“When control of a company is obtained, obviously what then becomes all-important is the value of assets, not the market quotation for a piece of paper (stock certificate).” —Warren Buffett
In this post I lay out my answers to the questions posted at CSInvesting.org as part of the DEEP VALUE course and the case study on Dempster Mill Manufacturing Company. Feel free to comment and share your own views, reflections and take-aways.
I do not think that these questions are that easy. But I have tried to come up with decent answers, since by not trying I won’t learn anything. So, take it for what it is and feel free to share our own thoughts, preferably over at the comment section at CSInvesting where you will find many others who also participate in the DEEP Value course.
How did Buffett find this investment and what ways did he reach an intrinsic value?
Buffett found Dempster since the “figures were extremely attractive.” In other words, a low price compared to book value.
How many margins of safety did he have?
When Buffett first acquired stock in Dempster the most important margin of safety was most likely in the great discount between price and book value.
Later on when Buffett realized that current management didn’t succeed he had Harry Bottle to take over as CEO. This provided sort of a second margin of safety, a great manager or management team is never a negative. And in Harry Bottle Buffett found himself a great CEO able to run the business in a way Buffett himself thought was most likely to create the most value. I put Harry as second, because I think that he was more important than any potential future improvement in earning power. The earning power was more likely to be an outcome of great operating management.
Third, possible improvement in earning power.
What “type” of investment is this—is earning power below Asset Value?
The investment in Dempster started out as a net asset value investment, this due to the great discount between price and book value. Buffett also wrote that “the figures were extremely attractive.” It wasn’t the qualitative aspects of Dempster that was the main reason why Buffett started acquiring stock, it was all based on the great discount to book value per share.
When Buffett started purchasing Dempster stock the earning power value was a lot lower than the value of the assets, even compared to net current asset value and Buffett’s valuation applying different discounts to each balance sheet item.
Buffett wrote that Dempster had “…earned good money in the past but was only breaking even currently.” Earning power value clearly had taken a hit, and was probably a big reason for the stock price trading at such a big discount to book value. As Graham & Dodd wrote in Security Analysis when discussing Westinghouse Electric and Manufacturing Company position; “…the stock sold for much less than the net current assets alone, presumably indicating widespread doubt as to its ability to earn any profit in the future.”
Buffett may have had some expectations for the earning power to come back and help support a higher stock price, even if this was far from a sure thing. The margin of safety was in the low price compared to book value. If earning power would be restored, that would serve as a bonus I think.
Is this a franchise? Why or why not is this occurring?
Dempster was not a franchise. Buffet wrote that “The operations for the past decade have been characterized by static sales, low inventory turnover and virtually no profits in relation to invested capital.” Not the characteristics to be expected from a franchise. Buffett also wrote that Dempster was in a “fairly tough industry,” and it also had “unimpressive management.”
If earning power was to be restored it would probably, even in the best case, only support the net asset value, thus no excess returns and no earning power value greater than the asset value. This would indicate a business without any franchise value, i.e., no sustainable competitive advantage—or moat.
Was Buffett lucky in this investment? Why or why not?
I think luck always plays some part. But Buffett started to purchase stock due to the margin of safety he deemed to be present. So even if Harry Bottle had not come along, Buffett might have been able to sell out without making a loss. When already invested and taking control he used his skill as a business owner in a pretty good way I think, mostly through Harry Bottle taking care of the daily operating activities.
How would Graham approach an investment like this?
Not really sure about this one. Graham also invested in businesses situations that could be compared to Dempster. But even if Graham did so, maybe the most likely way he would look at Dempster would be purely quantitative. From what I can see, Dempster never was a pure net-net during the time Buffett was an owner. So maybe Graham would have stayed away from it.
What would have been the big difference between Graham and Buffett concerning Dempster Mills?
That Graham never would have bought because the stock wasn’t cheap enough to provide a margin of safety to an estimated liquidation value (current asset minus total liabilities). But I’m not really sure about this one. Will be interesting to see the comments to this question.
So, now I shall start reading the comments to see what all other participants have to say about these questions. Even though the case study was posted a few days ago I have not read any comments that’s been posted, since this would sort of “anchor” my own answers.
BTW. Today I received my King Icahn book in the mail. Look forward to start reading. But will wait until John says go.
All for now!
Hurricane Capital 
I refer to the following para in the 1962 letter regarding dumpster. “The successful conversion of substantial portions of the assets of Dempster to cash, at virtually 100 cents on the dollar, has been the high point of 1962. For example, inventory of $4.2 million at last yearend will probably be about $1.9 million this yearend, reducing the discount on this item by about $920,000 (40% of $2.3 million reduction).” Is it possible to walk through the math with me ?
Hi there. Of course. When Warren valued Dempster Mill at year-end 1961 the company had inventory at book value worth $4.2 million. In his valuation, Warren went on to value this inventory at 60%, i.e., the same as saying that 40% of inventory are worth zero, or as saying that each dollar of inventory was only worth 60 cents. Now back to year-end 1962 where Dempster has inventory accounted for in the book at $1.9 million, a reduction of $2.3 compared to $4.2 million a year earlier. We know that these $2.3 million was valued at 60% at year-end 1961, i.e., $1.38 million. During 1962 Dempster managed to sell this inventory at 100% on the dollar, that is, no discount at all was required to sell the inventory. Customers were willing to pay a price equal to the value that inventory had in the accounting records. This explains the realization of the 40% that Warren in his valuation a year earlier didn’t appoint any value to. From selling this inventory at full price Dempster was paid $2.3 million. Warren valued these $2.3 million at 60% or $1.38. Dempster thus got these $1.38 million plus $920.000 that Warren in his conservative valuation a year earlier had put a value of zero on. From this, using Warren’s own words, Dempster managed to make a “successful conversion” of inventory. Hope that helps.
Hi,
Thanks for the reply, I just get confused as Buffett stated the book value of inventory of Dempster is 1.634m in 1962 and 60% discount of which will be around 0.98m. If I add the 0.92 m reduction in discount to 0.98m, I will reach the 1.9m that buffett was talking about. But I found it strange the 1.9m figure doesn’t appear on his November 1962 letters.
I’m not really sure that I understand, but Buffett wrote (November 1, 1962. Source: Warren Buffett’s Ground Rules) “For example, inventory of $4.2 million at last yearend will probably be about $1.9 million this yearend…” Note that Buffett is just saying “probably” when he’s talking about a potential yearend value, since it’s just a best guess. The actual yearend value of inventory per December 31, 1962, turned out to be $1.634 million. Hope that helps.
Hi. thanks for your input anyway. I will like to share some of my thoughts on this case study. I saw that there were some comparison with the typical net-nets that Graham will seek. However, I feel that Buffett’s method is very much similar to the principal behind net-nets. The idea is to place value only for the very liquid assets of a company and calculate the theoretical liquidation value. However, by placing a very large discount on some hard assets, they become fully comparable to a ‘ current asset’ . For example, a ‘property, plant and equipment’ at full value may be illiquid but at 10% value it would be very liquid. Hence, by taking the respective discount that Buffett judges, the entire balance sheet had transformed to a ‘ current asset’ . Its a bit like the ‘principle of equivalence ‘ in physics. So via this method, all kind of companies would be comparable at least from the viewpoint of liquidation. If we stick to the rigid net-net calculations, we would have exclude many real estate companies. In Asia, real estates are very valuable and liquid, perhaps much more valuable than receivables or inventories.
Just sharing.