Warren Buffett is most closely identified with wide-moat or quality investing and his investments that typified this approach, like Coca-Cola (NYSE:KO) and See's Candies. But in reality, Buffett's investing strategy has evolved over time, from a focus on deep value cigar butts where he was managing smaller sums of capital and was much more influenced by Graham (pre-Fisher, pre-Munger) to an emphasis on business quality, seeking out wide-moat compounders, with his investment in American Express (NYSE:AXP) and See's Candies in 1964 and 1972 respectively being notable shifts. The Warren Buffett today faced with the challenging of managing enormous sums of capital for Berkshire Hathaway (NYSE:BRK.A) has to invest in larger companies and also compromise on some of his investment criteria. At the 2016 Berkshire AGM, he acknowledged this constraint:
Well, it's one of the problems of prosperity. The ideal business is one that takes no capital but yet grows. There are a few businesses like that and we own some, but we'd love to find one that we can buy for $10bn/$20bn/$30bn that was not capital-intensive and we may, but it's harder and that does hurt in terms of compounding earnings growth... Increasing capital acts as an anchor on returns in many ways. One of ways is that just in terms of availability, it drives us into business that are much more capital-intensive. You just saw for example Berkshire Hathaway Energy where we just announced - just in the last couple of weeks - a $3.6bn investment coming up in wind generation. We've pledged over $30bn for renewables. Anything that Berkshire Hathaway Energy does, takes lots of money. We get decent returns on capital but we don't get the extraordinary returns on capital that we've been able to get and in some of the business that are not capital-intensive...Something like Berkshire Hathaway Energy may earn 11 or 12 percent on capital. That's a very decent return, but it's a different sort of animal than a low capital-intensive business.
I will come back to the topic of the individual investor's edge (managing smaller sums of capital) at the end of this article.
Two new books on Warren Buffett caught my attention recently, namely "Inside The Investments Of Warren Buffett: Twenty Cases" by Yefei Lu and "Warren Buffett's Ground Rules" by Jeremy C. Miller. The former profiles the 20 key investments that Buffett has made in his career, including as recent an investment as IBM Corp. (NYSE:IBM) in 2011, and tries to step into the shoes of Buffett appraising the specific investment, while the latter organizes each chapter of the book around a single idea or theme from the Buffett Partnership letters written between 1957 and 1970, such as Buffett's thoughts on compounding in Chapter 2 and his investing approach for workouts in Chapter 7. I will share the deep value investing insights I gleaned from these two books in the sections below.
Deep Value Investment 1: Sanborn Map Company
Buffett invested in Sanborn Map in 1958, a company which developed and updated maps used by insurers for the purpose of assessing the fire insurance risks for specific buildings in the areas surveyed. Sanborn Map became cheap (a 60% decline in share price from $110 in 1938 to $45 in 1958), as it faced a significant structural headwind: insurance companies were shifting away from maps to carding, a methodology of assessing risk for structures using algorithmic calculations.
At that time, the company owned an investment portfolio of bonds and stocks worth $7 million, compared with its market capitalization of $4.73 million (based on a $45 share price). This implied that investors were getting Sanborn Map's core business for free at current market valuations, and Buffett highlighted this was a company that used to trade at 18 times P/E two decades ago without the current investment portfolio.
Looking beyond the downside asset protection, there were other factors Buffett considered in making his investment in Sanborn Map. Firstly, the company remained profitable, generating approximately $100,000 per annum in operating income and investment income of around $200,000 per year in 1959. More importantly, Sanborn had limited maintenance capital expenditures and was not burning cash.
Secondly, the core mapping business of Sanborn Map was not going away anytime soon. Insurance companies relying on fire insurance maps for risk assessment still underwrote approximately half a billion dollars worth of fire insurance premiums, and they still needed revisions to existing maps, for which Sanborn Map will charge roughly $100 per year depending on the size of the city. Also, its maps had alternative uses for utilities, mortgage companies, and tax authorities, although insurance companies contributed 95% of the company's revenues then. This view is somewhat validated by the fact that Sanborn Map is still in business today with its service offerings such as geospatial data visualization, 3-D mapping, and aerial photography having links to its original mapping business.
Thirdly, Buffett subsequently took a controlling stake in Sanborn Map, which allowed him to unlock the value of his investment by pushing for changes, notably the exchange of the majority of the investment portfolio securities for approximately 72% of the company's outstanding shares.
I previously shared with readers how I was inspired by Buffett's investment in Sanborn Map in an article titled "Seeking The Asian Sanborn Map" published here.
Deep Value Investment 2: Dempster Mill Manufacturing Company
Dempster Mill is a manufacturer of windmills (a dying industry) and water systems, such as pumps and irrigation machinery, a company which Buffett invested into in 1961.
The adjusted net asset value (taking 100% of cash and applying 15% and 40% discounts to the value of receivables and inventories, respectively) that Buffett calculated for Dempster Mill was $35.25 per share, compared with his average purchase price for the stock ($28 per share). Dempster Mill was also a net-net trading at less than two-third of net current asset value (total current assets minus total liabilities).
There are similarities between Dempster Mill and Sanborn Map. Both were profitable and not burning cash in a big way. Furthermore, Dempster Mill's business and future prospects were not as bad as perceived. In the case of Dempster, there was an element of the "razor-and-blade" model in play as the company continued to earn money from the sale of spare parts and after-sales service from the original windmills sold for a long period. The recurring income and cash generated was used to fund its diversification into agricultural equipment.
As a controlling shareholder owning 70% of Dempster Mill's shares outstanding, Buffett had the tools at his disposal to realize the value of the company's assets. He chose to appoint Harry Bottle to manage Dempster Mill, and Mr. Bottle did not disappoint. Harry Bottle converted a high proportion into cash, slashed selling, general, and administrative expenses by half and disposed of loss-making plants. The cash freed up from working capital was used to pay down Dempster Mill's existing debt and invest in securities.
Deep Value Investment 3: Berkshire Hathaway
Berkshire Hathaway, currently the investment vehicle and holding company of Warren Buffett, was formerly a textile manufacturing company which Buffett invested into in 1965.
Berkshire Hathaway was a net-net with a market capitalization of approximately $11.3 million compared with its net working capital or net current asset value of $15.12 million. The stock was cheap, as it business was negatively impacted by cheap foreign fabrics imports.
It is noteworthy that similar to Sanborn Map and Dempster Mill, Berkshire Hathaway generated positive earnings in 1964 and 1965. More significantly, Berkshire derived positive cash flow in excess of $5 million, an amount equivalent to roughly 40% of its market capitalization in 1965, which illustrated the cash flow generating potential of the company. In addition, there was a positive regulatory development in the form of the extension of a legislation that allowed domestic mills to purchase cotton at lower prices established by the government. Warren Buffett also instituted a change in management, tasking Mr. Ken Chace with the responsibility of unlocking value of working capital and assets in a similar fashion to Harry Bottle at Dempster Mill.
Yefei Lu, the author of "Inside The Investments Of Warren Buffett: Twenty Cases," drew some lessons from this iconic investment. Firstly, the long-term financial track record matters. A long history of declining revenues and margins might suggest structural headwinds too powerful that the best of management cannot cope with. This reminds me of Buffett's famous quote, "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact." Secondly, net-nets are buy-and-sell investments, rather than buy-and-hold ones. Walter Schloss, the legendary deep value investor, generated awesome returns (20% CAGR over 49 years) by constantly churning a portfolio of dirt-cheap letters; John Huber compares portfolio turnover to asset turnover in the DuPont equation in his excellent article published here. Lastly, Buffett apparently had no exit strategy for his investment in Berkshire, unlike Sanborn Map and Dempster Mill.
Buffett Partnership Letters
In his book "Warren Buffett's Ground Rules," Jeremy C. Miller defined the deep value method as follows, drawing from Benjamin Graham:
Because his primary focus was not to lose money, Graham liked to "look down before he looked up." He relished acquiring companies that could (if necessary) be shuttered, where all the assets could be sold off and all the debts and obligations extinguished, and yet still, once all this activity was complete, a residual amount would be remaining as a profit above the market price. These companies were literally worth more dead (in liquidation) than they were alive (as going concerns). It's not that the companies were actually liquidated all that often, although sometimes they were-the point was that there was value in the equity even in liquidation. Graham's system not only generated healthy returns, but also all but ensured that he would never go broke again.
Referring to deep value stocks as "a "free puff" (profit) with little risk of permanent loss," Jeremy C. Miller highlights Buffett's acknowledgement of how profitable this category of stocks has been for the Buffett Partnership: "Over the years this has been our best category, measured by average return, and has also maintained by far the best percentage of profitable transactions." Miller advised deep value investors to use stock screeners to get familiar with all the listed net-nets, and then use the elimination approach (e.g., stocks with significant off-balance sheet liabilities are rejected) to shortlist potential investment candidates. I have also touched on rejecting ideas fast as a key aspect of deep value stock research in my article titled "How To Avoid Potential Value Traps With Net-Nets And Other Deep Value Stocks" here.
It must also be noted that Buffett had an edge over individual investors in his investment in deep value stocks, as he had the ability and was willingly to take an activist approach to realize the value of the net-nets that he was vested in. In his January 1965 letter, Buffett described the "acquisition of a controlling position in a business at a bargain price" as "an insurance policy most investment operations don't have." Individual investors today can choose to coat-tail activist investors in selected deep value investors by watching out for 13-Ds filed; one well-known activist investor actively involved with net cash stocks is Lloyd I. Miller III.
Jeremy C. Miller also shares his view that a choice between deep value and wide-moat investing approaches should be a function of "the size of funds you are working with, your personality, your own ability to do good valuation work, and your ability to define objectively the outer edges of your own competence," but "both can work."
Warren Buffett has not abandoned his deep value roots even till today. He bought a basket of Korean net-nets for his personal portfolio, as confirmed by Alice Schroeder, the author of "Snowball: Warren Buffett and The Business of Life," in a live Q&A discussion hosted on Reddit. Separately, value investor Shai Dardashti delivered a letter to Warren Buffett by hand in 2007 with the question below:
If you were today 20-something years old, again looking to allocate less than $10 million, and free to allocate capital into well over 8,000 opportunities (before even considering anything overseas), would your Latticework of Mental Models primarily be searching for: a) Situations reminiscent of 1957 - akin to Daehan Flour Mills, or b) Situations reminiscent of 1987 - akin to Moody's Corporation.
Buffett's reply to Shai Dardashti's question was:
Either is fine. [a] Better for small sums. [b] Better for large sums.
In Berkshire's 2014 letter, Warren Buffett shared his thoughts on this same topic again:
My cigar-butt strategy worked very well while I was managing small sums. Indeed, the many dozens of free puffs I obtained in the 1950s made that decade by far the best of my life for both relative and absolute investment performance.
Even then, however, I made a few exceptions to cigar butts, the most important being GEICO... Most of my gains in those early years, though, came from investments in mediocre companies that traded at bargain prices. Ben Graham had taught me that technique, and it worked.
But a major weakness in this approach gradually became apparent: Cigar-butt investing was scalable only to a point. With large sums, it would never work well. In addition, though marginal businesses purchased at cheap prices may be attractive as short-term investments, they are the wrong foundation on which to build a large and enduring enterprise. Selecting a marriage partner clearly requires more demanding criteria than does dating.
In summary, there is no reason why we should focus exclusively on high-quality, wide-moat stocks. Discarding deep value investment opportunities implies ignoring the significant opportunity set available to individual investors, and not institutional investors.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.