Now that the initial excitement over the release of Warren Buffett’s 2013 letter to Berkshire Hathaway shareholders has died down, it is useful to look past the deluge of “key takeaway” articles from around the blogosphere, and carefully study his commentary to glean valuable investment insights, particularly in the context of new all-time high valuations for common stocks.
Before delving into what I believe is extremely useful (and timely) guidance from Buffett on the valuation of businesses, I will first examine the 2013 Berkshire Hathaway business highlights as outlined in the opening The Year at Berkshire section of the letter. A considered reading of these highlights reveals much about Buffett’s current investment strategy and outlook in such a richly priced environment for common stocks and fixed income securities.
Berkshire’s business highlights can be summarised as follows:
• Buffett continues to favour large acquisitions as part of his strategy to increase Berkshire’s intrinsic value over time, illustrated by his joint acquisition of H.J. Heinz with 3G Capital, and subsidiary MidAmerican Energy’s acquisition of NV Energy, a utility company
• His “Powerhouse Five” businesses, BNSF (railways), Iscar (metalworking/tooling), Lubrizol (Chemicals), Marmon (industrial/transport) and MidAmerian Energy (utility) remain key investments that provide essential goods and services that underpin the US economy. Collectively this group delivered record pre-tax earnings in 2013
• Berkshire’s insurance businesses have been consistently profitable, and are integral to Buffett’s investment strategy, with insurance float providing investment capital at effectively no cost
• Buffett will continue to allocate capital to large bolt-on acquisitions as part of strategy to increase Berkshire’s intrinsic value over time
• Berkshire’s subsidiaries made record investment in capex during 2013 ($11 bilion), approximating twice the depreciation charge, with 89% of this spent within the US
• Berkshire’s ownership of its “Big Four” minority investments – American Express, Coca-Cola, IBM and Wells Fargo – increased via company share buy-backs and additional stock purchases by Berkshire during 2013.
• Buffett continues to look favourably on share repurchases by investee companies, where those purchases are made at prices below his estimate of intrinsic value
• Buffett is positive on the long-term outlook for the US, as evidenced by Berkshire’s capex, acquisitions and increased investment in his Big Four holdings
• Buffett’s stated objective is to grow Berkshire’s per-share intrinsic value for shareholders by:
o Improving earnings power of existing subsidiaries
o Increasing earnings power by bolt-on and occasional, large acquisitions
o Benefitting from the growth of investee companies
o Repurchasing Berkshire shares when priced below intrinsic value
• Finally, Buffett pledges to maintain financial strength by maintaining $20 billion of cash equivalents and maintaining immaterial levels of short-term debt
I believe the above highlights reveal Buffett’s investment strategy and outlook to be as follows:
1. A major part of strategy now involves the identification of opportunities that require massive deployment of capital. Given Berkshire’s size, Buffett’s return expectations may be shifting downwards, as it is much harder to grow a $200 billion+ company at 15%+ per annum, than a $2 billion company. Hence the huge allocations to capital intensive industries (utilities, railroads) and predictable, mature, large-capitalisation businesses (Heinz, Coca-Cola) – Buffett is accepting of relatively lower rates of return compared to his earlier years, because (1) such large/capital-hungry businesses are simply the only ones that can absorb the huge amounts of capital that he needs to deploy and still earn an acceptable return on capital, and (2) a lower, more steady return on a huge capital base is preferable to potentially high but unpredictable returns on alternatives, such as smaller or high-growth companies in sectors such as technology, which even if he were to acquire and prove successful investments, are unlikely to move the needle of returns, given Berkshires large capital base.
2. Buffett views well-managed US businesses that provide essential goods and services as having long-term favourable prospects – his investments in the Powerhouse Five and Big Four are clear evidence of this, and he expects these investments to continue to grow in value over time due to their long-term earning power. While the Powerhouse Five provide essential infrastructure for industry, the Big Four are American business institutions, tied to the fortunes of both American consumers and businesses, further reinforcing Buffett’s endorsement of the US economy.
3. Berkshire continues to make very material capex investments. This is interesting in the context of many industrial companies in the US at present operating at approx. 80% capacity utilisation and holding significant cash balances, while there are signs of capex spending broadly slowing again among US corporates. This is a continuation of a theme I explored in my analysis of Buffett’s 2012 letter, and seems to suggest that Buffett may expect significant inflation, rather than deflation in the coming years. Cash is a wasting asset in Buffett’s view, and it is better spent productively by acquiring assets (be it machinery, entire companies or common stocks), than held in reserve for a rainy day – this is the physical action of Buffett’s view that the macro-environment is irrelevant to his investment process: as Buffett reminded us in 2012, the world economy and corporations have always faced uncertainty, be it wars, recessions, natural disasters, economic booms and busts, and yet corporate profitability and economic progress has continued upwards over 200-plus years. Buffett is seemingly saying this time is no different.
This significant capex investment also has an additional benefit for Buffett’s businesses – by spending now when inflation is muted, while competitors hoard cash, Berkshire’s businesses may in fact be further boosting their competitive advantages over peer companies who choose not to spend. Once inflation eventually takes hold again, the price of machinery, equipment etc. will rise and competitors will be compelled to spend their depleted cash balances (in real terms) on comparatively more expensive assets. Meanwhile, Buffett’s investees will have the advantage of having already acquired essential assets to maintain and grow market share at more advantageous prices, thus positioning them to further outpace competitors.
4. Share buy-backs, when made at prices below sensible estimates of intrinsic value, constitute an intelligent allocation of capital for Buffett. As corporate cash piles and share buy-backs reached record levels in 2013 for US corporations, the risk of overpaying (and thus destroying shareholder value) has increased as stock prices also reached record highs. However, for those companies with positive long-term prospects (considering their likely long-term earnings power) and priced at a discount to intrinsic value, share-buybacks are a means of intelligently deploying available capital in the absence of better alternatives, and after adequate levels of capex and operational investment have already been met.
Buy-backs achieved by companies assuming significant levels of indebtedness to bolster earnings per share (and therefore share prices) in the midst of uncertain or low near-term growth is an altogether different matter however. Such actions may not enhance, and could possibly impair shareholder value in the medium to long-term. It is unlikely that Buffett would view such short-term oriented financial engineering as intelligent capital allocation, in that it increases the financial risk of a company, and is motivated by opportunism made possible solely by abnormal and temporary monetary policy rather than conviction in a company’s fundamentals and prospects.
5. Buffett’s stated focus of growing per-share intrinsic value over time for shareholders speaks directly to his preference to compound wealth in the long-term, rather than deliver volatile, yet outsized gains. His four methods for growing intrinsic value outlined above can be condensed to two key criteria – intelligent allocation of capital that will yield the best returns on that capital over time (acquisitions, share buy-backs) , and remaining focused on business fundamentals (improving earnings power, investee company growth), rather than macro-economic concerns.
6. Buffett assures shareholders that Berkshire will maintain a significant level of cash and minimal indebtedness as a means of ensuring continued financial strength. Buffett sees no need to assume additional debt, despite the currently advantageous cost of debt capital, to enhance capital resources for investment and returns. Of course, Buffett’s investment capital is supplemented by the ability to use Berkshire’s enormous insurance float as a type of non-interest bearing debt to leverage Berkshire’s equity investments. Furthermore, while cash can be a wasting asset if held simply out of fear of uncertainty, for Buffett an appropriate level of cash provides optionality that will allow him to make further investments when assets and businesses are available at discounts to intrinsic value, as well as providing sufficient resources in the event of economic stress.
I wish to now move onto what I believe is the most interesting and instructive element of Buffett’s latest 2013 letter – his very brief, but insightful comments on business valuation. In the context of current stock prices, I believe a rigorous appreciation of, and approach to valuation is especially relevant.
Much has been made investment sites and blogs online about the Some Thoughts About Investing section of the 2013 letter, and in particular the six neatly presented “fundamentals of investing” contained therein. While these are certainly important and timely reminders of the key principles that should underpin a sensible investing framework, I believe that the following extract from the same section of the letter provides perhaps the most useful guidance for investors:
When Charlie and I buy stocks – which we think of as small portions of businesses – our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out, or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings – which is usually the case – we simply move on to other prospects. In the 54 years we have worked together, we have never foregone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions.
From my reading of it, the above excerpt provides the following valuable insights:
1. Common stock purchase decisions should be made on the basis of valuation, with that appraisal of the business performed as if one was seeking to acquire the entire company, rather than using a simplistic price per-share approach. This reinforces the principle that common stock investment confers fractional ownership of an operational business, with products, customers, employees etc. to the purchaser, as opposed to being the trading of share certificates. Per-share analysis can often present a distorted picture of the real value of a business, as it tends to ignore capital structure (one never hears mention of enterprise value or debt per share, yet book and cash per share metrics are common in the financial media). Per-share analysis can also obscure fundamentals; for example significant share buy-backs can create the impression of earnings growth, where in fact earnings-per-share have simply increased due to the lower number of shares in issue, while the absolute level of income for the business may not have increased. A stock purchase should be treated in much the same way as the acquisition of an entire enterprise, and this must involve an appreciation of the totality of earnings and assets, rather than per-share metrics alone.
(Note that I do not believe this approach conflicts with Buffett’s stated objective of increasing per share intrinsic value for Berkshire’s general shareholders; as Berkshire’s existing shareholders already hold fractional ownership of the company, Buffett’s aim is grow the value of this existing ownership, and therefore a per-share metric for his minority co-owners is appropriate in this regard. The above approach prescribing the appraisal of an entire enterprise as opposed to a per-share evaluation is essential where prospective investment in a common stock not already held by an investor is being considered).
2. Valuation should generally be determined by estimating the future earnings of the business in question. Specifically, Buffett looks to estimate what level of earnings a business should be able to generate at least five years into the future, and is not concerned with near-term earnings e.g next quarter or next twelve months. Moreover, the output of his analysis in this regard is a range of earnings, and not a specific number – as Graham stated, the future is inherently unknowable, and the use of precise estimates is not necessary to determine if a common stock is under or overvalued; valuation can only be an art of reasonable approximation, not precision.
3. The Margin of Safety principle while not explicitly mentioned in the above excerpt, remains central to Buffett’s approach – note that it is the bottom end of the estimated earnings range that is used for valuation purposes, not a mid-point or average; additionally, the current price must be “reasonable” in relation to the intrinsic value of the business as determined using the bottom-end of the estimated earnings range. It should be understood here “reasonable” means an appropriate discount to estimated intrinsic value to protect against error, imprecision bad luck or timing, and the general vicissitudes of the stock market.
4. If he is unable to estimate this future range of earnings, Buffett simply ceases his analysis and moves on to other prospective investments. This ensures valuable time is not unproductively and inefficiently spent on those businesses that he does not understand due to some special characteristics or complexity, or that are unstable (and therefore not reasonably predictable). This necessity of understanding the business or situation in question is the essence of Buffett and Munger’s “Circle of Competence” principle – invest only in what can you know and understand. Additionally, those businesses that provide essential goods or services and therefore display reasonably predictable characteristics over a longer term outlook – essentially businesses with favourable long-term prospects – lend themselves best to sound valuation analysis and generally make more suitable investment candidates.
5. Finally, macro-economic or political variables are effectively irrelevant to any business analysis that Buffett undertakes; rather it is the fundamentals of individual companies that inform Buffett’s investment analysis and decision-making. This fundamental focus again reinforces the requirement to clearly understand the business in question, and it is only by truly understanding a business from the bottom-up that a reasonable estimate of future earnings power in the medium-to-long term can be made. This in turn allows Buffett to estimate the likely intrinsic value for comparison to the prevailing price, at which point the investment decision can be made based on whether a margin of safety exists. None of this requires analysis of global interest rates, currencies, or other macro-economic factors.
Upon close reading then, this brief extract comprising just six sentences not only encapsulates the basic principles of value investing but outlines how Buffett actually goes about valuing a business – this is extremely helpful and timely guidance given where common stock prices are at present. I think the most appropriate conclusion to the above analysis is a simple summary of Buffett’s valuation and investment approach:
• Firstly, Buffett looks only at generally predictable businesses that can be fully understood and about which reasonable estimates of future earnings can be made
• Buffett then estimates a likely range for future earnings power, at least 5 years from the point at which he is assessing the company
• He determines the intrinsic value of a business using this estimate of future earnings power, and buys the common stock when the share price is at a meaningful discount to this estimate of intrinsic value, i.e. when a margin of safety exists
• His analysis does not incorporate any macro-economic variables, and focuses solely on the fundamental operations and prospects of the business itself