I was recently watching Warren Buffett (Trades, Portfolio)’s 2001 presentation to Terry College students that is available at the bottom of the page. I was intrigued by his reference to Aesop as my mother use to read a lot to me as a child, and the fables from Aesop were some of my favorite parables and stories that I can remember. I still have the book to this day.
Starting at 23:00 minutes in, Buffett receives a question regarding a mathematical approach to calculating intrinsic value and answers that he wrote about it “last year,” or in the 2000 Berkshire Hathaway (BRK.A)(BRK.B) letter to shareholders. He goes on to say how Aesop did not fully have the statement, “A bird in the hand is worth two in the bush,” and that he needed to add how likely it is that there are birds in the bush and how long it will take to capture the birds from the bush?
It was very interesting to read also through the 2000 report, changing the reference of 1999 to 2013. We clearly are not at the same level of exuberance we were in the late '90s or in 2006 to 2007 (Don't tell Twitter, Facebook, Salesforce, Amazon, Tesla, Netflix, etc.). But we are working our way up the ladder, and the parallels /patterns are becoming similar. (Have you seen outstanding student loan and auto loan growth?)
"The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs." - Warren Buffett (Trades, Portfolio)
- 2000 Berkshire Hathaway Letter to Shareholders
Many people assume that marketable securities are Berkshire’s first choice when allocating capital, but that’s not true: Ever since we first published our economic principles in 1983, we have consistently stated that we would rather purchase businesses than stocks. One reason for that preference is personal, in that I love working with our managers. They are high-grade, talented and loyal. And, frankly, I find their business behavior to be more rational and owner-oriented than that prevailing at many public companies.
But there’s also a powerful financial reason behind the preference, and that has to do with taxes. The tax code makes Berkshire’s owning 80% or more of a business far more profitable for us, proportionately, than our owning a smaller share. When a company we own all of earns $1 million after tax, the entire amount inures to our benefit. If the $1 million is upstreamed to Berkshire, we owe no tax on the dividend. And, if the earnings are retained and we were to sell the subsidiary not likely at Berkshire! for $1million more than we paid for it, we would owe no capital gains tax. That’s because our “tax cost” upon sale would include both what we paid for the business and all earnings it subsequently retained.
Contrast that situation to what happens when we own an investment in a marketable security. There, if we own a 10% stake in a business earning $10 million after tax, our $1 million share of the earnings is subject to additional state and federal taxes of (1) about $140,000 if it is distributed to us (our tax rate on most dividends is 14%); or (2) no less than $350,000 if the $1 million is retained and subsequently captured by us in the form of a capital gain (on which our tax rate is usually about 35%, though it sometimes approaches 40%). We may defer paying the $350,000 by not immediately realizing our gain, but eventually we must pay the tax. In effect, the government is our “partner” twice when we own part of a business through a stock investment, but only once when we own at least 80%.
Double taxation is never a positive in the business or investment domain. It is one of the reasons I would rather see a company buying back shares hand over first (albeit at a discount) then pay a dividend. The income that is used to pay dividends is “after-tax” or “net” and when the income is distributed to shareholders they are again taxed at a personal level or business level depending on the vehicle/account.
Dividends for me from the U.S are subject to triple taxation if I were not utilizing a tax shelter at present time. This is simply because of the withholding tax by the U.S. government on foreign investor dividend income.
Leaving aside tax factors, the formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.).
The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was “a bird in the hand is worth two in the bush.” To flesh out this principle, you must answer only three questions.
How certain are you that there are indeed birds in the bush?
Translation: Is the business one we understand, is it within our circle of competence, does the business possess a moat that is enduring?
When will they emerge and how many will there be?
Translation: What is the total amount of cash flow (owners earnings) the business will produce from now until judgement day and when is the cash flow expected to be received?
What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)?
Translation: 7 to 13 percent; I believe Buffett is quoted somewhere saying to use 10% and keep it simple (Normalized Risk Free Rate + Equity Premium).
If you can answer these three questions, you will know the maximum value of the bush and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.
Aesop’s investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota — nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.
Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years.
Let us think of an NPV calculation that has large upfront costs and cash outlays during the first half of the project and only pays 75 cents to 85 cents on the dollar at the end. Factors like interest rates, inflation, liberal estimates and bad management can lead to projects being undertaken that should not have been, given the circumstances.
Let's think of the economics of the auto manufacture industry or airline industry versus computer software. The auto and airline industries require continual capex that grows proportionately with the business, has a large amount of fixed costs relative to revenue and utilizes working capital inefficiently, due to outsized overhead costs.
The software business on the other hand has one-time fixed costs to create the program code and very low variable costs with little or non-existent overhead. This enables the software company (Microsoft) to have enormous gross margins relative to the upfront investment that it takes. These types of businesses, however, have a hard time re-investing the capital at similar returns, as not much additional investment is required. This type of business can be classified as a cash cow, spinning off cash (through dividends or buybacks) for us to re-invest.
Market commentators and investment managers who glibly refer to“growth” and “value” styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component — usually a plus, sometimes a minus — in the value equation.
Alas, though Aesop’s proposition and the third variable — that is, interest rates — are simple, plugging in numbers for the other two variables is a difficult task. Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach.
Usually, the range must be so wide that no useful conclusion can be reached. Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startlingly low in relation to value. (Let’s call this phenomenon the IBT Inefficient Bush Theory.)
To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a well- founded positive conclusion. But the investor does not need brilliance nor blinding insights.
At the other extreme, there are many times when the most brilliant of investors can’t muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed. This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination. In cases of this sort, any capital commitment must be labeled speculative.
Now, speculation — in which the focus is not on what an asset will produce but rather on what the next fellow will pay for it — is neither illegal, immoral nor un-American. But it is not a game in which Charlie and I wish to play. We bring nothing to the party, so why should we expect to take anything home?
The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.
Last year, we commented on the exuberance — and, yes, it was irrational — that prevailed, noting that investor expectations had grown to be several multiples of probable returns. One piece of evidence came from a Paine Webber-Gallup survey of investors conducted in December 1999, in which the participants were asked their opinion about the annual returns investors could expect to realize over the decade ahead. Their answers averaged 19%. That, for sure, was an irrational expectation: For American business as a whole, there couldn’t possibly be enough birds in the 2009 bush to deliver such a return.
I could not find a Paine Webber-Gallup Survey specifically but I looked into the CFA 2014 sentiment report after reading through this letter and found the following trend in equity sentiment.
- 71% of members identified equities as the asset class most likely to perform best, a large increase compared to 50% in 2013 and 41% in 2012.
- The largest sentiment increase was in Asia Pacific with 68% in 2014 versus 41% in 2013.
- The asset class with the most significant decrease of sentiment was precious metals down to 9% versus 22% in 2013.
On a side note, it is likely a good time to examine junior gold miners, assembling some names for the wish list. Novagold (NG) has exposure to the Donlin Creek deposit with Seth Klarman (Trades, Portfolio) being a large owner.
Far more irrational still were the huge valuations that market participants were then putting on businesses almost certain to end up being of modest or no value. Yet investors, mesmerized by soaring stock prices and ignoring all else, piled into these enterprises. It was as if some virus, racing wildly among investment professionals as well as amateurs, induced hallucinations in which the values of stocks in certain sectors became decoupled from the values of the businesses that underlay them. [The virus is envy and institutional herding due to underperformance fears.]
This surreal scene was accompanied by much loose talk about “value creation.” We readily acknowledge that there has been a huge amount of true value created in the past decade by new or young businesses, and that there is much more to come. But value is destroyed, not created, by any business that loses money over its lifetime, no matter how high its interim valuation may get.
What actually occurs in these cases is wealth transfer, often on a massive scale. By shamelessly merchandising birdless bushes, promoters have in recent years moved billions of dollars from the pockets of the public to their own purses (and to those of their friends and associates). The fact is that a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them. Too often, an IPO, not profits, was the primary goal of a company’s promoters. At bottom, the “business model” for these companies has been the old-fashioned chain letter, for which many fee-hungry investment bankers acted as eager postmen.
But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street a community in which quality control is not prized will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest.
At Berkshire, we make no attempt to pick the few winners that will emerge from an ocean of unproven enterprises. We’re not smart enough to do that, and we know it. Instead, we try to apply Aesop’s 2,600-year-old equation to opportunities in which we have reasonable confidences as to how many birds are in the bush and when they will emerge (a formulation that my grandsons would probably update to “A girl in a convertible is worth five in the phonebook.”).
Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners. Even so, we make many mistakes: I’m the fellow, remember, who thought he understood the future economics of trading stamps, textiles, shoes and second-tier department stores.
Lately, the most promising “bushes” have been negotiated transactions for entire businesses, and that pleases us. You should clearly understand, however, that these acquisitions will at best provide us only reasonable returns. Really juicy results from negotiated deals can be anticipated only when capital markets are severely constrained and the whole business world is pessimistic.
It is fair to say we are not in a severely constrained environment and most people I have been talking to are once again upbeat about the economy, employment prospects, housing, business and (hold your breath) finally willing to talk stocks.
About the author:
"When you find yourself on the side of the majority, it is time to pause and reflect." - Mark Twain