I am not a hardcore follower of Buffett’s investing philosophy. It is not because I do not agree with Buffett’s/Graham’s investing philosophy, but primarily because, my situation is different. The environment which influences my investing decisions is quite different than in which Buffett makes his decisions. Having said that, I like to understand his thought process to see if there is anything that I can use. I may not be able to use them on ‘as is’ basis, but at least the notion behind them can be applied. For example, I like Buffett’s practice of asking its holding companies to share a significant portion of earnings in the form of dividends. He believes he is in a better position to use this capital than company management.
Buffett’s letter to shareholders is released as a part of Berkshire Hathaway’s (BRK) annual reports. In almost all cases, I completely ignore CEOs/MDs letters in annual report. They are pure garbage in a sense they do not tell you anything. That is not a case with Buffett’s letters. Each and every year, his letters provide an insight in his thought process. This year was no different.
This year’s highlight was a brief discussion on three pillars of BRK’s intrinsic value. Anybody who practices value investing knows that calculating intrinsic value is highly dependent on future assumptions. According to Buffett, these three pillars are:
- Investments per shares: BRK derives its value in the form of investments funded by shareholder equity and insurance float. BRK has $158 billion of investments in stocks, bonds and cash equivalents. Of which $66 billion is funded by insurance float. This insurance float is total funds held by BRK insurance companies. This total fund (i.e. float) is represented as liability on the balance sheet. According to Buffett this float is has the utility of equity for shareholders. Why? Because BRK’s insurance businesses are operating on break-even basis or on profit-basis. Hence, they need not dive into this float for balancing the operating losses.
- Value of earnings per share for non-insurance businesses: BRK also derives its value from value of operating earnings of all of its non-insurance businesses. All non-insurance business has certain earnings e.g. Coca-Cola, Wells Fargo, Johnson & Johnson, etc. All these companies are profitable and generate earnings. All of these operating earnings have certain value for BRK’s shareholders.
- Deployment of future retained earnings: This forms third pillar in valuing BRK (and probably any other company?). This is subjective and is the source of differences in intrinsic value estimates. Let us discuss this more.
On ‘as-is’ basis, or present day situation, a company generates income, and hence one can value based on its current earnings. What about future? Will company management deploy this capital, i.e. earnings, for future growth? In most cased managements either hoard cash, deploy in building business empires, and reinvesting in sub-optimal business ventures. Buffett notes that, quote, “t…urn these retained dollars into fifty-cents pieces, others into two-dollar bills”.
This “what-will-they-do-with-the-money” factor must always be evaluated along with the “what-do-we-have-now” calculation in order for us, or anybody, to arrive at a sensible estimate of a company’s intrinsic value. That’s because an outside investor stands by helplessly as management reinvests his share of the company’s earnings. If a CEO can be expected to do this job well, the reinvestment prospects add to the company’s current value; if the CEO’s talents or motives are suspect, today’s value must be discounted. The difference in outcome can be huge. A dollar of then-value in the hands of Sears Roebuck’s or Montgomery Ward’s CEOs in the late 1960s had a far different destiny than did a dollar entrusted to Sam Walton.
In essence, Buffett is saying, how earnings are re-deployed has significant impact on how company’s existing stream of earnings is evaluated. We all know item (1) and item (2) above. But what value would you assign to its earnings stream deployment?
The answer to this question is very subjective and will depend upon the context. In case of BRK, Buffett likely considers the earnings that are paid out to shareholders. The shareholders (in this case BRK) can estimate the cash flows they will personally receive from these earnings. This is because Buffett, on behalf of BRK shareholders, is more confident of allocating capital in optimal way.
What do I learn?
The point being, Buffett considers expected cash flow from its investments as a part of its valuation when buying any company shares.
Do I practice this?
Not exactly on ‘as-is’ basis. But I do use expected dividend cash flow in my valuations while buying shares for my long term buy and hold portfolio. I tend to look for companies that are likely to sustain their dividends over longer term. When a newbie is starting his investment journey, it may seem that these dividends are very minuscule. Such small amounts do not have any significant impact on overall portfolio. I agree they are small. But I do not agree with the notion that they are insignificant. It is a matter of perspective.
It has taken me about nine years to build my core portfolio that generates Rs 20000 as annual dividend. I have not determined the impact of re-invested dividends for last seven years. However, for last two years, these dividends have funded my opportunity portfolio. These dividends (i.e. capital for me) are now a continuous stream.
Readers, who have closely followed this blog and TIPBlog’s facebook page, should be able to extrapolate the impact this opportunity portfolio has had on overall returns on cost-basis.
While I still allocate capital to core portfolio from my primary full time source of earnings, I no longer have to worry about funding my opportunity portfolio. This opportunity portfolio is now on auto pilot!