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Berkshire Hathaway
The Buffett Approach - A Buy for Signal for BRK?

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By MisterMarket
March 10, 2005

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The Dichotomy of Buffett's Approach to Investing & the fundamental characteristics of Berkshire Hathaway, his investment vehicle.

Like most of the regular posters here, at the BRK board, I have grown up in the investment world with WEB as one of my guiding lights. His contribution to my own development has been extraordinary. As an aside, several years ago, I wrote WEB a brief letter explaining the positive impact his statements, writing and example had on my own development, fully indemnifying him for inevitable future losses resulting from my own ignorance. Specifically, within the letter, I informed WEB that I'd read everything by and about him to that point, yet one piece of BRK-related material had escaped me, a Munger speech at USC. I politely requested, if available, a copy or direction on where I could attain Munger's speech. I must say, I had little hope of actually receiving anything in return, but I was glad to express my gratitude regardless. Within about 12 days of mailing my letter to WEB, I received from Kiewit Plaza an OID reproduction of Munger's speech at USC. I still marvel to this day, given the innumerable, important things that must arrive at Kiewit on a daily basis for our man Buffett, that my relatively trivial request received such prompt attention. Do I think that WEB licked the return envelope himself? No. The reply may have occurred even before he saw my letter, but regardless the action of responding speaks volumes about the man and the organization.

That said the point of my missive is that over the years I have perceived a dichotomy, to some extent, with the approach to investing which WEB preaches versus the fundamental characteristics of Berkshire Hathaway, his investment vehicle. Before you start to punch out a response labeling me a heretic, please read on, because I don't necessarily view the dichotomy as a negative or sell-out on WEB's behalf (i.e. do as I say, not as I do), as much as I see the resultant dichotomy for two reasons: 1) approach to sensible investments, and 2) fundamental characteristics of a very complex investment vehicle, Berkshire Hathaway.

To begin, we are all quite aware of WEB's early investment training by Ben Graham and the absolute impact the experience had on WEB's philosophy, even still today. Of course, it is well known that WEB has matured, shall we say, beyond his roots, but then again as my own grandfather used to say, "The student excels the master." Does WEB find values (e.g. cigar butt's) at 2/3rds working capital? Of course not, we are all quite aware of the current cash balance of approximately $40B awaiting deployment. But what of Graham's philosophy does WEB seemingly still incorporate and deploy?

I would suggest the following qualitative & quantitative evaluations in brief:

Qualitative:
- Is business understandable?
- Are the company's products/services of high quality and represented by high customer loyalty?
- Are there moats, wide competitive advantages & barriers to potential competition?

Quantitative:
- Is business generating attractive/growing owner's earnings (or free cash flow)?
- Are there long-term records of increasing sales & earnings?
- Is there a long-term trend of ROE of 15% at a minimum?
- Is the business maintaining acceptable profit margins, especially relative to the competition?
- Is the current market price reasonable relative to current (and conservatively estimated earnings)?

The aforementioned, while not an exhaustive list, generally represent the qualitative & quantitative hurdles that WEB proclaims in his public statements and writing. So one is naturally led to ask the following, "Assuming the aforementioned, abbreviated list adequately represents our man WEB's filter, does WEB eat his own cooking?"

Let's have a look at the investment portfolio of BRK (per p. 16 of the current Annual Report) data included provided by TMF, 3/9/05:
Security ROE PM P/E
American Express Co. 22 12 21
The Coca-Cola Co. 34 22 22
The Gillette Co. 75 17 28
H&R Block, Inc. 38 -9 15
M&T Bank Corp. 13 22 19
Moody's Corp. 17* 29 33
PetroChina "H" shares 22 23 10
The Washington Post 16 9 29
Wells Fargo & Co. 21 21 16
White Mountain Insurance 16 7 43

* Represents Trailing 12-mo figure from WSJ-Online, as TMF did not publish a ROE figure for MCO.

WEB offers some anecdotal commentary on p. 16, particularly about the "Big Four" (as he calls them), AXP, KO, G & Wells Fargo. Interestingly enough, WFC is not the fourth largest position, falling behind both PetroChina & Moody's. Currently, I am not going to spend the time analyzing why WFC would have been included in the Big Four cumulative figures, hopefully if one cares to pull WFC and replace it with either of the larger two positions the published figures in the AR would reflect a more muted performance and not the opposite.

So the abbreviated figures above show a few things, with one glaring flaw in terms of my argument and that is that these figures are current and neither reflect the figures at the time of purchase, nor their trends prior to or since acquisition. Regardless, one can easily see, that the majority of these figures still represent attractive results, not that they should compel someone to make current investments, as WEB succinctly notes on p. 16 of the AR. However, in a general sense, each company, for the most part, continues to exhibit current strength in terms of ROE & profit margin, with P/E carrying less weight post-purchase since it is more directly impacted by the coy behavior of my maniacal namesake, Mr. Market. Given the recent popularity on this board of quoting WEB's notion that it is not so important to judge one's weight, as it is to determine whether one is fat or not, I'll skew this line of thinking a bit. Well, forgive me, but I'll employ writers privilege and further bastardize such a notion by suggesting that while I don't have the purchase dates of each security listed above and a 5 to 10 year historical record of earnings in each case, it is moderately safe to assume that the earnings, in most cases above, have been and are likely to be more consistent than say, Amazon.com, Silicon Graphics or Gateway Computers. Anyway, the larger point that I am poorly attempting to make here is that the portfolio companies listed above tend to substantiate WEB's filtering process, including earnings consistency/predictability. On those general observations, it would appear as though WEB does eat his own cooking.

To further substantiate my general observations, let's look at average growth rates for past five years of selected metrics, data provided by WSJ-Online:
Stock Rev. NI EPS Div. CapEx GM CF
AXP 6% 7% 9% 8% -100% 1% 7%
KO 3% 15% 15% 9% -7% -1% 12%
G 3% 6% 8% -100% -100% 10% 0%
HRB 21% 24% 27% 10% 7% -2% 25%
MTB 9% 22% 13% 29% 17% N/A 20%
MCO 19% 21% 24% N/A 8% 2% 20%
PTR 16% 38% 35% N/A 12% 4% 28%
WPO 8% 8% 9% 6% 9% 1% 6%
WFC 6% 12% 12% 19% -100% N/A 3%
WTM 51% 17% 5% -9% N/A N/A 9%

Obviously some of the 5-year growth rates are more compelling than others. Regardless of some decreases in dividends, capital spending and mildly shrinking margins, the larger picture is one of growth, albeit to varying degrees.

However, when one turns their focus to BRK (the stock) the complexities immediately abound, both in terms of the rapidly expanding decision-tree nodes of assumptions one must make, to the erratic earnings produced by BRK itself. Graham consistently noted that consistency in earnings growth was of paramount importance to appropriately valuing securities. For one thing, consistency in earnings shows either of two things: 1) a company that knows what it is doing and is committed to constant improvements in productivity and efficiency leading to growing profitability, or 2) an organization that lacks the former but employs charlatan financial executives. Graham assumed that the intelligent investor would be able to tell the difference.

On this very board, there exists a recent proliferation of those squawking that to determine IV, one simply needs to compute a PV for all the future cash that can be taken out of a company. Recently, a number of approaches have been proffered, some more detailed than others, attempting to peg the current IV of BRK. Meanwhile, I have yet to review a PV calculation of all future cash flows, even though some suggesting that technique develop IV values without employing the tried-and-true engineering economy procedures. Our own man WEB says that he doesn't employ DCF calculations, essentially the same thing as PV. Einstein is said to have suggested that (para.) things should be made as simple as possible, but no more so. Well, I simply continue to contend that one cannot adequately value BRK in a 3 or 4 bullet list. At the very least, one cannot do so in such short order using Graham + WEB notions. Why not? You ask. Well, for starters, BRK's earnings are too erratic. I do recall WEB saying that he'd prefer a choppy X% over a smooth x%, but no one should be fooled into believing that staring a choppy X% earnings history in the face compared to a smoother x% gives one comfort in plowing hard earned $ into the former. After all, statistically writing, the smoother trend certainly represents less variance (i.e. high probability of a future # in-line with historical trend). Of course the deep pockets (constantly refreshed pockets) of BRK enable it to take on more risk of in terms of volatile earnings, where as organizations & individuals with more modest income streams or more demanding shareholders may not have the luxury of choosing the more volatile security, whose growth trend over time may be more rewarding, but certainly more over a shorter period (one to two years) can be absolutely fatal; our man Munger certainly knows such pain from the early 70's (and HB that's not a ding on our beloved Munger; you know I admire him as much if not more than WEB). I would contend that developing an IV for AXP, MCO, PTR, or any of BRK's portfolio companies is difficult enough, but add multiple security positions to a growing list of wholly owned operating companies in conjunction with a large, multivariate insurance operation generating erratic earnings as the result of an amorphous combination of float and policy liabilities...I would argue that BRK is anything but easy to value and for all our beloved Chairman's efforts to simplify notions, it is one of the more complex conglomerates in the world today.

All that considered I have even more respect and admiration for our man WEB. He truly is a genius. However, his genius at seeking easily understood businesses (which tends toward more easily developable valuations) does not automatically translate to an easily understood cumulative business in BRK, nor does it tend towards an easily developable valuation. To paraphrase Phil Fisher, why bother trying to correctly estimate out earnings in two or three years, when a company's management cannot correctly do so even one year away? Well, that makes perfect sense and thank goodness for all us enterprising, would-be intelligent investors. Can you imagine being a Wall Street analyst and having your boss require you to develop such figures on less than full information? No thanks.

Back to the point, it appears to me as though WEB's investment filter, when overlaid to BRK's financials would necessarily raise some red flags in terms of a buy/no-buy decision, particularly the ROE hurdle, which WEB has been consistent on for years. Regardless of whether one can easily perform calculations producing a quick number, rationalizing them however is convenient, doesn't seem to jive with Graham or WEB's rather disciplines investment filtering process. For my money, BRK is not a buy at this point. Heck, I don't have an extra $90K lying around anyway. I do however get a lot of bang for my buck following the well proven, disciplines advice of Graham & WEB within the universe of publicly traded stocks.

Just for comparison sake, I've listed comparable BRK figures to those listed above.

Average Growth Rates for Past Five Years:

Stock Rev. NI EPS Div. CapEx GM CF
BRK.A 36% 24% 19% N/A N/A N/A 23%

Obviously, BRK's numbers in these categories are impressive and represent, in aggregate, a robust business.

Consider BRK's ROE & P/E figures:

5yr Avg ROE P/E 5yr P/E Ratio P/E v.
Stock BRK Ind. Curr. High Low Industry
BRK.A 6.00% 10.00% 22 141 17 138.00%

These figures paint a slightly different picture in terms of the volatile nature of P/E, but also BRK's lackluster ROE performance and relative cost to the industry. Given WEB's affinity for ROE no less than 15%, BRK would absolutely fail to clear the first hurdle.

Mistermarket


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