Archive for March, 2007
Helzberg’s Diamond Shops
There is a popular technique called “management by walking around” (MBWA). Warren Buffet has his own technique which is called “acquisitions by walking around”(ABWA).
In May 1994, Warren Buffett was crossing the street when a man called Barnett Helzberg, Jr. told him that he owned a business that Berkshire might be interested in. When someone tells Warren that, the usual case is that they have a lemonade stand – with potential to grow quickly in the next Microsoft.
Anyway, the financial statements of Helzberg’s Diamond Shops were subsequently sent over to Warren Buffett and it turned out they were far from a lemonade stand.
Helzberg’s Diamond Shops was started in 1915 as a single store by Bernett’s grandfather and had grew into 134 stores with $282 million in sales. It was currently very well run by Jeff Comment, former President of Wanamaker’s.
The key to Helzberg’s excellent profits was that it had an average annual store sales of about $2 million, far more than their competitors.
The deal was appealing to Warren for two reasons. Firstly, the company was the kind of business that they wanted to own. Secondly, Jeff was the kind of manager they wanted. Without an outstanding manager running the show, they would not have bought the business.
The acquisition was completed using a tax-free exchange of stock, and Barnett shared quite a bit of his proceeds with a large number of his associates. When someone does that, a buyer will know that he will also be treated right.
Warren Buffet’s 24-year-old wallet was previously sold for $240,000 at a charity auction. Inside the wallet was a personal item that reveals ten secrets of Warren Buffett.
The momento that was kept by Warren Buffett was a $50 bill issued by the Illinois National Bank and signed by Eugene Abegg, the owner and founder.
In what way does this item contain the secrets of Warren Buffett?
Well, one of Warren Buffett’s early purchases was that of Illinois National Bank. According to Warren Buffett expert Robert P. Miles, this purchase provides an excellent example of ten investment and management principles of the great investor.
Without going into details, here are the ten principles as explained by Robert P. Miles.
1) Invest in an old economy company that’s a leader in an industry you understand.
2) Invest in companies with consistent earnings.
3) Pay only a reasonable price even for an outstanding business.
4) Buy a lot of the company, and keep it.
5) Invest in businesses with experienced managers in place.
6) Leave talented managers alone to do their jobs and compliment them from a distance.
7) Buy companies from owners who care more about who’s buying the business than how much they’ll get for it.
8) Invest in companies whose managers are frugal and care about costs.
9) Don’t force experienced managers to retire.
10) Above all else, know the character of the manager.
Warren Buffett holds a view that most acquisitions do damage to the shareholders of the acquiring company. Often, the finanical projections made by the sellers paint a more rosy picture than the actual scenario. The seller will always know more about the business than the buyer and they get to pick the best time of sale (from their perspective).
One of the few advantages that Berkshire has in buying companies is that they don’t have any strategic plans. They are free to consider any acquisition opportunities (including the purchase of shares in the stock market) on their own merits without the need to proceed in any particular direction.
Another advantage is that they can offer sellers shares of Berkshire, a company with a collection of outstanding businesses. An individual can defer personal tax indefinitely by exchanging their ownership in a single business for shares of Berkshire.
Also, sellers know that placing their companies with Berkshire will give their managers autonomy to operate as before, with pleasant and productive working conditions.
Warren Buffett likes to deal with sellers who care about what happens to their businesses after the sale, rather than those sellers who are simply auctioning off their businesses. The latter often comes with unpleasant surprises.
In 1995, Berkshire had an increase in networth of 45%. Despite this, Warren Buffett does not think of it as anything amazing as it is a year in which any fool would have made a great deal in the stock market. As he paraphrases President Kennedy, “a rising tide lifts all yachts“.
There were also three good acquisitions: Helzberg’s Diamond Shops, R.C. Willey Home Furnishings and GEICO. These will be discussed later on. Warren Buffett and Charlie Munger likes to make acquisiton of two types:
1) A negotiated transaction that allows them to buy 100% of a company at a fair price.
2) A modest percentage purchase of an outstanding business from the stock market at a pro-rata price well below what it would take to buy 100%.
The employment of these two strategies gives them an advantage over other people who only stick to one strategy.
In addition, they have two factors operating in their favour:
1) Outstanding managers with strong attachment to Berkshire.
2) Their own considerable experience in allocating capital rationally and objectively.
The main disadvantage that they face is their big size. Instead of coming up with just good ideas, now they need to come up with good ideas that are big.
2 Mistakes That Warren Buffett Made
Late in 1993, Warren Buffett sold 10 million shares of Cap Cities at $63. At the end of 1994, the price was $85.25, a “loss” of $222.5 million.
This was a “repeat offence” because Warren Buffett had previously sold Cap Cities at $4.30 per share during 1978-1980 and then bought them again for $17.25 in 1986.
However, the top mistake of the year went to the $358 million purchase of USAir preferred stock, made five years ago.
In the analysis of the purchase, Warren Buffett had failed to consider the problems that would affect a carrier whose costs were both high and extremely difficult to lower.
In the beginning, this was not so much a problem as the airlines were protected from competition by regulation. They could absorb high costs by passing them on to consumers using high prices.
Even when deregulation came, the impact was not immediately felt as the capacity of low cost carriers was too small at first. But as the capacity of low cost carriers increased, the high-cost airlines were forced to cut their fares to stay competitive.
This poses serious considerations to their long term viability.
As it turns out, Berkshire’s $358 million worth of preferred stock in USAir was written down to $89.5 million, a loss of 75%.
Common Stock Investments
The number of companies where Berkshire had a stake of over $100 million continued to be low in number and simple in concept. The big investment ideas is summarised by Warren Buffett as:
“We like a business with enduring competitive advantages that is run by able and owner-oriented people. When these attributes exist, and when we can make purchases at sensible prices, it is hard to go wrong.”
The performance of an investment does not depend on the complexity of the investment. If you can evaluate correctly a company that is simple to understand and enduring, the result is the same if you had correctly analysed another complex investment alternative.
Rather than try to time his purchases, Warren Buffett will determine the fair value and buy when there is a margin of safety.
It is foolish to stop buying shares in an outstanding business whose long-term future is predictable, because of short-term concerns over the economy or stock market.
Also, before buying new investments, Warren will consider adding to old ones first. If a business is attractive in the past, it could still be in the present/future.
Incidently, quite a number of the purchases that Warren Buffett made for Berkshire are what similar to what he bought many years ago as a private investor.
Today, you are in for a short video treat. I will be sharing with you an exclusive morning interview that Liz Claman of CNBC did with Warren Buffett recently.
In this 14-min interview, Warren Buffett shares his thoughts on:
Regulation and whether the capital markets are competitive enough.
His investments outside the United States.
Should hedge funds be regulated.
The number one threat to stock markets and what investors need to have.
Current tax rates.
Posted in Look Through Earnings on Mar 14th, 2007
The letters of Warren Buffett are written one year apart. Sometimes, he will repeat certain points a few times in different years. This helps to remind existing shareholders as well as teach new shareholders his ideas.
On the other hand, my blog is more like Buffettology condensed. I take about two weeks to summarise each of his letter. So sometimes, in less than a month of so, you might read about the same topic twice.
After starting on this journey from 1977, I’m now at 1994 and closing in onto 2007. Hope to get there soon!
Look Through Earnings
Look-through earnings is used to more accurately portray Berkshire’s earnings. It consists of:
(1) the operating earnings, plus;
(2) the retained operating earnings of major investees that, under GAAP accounting, are not reflected in Berkshire’s 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.
The “operating earnings” that is mentioned here exclude capital gains, special accounting items and major restructuring charges.
For the intrinsic value of Berkshire to grow at 15%, their look-through earnings must also increase at about that pace.
Compensation For Managers
Today’s post is about Warren Buffett’s views on how managers should be compensated.
First of all, their compensation should be tied only to the results of the operation they are in charge of and control. For example, it makes no sense to tie the compensation of Ralph Schey (who runs Cott Fetzer) to the results of Berkshire.
Secondly, if capital invested in an operation is high, managers are charged a high rate for incremental capital that they use. Conversely, they are credited with an equally high rate for capital that they release.
A meaningful hurdle rate on the earnings of additional capital employed is also set and compensation increases when the target is met. The calculation is symmetrical and if incremental investment yields are sub-standard, it will be costly to the manager.
Using this arrangement, managers have an incentive to send back to Berkshire any cash that they can’t employ advantageously.
The use of stock options does not really align management’s interests with that of shareholders. Rather, it is like a “Heads I win, tails you lose” situation.
Furthermore, the exercise price of the option does not increase to take into account the fact that retained earnings are building up in the company. Even if a manager adds absolutely no value to a company, a policy of low dividend payouts and compound interest will ensure that earnings (and subsequently share prices) increase.
You can even say that by withholding cash to the shareholders, the profit to the option-holding manager increases.
In all cases, Warren Buffett works out the compensation of his managers in a rational and simple way. There is no need of consultants or lawyers to work out complicated compensation plans. The compensation arrangement with Ralph Schey was worked out in about five minutes, and has never changed.