Tuesday, May 26, 2015

Berkshire's Architect

Last year, at the 2014 Daily Journal (DJCO) annual meeting, Charlie Munger said the following:*

Berkshire has been a huge exception. In this year's annual report Warren [Buffett] intends to deal extensively with: Why did it happen at Berkshire? Will it continue? We've reached a size and the record is interesting enough that those are very important questions.

From 1965 though the end of 2014, the share price of Berkshire Hathaway (BRKa) has increased at an annualized rate of 21.6%.

That rate of return would have turned an initial $ 10,000 investment into over $ 180 million over those fifty years. Importantly, Berkshire's long-term returns were driven by increases to per share intrinsic business value. Speculative (and even nonsensical) prices can persist for a period of time but, ultimately, prices will roughly track changes in business value on a per share basis.
(Of course, at Berkshire's present size, future returns have little to no chance of coming anywhere close to that rate of return. That reality doesn't negate what can be learned and applied.)

This year, consistent with what Munger said last year and to recognize the fifty years that have passed since first taking charge of Berkshire, Warren Buffett wrote a special letter to reflect on the company's past and to offer some thoughts on the next fifty years.**

From Buffett's letter:

"My cigar-butt strategy worked very well while I was managing small sums. Indeed, the many dozens of free puffs I obtained in the 1950s made that decade by far the best of my life for both relative and absolute investment performance."

Yet there was a weakness to the approach....

"Most of my gains in those early years, though, came from investments in mediocre companies that traded at bargain prices. Ben Graham had taught me that technique, and it worked.

But a major weakness in this approach gradually became apparent: Cigar-butt investing was scalable only to a point. With large sums, it would never work well.

In addition, though marginal businesses purchased at cheap prices may be attractive as short-term investments, they are the wrong foundation on which to build a large and enduring enterprise."

That's where Charlie Munger's influence comes into play...

"It took Charlie Munger to break my cigar-butt habits and set the course for building a business that could combine huge size with satisfactory profits."

Buffett goes on to explain it this way:

"What most of you do not know about Charlie is that architecture is among his passions. Though he began his career as a practicing lawyer...he designed the house that he lives in today – some 55 years later. (Like me, Charlie can't be budged if he is happy in his surroundings.) In recent years, Charlie has designed large dorm complexes at Stanford and the University of Michigan and today, at age 91, is working on another major project.

From my perspective, though, Charlie's most important architectural feat was the design of today's Berkshire. The blueprint he gave me was simple: Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices."

Munger thinks others would be wise to put at least part of what Berkshire has done into effect. Yet, in too many cases, they just don't.

So why don't more try to emulate Berkshire's approach? He thinks some of it comes down to how institutional forces impact behavior.

More from the same Daily Journal meeting:

There are vast institutional pressures on people to do it differently. Will it continue? I think Berkshire's going to continue way better than most people think. Way better. But there's so much power in what we already have. Part of the reason we have a decent record is that we pick things that are easy. Other people think they're so smart, they can take on things that are really difficult, and that proves to be dangerous.

You have to be very patient, you have to wait until something comes along, which, at the price you're paying, is easy. That’s contrary to human nature, just to sit there all day long doing nothing, waiting. It's easy for us, we have a lot of other things to do. But for an ordinary person, can you imagine just sitting for five years doing nothing? You don't feel active, you don't feel useful, so you do something stupid.

Munger then adds...

Three failing businesses together created Berkshire Hathaway. There are about the same number of shares outstanding now as they were then. I can't think of anything like it at this scale. You'd think people would be paying more attention to it than they do.

Part of the problem is it just appears to be too easy.

It looks so damned easy, they think there must be something wrong with it. The people there [at Berkshire, that is] don't work that hard. They have all these outside interests – Warren's playing bridge twelve hours a week (laughter). They just keep spinning and winning and it just looks too easy. So it's confusing. There must be something wrong with it. (laughter)

A sound investing approach need not be overly complex. Sometimes, very smart people seem willing to ignore a gem in plain sight and, instead, choose the path that's far more difficult. It's as if their abilities causes them to become bored by what's sensible and straightforward though maybe, at least seemingly, a little less challenging than they might like. Maybe they assume there must be more to it. Otherwise, why would such an approach work? Some of their behavior, as Munger points out, can be explained by pressures that are institutional in nature.

Now, that's not to suggest Berkshire's record is easy to replicate. It's clearly not. It does, however, at least imply that some participants would be well-served more carefully studying/thinking about what has led to such an astonishing result then figuring out how it might apply to their own situation and capabilities.
(And, where applicable, maybe spending less time attempting to speculate on near-term price action.)

Personally, if I couldn't find a plane and needed to get across the ocean I'd take a ship. Well, very intelligent and capable individuals at times choose the equivalent of attempting to get across on the back of a sailfish when a perfectly good ship is available.***

They take the tougher than necessary voyage that, in theory, could enhance returns but in the real world likely achieves a similar or even worse outcome.

A similar or worse reward at far greater risk.

Those who think -- and this is just one example among many -- Berkshire's record comes mostly down to the attractive deals Buffett negotiates have pretty much guaranteed they'll miss out on some important lessons.

Of course those deals to an extent matter, but they're just one part of the overall story in my view.

Similarly, each ingredient of the Berkshire investing recipe -- including (but not limited to) things like portfolio concentration, "float" utilization, margin of safety, wide economic moats/enduring advantages, able and trustworthy management, buying only what's understandable, being greedy when others are fearful, extreme patience, lots of cash/liquidity to allow for decisive action, etc. -- is important but, individually, only explains a small part of the exceptional long-term performance. In other words, in a vacuum just one or two of these, even if applied effectively, isn't likely to lead to an unusual result.

It's about how they all work together. What Munger has referred to as a "Lollapalooza Effect".

In fact, in a vacuum, some of these might lead to subpar or even disastrous results in the wrong hands. Those who choose to concentrate their portfolio without the requisite other capabilities comes to mind.
(Indexation at a low-cost ends up being, for many, often the vastly better way to go. It's not just John Bogle who argues for such an approach. Munger and Buffett have also both said as much.)

So the Berkshire approach isn't exactly rocket science but needs to be considered comprehensively. Those willing to do so might find some useful lessons. It can at first appear almost too straightforward, but the challenge of putting it into effect should not be underestimated.

Essentially, there are a number of important pieces that make up the Berkshire puzzle, and it's a mistake to assume one or two of those pieces could possibly provide a full enough picture to explain the exceptional long-term investment results.

Adam

Long position in BRKb established at much lower than recent prices; no position in DJCO.

* From some excellent notes that were taken at the meeting. These notes, presented in four parts, are well worth reading. Not a transcript.
** Charlie Munger also wrote a special letter.
*** Apparently, the sailfish can hit 68 mph for shorter periods of time. That is quicker than any other fish. So someone could, at least theoretically, get to their destination more quickly than on a ship. Obviously, that doesn't make it a brilliant alternative means of transport.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, May 18, 2015

Berkshire Hathaway 1st Quarter 2015 13F-HR

The Berkshire Hathaway (BRKa1st Quarter 13F-HR was released yesterday. Below is a summary of the changes that were made to the Berkshire equity portfolio during that quarter.
(For a convenient comparison, here's a post from last quarter that summarizes Berkshire's 4th Quarter 13F-HR.)

There was plenty of buying and selling during the quarter though no entirely new positions. Here's a quick summary of the changes:*

Added to Existing Positions
Wells Fargo (WFC): 6.83 mil. shares (incr. 1.5%); total stake $25.6 bil.
IBM (IBM): 2.59 mil. shares (3.4%); tot. stake $ 12.8 bil.
U.S. Bancorp (USB): 3.68 mil. shares (4.6%); tot. stake $ 3.66 bil.
Deere & Co. (DE): 213k shares (1.2%); tot. stake $ 1.52 bil.

I've included above only those positions worth at least $ 1 billion at the end of the 1st quarter. In a portfolio this size -- over $ 238 billion (equities, fixed income, cash, and other investments) as of the latest available filing with roughly half made up of common stocks** -- a position that's less than $ 1 billion doesn't really move the needle much.

Other positions that were added to but worth less than $ 1 billion include: 21st Century Fox (FOXA), Precision Castparts (PCP), and Phillips 66 (PSX).

There were no entirely new positions established during the quarter.

Also, Berkshire's latest 13F-HR filing did not indicate any activity was kept confidential.

Occasionally, the SEC allows Berkshire to keep certain moves in the portfolio confidential. The permission is granted by the SEC when a case can be made that the disclosure may cause buyers to drive up the price before Berkshire makes its additional purchases.

Reduced Positions
Charter (CHTR): 219k shares (reduced 3.5%); tot. stake $ 1.15 bil.

Other positions that were reduced somewhat but not sold outright include Bank of New York Mellon (BK), Visa (V), Viacom (VIAB), Liberty Global (LBTYA), WABCO (WBC), Mastercard (MA), and National Oilwell Varco (NOV) with each being worth less than $ 1 billion.

No positions were sold outright.

Todd Combs and Ted Weschler are responsible for an increasingly large number of the moves in the Berkshire equity portfolio. These days, any changes involving smaller positions will generally be the work of the two portfolio managers.
(Though some of the holdings they're responsible for have become more substantial over time.)

Top Five Holdings
After the changes, Berkshire Hathaway's portfolio of equity securities remains mostly made up of financial, consumer and, to a lesser extent, technology stocks (mostly IBM).

1. Wells Fargo (WFC) = $ 25.6 bil.
2. Coca-Cola (KO) = $ 16.2 bil.
3. IBM (IBM) = $ 12.8 bil.
4. American Express (AXP) = $ 11.8 bil.
5. Wal-Mart (WMT) = $ 4.97 bil.

As is almost always the case it's a very concentrated portfolio. The top five often represent 60-70 percent and, at times, even more of the equity portfolio. In addition, Berkshire owns equity securities listed on exchanges outside the U.S., plus fixed maturity securities, cash and cash equivalents, and other investments.

The portfolio excludes all the operating businesses that Berkshire owns outright with ~ 340,000 employees (25 being at headquarters) according to the latest letter.

Here are some examples of Berkshire's non-insurance businesses:

MidAmerican Energy, Burlington Northern Santa Fe, McLane Company, The Marmon Group, Shaw Industries, Benjamin Moore, Johns Manville, Acme Building, MiTek, Fruit of the Loom, Russell Athletic Apparel, NetJets, Nebraska Furniture Mart, See's Candies, Dairy Queen, The Pampered Chef, Business Wire, Iscar, Lubrizol, Oriental Trading Company, as well as, at least until the Kraft Heinz deal closes, slightly more than 50% of Heinz.***
(Among others.)

In addition, the insurance businesses (BH Reinsurance, General Re, GEICO etc.) owned by Berkshire have naturally provided plenty of "float" for their investments over time and continue to do so.

See page 125 of the 2014 annual report for a full list of Berkshire's businesses.

Adam

Long positions in BRKb, WFC, KO, AXP, USB, WMT, and PSX established at much lower than recent market prices. Also, long position in IBM established at slightly lower than recent market prices. (In each case compared to average cost basis.)

* All values shown are based upon the last trading day of the 1st quarter.
** Berkshire Hathaway's holdings of ADRs are included in the 13F-HR. What is not included are the shares listed on exchanges outside the United States. The status of those shares, if a large enough position, are updated in the annual letter. So the only way any of the stocks listed on exchanges outside the U.S. will show up in the 13F-HR is if Berkshire happens to buy the ADR. Investments in things like preferred shares (and valuable warrants, where applicable, as explained in recent letters) are also not included in the 13F-HR. The same is true for the Heinz common shares (i.e. not just the Heinz preferred shares). Heinz common and preferred investments are currently valued on Berkshire's books at $ 11.5 billion.
*** A deal was recently announced that will combine Kraft (KRFT) with the Heinz assets. Berkshire will own a smaller percentage (more than 26%) of the much larger combined company after the Kraft Heinz deal closes.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Wednesday, May 13, 2015

Multiple Expansion, Buybacks, & The P/E Illusion

...if you expect...[total] rationality either in humans or human institutions, you're expecting what's not going to happen. - Charlie Munger at the 2014 Daily Journal (DJCO) Annual Meeting*

Multiple expansion -- that enough market participants will someday be willing to pay more for a given amount of recent, future, or maybe normalized earnings -- is brought up from time to time and it's often in the context of how it has contributed to returns or, alternatively, might contribute to forward returns.

Well, consider the following...

Let's say a stock with no earnings growth is bought at a P/E of 10 times earnings and sold for 15 times earnings twenty years later. In this case the benefits of multiple expansion appear to be working for the investor.

For simplicity, we'll assume all profits are used for buybacks and the price increases immediately such that the earnings multiple becomes 15 not long after purchase. That multiple of earnings per share then persists over the next twenty years. The shares are sold at the higher multiple at the end of year twenty.

This "multiple expansion" scenario would turn a $ 10,000 investment into ~ $ 60,000 over twenty years.

Not a bad outcome at all.

Now, let's say the same stock with no earnings growth is bought at 10 times earnings and sold for 6 times earnings twenty years later. Once again, assume all profits are used for buybacks but the price drops immediately such that the earnings multiple becomes 6 shortly after purchase. That multiple of earnings per share then persists over the twenty years. The shares are sold at the reduced multiple at the end of year twenty.

On the surface this "multiple contraction" scenario feels like the relatively unlucky outcome and in the short or medium run, of course, it is.**

Yet when the time horizon increases enough, and the compounded effect of buybacks becomes the dominant factor, it's actually the second scenario -- even though it was sold at the reduced multiple -- that produces the better result.

The second scenario actually would turn a $ 10,000 investment into more than $ 200,000 over twenty years.

Basically, that's less than a 10% annualized return with expansion compared to a more than 16% annualized return with contraction.

At first the math may seem off but run the numbers in a spreadsheet and the reason why this works out so well should become more obvious. The fact that it's not intuitive is what makes it useful to those who look for assets that are mispriced.

In the multiple expansion scenario, the purchaser of the stock experienced an immediate 50% gain while, in the multiple contraction scenario, the purchaser of the stock experienced an immediate 40% decline. So naturally the short-term trader -- or even someone who's holding period is several years -- would clearly prefer the former outcome and view the latter outcome as a disaster.***

That multiple expansion isn't always a good for the long-term investor seems to too rarely get consideration. Yet, with a simple spreadsheet, it's easy to show contraction can lead to a better long-term outcome for the business with a durable competitive position, selling at a discount to intrinsic value, with solid, even if unspectacular, core economics, and a sensible buyback plan. It's worth highlighting that these investment results are being produced without exciting business growth. The earnings are flat (though, importantly, there's very significant per share earnings growth due to the buybacks). This is just one example where purchasing, at a fair or better price, part of a business with modest growth but durable and sound economics can trump those with more exciting growth prospects.

The specific circumstances where multiple expansion is not necessarily such a wonderful thing are worthy of more attention than they get.

So why isn't multiple contraction viewed more favorably by those who have a long enough time horizon? A contributing factor might be a market dominated by participants who are mostly speculating on what'll happen in the near-term or intermediate-term -- time frames where multiple contraction is not at all a benefit. It might also be in part due to what I've in the past described as "The P/E illusion". The end result being the long-term benefits of multiple contraction is underappreciated.

Intuitively, that multiple expansion would be less than beneficial to a long-term owner doesn't seem right. Yet it is. This is a case where mathematical intuition leads to an incorrect conclusion.

Understanding the math here isn't difficult, but understanding how framing effects cause this to initially be a bit less than intuitive is, to me, the more important thing.

The reason for the higher return in the multiple contraction scenario essentially comes down to how the earnings yield (inverse P/E) is working for the investor. When you start at a P/E of 10, the 40% drop to a P/E of 6 creates a significant incremental earnings yield tailwind that makes the buybacks extremely beneficial for continuing owners. In this case, the earnings yield increases from 10% to 16.7%. That tailwind combined with buying back stock over twenty years becomes, increasingly, the dominant factor.

This effect becomes much more important than multiple expansion over the longer haul. The implications are significant when it comes to managing the risk of permanent capital loss relative to the potential rewards.

Framing effects can influence decision-making in a way that's easy to underestimate.

The math may not feel intuitively right, but the important thing is that it is right.

Multiple expansion is overrated when it comes to long-term investment.

Essentially, part of what's occurring is an intrinsic value transfer from impatient owners to continuing long-term owners. This only works out well if the buybacks occur when the shares sell for less than per share intrinsic value.

Those who own part of any good business for the long haul should prefer that stock prices lag and multiples contract.

The challenge isn't just buying shares at a discount; it's getting comfortable with the idea that it's better if they remain at a discount -- even if that means the price remains below the initial price paid -- for an extended period of time.

That's understandably a tough sell for traders.

It shouldn't be a tough sell for investors.

For the long-term investor, multiple expansion is a good thing on the day of the sale but that's about it. The key being that the expansion isn't required to get a very nice result. The above multiple contraction scenario is a case in point.

Selling at a high multiple of earnings shouldn't be a necessity to achieve the desired investing outcome. It's best to assume market prices won't be spectacular when the time to sell arrives (many years down the road) then simply consider it a bonus if they turn out to be.

If the total return would be attractive assuming merely a decent selling price, there'll be no complaints if the multiple of future earnings per share the stock can be sold at ends up being somewhat (or quite a bit) higher.

Margin of safety is, in part, about how the price that's paid upfront compares to an estimate of intrinsic value; it's also about making conservative assumptions including, but definitely not limited to, the eventual selling price.

Since an investor can't control near-term market price fluctuations no sensible approach should depend on selling at a great price.

As I've noted in prior posts -- when they were much cheaper than now -- the shares of many consumer packaged goods makers have not only been solid defensive investments, they've also, in the longer run, done rather relatively well in terms of total return. Much of this comes down to the quality of the businesses; the current problem is they're mostly no longer cheap. Too many are selling for a high multiple of their earnings these days. This necessarily means, if these higher multiples persist over time, they'll likely return less for owners in the long run all else being equal. So the tailwind noted above generally doesn't currently exist with these stocks right now. Long-term returns will be adversely effected if this persists.
(In this case -- unlike the examples above where it was assumed all profits were used for buybacks -- it's also dividend reinvestments, not just the buybacks, that won't be as effective or could even destroy value if/when shares sell for a premium to value.)

The combination of a strong competitive position, business economics that are durable and the high return variety, along with shares frequently selling at a discount to intrinsic value accounts for a good chunk of what's been an attractive risk-reward profile for consumer staples companies. Going forward, what needs to be carefully considered is how a changing competitive landscape might alter what have been attractive core economics for a very long time. Are any key advantages being diminished over time? Are viable alternative brands with sufficient distribution being created? Does the internet make it easier/cheaper to create competing brands? Are some of the largest retailers becoming an increasing threat?

The list goes on.

Just because they've produced great results for many decades guarantees nothing.

That doesn't mean these have become horrible businesses.

In fact some are, and seem likely to remain, fine businesses.

It just means the investment risk-reward -- partly due to market price and partly due to prospects -- has become less favorable in some cases.
(Naturally not all are created equal. Some continue to have substantial advantages and possess extremely wide moats.)

Naturally what matters is future performance. Well, if the valuations remain persistently on the high side, these stocks will not do nearly as well even if the businesses perform.

Those that own shares of these small-ticket branded goods makers for the long haul should be hoping for a steep decline in market prices sooner rather than later.

Adam

No position in DJCO

Related posts:
Buffett and Munger on IBM
The P/E Illusion
The Benefits of a Declining Stock
Buffett's Purchase of IBM Revisited
Buffett on Buybacks, Book Value, and Intrinsic Value
Buffett on Teledyne's Henry Singleton
Why Buffett Wants IBM's Shares "To Languish"
Buffett: When it's Advisable for a Company to Repurchase Shares
The Best Use of Corporate Cash
Buffett on Stock Buybacks - Part II
Buffett on Stock Buybacks
Buy a Stock...Hope the Price Drops?

* From some excellent notes that were taken at the meeting. These notes, presented in four parts, are well worth reading. Not a transcript.
** Working through a simple spreadsheet makes what might at first be mathematically counterintuitive less so. Simply put, the persistent and extremely high earnings yield combined with consistent buybacks creates a tailwind over twenty years that trumps the initially negative effects of multiple contraction. Naturally, a price drop of 40% usually coincides with something happening that at least appears material and not good. Whether temporary but fixable or indicative of something more serious is what has to be understood. Multiple contraction is a good thing (or, at least, can be when the circumstances are right) but sustained and meaningful earnings contraction is not. Are the near-term difficulties indicative of a permanent and material reduction in earnings power? Have the core business economics changed for the worse? Has something like a fundamental change in competitive position occurred? Near-term setbacks that temporarily reduce earnings power don't matter nearly as much. In the moment, it's not always easy to differentiate temporary challenges from those that are more permanent. Sometimes, recent results get incorrectly extrapolated. Mispricings can occur when there's confusion about what recent events will end up meaning in the longer run. Judging this well, and acting accordingly when the opportunity presents itself, is often the toughest part. When the price paid upfront is reasonable, and market prices remain persistently below intrinsic value, even a permanent (though not catastrophic) reduction in earnings power can still potentially produce a more than satisfactory investment outcome. The price paid must represent a discount to per share intrinsic value, estimated conservatively. Any decline in earnings needs to be at least roughly accounted for in the present value calculation. None of this should distract from the fact that, when years away from selling  -- all else equal -- multiple expansion is not such a wonderful thing if a stock was bought well (i.e. at a discount to value) in the first place. For the speculative trader, multiple expansion is generally a good thing because they're likely selling soon enough. In addition, multiple expansion is helpful if a premium was paid and the speculator hopes to sell at an even greater premium before enough other participants have figured out the folly. Of course, after all the buybacks and dividend reinvestments have been completed (at a discount) over the twenty year period, the long-term investor certainly isn't going to mind if the multiple suddenly were to become rather high when it's time to sellOtherwise, an expanded multiple actually reduces long-term returns in a scenario similar to the one described in the above post (as well as many other variations including both situations where earnings are growing or in decline). Somewhat different assumptions can alter the specific returns but don't negate the effect. This works best when the earnings yield is on the high side. Stocks that are speculatively priced for lots of growth but prove unable to deliver on the promise generally have insufficient earnings yield for multiple contraction to make a real difference. In other words, a 100 P/E stock that drops to a 60 P/E goes from a 1% earnings yield to a 1.67% earnings yield. That's just not enough of a tailwind. In the real world, unfortunately, businesses with sustainable advantages don't usually sell for a multiple of six times earnings over many years. In fact, a business with that kind of multiple often -- though not always -- is mediocre or even low quality. That doesn't change the reality that multiple contraction, even if to a lesser extent, of a sound business (selling at a discount to value) can be preferable for long-term investors when combined with sensible buybacks and dividend reinvestments.
*** It'd be tough for anyone to complain about a quick 50% gain, of course, but in the real world most of us can't reliably produce quick gains without also risking big losses. Investing is about the net long-term result with all risks considered -- especially the risk of permanent capital loss.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Wednesday, May 6, 2015

Buffett and Munger on IBM

In an interview just prior to the start of 2015 Berkshire Hathaway (BRKa) shareholder meeting, Warren Buffett said that he purchased more shares of IBM (IBM) in the 1st quarter on 2015.

One thing to keep in mind is that IBM's stock dropped substantially during the 1st quarter. The stock currently sells at a higher price than what became available during the quarter.
(Though the shares are currently selling just below what was Berkshire's ~ $ 171/share cost basis at year-end 2014. )

We'll find out just how much additional buying occurred when the next 13F-HR is released later this month. The latest 10-Q shows that a bit more than $ 1.6 billion in equity purchases were made during the quarter.

So how much of these purchases was for IBM isn't known just yet.

According to the Wall Street Journal, Charlie Munger was asked at the meeting whether he considers IBM to be a "cigar butt." His response, essentially, was to say it's an enterprise that has mostly been able to adapt over the years and, importantly, they paid a "reasonable price."

Munger's comments were followed then by a noteworthy exchange with Buffett. From the Wall Street Journal's recap:*

Buffett jumps in to say that he never understands when people expect him to talk up Berkshire investments.

If we talked our book, he says, "we would say pessimistic things about all four of the biggest holdings we have" because all four are repurchasing their shares at the moment.

He asks Munger why people expect the opposite. Munger: "If people weren't often so wrong, we wouldn't be so rich."

Munger is usually good for some one liners.

This article offers some additional examples from the meeting.

Of course, Buffett previously explained in his 2011 letter -- in some detail -- that, for those with a long enough time horizon, it makes little sense to want well bought shares of a sound business to go higher in the near-term (or even longer). From the letter:

"When Berkshire buys stock in a company that is repurchasing shares, we hope...that the stock underperforms in the market for a long time as well."

Later he adds:

"'Talking our book' about a stock we own – were that to be effective – would actually be harmful to Berkshire, not helpful as commentators customarily assume."

A rising stock simply makes the buybacks less effective. A higher stock price simply means it's more costly to reduce the share count. That higher price paid, on a compounded basis, naturally hurts continuing owners. Yet Munger and Buffett understand this is usually a tough sell for those who are more interested in making speculative bets on near-term stock price action. More from the 2011 letter:

"Charlie and I don't expect to win many of you over to our way of thinking – we've observed enough human behavior to know the futility of that – but we do want you to be aware of our personal calculus."

With this in mind, Munger's quip about the benefits of others being "often so wrong" is worth remembering.

At the meeting Buffett also said, when it comes to buybacks, "there's been more stupid stuff said and stupid stuff done" and emphasized that shares should only be bought back if selling below intrinsic value.

Seems obvious but, well, for some it's apparently not.

This past Monday on CNBC, Buffett once again talked about the importance of having the discipline to only buyback shares when they're selling below what they're intrinsically worth:**

"Buying in stock can be extremely dumb; it can be extremely smart. It was extremely smart for Henry Singleton at Teledyne, and I won't give you the names of people where it was extremely dumb. It all depends on whether your buying the stock for less than it's worth."

And he also said:

"...it's all case specific. We say that at Berkshire we'll buy our stock in -- and we'll buy it aggressively -- at 120% of book value. I know that at price the shareholders who stay are gaining on a per share basis because we are doing that. If we were to buy it in at 200% of book value our shareholders that were staying would be...penalized by that action."

What matters is if the shares were bought cheap against per share intrinsic value and compared to alternatives (opportunity costs). This is too often ignored by investors and managements alike. Some seem to think that if shares are repurchased then the stock proceeds to go lower prices it wasn't a smart buyback. That may be useful way of thinking for traders but it's the wrong way to think for long-term continuing shareholders.

CNBC Video - Buffett: We'll make 'considerable' money on IBM
CNBC Video - IBM's buybacks beneficial to shareholders: Buffett
CNBC Video - Why IBM and not Apple? Warren Buffett answers

I'd add that the estimate of intrinsic value should be calculated with conservative assumptions. Using more aggressive assumptions to justify estimated value is a recipe for insufficient margin of safety or worse. A satisfactory result shouldn't be dependent on great things happening.
(At least if risk and reward is being managed in a sound way. IBM may have been able to adapt in the past but that reveals little about the future.)

As a stock, IBM hasn't done much since Berkshire first bought it several years ago. Yet both Buffett and Munger still seem to consider it a sound investment. Time will tell whether they're correct in their judgment (mistakes are made by even the most capable investors), but it's not about what the stock does in the near or even intermediate term; it's whether IBM can maintain meaningful competitive advantages in a rapidly changing environment; it's whether IBM's core business economics will remain roughly intact and how excess capital will be allocated over the coming decades; it, ultimately, comes down to the price paid relative to per share intrinsic value and how that value changes over time.

Under the right circumstances -- primarily when shares sell at a nice discount and the business can easily afford it -- repurchases can end up being, all else equal, incrementally beneficial to per share intrinsic value.***

Those who speculate on price action, even if in a very skilled manner, are mostly involved in an entirely different game.

Adam

Long position in BRKb established at much lower than recent market prices. Also, long position in IBM established at slightly lower than recent prices. (In both cases compared to average cost basis.)

Related posts:
The P/E Illusion
The Benefits of a Declining Stock
Buffett's Purchase of IBM Revisited
Buffett on Buybacks, Book Value, and Intrinsic Value
Buffett on Teledyne's Henry Singleton
Why Buffett Wants IBM's Shares "To Languish"
Buffett on IBM: Berkshire Buys Big Blue
Buffett: When it's Advisable for a Company to Repurchase Shares
The Best Use of Corporate Cash
Technology Stocks
Buffett on Stock Buybacks - Part II
Buffett on Stock Buybacks
Buffett: Indebted to Academics
Buy a Stock...Hope the Price Drops?

* Also see The New York Times coverage of the meeting.
** From the 2011 letter: "Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company's intrinsic business value, conservatively calculated."
*** Keep in mind that overall business value can change much more modestly than per share value over time or, actually, even not at all. For example: if share count is cut in half through share repurchases and the earnings of a business remains constant in perpetuity over time, then the per share value, assuming for simplicity that all other elements of value are equal, doubles while overall business value does not; the same earnings divided by half as many shares outstanding will naturally double earning per share. If the doubled price -- to simply reflect the doubling of per share earnings -- is multiplied by one half as many shares outstanding, the market value will be the same overall even though each owner who hangs in there owns something roughly twice as valuable on a per share basis. If one assumes durable earnings are 100% used for buybacks, and shares are bought back, on average, at a high single digit multiple of earnings, then share count is comfortably more than cut in half over 7-10 years (even accounting for the likely repurchase price increase over time as per share earnings rises due to share count reduction). Instead of growth it's the high earnings yield (inverse of price-to-earnings), over a long enough time horizon, that increasingly becomes the dominant factor when it comes to producing returns. This works for even the largest enterprise. The so-called law of large numbers can distract from this possibility. Individual owners can do just fine when a business -- large or small -- is able to reduce its share count at attractive prices with modest or even no growth. Now, there's no guarantee the market price will fully reflect the increase in per share value but, in the long run, if earnings per share is increasing (while, once again, overall business value hardly changes if at all) at a satisfactory rate, good things seem likely to happen for those who stick around. In other words nothing spectacular has to happen to get a satisfactory or better result. It's possible that the future multiple of earnings investors are willing to pay contracts further but, in fact, that would simply create an additional earnings yield tailwind over the longer run. The compounded effects of this over many years is at times underestimated. What's most important, at least for me, is the implications of this when it comes to balancing risk and reward. Not insignificant. No one complains when a stock rises after purchase, of course, but the opposite can work out more than just fine under the correct circumstances. So, mo matter what direction the stock goes soon after purchase, it can be heads I win...tails I win more for someone able to judge growth-challenged/turnaround situations reliably well enough. The same effect is not meaningful for a stock that sells at 100 times earnings because the earnings yield, and incremental earnings yield as the market price drops, is just not substantial enough to matter. For the high multiple stock, growth then necessarily becomes the dominant factor with the downside usually being not small if growth prospects don't quite materialize. Consider two scenarios where a stock suddenly drops 50%: 1) A stock selling for 100 times earnings that drops to 50 times earnings turns a 1% earnings yield into a 2% earnings yield -- incrementally, a 1% increase in yield for every future incremental purchase/share repurchase. 2) A stock that goes from 10 times earnings to 5 times earnings turns a 10% earnings yield into a 20% earnings yield -- incrementally, a 10% increase in yield for every future incremental purchase/share repurchase. If the multiple stays low long enough and the investor hangs in there long enough that substantial yield becomes the main driver of returns. The high multiple stock can't put a meaningful dent in share count over 7-10 years with a 1-2% earnings yield; the low multiple stock certainly can. If nothing else it's worth remembering that the math is such that growth is not necessarily required when the multiple is low enough and the earnings prove durable enoughThis way of thinking may be of little use to those who mostly make bets on near-term price action, but matters a great deal for those who tend to invest in shares with a decade or two in mind. Growth often comes at too high a price. A premium price should only be welcome when it comes time to sell. Multiple expansion is overrated for the owner who truly has no intent to sell for many years; it matters a great deal to those who place short and intermediate term bets. Selling is almost always imminent for the speculator; less so for the investor. The challenging part, of course, is gauging whether earnings power will prove persistent roughly near current levels. Most businesses that sell for a single digit multiple of earnings have the kind of fundamental difficulties ahead that make figuring out what normalized earning power really is not at all straightforward. More specifically, that's what makes IBM's longer term prospects so tough to judge. The earnings may in fact keep going down down down. Permanently and meaningfully impaired earnings is a real problem. A temporarily reduced stock price, even if it persists for years, is certainly not. The job of a long-term investor, while never easy, in fact becomes at least somewhat easier when a stock already bought at a nice discount to conservatively estimated value drops even further.
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