Berkshire Ruminations

Friday, March 31, 2006

Is Coke underappreciated?

I don't know the answer to that question. All I know is that the stock has done nothing for Berkshire Hathaway or any other investor over the last ten years. Yet its sales and earnings are up. Without question Pepsi has done better, in both terms of earnings and stock performance. But does that mean Coke should actually be down for the decade? Might this be a case of undue pessimism? Coke still is the strongest brand in the world...

Wednesday, March 29, 2006

The failure of invariance

Anyone with any doubt that psychology plays a role in the behavior of the stock market should closely examine his or her own trading behavior before jumping to any conclusions. I believe that nearly everyone can find examples of times when he made an irrational financial decision as the result of biases that may even be at the subconscious level. Economics and finance are social sciences – they are affected primarily by the way people interact with each other.

Behavioral economists warn of the “failure of invariance,” a mistake that just about every investor will make from time to time. But the best investors are aware of it and minimize its impact on their decisions. This is the phenomenon of an investor answering a question under identical circumstances differently simply because the question was framed differently.

Example adapted from Nofsinger’s The Psychology of Investing: Suppose you bought a ticket to a show for $40, but when you arrive you discover you have lost the ticket. Would you pay $40 for another one? Now suppose you intend to buy the ticket at the door, but when you arrive you discover you have lost $40 while on your way. Do you still buy the ticket? If your answer is different under the two scenarios, then invariance has failed. The economic consequences are identical (you are out $80 but see the show) but because of the way the question is framed people often make different decisions. By the way, the above example has been proven empirically by financial economists.

The biggest name in behavioral finance is Professor Richard Thaler of the University of Chicago. He has done a number of really interesting studies on this topic. One of my favorites is when he asked one group of students, “How much would you be willing to pay to eliminate a 1-in-one-thousand chance of death?” He then asked a different group of students, “How much would you require to accept a 1-in-one-thousand chance of death.” On average students said the would only pay $200, but would require $50,000!

Of course the all-time best example is a tale from the tech bubble. It involves the equity “carve-out” of Palm Inc. from 3Com.

Palm was wholly owned by 3Com. In March 2000, 3Com had an IPO for a fractional stake in Palm. In this offering, 3Com sold 5% of Palm to the public. It also announced it intended to sell the remaining 95% after IRS approval. At that time, 3Com shareholders would get 1.5 shares of Palm for each share of 3Com. Immediately before the IPO, 3Com closed at $104. After the first day, Palm closed at $95, so 3Com should have correspondingly risen to $145. But it didn’t . Instead, it fell to $82. Thus, the market was effectively pricing 3Com’s non-Palm operations at negative $23 billion.

Thaler eventually published a paper based on this entitled “Can the Market Add and Subtract?”

Wednesday, March 22, 2006

A stock for the watch list.

H&R Block has had a rough time lately. First it was the refund loan scandal a few years ago whereby Block charged usurious effective interest rates to clients who wanted their refund immediately, rather than six weeks later when the IRS got around to sending them. Block weathered that one ok by fixing the program and eventually rebounded to post record earnings.
But things turned south quickly thereafter, and the company began an effort to transform itself into more than just a tax preparer by originating a few mortgages. In the near term, this appears to have hurt its profitability. Indeed, sales were up considerably in FY2005, but income was down sharply. All indications for 2006 seem to be similar, and will be hurt even more by the legal costs the company now has to deal with.

Another of its areas of expansion has been investments, which seems to have gotten the company into yet another pickle. Today Block is defending itself against a $250 million Eliot Spitzer lawsuit for yet another of its take-advantage-of-the-idiots practices – the “Express IRA.” It seems this was a deal in which clients were encouraged use their refund check to open an IRA held by Block. Sounds good to me, but the always-politically driven New York Attorney General took exception to this practice since the fees Block charged often amounted to more than the account was earning.

There is little debate that Spitzer lawsuits usually have more to do with getting voters' attention in preparation for a gubernatorial bid than they do with trying to clean up business. A case can be made that he has resolved a lot of ugly problems, but more often than not a Spitzer lawsuit is nothing more than extortion. AIG worked out this way exactly. Nobody outside the insurance industry really understood what the heck was wrong with the transactions in question, so it was easy to paint Hank Greenberg as the bad guy and Eliot Spitzer as the hero. Needless to say, it is not certain that this new lawsuit has much merit.

So now we are dealing with the Spitzer lawsuit, several copycat class action suits and news that Block will have to restate its financials because it inaccurately calculated its own tax liability. Yikes. I can’t imagine Wall Street rewarding this company anytime soon.

None of this, though, changes the fact that H&R Block is without question the strongest franchise in the industry. Nearest rival Jackson Hewitt doesn’t even come close - compare Block’s 2005 revenue of $4.2 billion with the $233 million of Jackson Hewitt. The company produces boatloads of free cash flow and the potential threat of tax software has never really materialized. That is, the company is not going anywhere, but its stock price has been falling steadily for a few months.

So let’s watch this one and see if all this negative publicity doesn’t drive down the share price a little further. At its current price of around $21/share, the company’s 2005 free cash flow (owner earnings) would need to grow at less than 2% on average indefinitely in order for the present value of that free cash flow to equal the current stock price (assuming k=10%).

I remember at the 2002 annual meeting, Mr. Buffett mentioned a good investment idea was to buy shares of companies whose price was beaten down by asbestos litigation. Had I listened to him I might have bought Halliburton (yes, I realize there is a lot more to that company's stock price than an asbestos settlement but my point is made). It will be interesting to see if he adds to Berkshire's H&R Block position. Given that H&R Block is indeed in pretty bad shape right now and its near term prospects uncertain, I’m not to anxious to buy at $21, but should the stock continue to fall it may prove to be an ideal value purchase.

As of now, I do not own any shares of H&R Block.

Friday, March 17, 2006

A few thoughts on portfolio construction

The notion that owning a few stocks is much wiser than owning many stocks should be self-evident to the Buffett follower. If an investor concentrates in a small number of stocks, he is far more likely to critically analyze and track each one. In other words, limiting one’s decision making ensures that each decision will be given more thought.

Mr. Buffett has long advocated this philosophy and often uses his punch-card analogy to explain it. He recommends that every investor should invest as if he or she has a punch card with only twenty punches available over the investor’s lifetime. Each investment represents a punch, so once the investor has used all twenty punches, that’s it. This mindset will help the individual reduce the rashness of his decision making and increase his confidence in each decision.

If you are familiar with Mr. Buffett’s strategies, you probably already know this. But what you may not know is that this theory is supported by – believe it or not – academic research. Not all academics ardently sing the praises of modern portfolio theory and efficient markets. There is a wonderful trend towards alternative explanations of market phenomena. Whether or not this trend is the result of the undeniable success of Mr. Buffett we will never know.

Two professors from the University of Michigan and one from the University of Illinois collaborated on a paper entitled “Portfolio Concentration and the Performance of Individual Investors.” The paper explores differences in concentration among portfolios of individuals. It ignores institutional investors and simply compares investments of households using data provided by a discount broker over a five year period. It finds that, in general, investors with portfolios containing a small number of stocks outperform comparable portfolios consisting of a larger number of stocks.

More specifically, large portfolios that are concentrated in a few stocks perform significantly better than the more typical diversified portfolio of equivalent size. If we can assume that investors with large portfolios (that is, wealthy investors) are typically more financially sophisticated, then these findings provide evidence that financial sophistication and critical analysis can work to help an individual beat the market.

The paper further finds that individual investors who concentrate in local stocks tend to outperform others to the greatest extent. Might this suggest that familiarity leads to better decision making? It would certainly seem to follow. The authors of this paper are quick to clarify, however, that concentration in a few stocks is only rational if the investor has above-average stock picking acuity and a sufficient informational advantage. That is, unless you know exactly what the heck you are doing, it is best to diversify.

This is consistent with advice Mr. Buffett has given as well. Diversification is protection against ignorance, he says, but if the investor is not ignorant then a focused portfolio is best. If the investor is ignorant, then a low-cost index fund is the best route.

Friday, March 10, 2006

The new Chairman's letter and FORTUNE

The March 20 issue of FORTUNE starts off with a piece on the old, but important, notion that frictional costs can only hurt investors in aggregate. It is taken, interestingly enough, from the Berkshire Chairman’s Letter that was released last week. In it, Mr. Buffett provides another great market allegory and in typical Buffett fashion makes it fantastically easy to understand.

First of all, if the owners of equities are to earn much on their holdings in the future, business will have to expand at least at an equivalent rate. This is a simple but often overlooked principle. Businesses will become more valuable if they are more productive. This productivity provides earnings - capital - for investors to put into other investments. But investors cannot put all of this capital into new investments because of frictional costs. Although the most basic frictional cost is the broker commission that you pay every time you purchase a stock, we should consider any expense made in an effort to outsmart other investors a frictional cost. It is these costs that contribute nothing to the profitability of our business, but that eat away at what we take home. Notice too, that if businesses in aggregate do not expand, the stock market cannot either because there will be no new capital to reinvest in the market.

As Mr. Buffett indirectly points out, every vehicle out there to “aid” in the ownership of businesses - whether it be a mutual fund, costly investment advice, consultants or private equity funds – only prevents all of the business productivity from ending up in the pockets of the owners. In recent times, the level of frictional costs has increased horrifically. For this reason we should expect the owners of equities to see their wealth grow at a rate much lower relative to the level of business productivity growth than they have in the past.

Alarmingly, Mr. Buffett contends that frictional costs now may amount to as much as 20% of all business productivity. So investors today are earning only 80% of what they could if they worked for themselves, rather than hiring "helpers" to work for them. That remaining fifth of the pie is going straight to the helpers.

You may be surprised to read that the rate of return on the market over the last 100 years is only 5.3%, plus dividends. So should investors expect to earn even less than this much in the next 100 years? Not necessarily. It is reasonable to assume that we live in a much more productive economy than we did on average in the 20th century and thus we can expect business to grow at a higher rate than it did last century. But for shareholders to see their holdings fully reflect this growth, frictional costs will have to be reduced.

The individual, however, can see his wealth grow at or above the rate of growth of business generally. He can do this by simply avoiding frictional costs and investing in above-average businesses as Mr. Buffett has done so well over the years. This means selling only in extraordinary situations and making transactions through the lowest cost broker available. It also means avoiding the expensive consulting and investment advice promoted by brokerages. (Ironically, these services can actually be shown to hurt investors, but that is a topic for another day.)

Wednesday, March 08, 2006

Let's get things started.

I thought it was most appropriate to make the innaugural post of this blog about a company that I am sure Mr. Buffett would like to own. In fact, I actually pitched the idea to Mr. Buffett himself. For purposes of disclosure, I must point out that upon discovering this company, I purchased shares for myself, which I still own.

The company is called Leggett and Platt. This fortune 500 company makes components - primarily for furniture and automobile interiors. This means everything from bed springs to lumbar systems. In fact, there is a good chance you are sitting on a Leggett component as you read this. This is a fairly simple business idea - the way Buffett likes them - and Leggett has consistently stayed in this industry throughout its 122-year history - another Buffett plus.

In my interaction with Mr. Buffett, in addition to most everything I have read, I understood that one of his primary concerns is the integrity of management. This includes its honesty, candor and rationality. A read through of the Leggett annual report is telling. The tone and content of the text sounds as if it could have been in the Berkshire annual report. The managers of the company own a large amount of Leggett stock, often representing a substantial portion of their net worth. Managers also frequently choose to forego a portion of their salary in exchange for stock options. Once these options are granted, they are expensed.

Although Leggett doesn’t have a "moat" around its business in the same way as Coca-Cola or See’s Candies, I assert that its moat is as large as any business-to-business enterprise’s could be. The company has a reputation for product quality and customer service, all while often being the lowest cost producer in the industry. Leggett also has very strong relationships with its customers. Many of its plants are located right next door to the customer, creating both efficiencies and loyalties for all parties.

The customer base is also diverse. No one customer accounts for more than 5% of company sales, providing each customer with relatively little buyer power.

Further, Leggett has experienced average annual growth in earnings of just over 15% since its IPO in 1967. However, as Mr. Buffett first pointed out in his 1977 annual report, strong earnings growth is not all that impressive without a comparable return on equity. Leggett’s ROE has averaged 15.9% since the IPO in 1967 and has been very consistent. The standard deviation in ROE over this time is only 3.5%. All this has been done without the undue use of leverage. Long term debt has historically averaged around 30% of total capital, although that ratio is currently closer to 20%.

As recently as last fall, Leggett stock was significantly undervalued. If we run a Buffett-esque discounted cash flow valuation we find that the current stock price still falls short of what such a valuation would produce. What do I mean by Buffett-esque DCF valuation? Consult his 1986 letter to shareholders in which he defines "owner earnings" as reported earnings plus depreciation, depletion, amortization, and certain other non-cash charges less the average annual amount of capitalized expenditures for plant and equipment, etc. We project these future "owner earnings" and discount them to present. Using even the most conservative assumptions of growth and discount rate, Leggett stock looks cheap.

Tuesday, March 07, 2006


I am establishing this blog in response to the huge reception of an article in a not-so-huge newspaper. On March 5, 2006, an article was published in the Columbia Missourian that chronicled a trip I took to Omaha, Nebraska on October 17, 2005 with fifty of my closest friends. The purpose of the trip was to meet Warren Buffett, the most successful investor of all time. The publicity that followed us home elicited the interest of an impressive portion of the Columbia community.