Boring Cornucopia (Bore Port) August 20, 1999

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Boring Cornucopia
Friday musings

By Dale Wettlaufer (TMF Ralegh)

Alexandria, VA (August 20, 1999) -- A couple different topics today:

1. On Carlisle's (NYSE: CSL) agreement to acquire Titan International (NYSE: TWI), I didn't have anything more to add to outside of what I said about it last week. Carlisle knows the tire and wheel industries very well, and despite this deal being a different sort of transaction than usual, in that this is a turnaround situation, I have no question about the acuity of Carlisle's management in this deal.

The equation is simple: If Carlisle beats its cost of capital over a business cycle in this transaction, it adds a bunch of value to the combined company. Even when we do mark up the unrecorded goodwill on the combined company's balance sheet, if the transaction closes, there won't be that much goodwill. So the financial capital addition that comes about through such a transaction isn't going to be such a huge burden on operating capital and managers that the chance for stupid decisions goes up. Given all of this, I really don't have any more commentary.

2. On Berkshire Hathaway (NYSE: BRK.A), when I talk about underwriting gains or losses as a percentage of float and how that translates into cost of capital, remember that the underwriting gain or loss after taxes then goes into either cost of capital or into the return on invested capital calculation. With the latter, there's no cost of the float, as it's expressed in the net operating profit after taxes (NOPAT). In the former, you take the gain or loss out of NOPAT and assign it to cost of capital. In either case, the spread between return on invested capital (ROIC) and weighted average cost of capital (WACC) doesn't change.

The reason I make this point is that the concept of economic value added is a common framework for looking at any business, whether that's an insurance company, a manufacturer, or a services company. Economic value added analysis is the same as discounted cash flow analysis, but you're considering that the gross cash flows aren't free. Equity costs something, as does debt, as does joint venture capital, as do certain equity equivalents, such as appropriated surplus (tax reserves and the like).

Now, some companies can take this too far and leverage the heck out of a crummy business without getting the return on capital needed to make the business an economic success. In other words, some companies focus way too much on their cost of capital and not enough on their return on capital. But other firms, such as Wal-Mart or McDonald's, have been leveraged to the teeth and have done spectacularly as the result of their high returns on capital.

It boils down to this: I prefer companies that can generate economic returns even if they're completely equity financed. I do like business models, however, where low-cost capital comes in the door through the normal course of business. International Speedway Corp. (Nasdaq: ISCA), for instance, generates large and growing amounts of deferred income in taking advance sales of tickets each year. This doesn't show up on the income statement, but it increased NOPAT by about one-third last year. In a company building out investments, that reduces the need for external financing and directly increases gross cash flow and free cash flow. At the same time, I don't see it as having an implicit cost, such as you have with equity capital, and I don't see it as having any explicit cost other than what is reflected in expenses at the time the income is earned. That's the best of all worlds, financially speaking.

On Wednesday, I gave a simple model of how much an insurance company's capital might cost when its float costs 2.23%. If you look at it on the basis of what it takes to meet this cost of capital, you know that 30-day T-bills can get you 3.13% after tax. There aren't many business models out there that allow you to make an 90 basis point spread between ROIC and WACC while the capital is in cash equivalents. The engine is totally idling here and the company is generating economic value off the insurance float.

This is very unusual and fits perfectly well with an investment style where management doesn't believe that good long-term returns are available in investments with longer maturities, including equities. The company can easily meet the cost of capital as it comes in through float. On equity capital, meanwhile, some of this 1999 performance was prepaid back in 1994 and 1995 with Coca-Cola. Things like that aren't going to go up 40% per year, and if they do so for a long period of time, I think it's reasonable to expect a period of underperformance.

If you correctly measure equity investment performance over five-year chunks of time, the performance of Berkshire's equity portfolio in 1998-1999 shouldn't really bother you. In my model of Berkshire, I assumed it wouldn't meet its cost of capital in either 1999 or 2000. So, another 16 months of Berkshire's stock going nowhere is within my range of expectations. That's been priced into my assumptions since day one on this investment, so unless something really strange happens in the near term, this company is tracking to expectations.

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