Boring Portfolio

Buffalo Report
More on valuation

by Dale Wettlaufer (TMF Ralegh)

BUFFALO, NY (Nov. 27, 1998) -- Dale here, taking the reigns for Alex on this day after Thanksgiving. I think Alex can't move today after the big homecooked celebration he enjoyed yesterday. So I'm here in my hometown picking up as many boxes of Flutie Flakes as possible and scouting how the Bills are looking for this week's game against the Patriots. I put as much fundamental analysis into wagering on sports as I put into investing. Just kidding there.

I have a couple things that I would like to review today. The first is to wrap up what we discussed on Monday -- our foil to the Fool Port's statement on valuation last week -- and second, to introduce the next company in which we will be considering making an investment. This one will come as no surprise to people who know me and/or my work.

As part of his discussion of valuation last week, David Gardner said that the current price of any stock:

"...represents by definition the fairest value presently conceivable for that stock. Because this notion will be a radical one for some, we reiterate again that if the price were not fair and efficient, it would immediately be driven up or down by buyers or sellers eager to cash in on that inefficiency. Think of inventory sitting on a retail shelf; if no one bought it, sales volume would be zero and the price would have to drop to find buyers. To believe our market -- or any open market -- does NOT operate this way is to believe that the pricing systems of capitalism and of the stock market don't work, making the stock market not worth investing in at all."

We'll state for the record that the market isn't always right in the short term. It is amazing how efficient the market is both in the short- and long-terms, but we don't think it's always right. Otherwise, how would one be able to add value in investing? If were fairly valued six months ago, why would it have risen by the hundreds of percentage points that it has? We're not efficient market theorists -- we don't believe that every fundamental fact about a company is priced into a stock at every moment. Rather, as David says, people's perceptions are priced into the present quotation. If you believe perception is reality, then OK, the market is efficient. But we think that intrinsic value is reality and very often the market price can get away from intrinsic value, both on the upside and downside.

Intrinsic value is the net present value of all future cash that can be extracted from an enterprise over the lifetime of that enterprise.

By net present value, we mean that a dollar a year from now is worth less than a dollar today, because we can use that dollar today to end up with $1.05, $1.11, or more in value one year from now. Reversing that process -- estimating the cash flows a company can generate in the future -- and discounting them to the present gives us net present value.

If stocks were always priced efficiently, the Foolish Four method of investing in beaten-down Dow stocks wouldn't beat the long-term rate of return on common stocks. No one would sell off any of these stocks, knowing that the long-term prospects of these companies would not be damaged by short-term problems such as the Bhopal disaster, the Exxon Valdez, the salad oil scandal that hit American Express, etc. No stock would give an investor any more than the market rate of return over a holding period if short-term inefficiencies did not exist. If fear and greed did not drive markets, there would have been no real estate boom and bust in the 1980s and all the S&Ls that had over-invested in real estate would have not been valued above $0 a year before the markets fell apart.

Unexpected things come along, though. The Tax Act of 1987 wasn't factored into the prevailing market sentiment. The disallowance of goodwill being included in regulatory capital would have been factored into more valuation models. The California recession ten years ago would have been factored into Wells Fargo long before real estate losses and defaults hit that company. Why, if the present quotation of all stocks represented the intrinsic value of all stocks, would the great crash have happened in 1929 or the crash in 1987 have happened? David went on to explain that: "Not only do we not believe short-term price movements are logical or can be predicted, but we wouldn't want to waste our time guessing at them anyway." I would ask, then, if short-term price movements are not logical, what does that say about the logic that David just laid out to justify the prices that prevail every day in the market? If the price is logical one day and logical the next, then the change in price from day to day must then ipso facto be logical.

What was the logic behind the $50 point rise in in the two trading days that followed the company's announcement that it would split its stock 3-for-1? That doesn't change the value of the company. Only the perception of a change in value would have driven that change. There was nothing new and undiscovered about the company that came to light in those two days that would change the company's value by over $2 1/2 billion dollars. While we believed, horrifyingly so in the eyes of value investors, that offered value at $20-40 per share, we don't believe it does today. Not that we want to totally harsh on David's mellow here. We totally agree with what he says in the next part of his piece:

Instead, we spend our time studying the much more interesting long-term variables: what's the company's industry, what's its business, what's its profit model, and will this company "win?" Once these questions are answered to our satisfaction, we invest and then find out in time whether we were right or not. THAT is the way the market rewards or penalizes long-term shareholders - on their ability to forecast whether a company will make increasing, long-term profits or not. Over the long term, value will out.

Exactly. We couldn't agree more. We don't agree with the prehistoric and wrongheaded approaches to value that say you can't pay more than a dollar for a dollar in sales, a dollar for a dollar in net asset value, or that you can't pay more than $12 for a dollar in earnings. Or whatever the valuation rules are that "value" people use. Maybe you can make money that way, but we don't believe in strict rules-based systems of making money in markets. That would put us in the same camp as Long-Term Capital Management. No thanks. An investor has to be more intellectually flexible than that. The brain is an incredibly complex computer. The more quality data you feed it, the more equipped it is to judge the value of something.

Three data points on valuation aren't enough. If one bought Nucor Steel in 1969 at 100 times earnings and five times book value and shorted Bethlehem Steel at 20 times earnings and 2 times book, one would have been very happy indeed 15 years later. There's more to investing than rules-based valuation multiples. That's what David is saying in his piece, but we think that an investor can certainly go way beyond these simple "traditional valuation" rules to assess value. In fact, in today's Fool on the Hill, analyst Warren Gump demonstrates a discounted cash flow of This method is much more useful in valuing than simple valuation methods contained in books written by people such as James O'Shaughnessy.

We could go on with this subject for a long time, but we'll cut it off here. We disagree with some of what David said last week. But we agree very much with the Fool Port's philosophy of being long-term investors and thinking of oneself as a business owner rather than a holder of stock certificates that are ready for trading at the drop of a hat. In summary, we believe the market-clearing function of the securities markets is very efficient in demonstrating all the current perceptions of value that exist in the market at the immediate moment. We don't believe the market is always efficient in the short-run at indicating the intrinsic value of an enterprise. We do agree with David, wholeheartedly, that over the long-term, value will out.

Potential New Investment

This won't come as any surprise to anyone that knows me or my work, but the first company we will be looking at as an investment will be Berkshire Hathaway (NYSE: BRK.A). The company is not an easy one to analyze at first blush. Analysts, investors, and commentators have struggled with placing a value on the company for years, almost always reaching the wrong conclusion because they look at it as a closed-ended mutual fund rather than as a vibrant insurance, services, and manufacturing company that happens to invest its cash flow in common stocks. In fact, this is a great instance where people look at book value and come to the simple-minded conclusion that the company is overvalued because it trades at a premium to its book value. But we'll get into that later. There are a lot of valuation and economics topics to discuss in regard to Berkshire Hathaway. We'll get into those as we look at the company starting on Monday.

As a preface to our look at the company, let me say that I am biased, being an owner of the company and having bought it on behalf of family members. I also enjoy a multiyear relationship with numerous Berkshire shareholders on the now world-famous Berkshire Hathaway message board on AOL. The message board is populated by people calling themselves the "Yellow BRKers" and we're kind of like Deadheads (Grateful Dead fans), though you probably wouldn't smell much pot smoke or run the risk of being "dosed" at a gathering of the Yellow BRKers.

And I don't say that to be unfair to or to summarize Deadheads; I've been to a few Dead shows and know what I'm talking about. What I'm trying to say is that a commonality that has drawn me together with shareholders of this company now goes beyond that commonality to friendships that go beyond Berkshire. So let me say once again that I carry a personal bias here, though the veracity and accuracy of any analyses that Alex and I turn out on the company are certainly open to criticism. To keep us in check, please feel free to comment on our analysis of this company, or any other one, on our Boring message board on the web or on AOL.

Have a great weekend, and please take a look if you have a moment at helping us help out Share our Strength.


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11/27/98 Close

Stock  Change    Bid
ANDW  +  1/8   17.00
BGP   +1 7/8   25.25
CSL   -  3/16  45.88
CSCO  +2 3/4   79.81
FCH   +  5/16  24.06
PNR   -  3/16  37.69
TBY   +  1/16  7.31

                   Day   Month    Year  History
        BORING   +2.30%  10.19%   0.79%  26.82%
        S&P:     +0.46%   8.52%  22.86%  91.80%
        NASDAQ:  +1.57%  13.83%  28.41%  93.71%

    Rec'd   #  Security     In At       Now    Change
  6/26/96  225 Cisco Syst    23.96     79.81   233.17%
  2/28/96  400 Borders Gr    11.26     25.25   124.32%
  8/13/96  200 Carlisle C    26.32     45.88    74.26%
  4/14/98  100 Pentair       43.74     37.69   -13.84%
  5/20/98  400 TCBY Enter    10.05      7.31   -27.20%
  1/21/98  200 Andrew Cor    26.09     17.00   -34.84%
  11/6/97  200 FelCor Sui    37.59     24.06   -35.99%

    Rec'd   #  Security     In At     Value    Change
  6/26/96  225 Cisco Syst  5389.99  17957.81 $12567.82
  2/28/96  400 Borders Gr  4502.49  10100.00  $5597.51
  8/13/96  200 Carlisle C  5264.99   9175.00  $3910.01
  4/14/98  100 Pentair     4374.25   3768.75  -$605.50
  5/20/98  400 TCBY Enter  4018.00   2925.00 -$1093.00
  1/21/98  200 Andrew Cor  5218.00   3400.00 -$1818.00
  11/6/97  200 FelCor Sui  7518.00   4812.50 -$2705.50

                             CASH  $11273.22
                            TOTAL  $63412.28