On February 27th, Whitney Tilson appeared on CBNC to talk about Berkshire Hathaway (link here), which is now his (along with Glenn Tongue, his partner at T2 Partners) largest position. Among the normal back and forth, the conversation turned to the catalysts that will drive Berkshire (BRK.B) stock in the future (as asked, "how do you know you're going to close that gap?"). Here’s what Mr. Tilson had to say on the topic (bold added for emphasis):
“As investors, we like asymmetric risk/reward; up 50% [to reach T2’s estimate of intrinsic value], down 8% [to 1.1x book, where Buffett can repurchase shares in size], I’ll buy that all day long. We have encountered periods where the stock has traded for whatever reason… there’s no obvious catalyst here, we’ll concede that for sure; but we’ve always been rewarded if we are just patient and here we think we’re going to be rewarded sooner rather than later.”
I really think that the idea of a catalyst might explain why so many people don't practice actual investing, or to be more specific (while essentially saying the same thing), value investing. While most people (I think) understand the concept of a divergence between the market value of a company and its intrinsic value (based upon a much less volatile set of future cash flows to the owners), the question always comes back to one of closing that gap, and the catalysts that will cause the price and the value to do so.
The problem is that most people aren’t investors; they are traders, looking to make a small profit on a stock over the next day, week, or month before they abandon ship. Instead of looking at the fundamentals and conservatively estimating a business’s intrinsic value, they watch how Mr. Market yanks the price back and forth to determine the merits of a company at its current valuation; for these people, “intrinsic value” is nothing more than what can be extracted as profit due to market timing (in the majority of cases, it’s called luck).
But for investors, a catalyst is still quite important; if you buy a net-net, for example, the convergence between price and value is critically important: whether it happens over 3 months or 3 years will have a material impact on the investment return, particularly if the value portion of the equation is shrinking over time. For me, this is largely the reason why I have avoided these types of investments in the past; interestingly, Monish Pabrai talked about this back in 2010 (link here):
“One of the things I have found about net-nets and companies which are trading close to net asset values or have a lot of cash is that there’s a seductive element to them that can lead you astray. Let me give you an example. Let’s say I have a company that has a $100 million market cap and let’s say it has $95 million in cash. And let’s say it has a business that generates a million dollars a year.
Well that type of investment is of zero interest to me because the cash is an anchor. The million is going to happen for sure year in and year out in a business like that without cash. Maybe its worth somewhere between $10 and $15 million; let’s say $15 million. So that business has a value of $110 million. And you’re paying a $100 million for it and that’s just not interesting. So I would not have an interest.
In fact you could go to the other end and say it has $110 million of cash and the market cap is $100 million and it’s still not of interest. Even if it’s generating a million a year because now it’s worth $125 million and you’re paying $100 million or so. It’s not that interesting.
Now of course it has a lot of downside protection elements, which is fine. But you can find those types of businesses a dime a dozen in Japan today, for example. I’m more interested in a business where everything is there. Where there is downside protection and there’s an upside pop.[/b]
[b]One of the problems you have with net nets is that you have only one side of it. You have downside protection. You don’t have the upside. I really try to look for ones where I can get both. And it’s few and far between but that’s what we try to do.”
As Mr. Pabrai notes, the home-run’s come when you have the downside protection IN ADDITION TO upside potential; as Mr. Tilson notes, Berkshire has downside protection of roughly 8-10% due to Warren’s ability to repurchase shares at 1.1x book and $40 billion in excess capital. More importantly in my opinion, Berkshire is roughly 50% below a conservative estimate of intrinsic value AND GROWING; by Mr. Tilson’s estimate, the company can increase intrinsic value by a high single digit rate per annum, closing in on $200,000 per “A” share by the end of fiscal 2012 (more than 70% above Friday's close at $117,400).
At the end of the day, patience is a critical component of investing; luckily for many of us, we are planning for financial events that are years (or even decades) in the future. When you buy great businesses, you are given an extra kicker for your time – an increased margin of safety as the intrinsic value of the businesses grows over time; while you’re waiting, take comfort in Warren’s words of wisdom: “time is the friend of the wonderful company, the enemy of the mediocre”.
About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, "Patience followed by pretty aggressive conduct."
I run a concentrated portfolio, with a handful of positions accounting for the majority of my equity holdings (currently two). From the perspective of a businessman, I believe this is adequate diversification.