the prudent use of fundamental analysis allows to take advantage of such opportunistic times in the market. Focusing on the only three variables that really matter in a business - value, quality, and growth - investors can learn how intelligently exploit Mr. Market's mood swings. Unlike most great investing books that are focused on the buying process, Active Value Investing takes a very close examination of the selling process, something I find to be the most misunderstood area of investing. Make no mistake, if you can't buy at the right time, knowing when to sell won't mean much. Not only does Vitaliy walk you through his framework of knowing when to buy stocks, but he also takes a deep look at selling stocks, a topic not given enough discussion among value investors. Active Value Investing looks to change all of that.
We all realize that the markets are never a smooth ride and that market timing is mere folly. The key to taking advantage of the market's swings - buying on the stalls and selling on the surges - is to focus on valuation of individual securities. Indeed it is the price in which you buy that ultimately determines your return when you sell. Understanding what to look for in businesses and how to value them is an absolute must if you hope on succeeding in the markets for a meaningful period of time. Active Value Investing helps steer you in the right direction.
Friday, October 26, 2007
Security Analysis was published over 70 years ago. To this day, the teachings of Ben Graham and David Dodd hold truer than ever. Graham used to love buying his famous “net-net” stocks, companies that were selling for less than the value of their current assets minus all liabilities. As more entrants came into the markets, these types of opportunities all but vanished. Nonetheless, the enterprising investor applying some serious effort can still uncover some gravely mis-priced securities.
Graham and Dodd’s core concept was to apply analytical effort in examining securities and purchase those selling below their intrinsic worth. The behavior of market participants over the long-term is quite predictable and if you follow the above advice from Buffett, you will do better than most investors. Buffett holds one of the best long term investment records ever, compounding money at over 20% for 40 years. Buffett made his money by exploiting market opportunities where there is a high degree of fear or pessimism.
Welcome Bear Markets
Bear present the most common market environment in which to locate temporarily mis-priced securities. In 1974, after a bull market spanning nearly two decades, the markets fell hard. Overcome by fear most people missed out on one of the century’s best buying opportunities. It was around this time that Buffett began scooping up shares in the Washington Post and Buffett's $10 million investment back then is worth over a billion today. Again in 2003, securities again were cheap, but everyone was afraid even though gap between value and price was wider than it had been in a decade. Investors who are overcome by emotion always disregard market fundamentals leading to the purchase of securities when one should be selling and vice versa.
The year 1987 presents a classic example of the folly demonstrated by most market participants. The year began with surge in share prices for about eight months and was followed by the crash in the October. Bill Ruane and Richard Cuniff of the hugely successful Sequoia Fund remarked,
”Disregarding for the moment whether the prevailing level of stock prices on January 1, 1987 was logical, we are certain that the value of American industry in the aggregate had not increased by 44% as of August 25. Similarly, it is highly unlikely that the value of American industry declined by 23% on a single day, October 19.”
October 20, 1987 would later represent one the best buying opportunities for stock investors.
Investing is "simple but not easy." The idea is simple: simply buy when Mr. Market is acting irrational, but not easy in that most people do the opposite of what they are supposed to be doing: buying on the way up and selling on the way down.
Tuesday, October 9, 2007
The meeting began with Pabrai going over the past performance:
1. Since the 1999, the annualized return has been over 29% after fees.
According to data from Lipper, this performance ranks the Pabrai Investment Funds number 3 out of some 4,000 mutual funds during this eight year stretch.
The mutual fund comparison is appropriate because although Funds are legally structured as limited partnerships, consider that:
1. The Funds only take long positions in publicly traded securities - no shorting
2. No leverage (although in the past, a little margin was used during times of plenty at cheap prices)
Sitting Still Can Be Profitable
Buffett used to compare his investing to a baseball player at bat. Unlike baseball, in investing, you have no called strikes. You can wait and wait until the fat pitch comes to hit one out of the park.
Most market participants mistakenly assume that they will be penalized if they don't pull trigger and buy something (who wants to be sitting still when the Dow is up 400 points in a day?).
Let me now give you Sham's Theory on Investing (quite basic as I don't do well with complex situations):
There is no way that you will lose any money if you just sit still and do nothing. Wait for Mr. Market to serve you instead of guide you.
The above statement presents two takeaways:
1. The "price is what you pay/value is what get" concept. As Ben Graham alluded, every stock is a good investment at one price. One has to be patient and disciplined not to overpay. A good company (Google) is not necessarily a good investment ($500+ per share, over 40x P/E, etc.).
2. Be willing to watch your investment decline by 50% and sit still....or buy more. Buffett once remarked that you should be able to see your investment decline by half and have the conviction to buy more if your analysis and reasoning are right. (Remember that I am implying that nothing has occurred to change the intrinsic value - and that you would have caught such a deterioration way before such a drop).
Indeed the Pabrai Funds experienced such a situation and Mohnish discussed the issue at length:
Several years ago, Pabrai experienced a multi month time period during which the net asset values of his fund were down by more than 30%. Stocks he had bought were down by 40, 50 or more percent. According to Mohnish, this was not a hypothetical situation. There were some investors who literally entered his Fund right before the decline and they received statements indicating that their investments were down by over 30%.
There was no specific reason for the decline. The businesses were still intact. There was no direct correlation in the fund's holdings. There was no particular sector or industry weighting on the portfolio. Each company operated in a different industry, with a different set of economic considerations. What had happened was that the Dow Jones average had dropped from around 10,000 to 7,000.
Sometime during this situation, many investors would have gotten out at a decline of 10-15% giving no second thought to the fundamental soundness of the individual businesses.
Once the paper loss is realized, the investor is focused on recouping the loss quickly, an process that often ultimately leads to a less prudent investment approach.
Pabrai discussed the individual investments during that time, his cost, where they stood during the market decline, and ultimately where they stood when he exited.
In the end, the stocks recovered, some doubling and tripling the investment return.
As Mohnish responded to one question about his day to day activities:
"I consider myself a gentleman of leisure. I go into the office with no set goal of buying or selling. I just wait for something to grab my attention."
And that's all that needs to be said. The results speak for themselves.
The rest of the meeting Mohnish spent answering questions and as usual, there was no discussion on any current or potential investments.
Thursday, September 13, 2007
Where: Chelmsford Public Library, Chlemsford, Massachusetts
When: December 13, 2007 at 7 pm
I've never been to Chelmsford, Massachusetts, but I've been told it's a short drive from Boston.
This is a free event open to the public.
I imagine my time will be about one hour. I am of the impression that one of the most valuable ways to give a talk is if I do very little talking and let the attendees ask questions. That way, they get the most out of their time.
My plan is to spend about 15-20 minutes discussing six attributes/characteristics/qualities that seem to be common threads amongst the most successful money managers - Buffett, Miller, Pabrai.
I will follow with a brief case study of a past investment that provides a good example to the business-like approach to investing.
Then I will answer questions for the remainder of time.
Feel free to stop by if you are in the area at the time!
Thursday, August 30, 2007
Bear markets on the other hand, expose the intelligent investor from the fly by night speculator. My approach and the ultimate purpose of value investing is outperforming bear markets.
In his 1961 letter to partners, a thirty-one year old investor in Omaha named Warren Buffett told his partners that they should be judging him during times of turmoil and not times of jubilance.
Buffett told his partners
“I would consider a year in which we declined 15% and the [Dow Jones Industrial] Average 30%, to be much superior to a year when both we and the Average advanced 20%.”
Very early on in his career, Buffett was aware that performing well during market turmoil was the key to long-term success as an investor. During the 13 years that Buffett ran his partnership from 1956 to 1969, not only did he destroy the Dow Jones Average during both bull and bear markets, Buffett never had a down year. So while other investors have come along and produced records that better Buffett’s, its Buffett’s preservation of capital that has allowed him to compound money at such a staggering rate.
A simple illustration makes my point.
Consider two investors starting at the same point in time with the same initial capital. Over a two year period (assumed for simplicity) the investing climate is exposed to both a bear and bull market year. In year one, investor A suffers a 30% loss and investor B suffers a 10%. In year two, investor A enjoys a 50% and investor B enjoys a 30% return. After two years, investor A’s total capital has appreciated 5% and B has about a 17% overall return. Clearly the preservation of capital during the down market enables the enterprising investor to outperform over a satisfactory period of time.
There is a story that says when he was a 21 year old student at Columbia, Warren Buffett was in a classroom one day when he told his classmates to shut door so he could tell them how to get rich investing in the stock market. When he had their attention Buffett remarked,
“The key is to be greedy when others are fearful and fearful when others are greedy.”
If you think about it, what Buffett said is one of the most valuable pieces of advice in investing. The most difficult part is really putting it to use.
Back in the 1960’s Buffett bet big on American Express during the company’s involvement in the salad oil scandal. While everyone was running for the exits with fear, Buffett was being greedy and put 30% of his partnerships assets into that one stock. Similarly in 1971, Buffett began buying the Washington Post during a time when everyone fell out of love with media stocks. As the Post continued to decline, Buffett continued buy, investing close to $11 million. That stake is worth over $1 billion today.
The current market environment is shaping up to be rife with excellent companies at very attractive valuations. As always, the first goal is approach any potential investment very carefully in order to avoid mistaking a value trap for a bargain. But during these times of turmoil, making significant investments during times of maximum pessimism is one way value investors beat the crowd.
And here at Gad Capital, it is what I do each and every day for my partners - patiently waiting for Mr. Market to serve up wonderful businesses at significant discounts to intrinsic value.
Sunday, August 12, 2007
"You are neither right or wrong because the crowd disagrees with you. You are right because your data and reasoning are right." - Ben Graham
Thus, in studying the greatest (Buffett, Schloss, Miller, Pabrai), I see six fundamental characteristics that they methodically practice.
Each and every day, I put these six principles to work for the Gad Partners Fund.
1. A Sound Investment Philosophy (Ben Graham, Value Investing)
2. A Good Search Strategy
3. Ability to value a business and assess the quality of management.
4. The discipline to say no.
6. Courage to make a significant investment at the maximum point of pessimism.
Sunday, July 29, 2007
These words were officially brought to light in The Intelligent Investor by Ben Graham. And when you mention them to most money managers, they nod in approval and understanding. Yet, statistical performance results tell you another story. When 8 out of 10 mutual funds fail to be the benchmark, it means fund managers are simply over paying for businesses.
Only three types of investments exist -
1. under priced,
2. fairly priced, and
Value investors, by nature, engage in only three activities:
1. Buy the under priced assets
2. Hold or sell the fairly priced assets.
3. Avoid the over priced assets.
Yet finding under priced assets is not easy nor should it be. Further, an asset's intrinsic value is not an exact number but instead a value determined by several analytical inputs based on data and reasoning. Having a satisfactory margin of safety protects the intelligent investor from engaging in folly that results in a permanent loss of capital.
Ben Graham succinctly put it when he said,
"An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."
Whether or not money managers realize it, most "investments" are more often just mere speculative activities hinging upon the actions of management and the future results of the business. Of course in a bull market, speculation is mistaken for investing. Bull markets tend to disguise everyone as an investing genius. But we all know that a value investor is more focused on making it through bear market storms relatively unscathed.
Buffett said it best in his letter to his limited partners in 1961:
"I would consider a year in which we decline 15% and the [Dow Jones] average 30% to be much superior to a year when both we and the average advanced 20%."
Most investors don't fully grasp this investing approach, and the result is inferior long-term performance relative to the benchmarks. Value investors always demand a margin of safety. And a margin of safety can come in various forms, but its sole purpose is to diminish the probability of a permanent loss of capital. Most important, the margin of safety insulates the enterprising investor from the inevitable surprises that Mr. Market may have up his sleeve.
Finally, remember that the intrinsic value of a business changes over time, and therefore, so will the margin of safety. A 50% margin of safety one year may erode or widen the following year. If your assessment of intrinsic value changes, then so must your investment decision - to either buy more of a now more under priced assets with a greater margin of safety, or dispose of a 50 cent dollar that has now become a 90 cent dollar. Either way, all roads lead to one path in which you come out with minimal loss of capital.
Price is what you pay, value is what you get.
For more on margin of safety, check out my write up on at the Motley Fool:
Tuesday, July 24, 2007
1. "A few ideas, to be taken with a grain (or many grains) of salt: while it's good to talk about the articles you've written, I think most people don't like getting a detailed rundown of all of them. Perhaps writing a blog post that further expands on an article is better, that way you indirectly (thus subtle) point us blog readers in their direction...Also, perhaps posting more often? Sometimes you have really good, inspired posts. It'll probably be a challenge for you to post everyday, but even being consistent with posts every other day would help. Hey just some constructive ideas..."
These are indeed some very constructive ideas. I am sure that it would have been more informative to expand on the articles that are being written for the Fool, so I will keep this in mind. My ultimate goal was to really provide an "archive" link if you will, of my various other writings. I want this blog to be a central source for any other thoughts and ideas that I may cover outside of the blog.
The lack of consistency in the postings is something I have been aware of and I am glad someone mentioned it (hence why I took the easy way out and just gave you links to other articles). Beginning next month, my priority will naturally shift to running the Gad Partners Fund via Gad Capital Management. The blog will remain active, but it will certainly have to take a back seat. Nonetheless I will provide some new content as best I can.
I had one comment asking whether or not I would post the partnership letters on the blog. Unfortunately, because of the "hedge fund" like similarities of the partnership with respect to its legal formation, I can not advertise the partnership like a mutual fund. While posting the letters might not be considered "advertising," I feel better playing in the center of the court rather than around the edges.
2. "Congrats on getting GCM off the ground. Do you still plan on writing for fool.com and the blog once you’ve started GCM? Thanks for the blog it has helped lead me in the right direction for my investing education."
I don't deserve this compliment. There are plenty of wonderful value investors out there that have allowed me to make this blog a possibility. I am glad I can be of some help.
With regards to my future writing commitments, let me post my response to this comment:
"Yes, I still plan to continue writing for the blog, the Motley Fool, etc. I feel that the written word is very helpful to an investor. Putting my reasoning on paper is a great mental exercise for me. For example, last week I was wanting to understand the fine points of the securitization process.
As I begin to mentally gather ideas, it occurred to me that it would be very helpful to me to write down the process. The end result was an article. I wish I could say that I would contribute on a regular basis, but with the start of the partnership, the rate of postings will be a little slower, at least initially."
Thursday, July 19, 2007
Over the past year, I have been extremely lucky to have personally met some of the best investors on the planet.
First in January of this year, I met Warren Buffett. After my mother and father, Buffett is without question the greatest influence and inspiration in my life. Without Buffett's teachings and writings, I can guarantee that I would not be the person I am today. Aside from being the greatest investor in the history of mankind, Buffett's leads a life that sets an example for all to follow. When I asked Buffett about what the most important advice he had for me, he quickly remarked, "Do what you love and make sure your kids love you." The two day visit I had with Mr. Buffett is an opportunity I will always be grateful to him for.
Secondly, this past spring, I visited with Mohnish Pabrai. I first met Mohnish last November at the Value Investing Congress in NYC. On the last day of the event, Mohnish sat next to me during breakfast. Since then, I am very proud to call Mohnish a friend. Already, Mohnish's investment record is legendary and he has decades to go. One day the world will be very grateful that Mohnish is doing what he is doing. I am grateful to call him a friend.
Thirdly, I had an opportunity to visit and spend time with Mason Hawkins. Mason Hawkins is quite simply the most underrated money manager in the business. The accomplishments he has achieved operating under the regulatory framework of the mutual fund industry is impossible to accomplish unless you're Mason Hawkins. True to his form, Mason does what he does because he loves it. As far as I'm concerned, any investor in the Longleaf Funds should name their first born child Mason. As a steward of capital, Mason Hawkins sets the standard all should follow.
In less than six months, I had the honor to spend time with three phenomenal human beings and individuals that I look up to not only for thier impeccable investing ability, but also for the example they set each day. All three were gracious with their knowledge about the world and business and most importantly, thier time. Time to give to someone like me and everyone else who's just as passionate about investing.
Some of you may be wondering why the postings on this blog have been more and more infrequent. Gad Capital Management will begin operations in about a month. GCM will be running the Gad Partners Fund, a value-centric investment partnership deeply rooted in the teachings of Graham, Buffett, Hawkins, and Pabrai. Some really terrific individuals and families have decided to join the partnership. I am very lucky to call them partners.
Monday, July 16, 2007
"The Intelligent Investor's Investment"
Buffett and Pabrai Break Bread
Investing Lessons From Benjamin Graham
Long-Term Riches on Tap
The Skinny on Sub-Prime
Tuesday, July 3, 2007
Lest you think that this was a ridiculous sum of money to fork over for lunch with anyone, I would like to invite you to read my following article at the Motley Fool:
By looking at this lunch from several angles, you begin to realize that this lunch bid was a typical Pabrain value play.
This morning, CNBC interviewed Mohnish about his winning bid. (Thanks to Lincoln Minor for graciously sharing valuable information on all things value investing)
Thursday, June 21, 2007
Thanks to Lincoln Minor for sharing these wonderful video clips:
Part 1 http://wpi.clipsyndicate.com/publish/index/339725
Part 2 http://wpi.clipsyndicate.com/publish/index/339737
Tuesday, June 5, 2007
1. What do people really mean when they say that they are value investing?
2. What makes a value investor?
Let's be clear from the start. Ben Graham was an investor. Warren Buffett is an investor. Mason Hawkins is an investor. The term value investing was given to their style simply to define what they do best: finding valuable--companies worth more than their current market price--investments.
In my opinion, the best definition of an investment was given by Ben Graham in Security Analysis:
“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”
So there it is. A simple, yet elegant definition of what investing ought to be. If you want to call it value investing, be prepared to explain what that really means. When Charlie Munger remarked "all intelligent investing is value investing," he knew exactly what he was saying. If you say you are a value investor, then without exception, you should be applying the three qualifications that Ben Graham laid down over seventy years ago. Each investment should be made only after a detailed assessment of the facts, a compelling valuation that provides a margin of safety, and a return that is better than other viable options adjusted for risk. I would be willing to wager that at least 75% of so called value investors don't come close to passing the test. You can forget about the majority of mutual funds with the name "Value" in them, as they define their investment operation as low P/E, low P/B stock picking.
Charlie Munger said it best when he remarked:
"Our investment style has been given a name - focus investing - which implies ten holdings, not one hundred or four hundred. The idea that it is hard to find good investments, so concentrate in a few, seems to me to be an obvious idea. But 98% of the investment world does not think this way. It's been good for us."
The key to remember is that a value investor does not exist in bull markets. Just about any approach during bull markets will make you money. As Seth Klarman aptly put it "Bull markets have of way making everyone look like a genius." A true value investing based approach is designed for bear markets. A value investor's approach is one that can weather the storm during the bear markets and come out with a minimal loss of capital. A successful investing record should be measured in bear markets alone. Earning 90% in a year when the overall market is up 25% tells me zilch about your abilities as an investor. Just look at how many Internet funds were up over 100% per year during their heyday. Losing 10% when the market has tanked 25% on the other hand shows me that an intelligent and disciplined approach was used in making investment decisions.
As Warren Buffet said "Investing is simple, but not easy." There are only three types of stocks: undervalued, overvalued, and fairly valued. What determines the category is simply the price you pay. The worst business in the world can still be undervalued at the right price. So based on the price you pay, the business will either be overvalued, fairly valued, or undervalued. One simply must sell the first, ignore the second, and buy the third without any deviation in approach. This is intelligent investing.
Tuesday, May 22, 2007
I also very strongly recommned watching the interview with Kevin Clayton of Clayton Homes.
Enjoy them at:
Tuesday, May 15, 2007
Because Mason Hawkins runs a mutual fund, I sometimes think that he is not given the ultimate credit that ought to be afforded to someone with his achievements. In retrospect, I think the record at Longleaf is all the more spectacular given the operating regulations beholden to mutual fund managers. Mason opened the meeting by citing six principles than any true investor must have in order to succeed in the long-term:
1. You need a sound philosophy
2. Good Search Strategy
3. Ability to value businesses and assess management quality
4. Discipline to say no.
6. Courage to make a significant investment at the point of maximum pessimism
It is easy to see that not many people can truly admit that they adhere to these principles. Admittedly when I first started investing my money at 21, I can easily say that I was still in the early stages of developing a sound discplined approach. Having said that, I know now, seven years later, that because of my somewhat "early" start, and my steadfast belief in the principles set forth in The Intelligent Investor, I am very aware of the attributes needed to ensure a successful long-term investment operation. Understand however, that it's the true application over time that shapes the development of these principles. Charlie Munger remarked at the 2007 Berkshire Annual Meeting that "Warren has gotten better over the years." One needs to really think about Munger's statement. Berkshire shareholders have been fablously rewarded because that they have had the good fortune to have the same guy at the helm who has gotten better over time. The point is that over time the investment philosophy will become more sound, your search strategy will improve, the ability to value a business will expand, and your experience should keep you disciplined. If you are not patient, then odds are that you will not do well over time.
If you are among the minority that can truly say they mentally grasp the first five principles, and your reasoning and data are right, back up the truck and make a substaintail investment. Forget all the EMT non-sense about diversification. A well-chosen, carefully selected portfolio of 7-10 securities is all you need to have a market beating portfolio. You have to be able to eliminate all the noise and accept the fact that most superior investments will be made at the exact time all the "smart" people want nothing to do with it. In the 1960's Buffett put over 30% of his partnership's assets into American Express amidst a scandal. In 2006, Mohnish Pabrai loaded up on Pinnacle Airlines when everyone thought the airline industry was the worst investment ever.
The key to all of this can be summed up in one word: rationality.
Success in investing has nothing to do with your IQ level and everything to do with your ability to be rational in your thinking and being able to eliminate all the excess noise. A good investment can usually be explained by three or four fundamental reasons as to why it is underpriced relative to intrinsic value. To draw an analogy, consider the great chess masters Kasprov, Spasky, etc. Chess masters have developed very specific patterns on how to approach a match. While certain adjustments may need to be made, the overall pattern remains the same each time. The same approach and discipline is required in investing. Mohnish Pabrai told me once "that I can eliminate most companies in 10 minutes or less." Why? Because he has his pattern and knows what to look for in a business in order to pursue it further. At Longleaf, and with any sound investment operation, the approach should be both qualitative and quantitative. The key is buy cheap, not what is down in price. On the quantitative side, a margin of safety requirement demands one to look for businesses that are trading at significant discounts to intrinsic values - at Longleaf, they want at least 60%. There also must be qualitative elements as well in the business like shareholder oriented management, a competitive advantage and so forth or otherwise you really don't have a intelligent investment. Mason Hawkins read The Intelligent Investor as a senior in high school. At the meeting he told the partners that the most fundamental concepts to investing are summed up in two Chapters: 8 and 20--Invest with a margin of safety and look at every investment as part ownership in a business.
Asked about private equity and all the froth in the industry, Mason replied,
"Capitalism has a way of turning a good idea at a low price into a bad idea at a high price. It makes sense to buy at 6x operating cash flow, but at 14x operating cash flow it is very problematic and harmful to do so using massive leverage."
I would like to share another quote of Mason's that he shared to business students a few months ago that I feel sums up the whole idea,
"If you are not willing to look stupid in the short run, you are not likely to be a successful investor in the long-run."
Afterwards, I had the great fortune to have dinner with Mason and the wonderful people at Longleaf after the meeting. I met some really wonderful people, both successful in business and their personal lives. I found this combination to be the rule and not the exception at Longleaf as this is the culture that Mason has created. As impressive as Mason has been managing money, he is even more so with his efforts in his community and hometown. You wouldn't know this because like all great individuals, Mason refuses to take any personal credit for his philanthropy and prefers anonymity
Tuesday, May 8, 2007
I will add this: it is clear that Buffett is looking beyond North America more and more. He made some very subtle, yet valuable comments alluding as much. According to Buffett, Berkshire has two stakes in German companies. Buffett also indicated that Berkshire is involved in a currency transaction that he will get into next year. "You won't believe it" says Buffett.
It's important to realize a couple of things about Berkshire and its forays into foreign investments. First, Buffett hates it when his buying becomes public knowledge. In Germany, for example, laws dictate that upon a 3% accumulation of shares, one must make a public filing. Thus if Berkshire finds an attractive $30 billion company, after accumulating $900 million worth, the word gets out and Berkshire is unable to quietly continue adding to the position at its preferred price. This just one example, but it serves to illustrate that Buffett's "minimal" participation in the global markets doesn't necessarily equate to not having attractive valuations overseas. Buffett has said time and time again, Berkshire's size is such that its performance CAN NOT come close to what is was in the past. Berkshire's need to find investments that can move the needle simply preclude a lot of attractive opportunities domestic and foreign.
Buffett is looking very closely at South Africa and has been presented with some very attractive businesses.
Thursday, May 3, 2007
I will be at the Yellow BRKers gathering on Friday at the Double Tree Hotel.
Find out more about at www.YellowBRKers.com
Please introduce yourself if you are there as I am looking forward to meeting everyone who has visited this site.
Thursday, April 26, 2007
In 1999 Mohnish set up shop with $1 million. Today he manages $500 million and has an annualized rate of return of 29.1%. And just to be sure, this is after he takes his cut (as Mohnish eloquently says, "after my outrageous fees".)
I enjoyed the opportunity to hear Mohnish speak to a group of business school students at USC, chat with him privately, and have dinner with him. Most of what Mohnish had to say he gives to you in his newest book, The Dhandho! Investor, a must read for any true investor.
Nonetheless, it pays to listen very carefully to Mohnish as one will take home some pearls of wisdom.
On becoming a successful investor,
"All the great investors have given you their methods. Read everything Buffett has to say...he tells you how to succeed in investing. Joel Greenblatt, wrote the The Little Book that Beats the Market for his young daughters. In the book he tells you how beat the market. His website, http://www.magicformulainvesting.com/ screens for the best stocks. Find the best ones and you will beat the market. Patience is the key"
With regards to his investments,
"When I buy a stock, two things ALWAYS happen: immediately after I buy, the stock tanks and once I sell the stock, it really takes off"
If you're asking yourself how this is possible alongside with 29.1%, pay attention to this,
"When I invest in a business I have a very good idea about the intrinsic value of the business. I never have an exact figure, but I know the business well enough to arrive at a very comfortable range with a high degree of probability. If in invest in a business, I now wait three years before I sell if the price has gone down as long the present intrinsic value has not deteriorated.
This routine comes from Mohnish's investment in USAP, which I won't go into great detail here. Basicailly, he bought the stock, after which it proceeded to go down by two thirds. After a reassessment of the underlying economics of the business, Mohnish concluded that the intrinsic value has actually gone up. This continued to be the case over the next two years and the stock remained dormant. Sure enough, the market caught on and USAP climbed to a point where Mohnish had more than a 100% unrealized gain. Now, the security is up over 200% from his investment point and Mohnish has since exited with only a very minor position.
The takeaways you should have from this are simply:
1. Understand your investment well and make sure you have a thesis that clearly explains your reasoning for investment. This should be no more than 3-4 lines.
2. Approximately 80% of a stocks price movement occurs during 10% of time. Timing the market is a fools game. Exercise patience.
Dinner with Mohnish, was very entertaining to say the least. He's full of humor and witty wisdom...much like a guy in Omaha.
Mohnish was kind enough to keep a copy of my Letter to Potential Limited Partners regarding the formation of the Gad Investment Partnership. I only asked him to take look and he was very kind enough to do so. As we all know Mohnish eats his own cooking and invests all his money in the Pabrai Investment Funds. Nonetheless he was impressed with what he saw and I hope to someday catch up with his phenomenal pace.
On that note, I am happy to report that the formation of the Gad Investment Partnership is moving right along. I appreciate everyone's interest. I have been studying business, and specificially the workings of Graham and Buffett since I was 15. My setup will be very much like the original Buffett Partnerships of the 1950's and the Pabrai Fund in 1999.
Accredited investors should contact me directly regarding investment interest.
Tuesday, April 17, 2007
Warren Buffett on June 25, 1999 (Business Week)
By now most of us our familiar with this statement from Warren Buffett or have heard something similar. Well, it was this quote that got everyone so curious about how Buffett would be able to generate such a outstanding performance today.
In order to really understand what Buffett had in mind when making this remark, you need to know this: Buffett is not the same investor in 2007 as he was during the 1950's and 60's.
Let's go back and look at Buffett's early years compared to today.
During the 1950's, Buffett's returns exceeded 50%
His investment strategy was concentrated into three categories:
- undervalued securities, and
- control situations.
Workouts essentially constituted of investments which were dependent on a specific corporate action for their profits rather than a general advance in the price of the stock as in the case of undervalued situations. Work-outs came about through sales, mergers, liquidations, tenders, etc. This is arbitrage in the purest sense. With work-outs the risk is that something will upset the applecart and cause the abandonment of the planned action, not that the economic picture will deteriorate and stocks decline generally.
Control situations involved an investment stake substantial enough in which Buffett was able to take part in corporate decisions. At times these positions could make up to 20-30% of the capital under Buffett's management. An example of such a situation was the purchase of the common stock of the Commonwealth Trust Co. of Union City, New Jersey in 1957. Buffett concluded that the stock, priced at $50 per share, had an intrinsic value of about $125 on a conservative basis. Buffett accumulated 12% of the stock before it reached a price of $65 in which case he neither bought or sold. By the following year, he had negotiated a private transaction and sold the shares for $80, with the current market price quoted at 20% lower than his sale price. The most famous control situation, of course, was Berkshire Hathaway.
The 50's and 60's was a good period for these types of investment situations and Buffett took advantage by committing large portions of his partnerships capital. He was concentrating his portfolio in the best ideas regardless of market environment. While Buffet is indeed an extraordinary stock picker, he was a brilliant businessman, and his track record of the 1950's and 60's lay evidence to that.
With only millions to invest, the opportunities for workouts and control situations were easier to exploit. With tens of billions to invest today, Buffett simply cannot employ the same investment strategy. To be sure, he always sees hidden value in his investments, but you have to remember one important thing: Berkshire is so huge and well diversified that Buffett's investment decisions are now about keeping the company going in line with economy as opposed to beating the pants of the Dow Jones. Over a third of Berkshire is ultimately going to the Bill and Melinda gates foundation, so Buffett needs to really make long-term stable investments and not necessarily workouts situations. One might argue that USG is a workout situation, but the corporate action --emerging from bankruptcy-- has already occurred. USG is simply a fantastic business that is waiting for the next cyclical demand boon in wallboard (an economic event). Berkshire's investments in Posco and most recently, Burlington attest to this.
In end all this means is that Buffett is still the greatest capital allocator in the history of mankind. He has a unique ability to shift gears when the situation calls for it. There a lot of other points I skipped over, like Munger's influence on Buffett's investment philosophy with the purchase of See's candies in the 1970's. My goal here was to simply show evidence that one can not and should not analyze Buffett's investments of today with the same parameters of Buffett's investments during the early years.
Monday, April 9, 2007
Here is the link to the Berkshire disclosure filing:
Consider that Burlington hauls enough low sulfur coal to produce about 11% of the country's electricity needs. If you have any long-term favorable outlook for U.S. energy demand, then Burlington makes perfect sense. We know Buffett does, as years ago he publicly stated that Berkshire can be expected to make "substantial" investments in the electric/utility industry.
Monday, February 26, 2007
Emil Lee: How do you do your due diligence? Do you generally stick to industries you are already familiar with? How in-depth do you get, in terms of studying a company, its industry, and its competitors? Do you talk to a lot of people in the industry?
Mohnish Pabrai: I don't call or meet with management or company insiders. I do rely, from time to time, on the investors in Pabrai Funds. I am blessed to have a large contingent of CEOs and entrepreneurs as investors. Many of these folks know their industry cold. So, if I'm looking at something in real estate, there are [a] few real estate experts in my circle. I read up on the business, try to honestly assess whether it is within my circle of competence, and then send my thesis to the investors with domain knowledge and get their perspective.
Lee: You don't use Excel models. How do you keep track of all the moving parts (i.e. unit costs, discounted cash flow)? Are the economics of your investment ideas so compelling/simplistic that they can be done on the back of an envelope?
Pabrai: Usually two to three variables control most of the outcome. The rest is noise. If you can handicap how those key variables are approximately likely to play out, then you have a basis to do something. Things that are approximate and probabilistic don't lend themselves too well to Excel modeling. For me, if I find myself reaching for Excel, it is a very strong sign to take a pass. The thesis ought to be painfully simple in your head.
Lee: There's a ton of books about value investing, but very few about "special situation" or "event driven" investments -- do you recommend any books/magazines? Do you recommend any other business publications/trade magazines? Also, you mentioned Timothy Rick in Altucher's book -- I couldn't find anything on him (was it supposed to be Timothy Vick?) -- can you point me in the right direction?
Pabrai: Yes, it's Tim Vick. Buffett has spoken and written a lot about special situations. One should read up on the Buffett Partnership letters and Shareholder letters, as well as the annual meeting transcripts printed in OID. Tim talks about it in his book as well. Finova was a recent Buffett Special Situation, as were his adventures with Level 3 (Nasdaq: LVLT) Bonds, Korean stocks, American Express (NYSE: AXP) in the 1960s, etc.
Lee: What do you hope to accomplish with your new book? Is there a message or point you'd like readers to pay particular attention to?
Pabrai: The best way to learn is to teach. Writing the book was tremendously helpful for me to systematize the framework that I had in my head. I enjoyed writing it. I wrote it for the intelligent individual investor. And I wrote it for the great-grandkids that I'll probably never meet. If it improves the investing results of a few humans, I'd consider it a success.
Lee: Do you have any additional advice that would be helpful to people like me, who are trying to learn as much as possible about investing?
Pabrai: Pursue your passion, whatever it is. If you pursue what you love, you're pretty much assured of doing well at it. If investing is your passion, then study the best intently. The best investor is Warren Buffett and he's an open book. I'd suggest spending all one's energies getting to understand Buffett's modus operandi. To the extent that it's consistent with your temperament, adopt it.
Sunday, February 25, 2007
1. "We will treat your investment...as if it were our own."
2. "We will remain significant investors with you..."
Mason Hawkin's Annual Letter to Partners has just come and I wanted to share some highlights. (read the whole thing at http://www.longleafpartners.com/pdfs/06_q4.pdf. It's a wonderful document and truly reflects how managers should communicate with their investors)
Here's Mr. Hawkins take on 2006 and the investing climate in general:
We have no view on what markets will do, but this environment presents a challenge as we enter 2007. There are few available bargains as we look for new opportunities to strengthen the foundation for compounding over the next five years. The domestic “on deck” list of potential investments is relatively small, but we are buying several new international companies.
Spoken like a true creator of long-term value.
Our long term success has emanated from several core principles:
- Buy a business with expected value growth
- Parnter with capable, honorable management
- Pay a signifcant discount for stocks
- Invest with a minimum five year horizon, deferring taxes and minimizing transaction costs
- Charge reasonable fees
What has all of this done for Longleaf under the tutelege of Mason Hawkins? I will let the numbers speak for themselves (results are 10 year annualized returns)
Longleaf Partners Fund - 12.8% vs. 8.4% for S&P 500
Longleaf Small Cap - 14.5% vs. 9.4% for Russell 2000
Longleaf Int'l - 15.5% vs. 8.0% for EAFE
Friday, February 23, 2007
Emil Lee: You've modeled your partnership after the Buffett Partnership -- do you mind providing any detail on how that's going? Are you on track in terms of performance, assets under management, etc.?
Mohnish Pabrai: It has gone far better than I would have forecasted. Mr. Buffett deserves all the credit. I am just a shameless cloner. A $100,000 investment in Pabrai Funds at inception (on July 1, 1999) was worth $659,700 on Dec. 31, 2006. That's seven and a half years. The annualized return is 28.6% -- after my outrageous fees and all expenses. Assets under management are over $400 million -- up from $1 million at inception. On all fronts, Pabrai Funds has done vastly better than my best-case expectations.
Going forward, I expect we'll continue to beat the major indices, but with just a small average annualized outperformance.
Lee: You clearly believe in having a broad latticework of knowledge from different educational disciplines from which to draw upon when judging investment ideas. Can you describe how you spend your day? Do you devote a general percentage of your time to reading "non-investment" material versus 10-Ks, etc.?
Pabrai: My calendar is mostly empty. I try to have no more than one meeting a week. Beyond that, the way the day is spent is quite open. If I'm in the midst of drilling down on a stock, I might spend a few days just focused on reading documents related to that one business. Other times, I'm usually in the midst of some book, and part of the day goes to keeping up with correspondence -- mostly email.
I take a nap nearly every afternoon. There is a separate room with a bed in our offices. And I usually stay up late. So some reading, etc., is at night.
Lee: In Trade Like Warren Buffett, you mention that you let investment ideas come to you by reading a lot, and also monitoring familiar names on the NYSE. Can you describe your process of generating investment ideas -- is it simply just reading a lot? Do you do anything else to actively seek out ideas?
Pabrai: The No. 1 skill that a successful investor needs is patience. You need to let the game come to you. My steady-state modus operandi is to assume that I'm just a gentleman of leisure, and that I'm not in the investment business. If something looks so compelling that it screams out at me, saying "Buy me!!," I then do a drill-down. Otherwise, I'm just reading for reading's sake. So, I scan a few sources and usually can find something scream out at me a few times a year. These sources (in no particular order) are:
1. 52-Week Lows on the NYSE (published daily in The Wall Street Journal and weekly in Barron's)
2. Value Line (look at their various "bottoms lists" weekly)
3. Outstanding Investor Digest (www.oid.com)
4. Value Investor Insight (www.valueinvestorinsight.com)
5. Portfolio Reports (from the folks who put out OID)
6. The Wall Street Journal
7. Financial Times
12. The Sunday New York Times
13. The Value Investors' Club (www.valueinvestorsclub.com)
14. Magic Formula (www.magicformulainvesting.com)
15. Guru Focus (www.gurufocus.com)
Between all of the above, I have historically found at least three to four good ideas every year. Sometimes I make a mistake, and a good idea turns out to be not so good.
Lee: A big part of investing is knowing what to pay attention to and what not to [focus on]. How do you sift through the thousands of investment ideas? Often, bargains are bargains because they're unrecognizable -- how do you spot the needles in the haystack, and how do you avoid the value traps?
Pabrai: I wait to hear the scream. "Buy me!" It needs to be really loud, as I'm a bit hard of hearing.
Lee: Would it be fair to say you are more balance sheet-oriented, versus income/cash flow statement-oriented? If so, how do you get comfortable with the asset values (i.e., Frontline, death care)?
Pabrai: John Burr Williams was the first to define intrinsic value in his The Theory of Investment Value, published in 1938. Per Williams, the intrinsic value of any business is determined by the cash inflows and outflows -- discounted at an appropriate interest rate -- that can be expected to occur during the remaining life of the business. The definition is painfully simple. So, cash can be gotten out of a business in a liquidation or by cash the business generates year after year. It is all a question of what is the likelihood of each. If future cash flows are easy to figure out and are high-probability events, then liquidation value can be set aside. On the other hand, sometimes the only thing that is a high probability of value is liquidation value. Both work. Depends on the situation. But you first need to hear a scream ...
Sunday, January 28, 2007
Monday, January 22, 2007
Unlike most student visits to Omaha, this one was unique in that we had extensive access to Mr. Buffett...nearly seven hours over the course of two days. Most schools consider it a major coup to score 2 hours with him and others spend tens of thousands of dollars for a two hour lunch with Buffett (see eBay for future lunch dates).
The time was priceless...we spoke of the early years with Buffett working for Ben Graham, the formation of the legendary partnership in 1956, his remarkable gift to the Bill and Melinda Gates foundation, and of course, investing.
The notes of this trip will be available on this blog shortly. For now, I will share some highlights of the meeting.
I asked Buffett about the state of the securities markets in the U.S. going forward and how they will compare to the period in which he operated and how he could make 50% or more per year...
Buffett: "It's a structural issue...yes, with a small sum like a million dollars, I could make 50% or more a year. The key is rationality. There are always going to be times when humans act irrational and this is time to make your money. I've made a career of cashing in when people act irrational."
If you consider some of Buffett's most successful investments--American Express, the Washington Post Company, and Gieco--they were all made during the absolute worst times for these companies. Times when nobody wanted anything to do with them.
Buffett then picked up a copy of the 2004 Citigroup Investment Guide to Korean stocks and began flipping through the pages,
Buffett: "A couple of years ago I got this investment guide on Korean stocks. I began looking through. It felt like it was 1974 all over again. Look here at this company...Dehan, I don't know how you pronounce it, Flour Company. It earned 12,879 won previously. It currently had a book value of 200,000 won and was earning 18,000 won. It had traded as high as 43,000 and as low as 35,000 won. At the time, the current price was 40,000 or 2 times earnings. In 4 hours I had found 2o companies like this."
What Buffett said next is critical,
Referring to having found 2o or so companies like Dehan Flour Buffett remarks,
"When you invest like this, you will make money. Sure 1 or 2 companies may turn out to be poor choices, but the others will more than make up for any losses."
It's critical to understand the mental model Buffett has going into these investments in Korea. A portfolio of carefully selected stocks in understandable businesses trading at very attractive valuations generate abnormal returns. While I don't have Buffett's personal investment record, I am certain he was making 40-50% returns in Korea simply by choosing a portfolio of stocks with strong earnings records trading at very low multiples to earnings. Ironically, this model is not new...it was actually revealed by efficient market advocates Fama and French in there three-factor model. Over time, low P/E, low book, small companies tend to outperform. Apply a little more intensity, as Buffett is famous for doing, and you can make lots of money.
One of Buffett's most successful international investments was PetroChina, China's largest oil producer.
Buffett: "The whole company was selling for $35 billion. It was selling for one-fourth of the price of Exxon, but was making profits equal to 80% of Exxon. I was reading the annual report one day and in it I saw a message from the Chairman saying that the company would pay out 45% of its profits as dividends. This was much more than any company like this, and I liked the reserves."
The Chinese government owns 90% of PetroChina, so only 10% was available to outside investors. Even with this lopsided ownership, Buffett liked the company enough to buy 13% (actually 1.3% of 10%, but Buffett likes to joke that the company is owned by him and the Chinese gov't)
"I was considering buying this company, but I was also looking at Yukos in Russia. This was cheap, too. I decided I’d rather be in China than Russia. I liked the investment climate better in China. In July, the owner of Yukos, Mikhail Khodorkovsky (at that time, the richest man in Russia) had breakfast with me and was asking for my consultation if they should expand into New York and if this was too onerous considering the SEC regs. Four months later, Khodorkovsky was in prison. Putin put him in. He took on Putin and lost. His decision on geopolitical thinking was wrong and now the company is finished. Petro China was the superior investment choice. 45% was a crazy amount of dividends to offer but China kept its word. I am never quite as happy as I am in the US, because the laws are more uncertain elsewhere, but the point is to buy things cheap."
Once again, "the point is to buy things cheap." Because the company is not in the U.S., Buffett applies more filters before committing capital.
"So we own 1.3% of this company and it cost us around $400 million. Now it's worth $3 billion."
Look closer and you can see the real value in this investment...the dividend payout. When Buffett made his investment, PetroChina was paying a dividend of close to 9-10% (I know because I bought some shares the minute I heard of Buffett's stake and about 5 minutes of my own research.) At the time the stock price was about $30 per ADR, but Buffett purchased H shares directly in China at a lower price. The stock currently trades at about $125 per ADR and yields 5%...you do the math...about $6 per share on a $30 cost basis or even lower...margin of safety?
Buffett also had a copy of the 1951 Moody's Banking and Insurance Manual.
"There were four Moody's manuals at the time. I went through them all, page by page, over 10,000 pages. On page 1433, I found Western Insurance Securities. Its earnings per share were as follows: 1949 - $21.66, 1950 - $29.09. In 1951, the low-high share price was $3 - $13. Ten pages later, on page 1443, I found National American Fire Insurance (“This book really got hot towards the end!”) NAFI was controlled by an Omaha guy, one of the richest men in the country, who owned many of the best run insurance companies in the country. He stashed the crown jewels of his insurance holdings in NAFI. In 1950, it earned $29.02. The share price was $27. Book value was $135. This company was located right here in Omaha, right around the corner from I was working as a broker. None of the brokers knew about it. This book made me rich."
Sham Gad can be reached at email@example.com