Intelligent Investor Club

Accounting Rules

A major accounting change, which was to be implemented by January 1, 1993, requires that businesses recognize their present-value liability for post-retirement health benefits.

For some reason, these were not required to be recorded on the books previously even though pensions to be paid in the future (something similar) were.

By ignoring the built-up of such liabilities, some companies had left themselves vulnerable to open-ended liabilities in the future.

The result of this new rule will many companies to record a huge balance-sheet liability (and a consequent reduction in net worth).

Warren Buffett tends to avoid companies with significant post-retirement liabilities when he is making his acquisitions.

Stock Options

Despite the accounting rule change for health benefits, no such change was required for stock options.

Stocks options were still illogically treated for in the accounts.

Some people have argued that “out-of-the-money” options (those with an exercise price equal to or above the current market price) have no value when they are issued.

Others have said that options should not be viewed as a cost because they “aren’t dollars out of a company’s coffers.”

Warren Buffett sees these as flawed as they would open up possibilites for companies to instantly improve their reported profits.

For example, they could now eliminate the cost of insurance by paying with it using options.

As long as something of value changes hand (and not just when cash changes hands), there will be a cost involved.

The arguement that options should not be recognised in the accounts because it is difficult to value them is also not right.

Currently, estimates are being used in accouting anyway. Examples include depreciation of a plane, a bank’s annual loan loss charge and losses of property-casualty ompanies.

In summary,

“If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”

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Fixed Income Securities

While Berkshire has done well with negotiated purchases of fixed income securities over the years, their purchases in the secondary market has performed better.

This corresponds with Warren Buffett’s belief that an intelligent investor in common stocks will do better in the secondary market than by buying new issues.

Why is this so?

First of all, the timing of new issues is determined by controlling stockholders and corporations. If the market is unfavorable, they can avoid an offering altogether.

The sellers in a public offering or negotiated transaction are also unlikely to offer a bargain. Most to the time, they are motivated to sell only when they can get a good price.

On the other hand, there are always times in the secondary market whereby mass folly takes place. No matter how low the price may be at that time, you can always find a few buyers who are willing to sell at that price.

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Besides investing wisely, it is also important to ensure that you manage your expenses carefully.

After all, if you cannot save money in the first place, how can you ever start investing?

I just found a site Upromise that will give you cashback into your college savings account whenever you spend money at companies registered with them.

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There are more than 100 national companies, 8,000 restaurants, 10,000 hotels, and 500 online retailers including companies like McDonald’s®, Exxon, Citi, Mobil and GNC.

Now, wouldn’t that be a great way to add to your savings?

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Value Investing

Compared to that stated 15 years ago, the only change in the equity-investing strategy of Warren Buffett is the addition of the word “very”:

“We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety. We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and (d) available at a very attractive price.”

The question one now needs to ask is how to decide what is attractive. Unlike most analysts who choose between either a growth or value approach, Buffett feels that growth is always a component of value. The important of which can vary from negligible to large, and the effects can be from negative to positive.

The term “value investing” is also redundant as all investing seeks to buy something of value that justifies the price paid. Overpaying for something in the hope of selling it at an even higher price is not investing, but speculation.

A “value investment” is not determined in any way by its price-earnings ratio, price to book ratio or even a high dividend yield.

Neither is it determined by the growth. While most growth often has a positive impact on value, it only benefits investors when each additional dollar used to finance the growth creates more than a dollar of long-term market value.

If business returns are low, growth actually hurts the investor.

Taken from The Theory of Investment Value written in 1937 by John Burr Williams, value can be defined as:

The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.

You will notice that the same formula is used for stocks as well as bonds. An important difference to take note is that for bonds, the future cash flows can be accurately determined from the coupon rate and maturity dates. While for stocks, the future cash flows has to be estimated.

This is the part where most people can go wrong.

Berkshire overcomes this problem by:

1) Dealing only with businesses that they understand, are simple and stable in nature. The best businesses to own are those that can employ large amounts of incremental capital at very high rates of return over an extended period of time. The worst businesses to own are those that does the opposite – that is, consistently employ ever-increasing amounts of capital at very low rates of return.

2) Having a margin of safety (as strongly emphasized by Ben Graham) in the purchase price.

Using the discounted-flows-of-cash calculation, the investment that is shown to be cheapest should be brought. Other factors like growth, earnings volatility, book value wouldn’t matter at all as these would all have been factored in.

And if the calculations show that bonds are cheaper, then they should be bought instead.

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Whenever you read annual reports, chances are that most of the CEO’s message will be done in a serious tone.

Seldom will you find a CEO who jokes in his message. Despite the size of the Berkshire empire, Warren Buffett never fails to inject some humour in his letters. Here’s one from his 1992 report:

Leaving aside splits, the number of shares we held in these companies changed during 1992 in only four cases: We added moderately to our holdings in Guinness and Wells Fargo, we more than doubled our position in Freddie Mac, and we established a new holding in General Dynamics. We like to buy.

Selling, however, is a different story. There, our pace of activity resembles that forced upon a traveler who found himself stuck in tiny Podunk’s only hotel. With no T.V. in his room, he faced an evening of boredom. But his spirits soared when he spied a book on the night table entitled “Things to do in Podunk.” Opening it, he found just a single sentence: “You’re doing it.”

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Today’s post looks into insurance operations for “super-cat” coverages, which are the policies that other insurance companies buy to protect themselves against major catastrophic losses. Read on to understand how Warren Buffett views this industry and manages his operations.

Insurance Operations

Due to Hurricane Andrew, Berkshire suffered losses of $125 million, an amount roughly equal to their 1992 super-cat premium income.

The nature of the super-cat insurance is such that in any year, it would “either enormously profitable or enormously unprofitable” (even though both 1991 and 1992 came in close to break even).

Generally, these policies (most of them) are activated subjected to certain conditions.

1) There is a deductible or retention that the policyholder has to absorb before the policy kicks in.

2) Industry wide insured losses from the castastrophe must exceed some minimum amount.

3) Occurrence of second, third or fourth event.

4) Catastrophe of a specific type.

5) Specific geographical region.

It is difficult to price super-cat policies as insurers cannot simply extrapolate past events. For example, slight changes to the world’s climate might produce huge changes in weather patterns.

For some reason, the likelihood of super-cats happening is higher towards the end of the year, when the weather tends to kick up.

Therefore, Warren takes a conservative approach of defering the recognition of revenue until a loss occurs or until the policy expires.

This results in a slight biased in the quarterly results: Large losses may be reported in any quarter of the year, but significant profits will only be reported in the fourth quarter.

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Look Through Earnings

For the 3rd year in a row, Warren Buffett talks about the concept of look through earnings. As explained by Warren, look through earnings consists of:

(1) the reported operating earnings, plus;
(2) the retained operating earnings of major investees that, under GAAP accounting, are not reflected in our profits, less;
(3) an allowance for the tax that would be paid by Berkshire if these retained earnings of investees had instead been distributed to us.

Warren believed that the look-through number more accurately portrays the earnings of Berkshire than the GAAP number.

For Berkshire’s intrinsic value to grow at 15% annually, the look through earnings also has to grow at that rate.

This means that not only does Berkshire’s operating subsidiaries and investees have to deliver excellent operating results, the skill of capital allocation will also be very important as well.

When capital is allocated today, it is with the thought of how that allocation will maximize look through earnings many years in the future.

However, this long-term focus does not eliminating the need for Berkshire to achieve decent short-term performance. After all, today’s performance is also the result of “long term” thinking made many years ago.

If a company fails to deliver for extended periods of time and blames it for their long time focus, then there is reason to be suspicious of their management.

Similarly, you should be suspicious of managers who increase their short-term earnings using tricks like accounting maneuvers, asset sales, etc.

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Acquisitions

Making an acquisition is like marrying a spouse: It pays to be active, interested and open-minded, but it does not pay to be in a hurry.

Warren Buffett analogises the acquisitions of many managers to that of princesses kissing toads, hoping that they would one day turn into princes.

He himself was guilty of “dating” toads in his early days but finally revised his strategy to buy good businesses at fair prices rather than fair businesses at good prices.

In 1992, Berkshire made a purchase of a company that matched the definition of what they were looking for. The purchase was 82% of Central States Indemnity, an insurer that makes monthly payments for credit-card holders who are not able to pay themselves because they have become unemployed or disabled.

This acquisition had much in common with the very first one made 26 years ago, another Omaha insurer, National Indemnity Company.

On top of purchases made by the parent company, the subsidiaries of Berkshire sometimes make small “add-on” acquisitions that extend their product lines or distribution capabilities.

These add-on acquisitions are expected to contribute modestly to Berkshire’s value in the future.

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Berkshire Hathaway seldom issues out shares. On 1st October 1964, there were 1,137,778 shares outstanding. On March 1993, that number has increased to 1,152,547 shares.

This is due to Warren Buffett’s firm policy about issuing shares of Berkshire only when they receive as much value as they give. Bershire’s size should only be increased when doing so increases the wealth of its owners.

The long term goal of Berkshire is to increase its per-share intrinsic value at a 15% annual rate.

This objective cannot be attained in a smooth manner because a high proportion of Berkshire’s net worth is represented by common stocks. Generally accepted accounting principles(GAAP) accounting rules require that these securities be valued at their market prices (less an adjustment for tax on any net unrealized appreciation).

Frequent changes in equity prices will ensure a great deal of fluctuations in their annual results. This is especially so when you compare it to the typical industrial company.

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Airlines

In 1991, Midway, Pan Am and America West from the airline industry all entered bankruptcy. (Stretch the period to 14 months and the list includes Continental and TWA.)

Warren Buffett does not like the airline industry at all.

Despite the huge amounts of equity capital that have been invested, overall, the industry has posted a net loss since its birth after Kitty Hawk.

The problem is made worse by the fact that the courts have been encouraging bankrupt carriers to continue operating.

These bankrupt carriers can temporarily charge fares that are below the industry’s costs because they don’t incur the capital costs faced by their solvent peers. These losses are then funded by selling off assets.

The low fares by bankrupt carriers contributes to the toppling of previously-marginal carriers, making it unprofitable (and spelling doom) for everyone.

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