Equities

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arren Buffett has repeatedly stated that when he buys shares of a company, he thinks of himself as an “owner” of that business rather than as someone who simply wants to flip those shares for a small profit (i.e., a trader). As stated in Chapter 1, there are many occa- sions where Buffett does take a rather short-term (less than forever) view of a stock, and he occasionally takes short-term profits or losses. However, that does not diminish the deeper sentiment expressed in his statement that you should not buy a stock unless you can put yourself in the shoes of an owner of that business and be able to say, “This business is going to gener- ate a return worthy of my investment.”

The best example is that of the old-fashioned lemonade stand. When you set up a lemonade stand you outlay some cash for the table, cups, the first batch of lemonade, and maybe the sign that you put up the street point- ing people in your direction. Whether or not your initial outlay of cash was a good investment is directly related to whether this lemonade stand is a good business. Several factors play a role:

• For each dollar you put into the business, will you expect to eventually make that dollar back plus additional money (the return on your investment)?

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• Could you have taken the same money and had a better investment elsewhere (either in setting up another business or simply putting the money in a savings account)? A corollary to this is that a “better invest- ment” can also mean an investment with a similar return but less risk.

As simplistic as it sounds, this is how Warren Buffett evaluates all his stock buying and selling decisions. He doesn’t do anything based on sophis- ticated technical analysis, volume indicators, chaos theory, or neural net- works. However, the reason it is hard to get high stock market returns is that for a somewhat complicated business, the predictability of what the business is going to earn (and what other alternative investments are going to earn) is very complicated.

At this point most investors snap their fingers and say, “Aha! Let’s break out the dividend discount model.” A business should be valued on the basis of its total cash flows from here to eternity, discounted by whatever the risk-free rate is. Why the discount? Well, assume that your business can earn five percent a year forever and that I can get a five percent return, for- ever, from Treasury bills. Your business is essentially worthless, then, since as long as the U.S. government is here to stay, putting my money in T-bills will be a better choice for me than putting it in a risk-filled business.

Example: My Story

My own example of the dividend discount model coming into play occurred in early 2000. I had started a wireless software company and at the time “wireless” was a favorite buzzword among investors.

Despite the fact that we had minimal revenues and were burning money at a fairly quick rate (we were, after all, a startup company), we were already being wined and dined by every investment bank and ana- lyst. On one occasion a group came in from a tier one investment bank to pitch us. The head of the group started off by saying that Mr. X (a well-known analyst now barred from the securities industry) would cover our stock despite the fact that we were a wireless software com- pany and he was an e-commerce/consumer analyst. Then came the fun part: valuation.

The junior member of the team broke out his dividend discount model. Apparently we were going to stop losing money within a year (thank God!) and then start growing earnings per share at a rate of 25 percent a year compared with a risk-free rate of nine percent. That

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miraculous growth (about as miraculous as miracle hair growth cures from carnivals of the 1920s) would continue for 10 years (why not?) and then slow down to a more terminal growth rate of 10 percent. It all sounded good, but the reality never quite matched the pretty picture this analyst created (although fortunately the company still exists, as compared with most of its peers).

So the question is, if the intrinsic value of a business can be determined by its future cash flows, then how can we improve the predictability of those cash flows? Note that if investors could truly predict cash flows, then Warren Buffett would never have been able to achieve his above-average market returns. The key is not only to find companies where the cash flows are somewhat predictable but also to find companies where, for whatever reason, the market perceives those cash flows as being at-risk. The more risk the market perceives in those cash flows (or the more unpredictable those cash flows are), the higher return an investor must demand to com- pensate for that risk.

For example, American Express in 1963 fell victim to the notorious Salad Oil Scandal. Anthony DeAngelis, a New Jersey meatpacker who started a company called Allied Crude Vegetable Oil Refining, was sending supposed shipments of vegetable oil to a warehouse in Bayonne, New Jer- sey, which then issued receipts for the oil. With those receipts, DeAngelis was able to obtain up to $175 million in financing (on the basis of $60 mil- lion worth of vegetable oil as collateral) and then use that money to specu- late on vegetable oil futures. The whole thing fell apart (as these things usually do) when DeAngelis lost it all on his speculation and had to go bankrupt. The company that vouched for the warehouse receipts and allowed DeAngelis to obtain his financing was American Express.

When American Express did an audit to collect their collateral, they found that instead of $60 million worth of vegetable oil there was only

$6 million. The vegetable oil had been watered down to make it appear as if there were more. To their credit, American Express very quickly made good on the hundreds of millions of dollars in potential liabilities, but this also created a very big black hole on their balance sheet, temporarily wip- ing out all shareholder equity.

Shares in American Express fell from $60 to $35 over a two-month period. Shareholders and speculators were both playing a momentum game (if it can fall $2 today, it will probably fall $2 tomorrow) and some had legit-

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imate fears that American Express was going bankrupt. To some extent, these fears were not entirely irrational. If American Express management was lax enough to let this scandal happen, who knows what other problems might lie underneath?

First, however, Buffett was comforted by management’s instant and honest response to the losses, taking the hit, and indemnifying many of the third-party victims to the scandal.

Second, Buffett recognized that this scandal had nothing to do with American Express’s core businesses—the traveler’s checks and credit card businesses.

Third, Buffett is always impressed by businesses where a large float can provide liquidity to the underlying operations of the business, as in, for instance, the insurance business. The traveler’s checks business involves consumers paying cash up front to American Express; American Express pays out that money at some future unspecified date. In the meantime, American Express can do whatever it wants with customers’ money. This idea of a float-based business is almost like getting a zero-interest loan.

Eventually, American Express has to pay all the money back, but with no interest charges attached. The cost of financing doesn’t get any better than this (at least until the 2003 SQUARZ bonds that Buffett himself put out—the first negative-interest bonds in history).

Finally, Buffett wanted to see what the consumer perception was of American Express’s problems. He went out to Ross’s Steakhouse in Omaha, stood behind the cashier all evening, and watched as customer after cus- tomer used their American Express cards to pay for their meals. He was able to conclude two things:

1. The American Express brand was not affected at all by the scandal; in fact, it was stronger than ever. This idea of brand strength was used by Buffett repeatedly (starting with this incident) over the next 40 years as a “gut” predictor of future earnings.

2. It was clear that the merchants were not worried about being paid by American Express. In other words, the Salad Oil Scandal was a one- time hit against earnings, but the underlying business was strong and getting stronger.

Buffett started accumulating shares at $35 apiece and sold them between two and four years later. Five years after the incident, American

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Express shares were trading as high as $185 a share. Note that this was not a long-term buy-and-hold “forever” investment for Warren Buffett, even though it had many of the characteristics of his buy-and-hold investments later on: strong brand, predictable earnings, strong moat, and so on. But at this point, the cash Buffett had to put to use, which consisted of the money in his hedge fund, was a lot smaller and allowed him to be more nimble.

Taking advantage of this nimbleness in a way that he can no longer do due to his enormous size allowed him to go in and out of trades as needed, tak- ing profits and moving on to the next opportunity.

What created the phenomenal trading opportunities (and excesses) of the dot-com era from 1997 to 2000 was directly related to the notion of intrinsic value. Basically, people had no idea what these companies would make. However, it was clear that the Internet was a revolution on par with the printing press. Suddenly, the cost of commerce got much cheaper. Peo- ple could shop from their homes, implying that the bricks-and-mortar approach of setting up stores everywhere, and the costs inherent with that kind of business, were not necessary for the winners in the Internet com- merce gain. Additionally, the Internet also decreased the costs of commu- nication as well as the costs of software development, since network protocols and interfaces were built into the underlying ideas of the Web.

With all of the costs out of the picture and a potential customer base in the billions, the earnings created would be phenomenal and so would the returns—if it were possible to pick the winners.

The idea that the Internet was a bubble is often implied by Buffett adher- ents but not necessarily by Buffett himself. He simply states that he had a hard time valuing these companies simply because he was not a computer expert. He had no way of determining what the future cash flows of these companies would be or which companies would be the winners. Nor does Buffett take a “VC-style” approach to his investing. Buffett likes to make as few bets as possible; with luck every bet pays off. A typical venture capitalist portfolio might have 20 investments, with 10 failures, eight break-even invest- ments, and two home runs. What happened in the so-called Internet bubble is that the public became venture capitalists instead of value investors. Many of the companies did turn out to be worthless. But the basic idea was correct.

There were enormous opportunities in the Internet space, as evidenced by eBay’s earnings just a few years after its inception (see Exhibit 3.1).

Never have a company’s profits grown this quickly so soon after its birth. Does this mean that all of the Internet speculators were correct and

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Buffett was wrong? Absolutely not. It is just a different approach. And the eBays of the world happen once in a lifetime; Buffett’s results, however, have stood the test of time over a 50-year period. I was always very sur- prised with all of the investors who consistently turned up their noses at the Internet and refused to even acknowledge that the potential was there.

Even in the summer of 2003, Barron’s had a cover article suggesting that perhaps Yahoo!, Amazon, and eBay were in another bubble; the magazine picked the exact companies that would end up doubling their earnings growth yet again over the next year.

That said, Buffett likes to keep it simple. He looks for earnings pre- dictability with companies that might be distressed but whose quality of business still remains high. Why might investors (Mr. Market) be putting more risk on the future earnings flow than Buffett? Here are a few reasons:

• Market risk. In recent years the market has become fearful that a future terrorist attack might slow down the U.S. economy and put pres- sure on even predictable earnings streams. As detailed in Chapter 12, Buffett does not care so much for market or systemic risk, assuming that there is no real event that can so drastically change the value of all securities in the market that he worry too much.

• Fear of corruption.When the Enron scandal broke in late 2001, the shares of many energy companies, even the most conservative utilities, fell in sympathy despite the enormous predictability of those earnings.

In Chapter 7, we will see how Buffett took advantage of this market fear to place a private investment in a public utility.

• Litigation risk.In the tobacco industry, the market and earnings have always been predictable but the fear of mass class-action litigation has often kept the price lower than would be suggested by any measure of intrinsic value.

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EXHIBIT 3.1 eBay's Earnings over the Past 5 Years

Year Earnings (in millions)

1999 $10.8

2000 $48.3

2001 $90.4

2002 $249.9

2003 $441.8

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• Setback in the business.When mad cow disease surfaced in Eng- land, shares of McDonald’s reacted, reaching multi-year lows. Investors had to assess whether this would have a permanent effect on the busi- ness. If the answer was “no,” then the assumption would be that the shares would go back to where they were before the stock started to fall—about a 50 percent return. If the answer was “yes,” then one had to assess how far the stock had yet to fall. If the stock had another 10 percent to go, but you felt there was more than a 20 percent chance that the market had already discounted enough the effects of mad cow disease, then the buying was certainly worth it.

The risks of investing go on and, in each specific case, are usually fairly straightforward. When a market or stock starts to sell off there are usually countless news articles, Internet message board postings, and television commentators documenting the rise and fall of once-proud companies. The Internet has closed the information gap and has made it possible to quickly assess the veracity of any story quickly. Similarly, very standard tools can be used to examine the predictability of future cash flows.

Note that we are talking about future cash flows and not necessarily price/earnings (P/E) ratios. In Chapter 11 I discuss the pros and cons of trading based on P/E ratios, but this section necessitates a few comments first. The P/E ratio refers to the price the stock is currently trading at divided by its net income per share. For instance, if a stock trades at $20, has 30 million shares outstanding, and earned $30 million last year, then it trades at a P/E ratio of $20 ×$30 million divided by 30 million shares out- standing, or 20. Many people also look at the earnings yield, which is sim- ply the P/E ratio upside down, or E/P. In the above example, the earnings yield would be five percent. The earnings yield is what the company could potentially pay out to shareholders if it did not reinvest its earnings in the business. If the earnings yield of a given stock is much higher than Treasury bill interest rates (that is, if the P/E ratio is low), then many investors think that the stock constitutes a good investment. We’ll look at this later in Chapter 12.

Note that the E in this equation might not be real earnings at all, but a modified definition of earnings, which might include various non-cash charges such as depreciations, amortization of goodwill, and (should a com- pany do this) options-related expenses. Also, for each company, the method

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for booking revenues varies significantly and is often an issue. The same can be said for how expenses are booked. For example, can a marketing expense be amortized, as Worldcom tried to do to the tune of billions of dollars? AOL was notorious for doing this throughout the 1990s but it didn’t slow down the rise in their stock price. Worldcom, however, almost instantly went bankrupt when their accounting discrepancies were exposed.

P/E ratios also do not tell you anything about the predictability of future earnings, the quality of current earnings, or the fundamentals of the business. Nor do we have any reason to believe that Warren Buffett looks at the P/E ratio. In fact, many of his acquisitions are occurring precisely when earnings are falling and the P/E ratio is skyrocketing higher. In chap- ter 11, I take the analysis one step further, and examine whether P/E ratios are truly predictive of the future.

What tools can be used, then, in helping predict future cash flows?

• Growth of the U.S. economy.In general, if the U.S. economy grows at a certain percent a year, then the cash flows of the market are most likely growing at the same rate, give or take one to five percent. The market has grown slightly faster than the economy only because the multiple over those cash flows has grown slightly over the years. If stocks go up much faster than the U.S. economy, as happened in the 1990s when the gross domestic product (GDP) was growing at approx- imately six percent a year and the Nasdaq was going up almost 30 per- cent a year, bad things can eventually happen.

• Operating Margin, Return on Equity (ROE), or Return on Capi- tal (ROC).A study by John Schmitz and Sean Cleary on what funda- mental criteria have been the most predictive for stocks on the Toronto Stock Exchange from 1989 to 1998 determined that return on equity and operating margin were consistently among the top factors for every time period. The higher the ROE and operating margin, the more likely a stock would go up in the next period.

Return on equity is defined as the net profits of a firm divided by the total amount of equity invested in a firm. In our lemonade stand example, if someone started with $15 ($10 for the table, $3 for the first set of cups, and

$2 for the first batch of lemonade) and earned $10 in the first day, then the ROE would be 66 percent. If the stand’s owner has a high operating margin

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