Buffett the Bondsman Revisited

Warren Buffett’s annual letter to shareholders arrived this past Saturday morning with the anticipated fanfare and has produced its usual industry of commentary. Ever since Berkshire’s 13-F became public (2/17/09), I have been thinking increasingly about whether current economic conditions should alter my investment strategy and return expectations. As we observed yesterday, Graham and Dodd seem to suggest that such changes are unnecessary, if our current holdings were acquired with reasonable expectations and a significant margin of safety. Yet, in Buffett’s letter, he discusses selling some equities (presumably purchased with the requisite margin of safety) in order to purchase fixed income securities:

“On the plus side last year, we made purchases totaling $14.5 billion in fixed-income securities issued by Wrigley, Goldman Sachs and General Electric. We very much like these commitments, which carry high current yields that, in themselves, make the investments more than satisfactory. But in each of these three purchases, we also acquired a substantial equity participation as a bonus. To fund these large purchases, I had to sell portions of some holdings that I would have preferred to keep (primarily Johnson & Johnson, Procter &Gamble and ConocoPhillips). However, I have pledged – to you, the rating agencies and myself – to always run Berkshire with more than ample cash. We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits.”

Of these three equities, I am most familiar with JNJ, a favorite of many value investors (including Prem Watsa and John Hussman). Joe Ponzio at F Wall Street has analyzed JNJ and given it an intrinsic value (using a discounted cash flow analysis) of $83.10. With future cash flows discounted at 15% and a 25% margin of safety, Ponzio would be willing to purchase JNJ below $62.33.

Though personally I find this valuation a bit high, it does show that JNJ has a significant likelihood of returning the investor at least 15% per annum. For Buffett to sell JNJ for his fixed income securities, I would contend that he either sees greater return potential in them, or a greater margin of safety for a similar rate of return. The conclusion then presses upon me—a 15% return in equities may not be sufficient in this market. If that’s true, then perhaps the appropriate strategic response is to increase the discount rate in my DCF evaluations, and/or increase my desired margin of safety.

Of course, we can still find wide moat businesses whose current prices look like bargains even with these heightened standards, but the list is shorter. Ebay makes the new list, but likely not the Washington Post Company.

Lastly, Buffett’s moves have inspired me to look further up the capital structure. In the past decade, corporate bonds rarely looked attractive relative to the projected returns for their equity. Now, however, one can find a few better risk-adjusted returns in the corporate bond market. Tomorrow we’ll look at one potential opportunity by comparing the equity of Sears Holdings with its outstanding bonds.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway, eBay, Fairfax Financial Holdings, and debt of Sears Holdings at the time of this writing.

Whither the Economy?

Over the weekend, I was paging through Graham and Dodd’s Security Analysis (5th edition, authors Cottle, Murray, and Block), and thinking especially about discount rates and the margin of safety concept, particularly in light of recent macroeconomic events. It is not yet clear to me how much attention an investor should yield to macroeconomic changes and predictions. Investors often take solace in Warren Buffett’s seeming ambivalence to most macroeconomic data, recalling his many quips about being wholly uninterested in the federal funds rate policy for the upcoming year. Cottle, Murray, and Block touch on these issues in their ninth chapter, on “Qualitative and Quantitative Factors in Security Analysis and the Margin of Safety Concept.” Having laid out the sources of information that an analyst should use, the authors move to the more difficult question—how should the analyst use them?

The basic quandary is this: the analyst could gather nearly infinite information about a given investment, information which would presumably help her to better judge its value. Any constraints on time and attention seemingly hold the analyst back from giving her best judgment. Yet, such constraints are not undesirable, for not all information is essential for a reasonably full evaluation. The analyst must cultivate discernment and practical wisdom in order to know whether the information she has is essential and enough. As our authors observe, “the analyst must exercise a sense of proportion in deciding how deep to delve” (114).

But the specifics here are likely the most useful. An analyst may not need to assess patent protections, geographical advantages, or labor conditions, which may or may not endure. For a stable company, five year financial statements “will provide, if not a conclusive basis, at least a reasonably sound one for measuring the safety of the senior issues and the attractiveness of the common shares” (114).

The company’s “statistical exhibit” though is not enough. “Exceedingly important” are qualitative factors, which—while difficult to assess—require the analyst to examine the nature of the business, the character of management, and the trend of future earnings (115). Particularly pertinent is the business’ position in its industry, its industry’s relative prospects, litigation risk, potential regulatory changes, and social issues. Management represent the face of the business, and many even consider picking good management more important than picking a business in a promising industry. Yet, our authors warn, “little tangible information is available about management… [and] objective tests of managerial ability are few and rather unscientific” (121). Even more worrisome, “there is a strong tendency in the stock market to value the management factor twice,” for both the fact that earnings growth is so robust, and that this capable management produced it (121). Though qualitative factors may be overemphasized and lead to an undue emphasis on perceptions of quality (think of the “Nifty Fifty” and the slogan “Make sure of the quality and price will take care of itself”), researchers Clugh and Meador have concluded that the predictive process is based primarily on qualitative factors.

Thoughout their discussion here, our authors say little explicitly about macroeconomic concerns, in large part because of their emphasis on the presence of a margin of safety for any true investment. As they observe, “when the price is well below the indicated value of a secondary share, the investor has a margin of safety which can absorb unfavorable future developments and can permit a satisfactory ultimate result even though the company’s future performance may be far from brilliant” (504). Though the margin of safety may not guarantee favorable performance by itself, when coupled with sufficient diversification, the margin of safety concept can produce acceptable returns in a variety of macroeconomic environments.

Since an analyst’s time and attention are limited, Graham, Dodd, and Buffett concentrate their energies almost solely on understanding businesses, and in particular, on those aspects of the business which management can control—namely, costs, marketing, and pricing. This concentration, coupled with the margin of safety concept, should be sufficient to defend the investor from unforeseen changes in the broader economy and render detailed economic analysis less relevant to the analyst’s work.