Charlie Munger On Deferred Tax Liabilities And Intrinsic Value – On Float Part 1
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The aim of today's post is to continue this process by talking about a topic few investors know about. And even fewer understand.
Below is an unedited thread from the value investment forum Corner of Berkshire and Fairfax discussing Charlie Munger's thoughts on deferred tax liabilities and intrinsic value.
Bolded emphasis is mine below.
So, I've been reading Monger’s Wesco letters (they are quite repetitive). However, while reading, I found the following section pretty interesting:
Consolidated Balance Sheet and Related Discussion
As indicated in the accompanying financial statements, Wesco's net worth increased, as accountants compute it under their conventions, to $2.22 billion ($312 per Wesco share) at yearend 1998 from $1.76 billion ($248 per Wesco share) at yearend 1997.
The $459.5 million increase in reported net worth in 1998 was the result of three factors: (1) $395.8 million resulting from continued net appreciation of investments after provision for future taxes on capital gains; plus (2) $71.8 million from 1998 net income; less (3) $8.1 million in dividends paid.
The foregoing $312-per-share book value approximates liquidation value assuming that all Wesco's non-security assets would liquidate, after taxes, at book value. Probably, this assumption is too conservative. But our computation of liquidation value is unlikely to be too low by more than two or three dollars per Wesco share, because (1) the liquidation value of Wesco's consolidated real estate holdings (where interesting potential now lies almost entirely in Wesco's equity in its office property in Pasadena) containing only 125,000 net rentable square feet, and (2) unrealized appreciation in other assets (primarily Precision Steel) cannot be large enough, in relation to Wesco's overall size, to change very much the overall computation of after-tax liquidation value.
Of course, so long as Wesco does not liquidate, and does not sell any appreciated assets, it has, in effect, an interest-free "loan" from the government equal to its deferred income taxes on the unrealized gains, subtracted in determining its net worth.
This interest free "loan" from the government is at this moment working for Wesco shareholders and amounted to about $127 per share at yearend 1998.
However, some day, perhaps soon, major parts of the interest-free "loan" must be paid as assets are sold. Therefore, Wesco's shareholders have no perpetual advantage creating value for them of $127 per Wesco share. Instead, the present value of Wesco's shareholders' advantage must logically be much lower than $127 per Wesco share. In the writer's judgment, the value of Wesco's advantage from its temporary, interest-free "loan" was probably about $30 per Wesco share at yearend 1998.
After the value of the advantage inhering in the interest-free "loan" is estimated, a reasonable approximation can be made of Wesco's intrinsic value per share. This approximation is made by simply adding (1) the value of the advantage from the interest-free "loan" per Wesco share and (2) liquidating value per Wesco share. Others may think differently, but the foregoing approach seems reasonable to the writer as a way of estimating intrinsic value per Wesco share.
Break Here. Below This Is The Writers - Not Munger's Comments.
It immediately struck me that such an evaluation could easily be applied to Berkshire, although Berkshire at this point is much more complex than Wesco was then. Turns out, someone had already done the analysis for 2011 and 2012:
(As a side note, I had trouble following Dan Braham's line of thinking on this evaluation in the comments of the first article)
This evaluation contrasts from the "investments per share" and "earnings from owned companies" approach, which I believe was advocated by Buffett more recently.
Break... Below Here Are My Comments.
The Importance of Float
‘Float is money that doesn’t belong to us, but that we temporarily hold.” Warren Buffett
Why does Munger think the above is a good approximation of Wesco's intrinsic valuation then? Because while the company "owns" these liabilities on their balance sheet the company can use them to grow the business.
This is an example of float and the power it can have on a company.
Munger only used an estimated 1/5th of the value of Wesco's float in his valuation. Why? Because when these "assets" are sold it comes off Wesco's balance sheet.
I agree with Munger that this is a necessary and conservative way to look at valuing float within a company.
And most people overlook float when evaluating companies because they either don't know what it is. Don't know the power it can have within a business. Or don't know how to evaluate it.
This won't be an issue here.
Press On Research subscribers already know this as I talk a lot about float in many issues I've written. But I want to begin talking about it more here for a simple reason. Float is one of the most powerful - and least understood - concepts when evaluating businesses.
We can gain a gigantic advantage over other investors by knowing what float is. How to evaluate it. And and how to value it.
Also, contrary to common belief float can be found in any business. Not just insurance companies.
But we'll get to this in a later post... In the next post I'm going to explain what float is in more detail.
What Is Float? On Float Part 2
Today's post is a continuation of the earlier post Charlie Munger On Deferred Tax liabilities and Intrinsic Value - On Float Part 1. And we're going to answer the question today, what is float?
But before we get to that next is an excerpt from the July 2015 Press On Research issue where I talk about float extensively.
The Biggest Investment Secret In The World
How Warren Buffett Got So Rich And How You Can Too
Warren Buffett’s admired around the world for his philanthropy as he’s going to donate 99% of his $70 billion plus net worth to charity when he dies.
He can donate so much money because of how great an investor he is. But almost no one knows how Warren Buffett made his fortune.
Yes, most investors know about his investments in Coke (KO), Johnson & Johnson (JNJ), and Wells Fargo (WFC). But this isn’t how he built his fortune.
Investor’s who’ve studied Buffet know he built his partnership, and then Berkshire Hathaway, buying small companies.
But this still isn’t the true secret to Warren Buffett’s success.
Today I’m going to tell you how he grew $100,000 into more than $70 billion. And tell you how we can start doing the same.
But before we explain the exact companies Buffett built his fortune on. We need to talk about why Press On Research concentrates on small caps.
A University of Kansas student asked Buffett about this in 2005:
“Question: According to a business week report published in 1999, you were quoted as saying: “It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”…would you say the same thing today?”
Here’s Buffett’s answer emphasis is mine:
“Yes, I would still say the same thing today. In fact, we are still earning those types of returns on some of our smaller investments. The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts. It would perhaps even be easier to make that much money in today's environment because information is easier to access."
Yes, I’ve said this before many times. But it’s an important concept to understand.
Small ultra safe investments that produce a ton of cash. Have little to no debt. Pay dividends and buy back shares. And are cheap are my favorite investments.
These kinds of businesses are what Value Investing Journey and Press On Research is all about.
Today’s recommendation has no debt. Owns more cash and cash equivalents than its entire market cap. And just its net cash and cash equivalents make up 77% of its market cap.
This doesn’t count any of its property, plant, and equipment, future premiums earned, or cost-free float. And this company is undervalued by 29% to 70%.
But this still isn’t all… It’s also much more profitable than competition.
Today’s pick isn’t just a great company with all the above traits. It’s also in Buffett’s favorite industry to invest.
Investing In Insurance
Most people won’t research insurance companies. I wouldn’t early in my investing journey. And many professional analysts stay away too.
This is because insurance companies are hard to understand at first. Have new and confusing terminology to learn. And normal profit metrics don’t matter much for them.
But if you learn how to evaluate them not only will you learn they’re easy to evaluate once you know what you’re doing. But you can use the same repeatable process on every insurance company. And Buffett has continued to buy into insurance – his favorite industry – constantly over the decades. And it’s why he’s so successful.
In reality insurance companies are easy to understand.
Insurance companies take money – premiums, the insurance version of revenue – as payment for insuring things like businesses, equipment, health, life, etc.
The insurance company doesn’t have to pay you a dime of the money it earns over the years until there’s some kind of damage or theft of whatever’s insured.
When this happens they pay the agreed upon insurance rate out to the policyholder.
While the company continues to earn money – premiums again - it invests some of it so it can pay back your policy in the future. And also make a profit in excess of the amount earned, invested, and paid out.
If the company writes its policies and invests well over time it will earn underwriting profits. And grow the assets it can use to write more policies and invest more money.
If it doesn’t, the company will go out of business when a major disaster strikes.
Think of insurance companies like investment management companies. But instead of only earning management fees. Insurance companies earn premiums on top of investment earnings.
These effects can double profits over time… If management is great at what they do.
The insurance business while easy to understand is one of the hardest businesses to be great at.
Other than being a low-cost operator like GEICO. Owned by Berkshire Hathaway. There are no competitive advantages in this industry. And it also experiences wild swings of huge profitability than massive losses.
But if the company writes policies and invests money well over a long period they can grow to great sizes at almost no extra costs. The only new costs may be to hire more staff.
Insurance companies also hold the greatest secret in the investment world… Float. This is how Buffett built his fortune. And how we’ll start to build ours.
But before we get to this we need to know why float is so important.
Brief Berkshire Hathaway History
Buffett began buying Berkshire Hathaway stock in 1962 when it was still a textile manufacturer. And when he still ran his investment partnership.
He bought Berkshire stock because it was cheap compared to the assets it had. Even though the company was losing money.
He continued to pour millions of dollars into Berkshire to keep up with foreign and non union competition. But none of this worked.
In time Buffett realized he was never going to make a profit again in the textile industry. So whatever excess funds Berkshire did produce he started buying other companies.
The first insurance company Berkshire Hathaway bought was National Indemnity Company in 1967.
Since then Berkshire’s float has grown from $39 million in 1970 to $77 billion in 2013.
Float compounds like interest does if you use and invest it well. But not only does float compound, if you use it right it also compounds the value of the company that owns the float.
Since 1967 when Berkshire bought National Indemnity, Berkshire’s stock price has risen from $20.50 a share to today’s price of $210,500. Or a total gain of 10,268%.
This is the power of insurance companies when operated well. And today’s recommendation is an insurance company that operates the right way too.
But before we get to that I need to explain how float makes this possible.
See the full PDF here.