Notes From The 2014 Berkshire Hathaway Annual Meeting

“When people talk, listen completely. Most people never listen.” ― Ernest Hemingway

Yesterday night I encountered the transcript of the comments made by Warren Buffett and Charlie Munger at the 2014 Berkshire Hathaway Annual meeting. Go here to read the transcript. 

The notes were a great read and I picked out some interesting parts which are shown below. All markings in the quotes below made by me.

Intrinsic value vs book value

“Q5: Jay Gelb (JG): Intrinsic value, you signal undervalued versus intrinsic value. What can you do about it? Would you consider an IPO of the operating units?

WB: No on the second part of that. We try to explain intrinsic value (and I’ve never seen an annual which uses that term) where there is a difference between carrying value and real value. GEICO is carried at $1bil over tangible, but it is really worth $20bil over. We are eager to buy stock at 120% of book value. Book is $230bil. And obviously I think that $45bil over that figure we are getting a bargain over intrinsic. It changes from day to day, but not a lot, but changes over the quarters and years. If you ask Charlie and me to write down a figure as to intrinsic value, I think we’d be within 5% of each other, but not 1%. We will continue to try to give information to shareholders on the important units at Berkshire. Some of our small businesses may be worth $1bil or even $2bil, but the small ones don’t have a big impact. Railroad, utility and insurance are big, and we try to use the words and numbers that we use when thinking about those businesses ourselves. We only believe in repurchasing shares when we can buy at a discount to intrinsic value. The 120% is a loud shout out as to a figure that we think is significantly below intrinsic. Some companies buy in shares to cover options. You shouldn’t buy it in if shares are overvalued. Negating dilution isn’t right when shares are expensive. If management can buy a dollar bill for 90 cents, they are doing shareholders a good job. If spend $1.10, not helping.”

About Marmon and Iscar: “WB: Those were two important acquisitions, partly due to accounting peculiarities. Carry value is much lower than intrinsic.“

Earning power

“WB: … Our goal is to buy big businesses. We are about building earning power. We are looking to add earning power to Berkshire. We don’t get opportunities that often. If opportunity is large enough, we can dip into huge reservoir of securities.”

Interest rates

“CM: … At Berkshire not many long term bonds are being bought.”

Risk of technology change

“WB: … All businesses should think about what can mess up their position. We look at all of our businesses as subject to change. GEICO set out in 1936 to operate with low costs and pass on those prices to the customer, on a necessity being auto insurance. They originally did it with mail offerings to government employees. They’ve adapted over the years, to widening classifications, to US mail, to telephone, to internet and social media. And in there they stumbled, when they left government employees and got too aggressive about expanding, and they really did go broke. We want managers who are thinking about change, and what is needed for the business model in the future. We know it won’t look the same. BNSF is looking at LNG for locomotives. Our businesses are strong and are generally not subject to rapid change, but sometimes slow change can be harder to see and lull you to sleep easier versus rapid change which you can see. I will make mistakes in future, that is guaranteed. We never make bet‐the‐company decisions that cause real anguish. Occasionally they work out very well. In 1966, we bought a department store in Baltimore. There was nothing dumber. The $6mil in that store became $45bil over time in Berkshire. You have to be very alert, and Charlie and I and our directors think about it.”

CM: I spoke earlier about the desirability of removing ignorance piece by piece. Another trick is scrambling out of your mistakes, it is enormously useful. We had a sure to fail department store, a trading stamp business sure to fold and a textile mill. Out of that comes Berkshire. Think about how we would have done if we had better start! [laughter]

WB: My uncle wrote a letter in 1942 that the day of the chain store was over. Our grocery store went out of business in 1969. The wish being father to the thought.”

Heinz earnings 

“WB: It was a reasonably run food company with 15% pretax margins for many years, not an unusual operating margin in food business. I think the margins will significantly improved from historical figures, have to watch quarter to quarter. What Bernardo has done is restructure the business model and the brands are as strong as ever, and they will have structurally lower costs. I don’t want to name a number, you will find it out soon enough.”

What to do and where to look if 23 years old

“Q39: Station 2, New Jersey. Tech and entrepreneurship, if you were 23 year old, in what non‐tech industry would you start a business and why?

WB: I’d probably do what I did when I was 23. I would look at lots of companies, and talk to lots of people, and learn about lots of industries. I would see CEOs of 8 or 10 coal companies. I often didn’t make appointments, but they almost always would see me. I would ask them, if they had to put all of their money into any coal company except their own, and go away for 10 years, which one would it be? And which would they sell short over 10 years and why? If I did that, I would know more about the coal companies than any manager would. But you wouldn’t learn about how to start Google or Facebook that way. You need real curiosity about it, it has to turn you on. Asking questions about coal companies? I mean really, you have to be a little odd too. I might find an industry that particularly interested you, and you might become very well equipped, and can start or go to work for someone good. If you are open to things and keep learning things you’ll find something.

But it is not a bad system to use. You really learn a lot by asking. I sound like a Yogi Berra quote perhaps. But if you talk to enough people about something they know a lot about, people like to talk. Here we are talking ourselves. You will find your spot. I was very lucky, I found what fascinated me when I was 7 or 8 years old. If you are lucky you will find it early.

WB: I have everything in life I wanted. Standard of living does not equate with cost of living. There is point where you get inverse correlation. My life would be worse if I had 6 or 8 houses. It doesn’t correlate. You can’t have more than that. It makes a difference up to a point. You can start thinking differently at x dollars. But it doesn’t make a difference at 10x or 1000x.”

Inflation

“…How does management factor into valuing instrinsic value. Which company do you fear the most, as even Coca‐Cola has their Pepsi?

WB: Actually Ben Graham didn’t get too specific about intrinsic value in terms of calculations. Now it is equated rightly with private business value. Aesop was the first who came up with it. It is intrinsic value if you can foresee the future, the present value of all cash that will be distributed between now and Judgment Day. You put money in and you take money out. One in hand is worth two in bush. The question is how sure are you that two are in the bush, how far away is bush, what are the interest rates ‐‐ Aesop wanted to leave us something to play with over next two thousand years so he didn’t spell it all out. In calculating it, Ben would say he wanted two dollars of cash in the bush and pay a dollar. Fischer would use qualitative factors to estimate the number of birds in the bush. I started out very influenced by Graham, so more quantitative, but Charlie came along and said look more at qualitative. If you buy McDonald’s franchise, you think about the cash in, the cash out, when, and at what discount.“

…

CM: There is nothing in business school that teaches people to do what we do at Berkshire.”

“WB: Inflation would hurt us, but other businesses more. Some assets would do better under inflation. If drones set off and drop $1mil in every household, would everyone be better off? Berkshire would be worse off. Trick is to find out you have $1m before anyone else does. You don’t create wealth with inflation, but you can move it around. You don’t with a firm like Berkshire, our earnings per share up, intrinsic value per share would be up but, unless we leveraged the businesses, the value per share in real terms would go down.”

Acquisitions

“CM: Sum total of all acquisitions in America has been lousy. It is the nature of successful companies that they will be talked into dumb deals. It has been path to wealth for us, but luckily many don’t want to be peculiar in our way.

WB: When we read that a company we own but don’t control is going to make an acquisition, I’m more likely to cry than smile. But we love them ourselves. I have sat in on hundreds of acquisition discussions conducted by people I didn’t control. Most have been disasters…

CM: Some are mediocre.

WB: Look at GEICO ‐ it had been an incredible business until the 1970s. They made acquisitions after getting back on track and then took their eyes off the ball. Accounting cost of those two acquisitions was poor but not disastrous. But secondary effects were huge. It was a dozen years there that they couldn’t get back. We bought half the company, so it was wonderful for Berkshire. It is human nature, CEOs have animal spirits and supporting staff senses that they like to do things. They keep coming in with deals. Investment bankers are calling them daily. All these forces push towards deals. We’ve tried very hard to not be eager to do deals, just to be eager to do deals that make sense. That would be harder if we had strategy departments pushing us. The setting in which you operate can be very important.“

Worst case scenarios and BP

“CM: Big surprise was British Petroleum. No one thought loss from one well would be many billions of dollars. After that I would have less enthusiasm for drilling in Gulf. Such a big loss can offset any possible gain. The biggest rail accident cost $200m.”

Returns and capital spending

“Q55: Station 8, New Hampshire. Looking at page 64 segment data for the energy business, when I take ebitda less capex, the result is negative operating cashflow. When I repeat exercise in each of last five years, in best years, $300m of operating cash flow. Divide by tangible assets, 0.8% return, why allocating capital to a business with such low returns?

WB: You were doing great until return on tangible assets. We love the math you describe, as long as we get return on capital investment. We are looking forward to putting more capital in, as long it is treated fairly, and we will get appropriate returns on that. It is not cash minus increased capex, it is operating earnings less depreciation. There are times when no net investment is required, but we prefer where net investment must be higher because we get more capital in and our bet is that regulators will treat us fairly in future. One reason we believe this is true is that we have done so much better than many at delivering electricity at lower rates than charged by most. In Iowa there is a public utility, and our rates are significantly below competitors. A friend with a farm who is served by two utilities tells me that rate from us is dramatically lower than the competitors. We have a deserved good reputation with regulators, including safety. They welcome us when we come to new states. If we can put new money into those projects, we will get good return. But you will get negative returns if you include adding to capital spending. This is somewhat similar at the railroad.

CM: if numbers you recited come from a declining department store, we would hate it. But we have confidence that the reinvested capital will give us a good return from a growing energy business. It is that simple.

WB: Greg, can you quote some rates?

Greg Abel: We are generally lowest quartile, if not cheapest. We recently took the first rate increase in Iowa in 16 years, and we don’t see one in near future. There is a 1000 megawatt project adding up to $1.9billion, and deploying over 2 years and we are earning an 11.6% return on it. We try to keep our capital close to depreciation. But the lion share of our capex is growth capital.”

Habits

“Habits are such a powerful force in everyone’s life.”

Mental Model: Compound interest

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” ― Albert Einstein

“Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things.” ― Charlie Munger

“We’ve going to compound it at a reasonable rate without taking unreasonable risk or using leverage. If we can’t do this, then that’s just too damn hard.” ― Charlie Munger

Back in 1963 in his letter to partners Warren Buffett wrote about the joys of compounding explaining the difference of compounding depending on the level of growth over different time periods – see image below. Click on image to enlarge.

In the Snowball Warren said “Anything times zero is zero.” So, the lesson here is to always remember Warren’s advice “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.”

Mental Model: Anchoring bias

“In many situations, people make estimates by starting from an initial value that is adjusted to yield the final answer. The initial value, or starting point, may be suggested by the formulation of the problem, or it may be the result of a partial computation. In either case, adjustments are typically insufficient (Slovic & Lichtenstein, 1971). That is, different starting points yield different estimates, which are biased toward the initial values. We call this phenomenon anchoring.” – Tversky and Kahneman (1974)

Since there is a lot of great articles already written on the subject, I will refer to one of these. For a great summary of the mental model anchoring, head over to the superb blog Farnam Street and the post Mental Model: Anchoring for further reading.

Remember, never look at the stock price before you have done your own analysis and come up with an estimate of a conservative intrinsic value per share.

Go to the page Mental Models for a listing of all mental models.

Q&A: The Intelligent Investor – Chapter 10: The Investor and His Advisers

Below are my reflections and answers to the discussion questions posted at Modern Graham for chapter 10 – The Investor and His Advisers – of the Intelligent Investor written by Benjamin Graham. 

1. What quote from this chapter do you think best summarizes the point Graham is making?

“Our basic thesis is this: If the investor is to rely chiefly on the advice of others in handling his funds, then either he must limit himself and his advisers strictly to standard, conservative, and even unimaginative forms of investment, or he must have an unusually intimate and favorable knowledge of the person who is going to direct his funds into other channels.”

2. Do you rely on any investment advisers?  To what sources do you turn in your investment research?

No, I do not rely on any investment advisers. I haven’t done before and I’m not planning to do it either, at least not at the moment.

Sources for my investment research are original documents in the form of annual and quarterly reports, 10-K’s and 10-Q’s and earnings calls or transcripts etc. I sometimes use Morningstar.com when I want to get a quick glance at the financials and key ratios, this without seeing the share price. I manage to do this by having the financials section key ratios page for some small or unknown company as a bookmark, and then searching the ticker field from this page, which takes me directly to the same page for the company I want to look up. Beware anchoring bias. I also use the Swedish site Borsdata.se to get a quick look at the financial numbers for companies listed in Sweden.

Also regularly follow a few investment blogs.

3. If you are an investment adviser, what is your response to Graham’s points here?

Not an investment adviser myself, so not applicable.

4. What did you think of the chapter overall?

A good walkthrough of the different kinds of advisers working in the field of investing, and also what an investor should consider when thinking about using their services.

H&M’s ROIC incl. Value of Leased Assets

Operating leases – an off-balance sheet item

Operating leases play an important part for most retailers since they lease their stores in which business is being done. The option would be to own all the necessary real estate.

Due to the current accounting rules (in the case of H&M International Financial Reporting Standards – IFRS) the value of leased assets are treated as an off-balance sheet item. Rental costs are recognized in the income statement as an expense linearly over the term of the leasing agreement.

To get a better understanding of the returns generated by a business, an investor needs to make some adjustments to see the underlying return on invested capital including the value of leased assets.

From this I thought I would write a few words about Hennes & Mauritz (STO:HM-B), the Swedish retailer, and their operating leases, and how to think about lease accounting as of today and what to do about this when calculating the well-known financial metric returns on invested capital, often referred to as ROIC.

H&M’s return as reported in annual reports

In the annual reports H&M has reported the following numbers regarding their Return on Equity and Return on Capital Employed:

The ratios in the table above are calculated by H&M as follows:

• Return on shareholders’ equity: Profit for the year divided by shareholders’ equity.
• Return on capital employed: Profit after financial items plus interest expense divided by shareholders’ equity plus interest-bearing liabilities.

From the table above, the returns achieved by H&M in the last decade have been pretty good. But as a retailer H&M accounts for operating leases as an off-balance sheet item. If operating leases where accounted for as an asset (and a liability) ROIC would be affected due to the effects on operating profit and invested capital. Return on equity would not change, it would still show the same return, including operating leases as an asset or not.

In the accounting principles section in the notes to the financial statements H&M describes how leasing is accounted as follows.

“Leasing agreements in which a substantial portion of the risks and benefits of ownership are retained by the lessor are classified as operational leases. Financial leases exist when the financial risks and benefits associated with the ownership of an object are essentially transferred from the lessor to the lessee, regardless of whether the legal ownership lies with the lessor or the lessee. Assets held under financial leases are reported as fixed assets and future payment commitments are reported as liabilities in the balance sheet. As of the closing date the Group had no financial leases. Minimal leasing agreements relating to operational leases are recognised in the income statement as an expense and distributed linearly over the term of the agreement. The Group’s main leases are rental agreements for premises. Variable (sales-based) rents are recognised in the same period as the corresponding sales.” H&M Annual Report 2013 

In note 12 Buildings, Land and Equipment H&M reports their rental costs for the 2013 financial year that amounted to SEK 15,044 million, compared to SEK 14,056 million in 2012. 

Note 8 Depreciation states that depreciation has been calculated at 12 percent of the acquisition cost of leasehold rights. H&M has some leasehold rights accounted for as financial leases, which are on-balance sheet. These are depreciated over 8.3 years (1/0.12). Below I will use this length of useful life as a best guess for the asset life of operating leases when calculating the value of leased assets from these.

Thinking about operating leases

So, what is the most proper way to treat leases when trying to figure out the underlying returns of a business and to be able to compare returns on invested capital among different retailers?

In the book Valuation – Measuring and Managing the Value of Companies the authors discuss their view of operating leases and how to treat them in a financial analysis.

“When a company borrows money to purchase an asset, the asset and debt are recorded on the company’s balance sheet, and interest is deducted from operating profit to determine net income. If, instead, the company leases that same asset from another organization (the lessor) and the lease meets certain criteria, the company (or lessee) records only the periodic rental expense associated with the lease. Therefore, a company that chooses to lease its assets will have artificially low operating profits (because rental expenses include an implicit interest expense) and artificially high capital productivity (because the assets do not appear on the lessee’s balance sheet). Although these two effects counteract one another, the net effect is an artificial boost in ROIC, because the reduction in operating profit by rental expense is typically smaller than the reduction in invested capital caused by omitting assets. The result is especially dramatic for profitable companies that lease a substantial portion of their fixed assets, as is typical of retailers and airlines.” – Valuation – Measuring and Managing the Value of Companies, 5th edition

To calculate the value of operating leases the following formula from the book Valuation (see reference above) was used:

Asset Value = Rental Expense / (Cost of Debt + (1 / Asset Life))

• The numbers for rental expense was taken directly from disclosure in the notes in H&M’s annual reports.
• Cost of Debt was assumed to be 4%.
• Asset life was assumed to be 8.3 years from the disclosure in the notes about depreciation of 12% for capitalized leases.

I have made some assumptions about cost of debt and asset life that hopefully are reasonable. As Keynes once said “It is better to be approximately right than precisely wrong.” 

See table below for different calculations.

Comparing return on invested capital including the value of leased assets shows a materially lower return compared to the calculation of return on capital employed without these leases. See comparison in the table below.

The diagram below shows the adjusted operating margin, return on invested capital incl. value of leased assets, and the invested capital turnover during the last decade.

So, returns on invested capital including operating leases differ materially from the same calculation without including them. To be able to see the underlying returns a business is able to generate and also to be able to compare different companies, it’s very important not to forget to think about how to treat operating leases in a proper way.