Tag Archives: Bonds

Buffett’s Berkshire Letter for 1984

buffett1984 was a temperate year for the market indexers; after the S&P 500 opened the year near 165, it slipped through spring and early summer to bottom near 150 in July, only to rebound and close the year again near 165.

Over at Berkshire, net worth increased by $152.6 million, or $133 per share, which represented a gain of 13.6% on Berkshire’s 1984 book value of $1108.77. A “mediocre” performance, says Chairman Buffett.

All told, Buffett the teacher showed up with his lecture notes in 1984, and the business summary he provides gives the clearest insight yet into the way his mind understands and values businesses. If I had to recommend one letter that characterized his approach, this would be it.

Buffett opens by describing his approach to share repurchases; in short, “when companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.” Of course, outstanding businesses rarely sell below their intrinsic value, and Buffett would not encourage buybacks at any share price.  And 1984 saw some dear prices paid.

You see, in the Eighties, relatively cheap debt put companies under siege from “greenmailers,” who would buy large stakes in vulnerable companies and demand that their shares be repurchased by management if they wanted to keep their jobs without a risky fight. One of the best known greenmailers was T. Boone Pickens, who made stabs at Cities Service Company, Newmont Mining, and Diamond Shamrock, before getting his cash.

Regarding these hostile takeover “attempts,” Buffett minces no words, finding the greenmail share repurchase “odious and repugnant.” It is a “mugging,” in which entrenched management offers up its owners’ wallet to pacify the coercive extortionist. Management emerges unharmed, the mugger gets a fat payday, and the innocent shareholder “mutely funds the payoff.” An extreme counterexample to be sure, but illustrative of Buffett’s approach—only buyback shares when the price is right.

Though Buffett admits that general levels in the stock market make it difficult to find stocks that meet his quantitative and qualitative standards, business is excellent at Nebraska Furniture Mart (NFM). Compared to its reasonably efficient competitor Levitz, NFM’s operating expenses (payroll, occupancy, advertising, etc.) are about 16.5% of sales versus 35.6% at Levitz. These savings enable NFM to consistently widen its economic moat, by passing some savings on to customers and expanding its geographical reach far beyond the Omaha market.

How is this astounding efficiency possible? “All members of the family: (1) apply themselves with an enthusiasm and energy that would make Ben Franklin and Horatio Alger look like dropouts; (2) define with extraordinary realism their area of special competence and act decisively on all matters within it; (3) ignore even the most enticing propositions failing outside of that area of special competence; and, (4) unfailingly behave in a high-grade manner with everyone they deal with.” Enthuasism, self-analysis, prudence, decision, ethics—certainly not a bad list of business virtues, if you have the visible exemplars that embody them.

Over at the Buffalo Evening News, profits were greater than expected. Though management deserves praise, moreso does the industry, for “the economics of a dominant newspaper are excellent, among the very best in the business world.” Misplaced vanity may encourage “owners… to believe that their wonderful profitability is achieved only because they unfailingly turn out a wonderful product.” However, third-rate papers produce the same or better profits, as long as it is dominant in its community. When a paper reaches the homes of a desired geographical area, advertisers will pay for access, and if that access is a monopoly, the capitalist’s prices are wonderfully high. Even a poor newspaper commands attention because of its “bulletin board value,” and so it remains “essential” for most citizens, and by extension, most advertisers.

Lastly, in 1984, Buffett give his shareholders a golden key to business valuation.  Discussing Berkshire’s purchase of $139 million Washington Public Power Supply Service (WPPSS) bonds, Buffett reveals that his approach for analyzing bond investments does not differ from that for equities. For example, he asks us to imagine the WPPSS bonds as a $139 million investment in an operating business, which earns $22.7 million after tax (i.e., the interest paid on the bonds), and whose earnings are annually available to us in cash. Would you invest in that business? Intuition suggests to follow the master, and you would be right, as Buffett observes that “we are unable to buy operating businesses with economics close to these. Only a relatively few businesses earn the 16.3% after tax on unleveraged capital that our WPPSS investment does and those businesses, when available for purchase, sell at large premiums to that capital. In the average negotiated business transaction, unleveraged corporate earnings of $22.7 million after-tax (equivalent to about $45 million pre-tax) might command a price of $250 – $300 million (or sometimes far more).”

So what’s Buffett’s “fair value” earnings multiple? Basically 11-13 times unlevered earnings, or 6x EBITDA. Here Buffett’s purchase of the WPPSS equates to buying an unlevered equity trading at 6x earnings. And so Buffett showed up with his largest truck.

Buffett acknowledges that such an approach to bond investing may be “unusual” and perhaps “a bit quirky.” However, this rule of thumb would have saved the “staggering errors” made by the bond purchasers of 1946, who bought 20-year AAA tax-exempt bonds trading at slightly below a 1% yield. Using Buffett’s framework, the buyer, in effect, “bought a ‘business’ that earned about 1% on ‘book value’… and paid 100 cents on the dollar for that abominable business.”

All told, I have left too much of 1984’s letter aside. Buffett also briefly discusses inflation, retaining cash in a business, and reserving in Berkshire’s insurance units. Also, he offers an analysis of See’s Candies and their insurance subsidiaries. If you’re in the mood for some thick, rich business analysis with a Midwestern wit, it’s the letter I most highly recommend.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

Buffett’s Berkshire Letter for 1979

800px-warren_buffett_ku_visit1979 saw the Shah of Iran depart his homeland for Egypt, enabling Ayatollah Khomeini to return to Tehran after fifteen years of exile. Chrysler went begging to the U.S. government for $1.5 billion in loan guarantees. The S&P 500, like 1977 and 1978, spent the majority of the year trading within 10 points of 100.

Over at Kiewit Plaza in Omaha, Chairman Buffett reported operating earnings on shareholder capital of 18.6%. Though the tally fell short of the performances of 1977 and 78, the total approached within a few percentage points their best record. Buffett clearly describes the relevant metrics that shareholders should use to assess Berkshire’s annual performance—“we continue to feel that the ratio of operating earnings (before securities gains or losses) to shareholders’ equity with all securities valued at cost is the most appropriate way to measure any single year’s operating performance.” Over the longer term, owners should also assess the market value of its security investments. Speaking most generally, Buffett concludes that “the primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.”

During 1979, worries about inflation permeated everyday discourse. With the consumer price index increasing more than 10% annually, mortgage rates seemed to have no ceiling, and hording necessities appeared the best “investment.” And Buffett noticed the new competition with his characteristic frankness—“if we should continue to achieve a 20% compounded gain… your after-tax purchasing power gain is likely to be very close to zero at a 14% inflation rate. Most of the remaining six percentage points will go for income tax any time you wish to convert your twenty percentage points of nominal annual gain into cash… We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity.” In an economy with double-digit annual inflation rates, even the best capital allocators struggle to tread water.

And all this from a man who had the pleasure of owning some great businesses, like See’s Candies and Illinois National Bank. How much more is the misery of the mediocre business operator. Far wiser to be in a very good businesses with solid long-term prospects, like insurance, which “tends to magnify, to an unusual degree, human managerial talent – or the lack of it,” than to acquire new textile mills in Waumbec. As Buffett sums, “both our operating and investment experience cause us to conclude that “turnarounds” seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price.”

Lastly, Buffett concludes with some particularly useful comments about making bond investments. Observing that insurance competitors had given up one-year policies because of the inflationary environment, Buffett highlights the inconsistency expressed by their willingness to purchase long-term bonds. In short, “having decided that one year is too long a period for which to set a fixed price for insurance in an inflationary world, they then have turned around, taken the proceeds from the sale of that six-month policy, and sold the money at a fixed price for thirty or forty years.”

Inspired by Polonius, Buffett lays out what looks to be an absolute rule for bond investments: “neither a short-term borrower nor a long-term lender be.” For “even prior to this [inflationary] period, [Berkshire] never would buy thirty or forty-year bonds; instead we tried to concentrate in the straight bond area on shorter issues with sinking funds and on issues that seemed relatively undervalued because of bond market inefficiencies… Our unwillingness to fix a price now for a pound of See’s candy or a yard of Berkshire cloth to be delivered in 2010 or 2020 makes us equally unwilling to buy bonds which set a price on money now for use in those years.”

Here again we see Buffett’s reticence in projecting the earnings power for any business for any period longer than a decade. In his email conversation with Jeff Raikes of Microsoft, he insinuated that very few businesses are sufficiently predictable to submit to long-term forecasts about their earnings potential. And observers see this played out again and again in Buffett’s investments—in equities or fixed income. Berkshire will rarely give money away for longer than ten years, and it will rarely pay today for the discounted value of more than a decade’s earnings.*

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

* The one important and notable exception here is Coca Cola.

[This post continues our series on Warren Buffett’s letters to Berkshire Hathaway shareholders.]

Gambling before Bankruptcy

Much toil and time is given to the study of markets and businesses.  New insights can be interesting; the characters we encounter entertaining; and the bargains rock bottom. For the rainmakers out there, the latter are likely most useful, as every field needs a periodic downpour.

Yesterday it was the bondholders of Nova Chemicals Corporation that got the rain, as their $250 million in outstanding 7.4% medium-term notes were paid in full (cusip: 669936AA4). On the surface, the event may not strike you as noteworthy, but the story gets more interesting when you realize that these very bonds were trading at 58 cents on the dollar during the week of February 16th. Worried that Nova would not be able to pay these notes off or obtain the requisite financing by April 1st, buyers left Nova’s market deserted. Despite a book value of $750 million at December 31, 2008, the equity sellers on February 20th valued the company at less than $150 million.

Nova’s savior arrived though on February 23rd, as International Petroleum Investment Co. of Abu Dhabi came bearing the gift of $6 per common share, and a $250 million credit backstop. Nova’s debt and equity holders danced in the rain.

Reflecting on this scenario, let’s speculate about the relative attractiveness of Nova’s equity and bonds during the week of Feb. 16th. Imagine that we could go back in time; what would the expected value of each investment to be?

Looking at the equity then trading at $1.50 per share, let’s say you estimated the likelihood of bankruptcy (and an equity value of zero) at 40%. Then put a 40% likelihood on a successful debt refinancing, while positing that—in that scenario—the equity would trade marginally higher to $2 per share. And last, take the likelihood of a $6 per share buyout at 20%. All told, the expected value for the equity buyer would be (0*.4+2*.4+6*.2), or $2 per share—not at all a bad return (33%) in six weeks’ time.

How about the debt though, trading at 58 cents on the dollar? In the worst case scenario—bankruptcy—estimated at 40%, the court would have to order a restructuring, and the return to bondholders could vary widely. Authors Van de Castle, Keisman, and Yang have found the median recovery rates for defaulted senior notes to be near 43%. Since Nova has relatively abundant debt at this time (with 1.36 billion in long-term debt as of 12/31/08), let’s estimate that the recovery rates in bankruptcy would be lower than average, say 30%. Again, we’ll put a 40% likelihood on a successful refinancing, which would return 100 cents on the dollar, and the same return would follow from the 20% chance that Nova is acquired. Here the expected value for the debt holder would be (30*.4+100*.4+100*.2), or 72 cents on the dollar. On a purchase price of 58 cents, this would represent a 24% return—again, quite impressive for six weeks’ work.

In sum, either security looks favorable, given these assumptions. However, it is clear that a few small changes in our assumptions will much more negatively impact the equity’s expected value. For example, if the chance of a buyout were only 10% and bankruptcy instead 50%, the equity purchase would have a negative expected value, while the bond would still provide positive returns (30*.5+100*.4+100*.1). Therefore, in similar situations, I suspect that the prudent buyer of the debt will bear far fewer costs for any mistaken assumptions. Better to make rain with the debt holders, unless one’s assumptions are firm.

Disclosure: No position at the time of this writing.