Robert W. Bruce Lectures 2004-2007 to Bruce Greenwald’s Columbia Class

Robert W. Bruce Lectures 2004-2007 to Professor Bruce Greenwald’s Value Investing Class.

Introduction

The saying is: “To try to teach you how to fish rather than handing you a fish.”

Value investing is simply the search for bargains. Value investing involves determining a value of a company and then investing when the price is significantly below the value of the firm to allow for a margin of safety. Simple to say, but not easy to do.

I want to define some key terms as I use them. We may think we mean the same thing, but I want you to understand exactly what I mean when I use the terms: Value Investing, Intrinsic Value and Margin of Safety.

Value Investing: Appraising the intrinsic value of businesses and purchasing fractions of those businesses at significant discounts to those appraisals. Buying bargains.

That is what value investing means when I use the term. What is not to like about value investing?  How many people wouldn’t wish to be considered value investors? That is why I want to define terms as I understand them.

The definition of Intrinsic Value (“IV”) is the Present Value of all distributable cash flows whether operating or non-operating over the entire life of the business. Or another way of defining IV is the price at which a buyer and seller—equally knowledgeable and neither one operating under duress—would agree to a transaction for cash. Both of these definitions are easy to articulate, but not so easy to implement or to determine. For example, there are some businesses for which no one can ascertain their value within a tight enough range to be useful to make decisions.

What type of companies are those? A company where the future prospects are so uncertain both good or bad, that no one knows what the long term future or cash flows will be.  Then again there are businesses that we, I, or you do not have the knowledge to project the future cash flows and discount them back–that is a very important element of humility which you should take into this work.

The Margin of Safety is, of course, the discount from intrinsic value of the business. Needless to say, in the case of margin of safety, the bigger is better. Margin of safety is typically determined by the price discount but the concept may be embodied in the conservativeness of your assumptions and estimates.

What is your investing edge? Who is on the other side of your trade?

Combined in this idea of Intrinsic Value and a Margin of Safety is the idea of having an edge. An edge, being the circumstances, that is the opposite of operating on a level playing field. We are all looking for an insight or knowledge edge that allows us to perceive value perhaps where others are incapable of doing that. Find your competitive advantage.

This gets to the question of defining intrinsic value. One thing I want to make sure that you understand is that for some businesses, the intrinsic value is simply not knowable. The array or ranges of possible future cash flows are so wide, so unpredictable, that discounting them back is a fruitless exercise. Additionally, some businesses lend themselves to appraisal by me and not by other people. And for other businesses, some other people are better qualified to assess intrinsic value than I am to make the appraisal. Certain businesses and industries, I feel, I am better able to forecast the cash flows than other people.

There are many, many industries that I am very unqualified to come up with intrinsic value. Or the range of value is too wide to be helpful to me. In those instances I can’t come up with an intrinsic value that would be helpful to me.

EXAMPLE OF Microsoft Corporation (NASDAQ:MSFT) DCF

This is another way of saying, stick to what you know—this is Warren Buffett’s idea to stay within your circle of competence.

I try to be very humble and modest. I think the investment business is full of very bright, hard working people. I never would be so presumptuous to say I could compete with any of them on any subject. I think I am quick to acknowledge that there are other people who know more about certain things than I do. And I try not to be so egotistical as to try to play their game on their terms. Therefore I avoid being where I don’t have the edge.

Interrelationships between Intrinsic Value and Margin of Safety

It has to do with the usefulness of the appraisal of intrinsic value. If I conclude that the Intrinsic Value is somewhere between $100 to $300 a share, that is probably not a useful appraisal. If I can’t refine it more than that, then I should move on. If the stock is trading at $150 and the range is $100 to $300, then what do I know? I don’t know anything of value. If it turns out it (the company) is worth $200 to $300 then there may be a big margin of safety there. But if I can’t be sure the company won’t be worth $100 or not, move on to where the odds seem more attractive–where determining the tighter range is something that I am qualified to determine.

One of the old stories about giving a talk on value investing is you come in, stand up and say intrinsic value, margin of safety and then sit down. The talk is over. I wanted to pass over it quickly because I am sure you have heard it from others.

Buffett’s Definition of IV: Intrinsic Value (Owner’s Manual 2005 Annual Report of Berkshire Hathaway pg. 77 – 78.

The calculation of intrinsic value, though, is not so simple. As our definition suggests, Intrinsic Value is an estimate rather than a precise figure, and it is additionally an estimate that must be change if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts moreover will almost inevitably come up with at least slightly different intrinsic value figures. That is one reason we never give you our estimates of intrinsic value. What are annual reports do supply, though, are the factors that we ourselves use to calculate this value.

      I.  What is the definition is value?

Value investing is one of those terms like Motherhood and Apple Pie. Everyone is for it. Determine the valuation of a company then invest if the market price is less than the value.  What is the definition of value?

The intrinsic value has two (2) definitions:

1. The NPV of all future distributable cash and the assets sold outside of the normal operations.

There are some companies, which have valuable assets that are not intrinsic to their operations,

which can be sold for cash. An investment analyst should properly recognize those assets that

can be converted to cash—then value the NPV of that cash stream.

2. The other definition of value is the price at which an equally knowledgeable buyer or seller would negotiate under duress a transaction for cash. All those words are important especially the last two. The transaction is for cash that sets comparable values for looking at similar investments.  When transactions are not for cash as many acquisitions have been in recent years, there is much less informational content for investors in terms of determining comparable values. When there are acquisitions made with securities, you often get a $10 dog for two $5 cats. It doesn’t tell you anything about evaluating other cats. If, on the other hand, you see what an investor has paid in dollars for a cat.

Now, you say we should go out and look at all the companies and value all companies. Usually novice analysts and investors naively assume that almost all companies can be valued by them.  Investing experience will ultimately crush such hubris and naiveté.

Warren Buffett’s definition of Intrinsic Value Of Permanent Value: The Story of Warren Buffett, pg. 933): Intrinsic value is the discounted value today, of all future distributable cash generated by an entity less the additional capital, including retained earnings that the owners must put in to generate that cash.  A simple way to get to how much a company is worth is to ask how much you would get for it if you sold it today.

A very interesting characteristic of some of my companies like Coke is that they can grow without the addition of much of the owners’ capital, which remember, includes retained earnings. This, by the way, means that Coke can take its excess cash and repurchase its shares, such that Berkshire’s original 6% stake is now 8%.

If your discount rate is 10%, you are saying you have the low-risk alternative of putting $10 in, say, government bonds that will pay you $1 of interest, which never grows. But if you have a company that has $1 in distributable cash that will grow 5% per annum forever, you might be happy to own that company and pay up to $20 for it. If that cash grew 8% a year forever, you could pay up to $50 for it. If it grew 9% a year forever, you might even pay up to $100 for it. What you are paying as a multiple of cash flow is equal to 1 divided by (the discount rate less the growth rate).  Multiple = 1 divided by (k-g).  (Of Permanent Value: The Story of Warren Buffett)

Unfortunately, not nearly as many companies can be valued fruitfully. A fruitful valuation is in a narrow enough ban that the range would help you make an investment decision. For example, if you look at a company and you come up with a conclusion that the values ranged from $20 per share to $200 per share that is not a useful valuation. The reason you can’t tighten up the valuation range may be because the future cash flows of the business may be too inherently unpredictable or it may be that YOU do not have enough knowledge to adequately project the cash flows to value the business.

Self Awareness

You may not have enough industry knowledge to come up with an adequate valuation to make an investment decision. This is an important idea, because one thing that underlies the kind of value investing everything that I do is self-awareness. The awareness that you don’t know everything is important. There is a lot you don’t know. There are experts in lots of areas you might be looking and you should be humble and say you don’t know enough to make the investment or do the analysis, therefore, I will cast it aside and move on to something where I may have the knowledge.

I and others like me are always looking for an edge. We don’t want a level playing field. When I buy I want to know more than the guy on the other side of the trade. The other person knows less about that security than I do. If I don’t have that feeling of confidence; if I don’t think I have been very honest with myself, then I step aside. There are a lot of arrogant people in this business, quick studies who think they can run nimbly from one hot area like oil & gas to another like Biotech. I have learned the hard way that I can’t do that.

So the idea is to stick with what you know and be honest with yourself about what you know. Stay within your circle of competence.  If you look at our holdings, you will see they fit specific financial characteristics or industries. Charlie Munger has a concept where each of us has one in-box (represents ideas) and three outboxes: a yes box, a no box, and then there is a too tough to call box, which is where you put most things. You must be honest enough to say I don’t know enough to make a reasoned decision so I will pass. This is the concept expressed by Warren Buffett of waiting for a fat pitch and letting the balls go by with no called strikes. If you don’t have the knowledge or insight, don’t do anything.  Moreover, you don’t have to make a decision you don’t know enough about.

Buffett on learning from Ben Graham: In applying Ben’s guiding principles, Charlie and I try to be thorough and methodical. We must also be realistic. We look for businesses we can understand, where we’re familiar with the product, the nature of the competition and what might go wrong over time. We try to figure out whether the economics of the business–including its earnings power over the next 5, 10 or 15 years–is likely to resemble a fine wine–to be good and getting better. Then we decide whether we would be buying into a business managed by people we feel comfortable being in business with–people with intelligence, energy–and most important–integrity.

      II. How big a discount from intrinsic value is big enough?

Depending on the accuracy and confidence of your valuation of intrinsic value, the bigger the discount you buy the security, the better. There are practical limits, however. If you want to buy at 1/3 of your appraisal of intrinsic value, that would be an admirable approach, however, you might have to wait 10 years before you could find such a discount. Except for 1974 and 2008/2009 when stocks were incredibly cheap, I haven’t been able to find stocks below 1/2 intrinsic value.

Usually, when you think you find securities at 1/2 or less of your appraisal of intrinsic value, go back and check your work–you will find that you are probably making a mistake. My experience has been to use a 33% discount to intrinsic value to enable me to find a useful number of ideas. Now, there is nothing magic about buying a stock at 2/3 of intrinsic value, the price could go down further.  There is a wonderful book, Money Game, written by “Adam Smith” which said, “Remember that when you buy a stock, it doesn’t know that you own it.” When Warren Buffett bought the Washington Post Company in the 1970’s, he believed he bought it at 40% of intrinsic value, yet the stock declined another 50%.

Buffett in a talk to Columbia business school students in 1993, said: “If you had asked anyone in the business what their properties (Washington Post Company) were worth, they’d have said $400 million or something like that. You could have an auction in the middle of the Atlantic Ocean at two in the morning, and you have people to show up and bid for that much for them. And it was being run by honest and able people who had a significant part of their net worth in the business. It was ungodly safe. It wouldn’t have bothered me to put my whole net worth into it. Not in the least.”

By 1973, the beginning of the severe 1973-74 stock market slump, Post Company stock had dropped from its original $6.50 issue price to $4.00 per share, adjusted for later stock splits. Buffett struck, buying his $10.6 million of Post stock, a 12% stake of the Class B stock at or about 10% of the total stock. The $4 price implied a value of about $80 million evaluation of the whole company, which was debt free at a time when Buffett figured the enterprise had an intrinsic worth of $400 million. Yet it was not until 1981 that the market capitalization was $400 million.

Regression to the Mean

Why do you expect that a stock purchased below intrinsic value will rise to intrinsic value and close the gap between price and value? The answer is not scientific–because stocks have always migrated back to intrinsic value. There is a pull towards intrinsic value. Stocks overvalued move down, while stocks undervalued move up (Regression to the Mean). It would be extremely unusual for a diversified portfolio of undervalued stocks not to return to value. Ben Graham in his later years studied a method of mechanically buying stocks at 50% of book value or net working capital with no debt and then selling either when the stocks returned to value or after three years if the gap between price and value had not been closed.

Insert more on R-T-M

How and Why Value anomalies occur.

How do these kinds of sizable discounts arise?

I did not define for you how big (a discount) is enough. My experience is a Margin of Safety of 25% to 30% is something that can be found with some frequency. I could say I would like to find some investment at 20% of value or with a 50% or 80% discount to intrinsic value—that may be a perfectly reasonable idea to have, but I may have to wait until 1932 (or 1973 for those opportunities to buy at 50% to 40% of intrinsic value) to come around again.

Example from Fischer Black and the Revolutionary Idea of Finance by John Wiley & Sons 2005, p. 236: “We might define an efficient market as one in which price is within a factor of 2 of value; i.e. the price is more than half of value and less than twice value.  By this definition, I think almost all markets are efficient almost all of the time.  “Almost all” means at least 90%.” (Fischer Black, 1986, Journal of Finance 410).

I gave you quotes from these book excerpts, an excerpt from Fischer Black and the Revolutionary Idea of Finance that most markets are efficient.  Most sell for ½ of value and twice (2x) value. I can’t address the twice value part of that claim. I have almost had no success in many, many years of my investing career of finding companies trading at ½ of value. Usually when I find them, I go back and try to figure out what happened. That is not to say they don’t happen, but they are so infrequent. The people who tell you they find values at ½ of value are probably deluding themselves.

I know such people. People who tell spell-binding stories about incredibly cheap stocks they have found. If a cheap stock is at a 50% discount–usually, I find they are wrong.

Placing opportunities into Context-Greenblatt.

III. Why stocks do become so significantly undervalued?

Many people believe the market is efficient–why pick up a $100 bill from the ground, because it can’t be there! What allows me to buy stocks at a discount to intrinsic value? This is a commonality among all value investors whether they invest in big caps, small caps or real-estate; they are contrarians–buying when others are selling. Value investors have the ability to go against the emotions of the crowd.  Research shows that valuations get carried to extremes on the upside and downside relative to intrinsic value. People become too emotional, overreact, and focus on the short-term news.

Another characteristic of value investors is our timeframes. We have longer than normal time horizons.  Most of us, including me, manage money not being measured every day or living in fear that money will be taken away based on short-term performance. If you were to manage a mutual fund, you would be aware of being monitored daily and if there was a short period of underperformance, the money under-management could be removed. This pressure creates a mad dash for the exits, which we see when a company comes out with disappointing news or earnings. Frequently the market reaction is frequently far out of proportion to the actual reality. This creates opportunities to buy. Having a longer time frame offers an opportunity to take advantage of time arbitrage—the market slowly overcomes the short-term focus on news and eventually recognizes true values.

Arbitraging time

In fact, if you think about it in a general sense, what are the circumstances that are going to create valuation disparities that are favorable to investing? The bad news either relates to the company or to the market in general like an act of terrorism.

Another related question is how long does it take for the gap to close? You must understand that it takes time for psychology to change from negative to positive. Understand the concept of regression to the mean. Nothing is ever as good or as bad as it seems. Companies have a central tendency to normalize profitability and growth. If there should be some short-run deviations especially on the disappointing side, it creates an opportunity for a value investor. There is a tendency for a business to regress to its mean of LR performance. In fact, these opportunities present themselves. If I knew enough to determine the value of IBM. And I have looked recently at IBM, but I don’t have nearly enough expertise to value IBM.  But I can look at a Value Line. I can see over a long period of time that IBM as been a remarkably stable and predictable business in terms of its revenue growth, in terms of its profit margins, its cash generation. It is a financial engine that doesn’t really change much. However, there is enormous volatility in the price of the stock.

If I could establish a real, bedrock intrinsic value, there is not much that could radically change my appraisal of the intrinsic value of IBM from year to year given the size of IBM, the diversity and stability of its businesses–with one big exception–a change in interest rates. If interest rates, say, were to rise in the 30-year bond, it would effect my appraisal of intrinsic value because of the discount rate that I use.

Discount Rates to Use in Valuation

For the types of businesses that I invest in they have a long-term track record, which enables me to normalize their earnings. Value means where I find it–big or small. I don’t define myself as small, mid or large cap.

My valuation is a function of interest rates. I am sure none of you here will not make the mistake made on CNBC or Bloomberg of comparing stocks, which are very long duration assets–particularly in a time of very low cash dividends–against short term interest rates. When someone says, “I can’t afford to get sub 1% on my cash, so I must buy stocks.” This isn’t comparing apples-to-oranges; it is much larger apart than that. If you want to compare a fixed income instrument to a stock, it must be the longest risk free duration bond you can find.

Insert Hussman’s discussion of Stocks as perpetual assets.

The discount rate that I use would be the long-term risk free rate plus whatever premium you demand.  There is no right answer to that, because each of you has a different demanded return.  Each of you has different tolerance for risk. But if you say I will only buy companies selling at 1/3 to 1/2 intrinsic value or discount at 500 basis points over 30 year Treasuries, then you won’t find very much to buy. The tougher you are at setting discounts, the less you will find to buy.

The 1977 Buffett Article in Fortune, talks about 12% equity returns. Those numbers are obsolete in 2004 (more like 6% to 7%). I am sure he would like to rewrite that article. Buffett is saying the normalized earnings figure for the stock market is 12%. Over a long period of time, some years it is less and other years it is more, but on average the stock market returns 12%. In the 26 years since that article was written, the returns have been higher. Also, the Dow Jones return on equity has much more questionable content. Because of so much writing down of book value, there are probably better ways to assess the profitability of a business. What he (Buffett) was doing was normalizing the whole market place. And he was trying to make the point of first, understand what you are buying. And then how much are you willing to pay for that underlying business to earn the returns that you need to earn. If you could buy the Dow Jones at 1982 at book value you would be getting a 12% return for 100 cents on the dollar–like a 12% bond.

In the book, The Davis Dynasty: 50 Years of Successful Investing on Wall Street by John Rothchild, Chris Davis of NY Venture Fund heard in 1999 Warren Buffett tell an audience he expected stocks to return 6% a year for the next 17 years-less than half the payoff during the prior 17 years. Buffett based his sobering forecast on simple math: In 1999, the entire lineup of Fortune 500 companies was selling for $10 trillion, supported by $300 billion in annual earnings. When the annual fees shareholders paid to own those assets—roughly, 1 percent of $10 trillion, or $100 million–were subtracted the actual payoff from their investing was $200 million. Contemporary investors were buying Mr. Market for 50 times earnings.  Because an entire market can’t justify a multiple, of 50, Buffett surmised, stock prices would have to give. They might give slowly or give quickly, or meander until the nation’s earnings caught up to them, but they couldn’t rise at their former pace without violating the laws of financial gravity. A $3 trillion price tag on a market with $200 billion earnings might be reasonable—but $10 trillion? No way. (Page-279).

When you start paying a premium, then the financial returns decline.

If there is one thing that Wall Street misses out on–I see almost no mention of it anywhere–is the link between the financial characteristics of the business that you are buying and the return you get as a function of the price you pay for that business. Don’t forget that! The nonsense from Wall Street of X percent growth for 5x earnings. Life is not that simple. There are ways to look at valuing companies that are much more helpful to you.

So we talked about intrinsic value vs. market prices.

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The Specifics of What I Do

I am a financial analyst. I am very interested in the numbers. If you look at companies there is a wealth of  information in the financials.

If you speak to management and they have done well, they will say they will continue to do well.   Or if they have not done well, then they will do well. Not all companies have superior financial characteristics. As I have grown older, I am increasingly interested in only those companies that have superior financial performance. The relatively few companies that generate high returns on assets and high returns on equity. These companies generate cash in excess of their internal needs and because of their excess cash generation have little or no debt. My personal choice within those types of companies, I restrict my interest to seasoned companies. These are companies that have an operating history of 10 to 15 years.

When I say seasoned, I don’t mean mature or declining. I mean companies that have been around for awhile. And these companies have developed a record that includes some periods of recessions and adversity or other periods of stress.  I want to get some feel of the ebb and flow of the business. And the results of the company lend themselves to this normalization process.  You can assess the company through difficult periods. Again a personal preference, I am interested in companies of a pretty large size. The amount of money that I manage does not require that I invest in large companies, but that is where my interest is. Very rarely will I invest in companies having capitalizations with less than a billion dollars.

I certainly don’t restrict myself with a label like some money managers who say they are a large cap or a mid cap managers.  I find value where a find it–given the other criteria right now for companies being seasoned and having a long track record and also having superior financial characteristics. If a company has been around for 10 or 15 years and has superior financial characteristics, it is not going to be a small company. There are many rewarding opportunities in those (smaller) companies with shorter, 5 or 6 years of operating history, but without the long track record or without the period of adversity—it is arbitrary–but I am adverse to investing in them.

In terms of the companies that pass through all of my filters probably….. If you look at Value Line with more than 2,000 companies there that are included in regular research coverage, there are no more than 50 companies that meet the criteria of size, length of record and superior financial characteristics.  I would argue with any of you that it would be possible to have a wonderful career, make a lot of money and be very satisfied in every way if you excluded all but those 50 companies.  None of you, of course, will take that advice, but it would be possible.   Many investors would be better off if they stuck to those companies.

Also, I would say the bigger companies are like super tankers, they don’t change rapidly; they don’t change overnight. What we see in the papers, a company will miss by a few pennies and the stock will drop 15% to 20% overnight. That is crazy. The value of the company hasn’t changed, and therein lies your opportunity. The value of the company almost certainly hasn’t changed.  There is much more price volatility than is appropriate for companies like Coke, Intel, Cisco and the like than the underlying values.

Again I am looking for:

(1)   companies that are not very volatile (in their operating and financial characteristics) and

(2)   produce consistently good results that lend themselves to normalization.  To identify very big companies where there is an attractive opportunity.

Even companies that are so widely followed–they have so much research coverage that they have got to be efficiently priced–I would argue that there are opportunities that present themselves.

There are a Couple of Big Ideas I Want to Talk About.

I gave you an excerpt from Berkshire Hathaway (1996) where Warren Buffett says that the long run performance of the stock is linked to the long run performance of the business. This is not unique to Berkshire. The long run investment return that you make is linked to the long run performance of underlying business in which you are investing. This is where the element of margin of safety comes in. If you can buy a business at a 30% discount and the underlying value is growing, then you will benefit from that underlying growth of the business but also from the narrowing discount between the price discount and the intrinsic value. The market prices the discount in your favor.

If you buy something at 70% of value and the value grows over time then in 5 years then you will benefit by the growth in the underlying business and the accretion of the discount. In five years you will get 6 points a year of narrowing discount (5 x 6% = 30%)—that is the margin of safety.  Once you get to 100% of value, your investment will track the growth of the business as long as the relationship holds.

Understanding ROE.  ROE = Net Income/(Beginning Equity + Ending Equity)/2

Example: Microsoft had above 30% ROE with no debt in the early 1980’s

The key to understanding ROEs, Buffett notes, is to make sure that management maximizes use of the extra resources given it. (Source: How to Pick Stocks like Warren Buffett – Timothy Vick)

Robert Bruce: I find it an irony. Warren works so hard to keep his shareholders informed so the market value of Berkshire Hathaway stock does not deviate far ever from the intrinsic value of Berkshire Hathaway’s business.  I think that is an admirable goal for him.

The irony for him is that his vehicle of wealth creation has been to buy companies where the market price of the stock is trading below the company’s intrinsic value. The idea here also ties into John Maynard Keynes who talks about the long term yield of an investment over its life. An investment held for its full life. This is the same idea that Warren is talking about.

When you think about the stock market that way, what the stock market is affording you is liquidity. You make an appraisal of the company and an appraisal of the future cash flows for the business, you like the outlook for the business, you like the price and you make an investment.

Now you have two choices:

(1)   You can hold the investment for a very long period of time as the cash flows are realized or…

(2)   On the other hand, the stock market gives you an opportunity every minute of every day to say, “I won’t wait around for the long run for this business to develop but I will sell it to someone else who will wait around and I will take the present value of the cash flows today.”

In the long run, incorporation has a very long life. So what we try to do in assessing businesses is to figure out which ones we have the capability to figure out the long run cash flow projections.  As I said at the outset, some businesses lend themselves to that and others don’t. The idea being this price to value.

If I could offer anybody here a perpetual risk less cash flow of a dollar per year, you would understand that the price you pay for that cash flow would be a significant determinant of the return you would receive. And let’s say you said you would pay me $2 to receive $1 per year for 3 years. This is the important assumption about reinvestment.

The important concept of reinvestment assumptions at a certain rate—Yield-to-Maturity.  The same thing is true with common stocks. With stocks the cash flows are unpredictable, but once again, the price you pay determines your return.

Stocks Are Bonds with Less Predictable Coupons

1. Can beat inflation
2. Can beat govt. bond yields, which are priced to reflect inflation
3. Can rise over time

Assuming a constant return on reinvestment, the price you pay determines your return. Compare returns when paying $40 per share vs. $20 per share.

Once again the reinvestment assumptions of how the company uses its cash flow are the ultimate determinants of return.  Of course, as a fixed income investor, you know the reinvestment assumptions are very important in determining your yield to maturity. The same is true with common stock because, instead of buying a predictable cash flow, you are buying an unpredictable cash flow. Once again, the price you pay determines the return you get. The investment assumptions are the ultimate determinate of the enterprise. But the idea here is to think of being an owner, owning a piece of the enterprise. You are buying for the long haul. The idea being that you will probably not sell it unless it (the price of the stock) gets sufficiently above its intrinsic value.

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1. IV.              Now, what kind of company to look for?

One thing that comes up all the time is how do you screen stocks, what is the first thing you look for?  What I look for ideally is for good businesses. These are businesses that are consistently above average in profitability because of that they generate free cash and because of that they have low or no debt–all of these things go together. If you find a business that is superior in profitability, you will find it has nothing but good choices as to what to do with its cash: pay out dividends, buy back stock, reinvest, etc. A company generating free cash doesn’t have to borrow money.

So look for companies that consistently earn superior profitability. When you find a company that earns consistent superior profitability, then you need to look a little further. What is it about this company that allows it to earn superior returns and prevents competitors from coming into their market and pressuring those above average profits? This is the idea of a franchise business with a moat around it or a niche business.

What is it about Clorox that allows the company to sell a toxic chemical at a larger mark-up than a generic brand? The answer is advertising, the brand coupled with customer captivity. There are companies with patents that have great efficiencies, they control a regional geographic market. Less so than in the past, but there are one paper towns–monopoly newspaper. Warren Buffett said of the Washington Post, that if you gave him a billion dollars to compete against the Washington Post, he would fail miserably and he wouldn’t be able to dent the franchise. This is an example of an entrenched franchise with a moat around it.

The reality is in the very competitive world we live in, there are very few businesses, which have permanent moats. Franchises are under constant attack. Rarely do you have a business that has a franchise value and also the opportunity to grow. Companies fortunate to have a franchise business, they reinvest as much in that business as they can and still earn a superior profit. Rarely do they have the opportunity to reinvest their cash and earn the same returns as their original business. Probably the greatest success of my career and one of the greatest successes ever in one generation is Wal-Mart. In the space of one generation, a fortune of close to $100 billion was created. Wal-Mart was extraordinary, something I have never seen again, Wal-Mart (WMT) earned 25% or more on its equity and it had the opportunity to reinvest all its profits every year in new businesses, in new stores and continue to earn 25% or more–a wonderful compounding went on for a long, long time.

In contrast, Microsoft has huge cash flow, but there is nothing they can do with that excess cash to earn the high returns of their core business. MSFT has a core business that is a monopoly with a very high wall around it and they work very hard to protect what they have, but MSFT has nowhere to grow or reinvest their cash.

The reality is that the kind of businesses that combine these traits to be superior businesses are rare, and I will mention a few names here–we are not talking about multiple names–Liz Claiborne, an apparel manufacturer. There is Superior Industries, which makes wheels for the automobile industry, Rayco that makes paint sprayers. There are probably 50 to 100 in this category.

Buffett on researching a company: Buffett told Bob Woodward, the investigative reporter who uncovered Watergate, that, “Investing is reporting.”  ….”A sensible story to assign yourself would be, ‘What is The Washington Post Company worth? Now, if (Editor) Bradlee gave you that story to work on what would you do for the next week or two? You would go around and talk to people in the television business. You would try to figure out what are the key variables in valuing a television station and you would look at the four that the Post has and apply those standards to that. You would do the same thing to newspapers. You would try to figure out how the competitive battle between the Star and the Post is going to come out and how much different the world would be if the Post won that war. All of these things are a lot easier than the problems Woodward would be working on. Usually people would want to talk to him but on this subject they would be glad to talk to him, and then I said when you get all through with that, add it up and divide by the number of shares outstanding. All he had to do was assign himself the right story and I assign myself stories from time to time.”

If you want a really easy way to identify some of these businesses, go to the 13-D or 13-F filings of Berkshire Hathaway and look at some of the companies owned by a great investment manager, Lou Simpson. Then wait for the prices to fall from time to time. These are businesses, which generate cash, they generate more cash than they need. Companies, which have little or no debt, which buy-back stock, and pay dividends. This is the preferred type of investment, the preferred option in my opinion–a good business that appears to have a wall around it.

LOU SIMPSON: The Oracle of Rancho Sante Fe ( Of Permanent Value, 2004 Ed.)

Dun & Bradstreet    Manpower    First Data    Burlington Northern Sante Fe    Freddie Mac    Mattel    GATX    International Dispensing Corp    Great Lakes Chemical    Apache Medical Systems    Jones Apparel    CollaGenex Pharmaceuticals    Nike    Cohr    Shaw Communications
US Bancorp    Comcast
Fair Isaac
DSM.com

Buffett on Lou Simpson: He has the ideal temperament for investing. He derives no particular pleasure from operating with or against the crowd. He is comfortable following his own reason.

Simpson was picked for three qualities: intellect, character and temperament. Temperament is what causes smart people not to function well. Like Buffett, Simpson is a voracious reader of annual reports, newspapers and magazines. Plowing through 15 corporate reports in a row is his idea of a satisfying day.

      V. Research Management

If you find an investment and the value makes sense, then the next thing is to find out whom you will entrust your money to. Look hard at management. Find out how much stock the management owns, how management acquired stock in the company, how much each Director owns of company stock and find out about the relationships between the Directors and the management. Is management incentivized to build value for the shareholders?

On the one hand, we are talking about financial analysis and looking at the numbers but on the other hand in an investment in a company, you are becoming a silent partner or junior partner in that company. So before you make an investment in the company, you should do the best you can to ensure that the people running the company are people you can trust. If you look at the people in the companies involved in the front-page scandals in the business press, like Enron, Computer Associates and Imclone, the principals were involved with shady dealings long before those scandals erupted. Remember that you are entrusting a lot of responsibility to management when you invest your money.

If you are not a professional money manager and can’t talk to management, then read the proxy carefully and read the last 4 or 5 annual reports–read them sequentially to ascertain their candor and if they are self-critical and you have some comfort that you know what they are trying to do. All too many times, if you read the annual reports, there is no connection at all. The goals, tone and message change year to year–without explanation. It is very much an ad hoc kind of thing. Sometimes it is just a matter of what is popular at the time.

Example of ROAC annual reports

What I like to see is a company that sets forth its goals and objectives. The company says what it is trying to do, it says, this is what we are good at; this is what we are not good at. This is where we are trying to improve. Then at the next opportunity the same manager gives himself a report card. This is what we tried to do, this is what we accomplished this is what we have to do. It is honesty, candor, and admission of failure–a constancy of goals.

We have talked about the financial characteristics of the companies to look for. We talked about making an effort to identify the kind of people who are running those businesses. Whom we are partners with.

One of my pet peeves is the Imperial CEO. The idea that we have corporate CEOs as national heroes. Some of the publicity is unavoidable and some of it, quite honestly, is sought after whether it is Jeff Immel, Sandy Weil or Carly Fiorina–they may or not may not be good people, but that is not what I am talking about. The idea that CNBC or Bloomberg can say, “Jeff Immel, he is your friend. He is one of us.” I am talking about the CEO who may be a very rich man, a very successful man but no one outside his industry knows about him. So the idea those individuals are important–Bloomberg says, “Today, Sandy Weil went out and bought a bank.”–The news media personalize the CEO. Sandy Weil didn’t buy the bank, Citibank did. Citigroup is much bigger than Sandy Weil.

Buffett on choosing people. Buffett describing how he would choose a leader (to run Salomon Brothers).  “They all had the IQ, just like everybody in this room (Columbia Business School students).  It doesn’t make any difference whether your IQ is 140 or 160 if you’re running Salomon or doing most things in this world. They all had energy level and the desire. So the question was: Who would be the best leader? Who was going to go into a foxhole with me?”

“I devised this little system in getting you to think about how you might attack that problem yourself, or how you might be the person that would be chosen under those circumstances. Imagine that you have just won a lottery I conducted. And by winning it, you had a very unusual prize. The prize you get is the right to pick within the next hour one of your classmates. And you get 10% of the earnings of that individual for the rest of your life.

What starts to go through your mind? Are you going to give an IQ test or look up their grades and take the person with the highest grades? Are you going to try to measure desire or energy or something?  I think you’ll decide that those factors tend largely to cancel. They could be important up to some threshold limit, but once you hit those levels, you’re OK.

I think you’ll probably start looking for the person that you can always depend on; the person whose ego does not get in the way; the person who is perfectly willing to let someone else take the credit for an idea as long as it works; the person who essentially wouldn’t let you down; who thought straight as opposed to brilliantly.

And then, let’s say there is a catch attached. For the right to buy this 10% interest, you had to go short 10% of somebody else in the room. So in effect, you get the 10% of the first person’s earnings, but you have to pay out 10% of the second person’s.

Now again, do you look around for the person that is a little slippery, the one that everything has to be his or her idea, the one that never quite does what is expected of them, or pretends to do things that they don’t. You really get back to things that interestingly enough…are things that you can control.

You have these–what I would call–voluntary items of character, behavior. Essentially, you can pick out those qualities of behavior, and if you want them, you can have them yourself. And I would say that most if it’s habit. It is just as easy to have good ones as bad ones, and it makes an enormous difference.

    VI. Waiting for the right price

I just want you to be aware that this personalization of corporations is recent in the last five or ten years.  Now, in terms of finding franchise companies to invest in, checking to see if the managers of those companies are the type of people you want to be with.

Then what do you do? You want to wait for the stock to trade at a price discount to value. Nearly all the companies we are talking about have great financial characteristics, they are well regarded and nearly all of the time they will trade at or above intrinsic value. They are easy to like. So what makes the opportunity occur?  Sometimes the company fails to make its earnings expectations or the company recalls a product. There is some type of disruption, something goes wrong, that the market is worried about in the short run. My experience has been that you have to have done your work in advance, that you don’t have time to react. Chances are you won’t have enough time to do a good enough job to take advantage of the opportunity.

The image I have is shopping for shoes and waiting for them to go on sale. I know what I want and I wait for them to go on-sale. You go to a shoe store and you walk up and down the aisles and look at all the shoes. You like that one and that one, but they are too expensive. I think I will come back when they go on sale.

So what I do is I look for companies that fit my financial characteristics, my perceptions right or wrong of the quality of the company. I have a lifetime experience of getting to know 200 or 300 or 400 companies that might fit my description. And I never know when any one of them stumbles, but if it does, I would like to be prepared. I got my eye on a lot of different stores, but I have my eye on enough shoes that if any of them go on-sale, I am ready to act quickly.

VII. How do you know if the problem is a blip or the beginning of the end?

It is not an easy question to answer. The cliché of momentum investors is that there is never only one cockroach. The first piece of bad news is never the ultimate bad news. That isn’t my theory. In the kind of companies that I look at, if I understand the business well, if I understand what makes them work, if I have a reasonable understanding of its business model and the environment in which it operates, I should be able to distinguish if it is a long run or short run problem. If it is indeed, in fact, a long-run problem, then I exclude it.

The best example I have for that was what happened when Hillary Clinton had her health care scare.  When she put her study group together to socialize medicine, it caused all the major drug companies to be targets, the stocks sold down to levels that in retrospect were extraordinarily attractive. But the investor had to know the prospect of her bill/act passing. I didn’t know at the time, but if I had, then this would have been an opportunity.

There is one other type of company, speaking for myself, I like to find companies rich in assets.  Companies with hidden assets. These may be companies, which may be a little more difficult for the casual investor to understand, but the companies are rich in assets and may not have extraordinary attractive operating characteristics. For example there is a company–I am not long now–called St Joe Corporation which owns 4% of the state of Florida. It is a fascinating business. The operating characteristics are not particularly eye-catching. Other companies may have natural resources–timber, ore in the ground, oil and gas, real estate. These are assets that are not recorded accurately in GAAP financial statements. So you have to read the company’s footnotes.

Remember that when a company invests a million dollars to drill an oil well and the oil discovered is carried on the balance sheet for a million dollars whether the well produces 1000 barrels or a million barrels of oil. The GAAP numbers don’t tell you enough. You have to look behind those numbers.  The same thing is true in regards to timber assets. The market value may have little relation to the cost of the timber purchased 30 years ago.

       VIII. When do you sell?

Always be aware of intrinsic value. What happens when you buy at $70 because the intrinsic value is $100, but now the stock is $50 but the intrinsic value is $70–it is still selling at a big discount. What do you do? Your confidence might be shaken in your ability to judge intrinsic value. There is no easy answer. Warren Buffett in his 2003 Annual Report expresses regret in not having sold some of his large marketable securities–his Coke and Gillett during the bubble.

I am not dealing with companies, which go up and up and up for 10 years. Because I am sensitive to intrinsic value, because of the types of companies I am dealing with. If I buy a company at a big enough discount, I sell when it reaches intrinsic value. As a result I have almost never had a security that goes up several times.

Buffett has said he has identified companies that are so intrinsically wonderful, that he will hold them forever. Now, he is saying there is a time to sell. (Buffett mentioned this in his 2004 annual report to Berkshire shareholders).

H/T csinvesting