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John Huber
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I am the portfolio manager at Saber Capital Management, LLC, a Registered Investment Advisor that manages equity portfolios for clients using the principles of value investing and capital preservation in Graham and Buffett tradition. I am also the author of (BHI), a... More
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  • Some Thoughts On The Berkshire Hathaway Annual Meeting

    I had a great time in Omaha this past weekend. I got to meet with a couple clients, reconnect with some like-minded value investors, and meet some new friends as well. And of course, being in the same building with two of the greatest investment minds in history is something special.

    I wanted to make just a few comments on a couple things in my notes from the weekend. This is by no means a comprehensive summary-and there are many things of value that I'll leave out. The post would be too long to cover everything I found interesting. So these are just a very select few things I thought I'd comment on as I was reviewing my notes this morning.

    (Please note: When I am using quotes for Buffett and Munger comments-these are quotes from my notes as I was feverishly writing on scores of notebook pages all day. The quotes capture the gist of the topic and I believe they are mostly accurate, but may not be exactly verbatim at all times.)

    On "Cost of Capital"

    "I've never heard an intelligent discussion on cost of capital." - Munger

    This was an interesting discussion. And it also contained some classic Munger one-liners.

    Both Buffett and Munger agreed that the term "cost of capital" is an abstract concept that is often used by CEO's and CFO's to justify investments or acquisitions (i.e. "We think this is "accretive" because the returns exceed our "cost of capital"). Buffett said he has sat in on thousands of these types of discussions where "the CEO has no idea what his cost of capital is" and "I don't have any idea of what his cost of capital is either".

    Buffett and Munger had a much better way to view cost of capital that I thought was much simpler.

    "Cost of capital is what could be produced by our 2nd best idea and our best idea has to beat it".

    Buffett went on to say that the "deal test is whether $1 we retain produces more than $1 in market value… not 'cost of capital'".

    Classic Munger: "Cost of capital is stupid." He went on to say that Warren's test is the best way to view capital allocation and reinvestment opportunities within a business. "It's simple: We're right and they're wrong".

    We've heard Buffett discuss this "$1 of value for $1 of retained earnings" test plenty of times, but it really helps to hear its common sense logic reiterated. Buffett said that they are "always thinking in terms of opportunity costs". Thinking in this manner, rather than some model that can be manipulated in a spreadsheet, is a much more productive way to analyze investment opportunities within a business.

    Munger once used this idea when referring to stock investments in general. He basically said that whenever they were looking at a stock, he would compare it to Wells Fargo. His thought process was: if it's not a better value than Wells Fargo, then just buy more Wells Fargo.

    I personally view "cost of capital" as similar to DCF models. They both use numbers that appear to be provide precise and accurate information but in reality can be easily manipulated to achieve the desired result.

    Takeaway here: Set up a simple decision tree. Think in terms of simple opportunity costs. Look at whether a business is producing more than $1 of market value for every $1 retained-don't use "cost of capital".

    See's Candies

    "See's main contribution to Berkshire was ignorance removal." - Munger

    I don't recall the specific question, but Buffett and Munger began talking about the early days of their investment philosophy evolution-specifically their newfound and developing interest in quality businesses that could produce high returns on capital and consistent free cash flow.

    Munger said that "we were pretty stupid when we bought See's" and in fact "we were just barely smart enough to buy it". He is bluntly describing how they were willing to nearly walk away from See's because of their unwillingness to pay up for the business. They of course did pay up (although from my calculations still were still buying it for a pretty low earnings multiple), and more importantly, they began learning about the power of this type of business (one that produces much more cash than is needed and one that can grow without sizable investments).

    "I always understood brands, but there is nothing like owning one." - Buffett

    Munger said that if they didn't buy See's, there is a very good chance that they never would have bought Coke a decade and a half later. This demonstrates the power of compound knowledge. At first they had no interest in paying what seemed to be a premium for franchise businesses, but Munger convinced Buffett to buy See's, and in the process of owning that investment they almost serendipitously discovered the power of a business model like See's.

    Munger describes this process as "ignorance removal". It allowed them to remove their rigid focus on metrics and begin to view value in a much more comprehensive way, paving the way some of Berkshire's most significant home runs and-perhaps more importantly-presumably reducing many would-be errors of commission.

    On Circle of Competence

    "If you just keep learning things, eventually something will work." - Buffett

    This was a classic Buffett teaching moment. He basically said that to develop a circle of competence he would do the same thing that he did when he was 23. He said he would look at lots of companies to learn about them.

    He said that if he wanted to learn something about the coal industry, he would go around and talk to 8 or 9 coal executives, and ask them about their business models and their competitors. He implied that one can achieve an enormous amount of knowledge by talking to management and people who understand the industry better than you do.

    On Intrinsic Value

    "A bird in the hand is worth two in the bush".

    I had a reader ask me to define intrinsic value last week. I'll let Buffett define it here, as he does in Berkshire'sowner's manual:

    "Intrinsic value is the present value of all cash that will be distributed from now until judgment day".

    We hear that definition a lot. Buffett said that intrinsic value has really become equated to the value that a private business value. It's a relatively simple concept-how much cash will an owner receive from the business in the future? What is the present value of that future cash?

    We are trying to determine: Are the two birds in the bush (future cash flow) worth more than the bird in the hand (the cash required to buy the business)?

    He said that Graham would have focused on more quantitative aspects of a company to determine the future cash that could be withdrawn from the business. Conversely, Phil Fisher would have focused on more qualitative aspects to determine the same thing. He basically said that the objective is to lay out money now to receive more money back later. "That's the point of a business". Put cash in, get cash out. He said that Ben Graham and Phil Fisher would agree that the value of a business is based on this "cash in-cash out" idea.

    He also implied that determining intrinsic value is an art form. He said that if he and Charlie were to write down their intrinsic value estimate of Berkshire, they would probably be within 5% but wouldn't be within 1% of each other.

    On Conglomerates and General Investments

    "It's not a bad business plan to own a bunch of great businesses."

    The question was related to conglomerates but Buffett and Munger used it as a way to espouse some of their general wisdom on investing in general.

    They started by saying that most conglomerates fail because of financial engineering (issuing stock at 20x to buy at 10x-Buffett likened this process to a chain letter). This practice doesn't create long term value. The key is to buy great businesses and focus on earning power, not engage in financial engineering.

    Keys to successful conglomerates:

    • Common sense business principles
    • Good capital allocation
    • Focus on earning power, not stock promotion (issuing stock to make investments)

    Buffett said that "our goal is to buy really good businesses that can grow over time and that have great managers".

    Charlie added that there are two main differences between Berkshire and the failed conglomerates:

    • We can buy stocks
    • We don't feel the need to always be doing something

    This last point is underrated. Berkshire doesn't have to deal with limited partners who have expiring lock up periods (thus demanding shorter term results). They can sit on piles of cash as long as they want and wait for the proverbial "fat pitch". This is incredibly valuable when things become distressed.

    On Identifying Winning Businesses in "Disruptive" Times:

    • "We stick to businesses where we can identify the winners". Buffett discussed his classic and simple idea that he likes to look for businesses where he can imagine the earnings being much higher 10 years from now.
    • He and Munger try to stick to businesses that have slow changing characteristics (likely will be providing the same basic product or service in 10 years that they are currently providing). He mentions that all businesses go through changes, but he tries to invest in ones where change is happening slowly and over time.

    Final Thought

    There were many other interesting topics broached during the 6 hour Q&A session. One book I added to my ever growing Amazon wish list is Dream Big by Cristiane Correa, which is about Jorge Paulo Lemann and 3G Capital, the firm Berkshire partnered with to buy Heinz. Buffett spoke very highly (and very often) on Saturday about 3G and how he believes they are incredibly talented managers.

    As I continue perusing my notes, there are many other thoughts, but they'll have to be reserved for future posts.

    Have a great week!

    May 06 1:17 PM | Link | 6 Comments
  • An Exercise On Thinking Differently And A Great Business

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

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

    Quality Business Characteristics

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

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

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

    Much to Learn from AMZN's Model

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

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

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

    Good, if Not Cheap

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

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

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

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

    The Importance of Long Term Oriented Managers

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

    "When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we'll take the cash flows."

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

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

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

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

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

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

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

    Beware of Your Biases

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

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

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

    Here's some relevant links:

    Tags: AMZN
    Mar 03 12:28 PM | Link | Comment!
  • A Few Thoughts On Buffett And Great Banks

    I wrote a post about screening for quality bank stocks and another one here about Wells Fargo vs Cheap Community Banks and thought I'd post on some other comments I have here. Some of these thought might sound contradictory (everyone wants to separate stocks into categories based on quality/earnings and cheapness/assets). It's not black and white, and all we're really trying to do is figure out what something is worth and pay less for it. As Alice Schroeder has said, if Buffett were handed a dollar and asked to pay 50 cents for it, he would (despite the fact that the dollar bill has no moat!). So the first thing to remember is that we are trying to determine value in relation to price, regardless of what "category" the investment falls into.

    I love looking at cheap stocks. When it comes to banks, I've traditionally started by looking at big discounts to tangible book value. But I've spent a lot of time thinking about why Buffett keeps buying Wells Fargo (which is the subject of another post I have to organize at some point).

    There are different reasons for this, which I'll discuss later, but for now, the basic question I've considered is why does Buffett get so enthusiastic about paying 2-3 times tangible book for banks? And it's not because of his size. He easily could have plowed much more capital into large banks like BAC, C, and many other large liquid banks when they sold for significant discounts to tangible book (I realize he made some investments in some of these "other banks" but they were dwarfed by the size of his WFC position). Of course, the simple answer is that he feels Wells is the better business, and of course that's true. But what specifically does he like?

    See my last post for some more thoughts on WFC, and I'll have more to say later, including some comments on the 1991-1993 annual reports that Buffett, Berkowitz, Greenblatt, and others were looking at in real time when they decided to make significant investments into Wells Fargo in the early 1990's.

    But for now, one thing to keep in mind when using simple valuation metrics like P/B is another Buffett comment on banks:

    "You don't make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on."

    I think what Buffett implies here is to not get too caught up with discounts to tangible book values if you plan to be a long term owner of the business. Of course, that's how Buffett thinks of himself: a long term business owner. Many pay lip service to this, but few actually think this way. I'm not sure that everyone buying bank stocks at huge discounts to tangible book necessarily think this way. They most likely are thinking about flipping their discounted merchandise to someone else once that merchandise gets priced fairly.

    For example, you can buy a bank at 0.7 times book, sell it at 1.0 times book for roughly a 50% gain... a very simple strategy, and one that I like to consider as well... and not that this is right or wrong strategically, but it's definitely not how Buffett thinks, and I don't think he thought this way in the 50's and 60's either, as I'll discuss when I review my Commonwealth Bank case study when I have time later.

    Buying and selling discounted merchandise is a very acceptable idea and it likely works over time with these banks. One of Irving Kahn's first jobs when he went to work for Ben Graham was to make a list of all the bank stocks trading below .7 P/B.

    Buffett does things differently, which doesn't necessarily mean better, but it has also certainly worked. One thing he looks for are the banks that consistently have the lowest costs and determines that their cost structure (low-cost deposit base) along with their scale and size are huge competitive advantages. He is willing to pay well over book, and in some cases 2-3 times tangible book for quality banks like Wells Fargo, US Bank, M&T and others.

    How has this worked out over time?

    Very well... We all know about Wells Fargo, but think about this: In the last 3 decades, Wells Fargo stock price has averaged about 16% per year including dividends! Wow, the S&P made about 8.5% CAGR before dividends during that time. Including dividends, let's call it about 11% per year for the S&P.

    M&T Bank, another Buffett holding and a very high quality bank, has actually been one of the greatest performing stocks over the past 30 years, going from $1 to $113, and including dividends has averaged about 18% compounded annually!

    Note: I'm assuming about 2% annual dividends (which likely is on the conservative side) because I didn't go back and check dividend yields for each year since the 1980's, but we can summarize the specific numbers for these two banks (adjusted for splits, but without the benefit of dividends) as follows:

    Wells Fargo:

    • Stock price 30 years ago (12/12/1983): $1.38
    • Stock price currently: $43.62
    • Compounded Annual Growth Rate: 12.2% (not including dividends)

    M&T Bank:

    • Stock price 30 years ago (12/12/1983): $1.54
    • Stock price currently: $113.92
    • Compounded Annual Growth Rate: 15.4% (not including dividends)

    S&P 500:

    • Index Value on 12/12/1983: 166
    • Index Value on 12/12/2013: 1775
    • CAGR: 8.2% (not including dividends)

    So it's remarkable that even after two significant banking crises, the most recent one causing roughly a 70% drop in stock price for these banks, they have both significantly outperformed the S&P 500 over many years.

    These are long time Buffett holdings, so I included them here, but there are many others. I came across this post when doing some research: 5 Top Bank Stocks in Last 30 years. It references the two I focused on above, along with a few others like US Bancorp, State Street, and Northern Trust. USB is another long time Buffett holding, and not surprisingly has an incredible long term record of creating shareholder value with a CAGR of about 13% not including dividends over the past 30 years. State Street and Northern Trust also have performed very well, with their stocks averaging around 13-14% per year before factoring in the benefit of dividends.

    Perpetually High P/B Multiples

    The other interesting thing is that none of these banks appear to be cheap if you look at the price to tangible book values. And it's not that they sell for premiums now but were cheap historically. I checked various time periods over the past 15 years (as far back as I could find just by quickly glancing through Value Line) and found that all of these bank stocks have historically traded well over tangible book (often between 2-3 times tangible book).

    In other words, at numerous times in the past, you could have paid 2-3 times tangible book for these quality banks, and simply held them and continued to achieve excellent returns over time.

    So the bottom line is why are these banks so good, and how have they maintained such a durable competitive advantage over the course of the last 30 years? The answer would have to be the subject of another post, and there are a few factors to consider. One of course is management. But I think Buffett would sum it up by saying that these banks have consistently been the "low-cost" providers, meaning that because they were able to gather deposits more cheaply than everyone else, they were able to create higher returns (higher spread between the yield on their assets and the costs of gathering deposits). To paraphrase him once again, in the business of banking (and this is generally true for most industries), the company with the lowest cost wins.

    A low cost structure is a huge advantage, and a significant margin of safety for banks.

    What's the Point?

    The intent here is not to say that I think the banks mentioned above are necessarily great investments and you should just buy them and forget about them. The intent here is to engage in some second-level type thinking to try and lay some initial groundwork for why Buffett is willing to pay much more than tangible book for a bank.

    It's also interesting to compare the strategy of buying a cheap stock and waiting for multiple expansion (i.e. buying a bank at 0.7 times book when it's worth 1.0 times book and waiting for the market to assign the correct multiple) vs. the strategy of buying the best businesses that (thanks to their durable advantages) will continue to create above average returns on equity over time which translate into passive above average long term investment results without the need for multiple expansion (i.e. you could have paid 2x book for WFC 20 years ago and it would have worked out very well, even though WFC only trades at about 1.5x book now).

    Some view the former as more of a trading approach, and the latter as more of a long term investment approach. I don't differentiate between the two. To me, a business owner can buy and sell businesses over time opportunistically, or he can hold the same business for years, or some combination of both.

    So it's just two different concepts. They can be used separately or integrated together. I'm not suggesting one over the other. Graham and Schloss loved cheap stocks and did well buying, holding, and selling them. Buffett and Munger like permanent compounders. As I've said many times, I've learned a lot by studying and integrating facets of their approaches.

    One last comment on Buffett: We can look at what Buffett's doing now, and learn. Of course, the more relevant question might be "What would Buffett do now if he was starting from scratch with a small amount of capital?". He surely would be buying different stocks than he's buying now. He might still own some large caps, but he'd own many other smaller stocks. But I think he'd still be looking for quality stocks--he would just be looking for greater discounts to intrinsic value because he'd have more opportunity.

    I think he'd still likely be looking at low-cost providers (remember GEICO-aka "The Security I Like Best" which was the lowest cost provider and a high quality business and one of his very first big investments in the 50's) and I don't think he'd be buying stocks at cheap multiples with the sole intent to sell them to someone else later at a higher multiple. In other words, regardless of the amount of money he has, I think Buffett would be viewing himself as an owner of a business and looking to create his returns through the operations of that business over time, and not necessarily relying on the market to assign a higher multiple to his holdings.

    To Sum It Up

    This post started with the idea to highlight a few outstanding historical bank stock investments, but I had a few comments on Buffett as well as the idea of buying cheap banks vs. quality banks. This post meandered a bit, but it's an interesting topic to me so I thought I'd write down some more thoughts. I've been spending a lot of time looking at a number of different opportunities in the banking industry lately, and I have a lot to say, but we'll have to focus on one thing at a time and save the other thoughts for later.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Tags: WFC, USB, MTB, Banks
    Dec 13 10:35 AM | Link | 2 Comments
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