“When control of a company is obtained, obviously what then becomes all-important is the value of assets, not the market quotation for a piece of paper (stock certificate).” —Warren Buffett
In this post I lay out my answers to the questions posted at CSInvesting.org as part of the DEEP VALUE course and the case study on Dempster Mill Manufacturing Company. Feel free to comment and share your own views, reflections and take-aways.
Q: How did Buffett find this investment and what ways did he reach an intrinsic value?
Buffett found Dempster as the “figures were extremely attractive.” In other words, a low price compared to book value.
Q: How much margin of safety did he have?
When Buffett first acquired stock in Dempster, the most important margin of safety was most likely in the great discount between price and book value.
Later on when Buffett realized that current management wasn’t capable, he had Harry Bottle to take over as CEO. This provided a sort of second margin of safety – a great manager or management team is never a negative. And in Harry Bottle, Buffett found himself a great CEO able to run the business in a way Buffett himself thought was most likely to create the most value. I put Harry as second, because I think that he was more important than any potential future improvement in earnings power. The earnings power was more likely to be an outcome of great operating management.
Third, possible improvement in earning power.
Q: What type of investment is this? Earnings power below Asset Value?
The investment in Dempster started out as a net asset value investment due to the great discount between price and book value. Buffett also wrote that “the figures were extremely attractive.” It wasn’t the qualitative aspects of Dempster for why Buffett started acquiring stock. It was all based on a big discount to book value per share.
When Buffett started purchasing Dempster stock, the earnings power value was a lot lower than the value of the assets – even compared to net current asset value and Buffett’s valuation applying different discounts to each balance sheet item.
Buffett wrote that Dempster had “…earned good money in the past but was only breaking even currently.” Earnings power value clearly had taken a hit, and was probably a big reason for the stock price trading at such a big discount to book value. As Graham & Dodd wrote in Security Analysis when discussing Westinghouse Electric and Manufacturing Company position; “…the stock sold for much less than the net current assets alone, presumably indicating widespread doubt as to its ability to earn any profit in the future.”
Buffett may have had some expectations for the earnings power to come back and help support a higher stock price, even if this was far from a sure thing. The margin of safety was low compared to book value. If earnings power could be restored, that would serve as a bonus I think.
Q: Is this a franchise? Why or why not is this occurring?
Dempster was not a franchise. Buffet wrote that “The operations for the past decade have been characterized by static sales, low inventory turnover and virtually no profits in relation to invested capital.” Not the characteristics to be expected from a franchise. Buffett also wrote that Dempster was in a “fairly tough industry,” and it also had “unimpressive management.”
If earning power was to be restored it would probably, even in the best case, only support the net asset value, thus no excess returns and no earning power value greater than the asset value. This would indicate a business without any franchise value, i.e., no sustainable competitive advantage—or moat.
Q: Was Buffett lucky in this investment? Why or why not?
Luck always plays some part. But Buffett started to purchase stock purely based on the margin of safety he deemed to be present. Even if Harry Bottle had not come along, Buffett might have been able to sell out without making a loss. When already invested and taking control he used his skill as a business owner in a pretty good way I think, mostly through Harry Bottle taking care of the daily operating activities.
Q: How would Graham approach an investment like this?
Not really sure about this one. Graham also invested in business situations that could be compared to Dempster. Even if Graham did so, maybe the most likely way he would look at Dempster would be purely quantitative. From what I can see, Dempster never was a pure net-net investor during the time Buffett was an owner. So maybe Graham would have stayed away from it.
All for now!
Further Reading
- Dempster Mill case study pdf
- Buffett’s 1963 Letter which includes commentary on Dempster Mills
- Dempster Mill case study thoughts
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Article by Hurricane Capital, Old School Value
About the Author
The pseudonymous Hurricane Capital was Born in the 80’s, lives in Sweden with a Masters of Science in Business and Economics from Stockholm University. Got interested in value investing and devotes his free time and investing. The main goal through the Hurricane Capital blog is to learn about different investing topics, investors and business cases for investment.
