A Comment on Warren Buffett's 2012 Letter to Shareholders

Warren Buffett's eagerly-awaited annual letter to shareholders was recently released.  As ever, Buffett highlights the negative, even as he downplays his accomplishments.  For example, he refers to last year's performance - 14.4% growth - as "subpar."  This is true in the literal sense that par is the S&P index, which returned 16%.  However, that's not much of a difference, and a gain in book value of $24 billion isn't all that shabby.

He quickly summarizes the basic terms of the Heinz deal, agreed to after the end of 2012, without a hint of the "Gotcha!" that he must feel.   Many long-time Buffett watchers likely scratched their heads when they learned that the Master offered a price that valued the venerable seller of ketchup and beans at about $28 billion (including debt).  However, once the details emerged, it became clear that the terms of the deal were extremely favorable to Berkshire shareholders.  Alice Schroeder responded to the deal in the Financial Times, explaining that it was the Buffett brand that allowed for the one-sided benefits of the deal, a transaction that will be studied decades from now in business case studies.

As usual, much of the letter's space was devoted to a summary of Berkshire's large business categories - a range of insurance companies; regulated, capital-intensive businesses; manufacturing, service and retail businesses; and finance and financial products - plus a few words about the stock portfolio.  Most of this section is similar to the comparable coverage in years past, with a few added comments, and, of course, numbers that are more recent by one year.

Buffett always offers sharp, clear insights into the sometimes fuzzy world of accounting.  This year, he illustrated the difference between "real" and "non-real" amortization charges – software-related write-downs are generally legitimate, while charges to the value of customer relationships tend not to be – and how they diminish the reported earnings of IBM and Wells Fargo, two of Berkshire's "Big Four" stock holdings.  He also holds forth on some of the arcana of GAAP purchase accounting as it relates to Berkshire's steadily increasing investment in Marmon.

This year, Buffett spilled much ink on the newspaper industry.  Because he has long prophesied that newspapers are in permanent decline, many have wondered about his sudden spending spree on them (people must not lose their sense of proportion, however: while he has bought many different papers, even in aggregate they represent only a small fraction of Berkshire's resources - so small in fact, that one wonders if his focus might be better used elsewhere).  Still, he offers a clear and insightful history of the newspaper industry, where it stands at present, and the direction it might take in the future.  While he remains pessimistic about papers in large, hyper-competitive markets, smaller papers with "primacy" in matters of interest to readers - high school sports, local coverage, obituaries - plus a sensible internet strategy can make for a buy, though only at very low prices.

Using the topic of dividends as a launching point, Buffett offers a concise general theory of capital allocation.  While he's shared most these thoughts in the past, this primer is excellent.  Both experienced and novice investors ought to read and re-read this section.

Now well into his 80s, Buffett's mind remains razor-sharp, and his performance continues to be stellar.  The 2012 letter to shareholders belongs in the same exalted company as all of the previous ones.  Here's hoping for many more to come.

Here is a rare summary of Warren Buffett's early letters to partners.

Disclosure: At the time this article was published, the writer was long IBM stock.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

 

Barry Schwartz on Valuing a Business

Baskin Financial Services is one of the finer investment outfits in Canada.  Both David Baskin, the company's namesake, and colleague Barry Schwartz have much to offer knowledge-hungry investors.  The two make regular appearances on BNN Market Call and Market Call Tonight, and correctly emphasize the competitive strengths of businesses, and important metrics such as return on capital.  In addition, both men contribute regular articles on the firm's blog, where they've had wise things to say about ignoring headline news, being patient, the perils of over-diversification, and much else.

A recent article by Barry Schwartz considers an important question: How do shareholders decide whether management ought to pay a dividend or repurchase shares?  If they pay a dividend, he points out, shareholders must pay tax, but are given control of the investment decision.  They have the option of buying more shares of the dividend paying firm, but if they believe that the newfound dollar in their pocket is better invested elsewhere, they can do exactly that.  A share repurchase saves owners the tax, but robs them of the alternative of investing elsewhere.  His narrowly framed question can stand in for a broader one: How should investors determine if a company is undervalued, regardless of whether management returns money to shareholders (via dividend or buyback) or if they retain all earnings to reinvest.

The formula he offers to resolve this question, unfortunately, is unsound.  Schwartz argues that a company ought to repurchase shares only if the P/E ratio is lower than its return on equity.  As he knows, P/E measures how expensive a stock is, and ROE gauges the profitability of the underlying business.  Though both are critically important, the two metrics are not on the same plane, the way, say, P/E and earnings growth are combined to form the PEG ratio.

To illustrate, in 2011 IBM posted adjusted earnings of $16.3 billion, on an equity base of $20.1 billion, for an ROE of 81%.  By Schwartz's logic - he prefers to pay no more than 75 cents for each percentage of ROE - management is wise to pay up to 60 times earnings to buy back shares of IBM.  That's $1000 per share, for a company now trading at $200, with a P/E ratio of 12x earnings.  A little rich, I think.

In fairness, I've used an extreme example, since IBM's ROE is radically high.  And, in practice, an investor that purchased only stocks with, say, an ROE of 20% and a P/E of 15 would likely do well over time.  In fact, the three companies that he cites as passing his test - CSX, Viacom, and Tim Horton's - are all superb companies, and probably undervalued, too.  Schwartz is profoundly right to covet companies offering both a high ROE and low P/E ratio.  Still, the formula he has concocted is flawed.

Disclosure: At the time this article was published, the author was long IBM stock.

Here is an article on how Mason Hawkins values a business.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

IBM - Investment Analysis

Warren Buffett sat out the Dot Com Bubble of the late 1990s, just as he had refused to partake in a similar mania in the 1960s, because fast-changing technology companies are inherently difficult to predict, prices were sky-high and, besides, he's a self-described "luddite."  The value of a business lies mostly in the earnings that it will generate over time, and a wildly unpredictable future makes it too difficult to reliably value a business.  Long time Buffett followers were surprised, then, when the technophobic investor announced a $10.9 billion stake in IBM.  For as long as anybody can remember, paradoxically, the company has been leading the world into the mysterious future.  What was the Oracle of Omaha thinking?

Though the company is indeed one of the world's most innovative, its business model, Buffett explained, is slow-moving and "sticky."  That is, the company's "switching costs" are high.  When the IT manager of an institution contracts IBM, the business's hardware, software, systems and staff become intimately entwined with Big Blue.  The costs of untangling - in time, money and risk - are high.  It's neither quick nor easy to move to a competitor's system: staff may need retraining, hardware may need to be replaced, and data could be corrupted, lost or stolen.  It's a hassle.  Besides, competitors have the same will and ability to hold on tightly to clients.  For IBM, however, it creates a solid, predictable revenue stream, and an installed base to add new products and services onto.

IBM not only retains existing customers, the firm pursues new business very aggressively.  Deep Blue checkmated grandmaster Gary Kasparov, Watson outwitted even Jeopardy's foremost contestants - and each dramatic "machine-over-man" encounter gave IBM the opportunity to demonstrate both its technical prowess and its canny salesmanship.  When there's new business to be awarded, IBM will get its share.

The historical financials show not a capricious, shape-shifting hi-tech business, but a steadily growing earnings machine.

Year	2011	2010	2009	2008	2007	2006	2005	2004	2003
Earnings	16.3	14.8	13.4	12.3	10.4	9.5	8.0	7.5	6.6
EPS	13.06	11.52	10.01	8.89	7.15	6.05	4.91	4.39	3.76
ROE	79%	67%	80%	49%	43%	29%	25%	24%	25%

From 2003-2011 earnings grew at a compound annual rate of 12% per year, EPS was even higher, at nearly 17%, due to share repurchases, and return on equity improved from high to radically high (the average North American business returns 10%-12% on equity).

There's reason to expect the foreseeable future to be nearly as attractive as the recent past.  Buffett approvingly cited the company's ambitious 5-year "road maps," which it consistently delivers on.  Between 2010 and 2015, IBM has pledged to return $70 billion to shareholders via dividends and buybacks make $20 billion of acquisitions and reach at least $20 per share in earnings.  Given that less than a quarter of revenues currently come from the fast-growth BRIC markets, and the company's move away from low-margin hardware sales to high-margin software and services offerings, it's all but guaranteed that the company keeps its promises. 

Assuming a 17.5x multiple times 2015 earnings of $20 per share, plus another $15-17 in remaining dividend payments, an investor that buys the stock at its current sub-$200 price stands to gain around 20% per year over in IBM over the next three and a half years.  Not only is there virtually no business risk, there is very little financial risk given the company's steady results, its low-capital business model, and its sound financial position.  Since the company is a large-scale, long-term buyer of its own shares, there’s at least a soft floor under its share price, though the lower it goes, the happier patient investors will be, since their per share economic interest in the company will increase.  On the whole, the company has significant upside and very little downside.

Sources: 2011, 2010, 2005 annual reports, available at the company's website.
Disclosure: The author had no position in IBM at the time this article was published.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.