The Buffett Series - Buffett on Book Value

The Buffett Series explores some of the interesting and timeless investment concepts discussed by Mr. Buffett in his annual Berkshire letters.  Over the years I've found there isn't a lot that Mr. Buffett and his partner Mr. Munger haven't worked out when it comes to investing. I am constantly discovering hidden investment gems, and new ways of thinking about businesses and the investment process.  

This Series contains ten short essays on concepts that have featured in Mr. Buffett's annual letters since the early 1980's [click here to read the other essays].  It's amazing how timeless and universal they are.  This short essay touches on the concept of "Book Value".

From the teachings of his mentor Ben Graham, Buffett focussed on book value early in his career.  In later years he recognised is was intrinsic value, not book value, that was the key to finding outstanding investments.  He recognised that a business can be worth multiples of book value.  Berkshire paid 4X book for See's Candy, 2X book for Scott Fetzer and more recently 2.8X book for Precision Cast Parts and 5X book for Iscar.

Over the years Buffett has written extensively about 'book value'.  I remember at different times over the last few decades when the markets had become focused on book value.  Investors talked of assets like steel mills, paper companies, mining stocks and shipping lines being attractive solely on the basis that they were trading at big discounts to book value.  In many cases, they were 'value traps'.  The industries had changed and the future returns just weren't what they used to be.   

One must remember book value is a historic number and provides little information about the future prospects for a business.  The best businesses are those with high returns on capital which need little further capital to grow earnings. 

I've included below some extracts from Buffett's letters which may assist your thinking when it comes to book value. 

"In past reports I have noted that book value at most companies differs widely from intrinsic business value - the number that really counts for owners." Berkshire 1986 Letter

"Book value’s virtue as a score-keeping measure is that it is easy to calculate and doesn’t involve the subjective (but important) judgments employed in calculation of intrinsic business value.

It is important to understand, however, that the two terms - book value and intrinsic business value - have very different meanings. Book value is an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings. Intrinsic business value is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out.

An analogy will suggest the difference. Assume you spend identical amounts putting each of two children through college. The book value (measured by financial input) of each child’s education would be the same. But the present value of the future payoff (the intrinsic business value) might vary enormously - from zero to many times the cost of the education. So, also, do businesses having equal financial input end up with wide variations in value." Berkshire 1983 Letter

"Some investors weight book value heavily in their stock-buying decisions (as I, in my early years, did myself). And some economists and academicians believe replacement values are of considerable importance in calculating an appropriate price level for the stock market as a whole.

Those of both persuasions would have received an education at the auction we held in early 1986 to dispose of our textile machinery. The equipment sold (including some disposed of in the few months prior to the auction) took up about 750,000 square feet of factory space in New Bedford and was eminently usable. It originally cost us about $13 million, including $2 million spent in 1980-84, and had a current book value of $866,000 (after accelerated depreciation). Though no sane management would have made the investment, the equipment could have been replaced new for perhaps $30-$50 million.

Gross proceeds from our sale of this equipment came to $163,122. Allowing for necessary pre- and post-sale costs, our net was less than zero. Relatively modern looms that we bought for $5,000 apiece in 1981 found no takers at $50. We finally sold them for scrap at $26 each, a sum less than removal costs.

Ponder this: the economic goodwill attributable to two paper routes in Buffalo - or a single See’s candy store - considerably exceeds the proceeds we received from this massive collection of tangible assets that not too many years ago, under different competitive conditions, was able to employ over 1,000 people." Berkshire 1985 Letter

"Of course, it's per-share intrinsic value, not book value, that counts. Book value is an accounting term that measures the capital, including retained earnings, that has been put into a business. Intrinsic value is a present-value estimatee of the cash that can be taken out of a business during its remaining life. At most companies, the two values are unrelated." Berkshire  1993 Letter

"We define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life. Anyone calculating intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move. Despite its fuzziness, however, intrinsic value is all- important and is the only logical way to evaluate the relative attractiveness of investments and businesses.

To see how historical input (book value) and future output (intrinsic value) can diverge, let's look at another form of investment, a college education. Think of the education's cost as its "book value." If it is to be accurate, the cost should include the earnings that were foregone by the student because he chose college rather than a job.

For this exercise, we will ignore the important non-economic benefits of an education and focus strictly on its economic value. First, we must estimate the earnings that the graduate will receive over his lifetime and subtract from that figure an estimate of what he would have earned had he lacked his education. That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day. The dollar result equals the intrinsic economic value of the education.

Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didn't get his money's worth. In other cases, the intrinsic value of an education will far exceed its book value, a result that proves capital was wisely deployed. In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value." Berkshire 1994 Letter

The Buffett Series - A Changing Media Landscape

The Buffett Series explores some of the interesting and timeless investment concepts discussed by Mr. Buffett in his annual Berkshire letters. Over the years I've found there isn't a lot that Mr. Buffett and his partner Mr. Munger haven't worked out when it comes to investing. I am constantly discovering hidden investment gems, and new ways of thinking about businesses and the investment process.  

This Series contains ten short essays on concepts that have featured in Mr. Buffett's annual letters since the early 1980's. It's amazing how timeless and universal they are. This short essay touches on the concept of "A Changing Media Landscape".

While everyone now recognises the changes going on in the media landscape due to disruption from the advent of high speed internet and the likes of Netflix and YouTube, this is not a new phenomenon. In fact, way back in 1990 Buffett recognised that media businesses were unlikely to be as profitable in the future as they had been in the past. Media businesses were transforming from quality franchises to ordinary businesses.

In his 1990 letter, Buffett acknowledged he was surprised at developments in the media industry that year and questioned whether the poor results of Berkshire's media investments was "just part of an aberration cycle - to be fully made up in the next upturn - or whether the business has slipped in a way that permanently reduces intrinsic business values". He concluded the latter … 

"Since I didn't predict what has happened, you may question the value of my prediction about what will happen. Nevertheless, I'll proffer a judgment: While many media businesses will remain economic marvels in comparison with American industry generally, they will prove considerably less marvellous than I, the industry, or lenders thought would be the case only a few years ago.

The reason media businesses have been so outstanding in the past was not physical growth, but rather the unusual pricing power that most participants wielded. Now, however, advertising dollars are growing slowly. In addition, retailers that do little or no media advertising (though they sometimes use the Postal Service) have gradually taken market share in certain merchandise categories. Most important of all, the number of both print and electronic advertising channels has substantially increased. As a consequence, advertising dollars are more widely dispersed and the pricing power of ad vendors has diminished. These circumstances materially reduce the intrinsic value of our major media investments and also the value of our operating unit, Buffalo News - though all remain fine businesses."

Buffett revisited the challenges facing the industry in his 1991 letter titled "A change in media economics and some valuation math"

"In last year's report, I stated my opinion that the decline in the profitability of media companies reflected secular as well as cyclical factors. The events of 1991 have fortified that case: The economic strength of once-mighty media enterprises continues to erode as retailing patterns change and advertising and entertainment choices proliferate. In the business world, unfortunately, the rear-view mirror is always clearer than the windshield: A few years back no one linked to the media business - neither lenders, owners nor financial analysts - saw the economic deterioration that was in store for the industry. (But give me a few years and I'll probably convince myself that I did.)

The fact is that newspaper, television, and magazine properties have begun to resemble businesses more than franchises in their economic behavior. Let's take a quick look at the characteristics separating these two classes of enterprise, keeping in mind, however, that many operations fall in some middle ground and can best be described as weak franchises or strong businesses.

An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company's ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital.

Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise's profitability, but they cannot inflict mortal damage. In contrast, "a business" earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management.

Until recently, media properties possessed the three characteristics of a franchise and consequently could both price aggressively and be managed loosely. Now, however, consumers looking for information and entertainment (their primary interest being the latter) enjoy greatly broadened choices as to where to find them. Unfortunately, demand can't expand in response to this new supply: 500 million American eyeballs and a 24-hour day are all that's available. The result is that competition has intensified, markets have fragmented, and the media industry has lost some - though far from all - of its franchise strength".

Buffett uses an example to show that a hypothetical media business which earns $1m a year that can grow at 6% per annum in perpetuity is worth $25m. This is in contrast to a business earning the same $1m with no growth which is worth only $10m. While a multiple of twenty-five times earnings is appropriate for the first company the second company fetches ten times earnings.  

"The industry's weakened franchise has an impact on its value that goes far beyond the immediate effect on earnings. For an understanding of this phenomenon, let's look at some much over-simplified, but relevant, math.

A few years ago the conventional wisdom held that a newspaper, television or magazine property would forever increase its earnings at 6% or so annually and would do so without the employment of additional capital, for the reason that depreciation charges would roughly match capital expenditures and working capital requirements would be minor. Therefore, reported earnings (before amortization of intangibles) were also freely-distributable earnings, which meant that ownership of a media property could be construed as akin to owning a perpetual annuity set to grow at 6% a year. Say, next, that a discount rate of 10% was used to determine the present value of that earnings stream. One could then calculate that it was appropriate to pay a whopping $25 million for a property with current after-tax earnings of $1 million. (This after-tax multiplier of 25 translates to a multiplier on pre-tax earnings of about 16.)

Now change the assumption and posit that the $1 million represents "normal earning power" and that earnings will bob around this figure cyclically. A "bob-around" pattern is indeed the lot of most businesses, whose income stream grows only if their owners are willing to commit more capital (usually in the form of retained earnings). Under our revised assumption, $1 million of earnings, discounted by the same 10%, translates to a $10 million valuation. Thus a seemingly modest shift in assumptions reduces the property's valuation to 10 times after-tax earnings (or about 6 1/2 times pre-tax earnings).

Dollars are dollars whether they are derived from the operation of media properties or of steel mills. What in the past caused buyers to value a dollar of earnings from media far higher than a dollar from steel was that the earnings of a media property were expected to constantly grow (without the business requiring much additional capital), whereas steel earnings clearly fell in the bob-around category. Now, however, expectations for media have moved toward the bob-around model. And, as our simplified example illustrates, valuations must change dramatically when expectations are revised."

Buffett recognised back in 1990 that the media industry had changed and was likely to continue to do so. Today, the equity value of many of the traditional media companies have been decimated by change. The fall in value in many cases has been a slow burn. The internet destroyed the newspapers classified sections. The advent of high speed internet has allowed Netflix and YouTube to access a global audience unavailable to traditional TV licence and cable operators providing economies of scale not available to the incumbents.

When evaluating businesses it's important to think about how conditions are changing and whether the changes are structural or cyclical. Today, new technology can allow competitors to penetrate a business' 'moat' and change the industry economics for the better or worse. It's important to think about how the businesses in your portfolio are placed to survive an ever changing world.

Further Suggested Reading - Tutorials - Quality Businesses, Change, Rear-View Mirror, Alternative Scenarios, Tech Invest, Thinking about Management, Permanent Loss, Intrinsic Value.
 

The Buffett Series - Businesses you Know

The Buffett Series explores some of the interesting and timeless investment concepts discussed by Mr. Buffett in his annual Berkshire letters. Over the years I've found there isn't a lot that Mr. Buffett and his partner Mr. Munger haven't worked out when it comes to investing. I am constantly discovering hidden investment gems, new ways of thinking about businesses and the investment process.  

This Series contains ten short essays on concepts that have featured in Mr. Buffett's annual letters since the early 1980's. It's amazing how timeless and universal they are. This short essay touches on the concept of "Businesses you Know."

In his 1994 letter, Buffett outlines why it can be profitable to revisit companies you know well. In investing it's important to understand the businesses you are investing in, know the limitations of your knowledge and stick within your circle of competence.

"Before looking at new investments, we consider adding to old ones. If a business is attractive enough to buy once, it may well pay to repeat the process. We would love to increase our economic interest in See's or Scott Fetzer, but we haven't found a way to add to a 100% holding. In the stock market, however, an investor frequently gets the chance to increase his economic interest in businesses he knows and likes. Last year we went that direction by enlarging our holdings in Coca-Cola and American Express.

Our history with American Express goes way back and, in fact, fits the pattern of my pulling current investment decisions out of past associations. In 1951, for example, GEICO shares comprised 70% of my personal portfolio and GEICO was also the first stock I sold - I was then 20 - as a security salesman (the sale was 100 shares to my Aunt Alice who, bless her, would have bought anything I suggested). Twenty-five years later, Berkshire purchased a major stake in GEICO at the time it was threatened with insolvency. In another instance, that of the Washington Post, about half of my initial investment funds came from delivering the paper in the 1940's. Three decades later Berkshire purchased a large position in the company two years after it went public. As for Coca-Cola, my first business venture - this was in the 1930's - was buying a six-pack of Coke for 25 cents and selling each bottle for 5 cents. It took only fifty years before I finally got it: The real money was in the syrup.

My American Express history includes a couple of episodes: In the mid-1960's, just after the stock was battered by the company's infamous salad-oil scandal, we put about 40% of Buffett Partnership Ltd.'s capital into the stock - the largest investment the partnership had ever made. I should add that this commitment gave us over 5% ownership in Amex at a cost of $13 million. As I write this, we own just under 10%, which has cost us $1.36 billion. (Amex earned $12.5 million in 1964 and $1.4 billion in 1994.)

My history with Amex's IDS unit, which today contributes about a third of the earnings of the company, goes back even further. I first purchased stock in IDS in 1953 when it was growing rapidly and selling at a price-earnings ratio of only 3. (There was a lot of low-hanging fruit in those days.) I even produced a long report - do I ever write a short one? - on the company that I sold for $1 through an ad in the Wall Street Journal.

Obviously American Express and IDS (recently renamed American Express Financial Advisors) are far different operations today from what they were then. Nevertheless, I find that a long-term familiarity with a company and its products is often helpful in evaluating it."

Buffett recognised that dealing with companys he had a history with and could understand provided an edge. Given Buffett's distaste for change, it's likely it also gave him some level of confidence in the sustainability of the business model, thereby also reducing risk. Buffett has always been a big believer in sticking within his circle of competence. Revisiting company's within that circle has proved to be a successful investing strategy over the last 50+ years.

"In his fifty years of practice, Buffett added one more principle; through unremitting hard work over a long period, investors can build up their own circle of competence. This can give them a deeper understanding than others of a company or industry, and allow them to make better judgements of future performance. Your unique strength lies within this circle." Li Lu

The Buffett Series - Investment Analysis

Charlie Munger loves the concept of simplicity. When it comes to investing it's important to understand what a company does and what the key factors are that will determine the company's success. You don't need a 2,000 line spreadsheet to determine if an investment is likely to be successful. But you do need to think. Talking to people involved in the industry and with the product can provide a huge edge.  

In Berkshire Hathaway's 1997 annual letter, there's a great snippet where Buffett details how he came about building a significant position in Amex. Buffett had purchased $300m of American Express hybrids in a private placement in 1991. The hybrids were due to convert to common stock in 1994 and in the month before Buffett had been mulling over whether to sell upon conversion.  While he thought the CEO was outstanding and likely to maximise whatever Amex's potential was, he was leaning toward a sale, as the company faced relentless competition from a multitude of card issuers, led by Visa. Buffett continues ...

"Here's where I got lucky. During that month of decision, I played golf at Prouts Neck, Maine with Frank Olson, CEO of Hertz. Frank is a brilliant manager, with intimate knowledge of the card business. So from the first tee on I was quizzing him about the industry. By the time we reached the second green, Frank had convinced me that Amex's corporate card was a terrific franchise, and I had decided not to sell. On the back nine I turned buyer, and in a few months Berkshire owned 10% of the company.

We now have a $3 billion gain in our Amex shares, and I naturally feel very grateful to Frank. But George Gillespie, our mutual friend, says that I am confused about where my gratitude should go. After all, he points out, it was he who arranged the game and assigned me to Frank's foursome."

In a recent CNBC interview, Buffett explained some of the analysis he undertook when he bought Berkshire's $17b stake in Apple ….

"Well, I would say Apple's — I mean, obviously it's very, very, very tech-involved, but it's a consumer product to a great extent too. And I mean, it has consumer aspects to it. And one of the great books on investing, which I've touted before, is one that Phil Fisher wrote back around 1960 or thereabouts, called "Common Stocks and Uncommon Profits." It had an effect on me. I went out to meet Phil Fisher after reading the book, I found him in this little office in San Francisco. And I recommend any investor read that book. And it's still in print. And he talks about something called the scuttlebutt method, which made a big impression on me at the time. But I used it a lot, which is essentially going out and finding out as much as you can about how people feel about the products that they ... it's just asking questions, basically. And Apple strikes me as having quite a sticky product and enormously useful product that people would use, and not that I do. Tim Cook's always kidding me about that. But it's a decision-based ... but again, it gets down to the future earning power of Apple when you get right down to it. And I think Tim has done a terrific job, I think he's been very intelligent about capital deployment. And I don't know what goes on inside their research labs or anything of the sort. I do know what goes on in their customers' minds because I spend a lot of time talking to 'em."

Buffett expands on the scuttlebutt process… 

"I had learned that from a fella named Phil Fisher who wrote this great book called "Common Stocks and Uncommon Profits." And he calls it the scuttlebutt method. And Phil was a remarkable guy.  And I first used it back in 1963 when American Express had this great Salad Oil Scandal that people were worried about it bankrupting the company. So I went out to restaurants and saw what people were doing with the American Express card, and I went to banks to see what they were doing with travelers' checks and everything. And clearly American Express had lost some money from this scandal, but it hadn't affect their consumer franchise. So I ask people about products all the time. When I take my great-grandchildren to Dairy Queen they bring along friends sometimes. They've all got a iPhone and, you know, I ask 'em what they do with it and how ... whether they could live without it, and when they trade it in what they're gonna do with it. And of course, I see when they come to the furniture mart that people have this incredible stickiness of — with the product. I mean, if they bring in an iPhone, they buy a new iPhone. I mean, they're ... it just has that quality. It gets built into their lives. Now, that doesn't mean something can't come along that will disrupt it. But the continuity of the product is huge, and the degree to which their lives centre around it is huge. And it's a pretty nice, it's a pretty nice franchise to have with a consumer product."

and on the Apple products ...

"But what I do know is when I take a dozen kids, as I do on Sundays out to Dairy Queen they're all holding their Apple, they barely can talk to me except if I'm ordering ice cream or something like that. And then I ask 'em how they live their lives. And the stickiness really is something. I mean, they do build their lives around it, just like you were describing. And the interesting thing is, when they come into ... when they come into get a new one, they're gonna get they overwhelmingly get the same product. I mean, they got their photos on it and, I mean, yeah, I know you can ... you can make some shifts and all that. But they love it."

Buffett reminded us of the need for simplicity in his 1994 letter ...

"Our investments continue to be few in number and simple in concept:  The truly big investment idea can usually be explained in a short paragraph.  We like a business with enduring competitive advantages that is run by able and owner-oriented people.  When these attributes exist, and when we can make purchases at sensible prices, it is hard to go wrong (a challenge we periodically manage to overcome).

Investors should remember that their scorecard is not computed using Olympic-diving methods:  Degree-of-difficulty doesn't count. If you are right about a business whose value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by many constantly shifting and complex variables."

While Buffett no doubt analysed Apple's historical financial statements, he recognised that it is Apple's future earnings power that will determine the success or failure of the investment. A key factor that will determine that future earnings power is the strength and sustainability of the consumer product franchise. Here, observing, speaking to, and thinking about the company's products and customers can provide an edge. Understanding the qualitative factors can be more important than the historical numbers. Keep it simple, it's not rocket science.

“The most important question you should be asking: will this business still be around a decade from now?  Numbers alone won’t tell you the answer; instead you must think critically about the qualitative characteristics of your business.” Peter Thiel

The Buffett Series - Look-Through Earnings

The Buffett Series explores some of the interesting and timeless investment concepts discussed by Mr. Buffett in his annual Berkshire letters. Over the years I've found there isn't a lot that Mr. Buffett and his partner, Mr.Munger, haven't already worked out when it comes to investing. I am constantly discovering hidden investment gems, new ways of thinking about both businesses and the investment process.  

This Series contains ten short essays on concepts that have featured in Mr.Buffett's annual letters since the early 1980's. It's amazing how timeless and universal they are. This short essay touches on the concept of ‘Look-Through Earnings.’

Buffett focuses on the earnings that are generated by the companies he owns. While a company may pay out some of the earnings it generates in the form of dividends, the retained earnings are no less valuable to an investor. In fact, if the company can retain and reinvest those earnings at a high rate of return, the investor is better served by the company doing so. Such companies are often referred to as compounding machines.  

Buffett recognises that while the price of a company's shares can fluctuate regardless of fundamentals over the short term, over the long term changes in the company's share price will reflect changes in the company's earnings.  

In his 1991 letter, Buffett advises investors ...

"We also believe that investors can benefit by focusing on their own look-through earnings. To calculate these, they should determine the underlying earnings attributable to the shares they hold in their portfolio and total these. The goal of each investor should be to create a portfolio (in effect, a ‘company’) that will deliver him or her the highest possible look-through earnings a decade or so from now.  

An approach of this kind will force the investor to think about long-term business prospects rather than short-term stock market prospects, a perspective likely to improve results. It's true, of course, that, in the long run, the scoreboard for investment decisions is market price. But prices will be determined by future earnings. In investing, just as in baseball, to put runs on the scoreboard one must watch the playing field, not the scoreboard."

In the 1994 letter Buffett related Berkshire's growth target with look-through earnings ...

"If our intrinsic value is to grow at our target rate of 15%, our look-through earnings, over time, must also grow at about that pace.”

In his 1996 letter Buffett once again advised …

"Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio's market value. Though it's seldom recognized, this is the exact approach that has produced gains for Berkshire shareholders: Our look-through earnings have grown at a good clip over the years, and our stock price has risen correspondingly. Had those gains in earnings not materialized, there would have been little increase in Berkshire's value."

Many successful investors adopt Buffett's approach to focus on earnings; rather than focus on short term share prices these investors build portfolios whose earnings will grow over time.  

“Note that I have no interest in the development of share prices. This is why I don’t waste your time with a discussion of the fund’s or individual company’s price development. If a company regularly increases its earnings power, the share price will track this over time. A robust investment process correctly identifies companies which increase their earnings power. A rising share price is the outcome. My sights are firmly trained on process.” Robert Vinall

“At Giverny Capital, we do not evaluate the quality of an investment by the short-term fluctuations in its stock price. Our wiring is such that we consider ourselves owners of the companies in which we invest. Consequently, we study the growth in earnings of our companies and their long-term outlook.” Francois Rochon

Paying a reasonable price for a portfolio of quality companies that can compound earnings in the years ahead is likely to deliver attractive returns.

The Buffett Series - A lower Tax Rate?

With the prospect of Corporate Tax cuts in the US post the election of Mr Trump it’s worth thinking about the implications for investments. Confronted with a change in the US corporate tax rate in the 1980's Buffett addressed the issue of winners and losers in his 1986 letter.

“The tax rate on corporate ordinary income is scheduled to decrease from 46% in 1986 to 34% in 1988. This change obviously affects us positively - and it also has a significant positive effect on two of our three major investees, Capital Cities/ABC and The Washington Post Company.”

I say this knowing that over the years there has been a lot of fuzzy and often partisan commentary about who really pays corporate taxes - businesses or their customers. The argument, of course, has usually turned around tax increases,  not decreases. Those people resisting increases in corporate rates frequently argue that corporations in reality pay none of the taxes levied on them but, instead, act as a sort of economic pipeline, passing all taxes through to consumers. According to these advocates, any corporate-tax increase will
simply lead to higher prices that, for the corporation, offset the increase. Having taken this position, proponents of the "pipeline" theory must also conclude that a tax decrease for corporations will not help profits but will instead flow through, leading to correspondingly lower prices for consumers.

Conversely, others argue that corporations not only pay the taxes levied upon them, but absorb them also.  Consumers, this school says, will be unaffected by changes in corporate rates.

What really happens? When the corporate rate is cut, do Berkshire, The Washington Post, Cap Cities, etc., themselves soak up the benefits, or do these companies pass the benefits along to their customers in the form of lower prices? This is an important question for investors and managers, as well as for policymakers.

Our conclusion is that in some cases the benefits of lower corporate taxes fall exclusively, or almost exclusively, upon the corporation and its shareholders, and that in other cases the benefits are entirely, or almost entirely, passed through to the customer. What determines the outcome is the strength of the corporation’s business franchise and whether the profitability of that franchise is regulated.

For example, when the franchise is strong and after-tax profits are regulated in a relatively precise manner, as is the case with electric utilities, changes in corporate tax rates are largely reflected in prices, not in profits. When taxes are cut, prices will usually be reduced in short order. When taxes are increased, prices will rise, though often not as promptly.

A similar result occurs in a second arena - in the price-competitive industry, whose companies typically operate with very weak business franchises.  In such industries, the free market "regulates" after-tax profits in a delayed and irregular, but generally effective, manner. The marketplace, in effect, performs much the same function in dealing with the price-competitive industry as the Public Utilities Commission does in dealing with electric utilities. In these industries, therefore, tax changes eventually affect prices more than profits.

In the case of unregulated businesses blessed with strong franchises, however, it’s a different story: the corporation and its shareholders are then the major beneficiaries of tax cuts. These companies benefit from a tax cut muchas the electric company would if it lacked a regulator to force down prices.

Many of our businesses, both those we own in whole and in part, possess such franchises.  Consequently, reductions in their taxes largely end up in our pockets rather than the pockets of our customers.  While this may be impolitic to state, it is impossible to deny. If you are tempted to believe otherwise, think for a moment of the most able brain surgeon or lawyer in your area. Do you really expect the fees of this expert (the local "franchise-holder" in his
or her specialty) to be reduced now that the top personal tax rate is being cut from 50% to 28%?

Your joy at our conclusion that lower rates benefit a number of our operating businesses and investees should be severely tempered, however, by another of our convictions: scheduled 1988 tax rates, both individual and corporate, seem totally unrealistic to us. These rates will very likely bestow a fiscal problem on Washington that will prove incompatible with price stability. We believe, therefore, that ultimately - within, say, five years - either higher tax rates or higher inflation rates are almost certain to materialize.  And it would not surprise us to see both."
 

The Buffett Series - Thinking about Bonds

The bond market has witnessed a truly spectacular rally over the last thirty five odd years. In recent times there have been trillions of dollars of bonds trading at negative yields - something that has never happened before. Over the years Mr Buffett has written about investing in bonds. Revisiting his 1984 letter, it's no wonder he wouldn't think of investing in bonds at current prices.

"Our approach to bond investment - treating it as an unusual sort of “business” with special advantages and disadvantages - may strike you as a bit quirky. However, we believe that many staggering errors by investors could have been avoided if they had viewed bond investment with a businessman’s perspective. For example, in 1946, 20-year AAA tax-exempt bonds traded at slightly below a 1% yield. In effect, the buyer of those bonds at that time bought a “business” that earned about 1% on “book value” (and that, moreover, could never earn a dime more than 1% on book), and paid 100 cents on the dollar for that abominable business.

If an investor had been business-minded enough to think in those terms - and that was the precise reality of the bargain struck - he would have laughed at the proposition and walked away. For, at the same time, businesses with excellent future prospects could have been bought at, or close to, book value while earning 10%, 12%, or 15% after tax on book. Probably no business in America changed hands in 1946 at book value that the buyer believed lacked the ability to earn more than 1% on book. But investors with bond-buying habits eagerly made economic commitments throughout the year on just that basis. Similar, although less extreme, conditions prevailed for the next two decades as bond investors happily signed up for twenty or thirty years on terms outrageously inadequate by business standards. (In what I think is by far the best book on investing ever written - “The Intelligent Investor”, by Ben Graham - the last section of the last chapter begins with, “Investment is most intelligent when it is most businesslike.” This section is called “A Final Word”, and it is appropriately titled.)"

In a recent CNBC interview Mr Buffett once again re-iterated the attractiveness of American companies return on tangible capital which allows many companies to reinvest capital in their businesses well above current interest rates. With regards to bonds he made the following remarks ...

“The ten-year bond is selling at 40 times earnings. And it's not going to grow. And if you can buy some business that earns high returns on equity and has even got mild growth prospects, you know, at much lower multiple earnings, you are going to do better than buying ten-year bonds at 2.30 or 30-year bonds at three, or something of the sort. But that's been true for quite a while. And I've been talking about it the whole time. I said people were idiots in 2008 to put their money in cash. I mean, it was the one thing that wasn't going to go anyplace. And interest rates are enormously important over time. And that's – if bonds yield a whole lot more a year from now than they do now, stocks may well be lower.” 

“I think that when rates have been where they've been the last five or six years, or even a little longer, selling very long bonds makes sense for the same reason I think it's dumb to buy them. I wouldn't buy a 50-year bond, you know, in a million years at these rates. So if it's that dumb for me to buy it, it's probably pretty smart for the entity to sell them if I'm right. So I would say that the Treasury – I would've been – there's a lot of considerations they have. But I would be shoving out long bonds. And of course at Berkshire, you mentioned we had $80-some billion in very short stuff. I mean, everything we buy in the way of bonds is short.” 

“It absolutely baffles me who buys a 30 year bond. I just don't understand it. And-- they sell a lot of them so-- clearly, there's somebody out there buying them. But the idea of committing your money, you know, at roughly 3 percent for 30 years-- now-- I think Austria sold some 50 year bond here, you know, at-- below 2 percent. I just don't understand the-- in Europe, there are certain inducements actually for the banks in terms of capital requirements to load up on governments. But it doesn't make any sense to me”.

Those investors buying bonds at the negative or very low yields now on offer are likely doing so because a) they're scared, b) their mandate makes them or c) they're speculating rates will go even lower.  It's unlikely they're buying them because d) they think they're good value.  

Understanding history can provide an edge in investing and Buffett brings up the 1946 bond market as an example in his 1984 letter above [I recommend reading the David Dynasty chapter 4 on the 1940's bond market titled "The Last Hurrah for Bonds"]. It's important to remember that the recent past is not necessarily a good guide to the future, that the unexpected can happen and the crowd is usually wrong.  

The bond market looks very much like a bubble. Howard Marks makes an insightful observation regarding bubbles … "The belief that some fundamental limiter is no longer valid - and thus historic notions of fair value no longer matter - is invariably at the core of every bubble and consequent crash."

The first breach of a fundamental limiter was real bond returns had to be positive. The final limiter breached was bond investors accepting negative rates. It's likely investors of the future will look back on this era and ask … "What were they thinking?"

The Buffett Series - Thinking about Competitive Advantage

This Series contains ten short essays on concepts that have featured in Mr Buffett's annual letters since the early 1980's. It's amazing how timeless and universal they are. This short essay looks at competitive advantage.  

A key requirement for a company to earn high returns on capital over a long period of time is to have a competitive advantage, commonly referred to as a 'moat'. Mr Buffett addresses the issue of competition in his 1993 letter where he talks about the Nebraska Furniture Mart, a businesses he acquired from Rose Blumkin [aka Mrs B.] in 1983. Under the motto, "sell cheap and tell the truth," she worked in the business until the ripe old age of 103.

Nebraska Furniture Mart is a pretty simple business, it sells furniture, flooring and home appliances. It's easy to understand and it's unlikely to be subject to a lot of change. In ten years time it will still be selling furniture.  

"One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it. I’d rather wrestle grizzlies than compete with Mrs. B and her progeny. They buy brilliantly, they operate at expense ratios competitors don’t even dream about, and they then pass on to their customers much of the savings. It’s the ideal business - one built upon exceptional value to the customer that in turn translates into exceptional economics for its owners." Warren Buffett 1993

Nebraska Furniture Mart's competitive advantage is the lower prices it offers it customers and its large range. It's a virtuous circle. Lower prices lead to more sales which allows the business to secure better pricing and spread its fixed costs over a wider revenue base and then offer the savings back to the customers. It's a win-win situation. The massive scale advantage makes it almost impossible for a newcomer to set up shop and offer cheaper products. 

While Buffett wasn't thinking about the internet back in 1983, today the major competitive threat to a retailer is on-line competition. The furniture business is more immune to on-line competition given product size and a customers desire to try before they buy. As a furniture retailer I know recently told me "I won't sell anything that fits in a car!"

It's important to take the time to think about a company's competitive advantage. How easy would it be to re-create the business, are there barriers to entry? What makes the company so unique that allows it to maintain high returns. What could change that? A business with high margins and low barriers to entry is unlikely to be able to maintain those margins for long.  

“If you have an economic castle, people are going to come and want to take that castle away from you. You better have a strong a moat, and a  knight in that castle that knows what he’s doing.” Warren Buffett

"Frequently, you'll look at a business having fabulous results. And the question is, "How long can this continue?" Well, there's only one way I know to answer that. And that's to think about why the results are occurring now - and then to figure out the forces that could cause those results to stop occurring." Charlie Munger

The Buffett Series - What is Value Investing?

The Buffett Series explores some of the interesting and timeless investment concepts discussed by Mr Buffett in his annual Berkshire letters. Over the years I've found there isn't a lot that Mr. Buffett and his partner Mr. Munger haven't worked out when it comes to investing. I am constantly discovering hidden investment gems, new ways of thinking about businesses and the investment process.  

This Series contains ten short essays on concepts that have featured in Mr Buffett's annual letters since the early 1980's. It's amazing how timeless and universal they are. The first essay looks at "What is Value Investing?".

".. we think the very term "value investing" is redundant. What is "investing" if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labeled speculation (which is neither illegal, immoral nor - in our view - financially fattening).

Whether appropriate or not, the term "value investing" is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics - a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield - are in no way inconsistent with a "value" purchase."  Warren Buffett - 1992

Over the years Mr Buffett has shifted from buying fair companies at wonderful prices to buying wonderful companies at fair prices. Wonderful companies have the ability to compound earnings over time, unlike optically cheap companies which may provide a one off kicker.  

Some examples of such acquisitions by Mr. Buffett include buying See's Candy at 4X book, Scott Fetzer at 1.8X book and more recently Iscar at 5X book.  

"In GEICO, we paid 20 times earnings and a fairly sized multiple of book value." Warren Buffett, Berkshire 2013 Meeting.

Ultimately ‘Value’ is determined by what you get for what you give. While it is more difficult to ascertain the sustainability of high growth, it doesn't mean a high growth, high PE and high price to book value stock is not a ‘Value’ investment. At the same time, lots of stocks that trade on low PE's, low price to book values and high dividend yields have turned out to be terrible investments. They're generally referred to as "value traps". The key is to get back more in future returns than you give up at the time of acquisition. That's what investing is all about.