Winners Of The Great Recession

By Bud Labitan

 

Over the past five years, these businesses have prospered mightily. They have produced excellent returns in generating free cash flow for shareholders.

 

Apple Inc.         AAPL

Google, Inc.      GOOG

CF Industries    CF

Priceline.com    PCLN

BlackRock, Inc.   BLK

ExxonMobil     XOM

How did these businesses manage to prosper in a time many consider to be the worst economic period since the great depression of the 1930’s? First, let me place this disclaimer. Some of these business descriptions are taken directly from each company’s marketing material as well as other online sources.

The Great Global Recession of 2009 began around December 2007 and it took a sharper dive in September 2008. Recall that U.S. housing bubble peaked in 2006. But, irrational bubble valuation forces caused the values of securities tied to U.S. real estate pricing to plummet and damage financial institutions globally. It was sparked by the outbreak of the U.S. subprime mortgage crisis and financial crisis of 2007–08. The exact start and end-point for the recession greatly varied from country to country. Overall, it was the worst global recession since World War II.

Let’s review how these businesses prospered during this Great Global Recession.

First, Apple designs, manufactures, and markets personal computers, mobile communication devices, and portable digital music and video players. It sells a variety of related software, services, peripherals, and networking solutions. It’s products and services include iPhone®, iPad®, Mac®, iPod®, Apple TV®, a portfolio of consumer and professional software applications, the iOS and OS X® operating systems, iCloud®, and a variety of accessory, service and support offerings. Apple sells its products through its online stores, retail stores, direct sales force, and third-party wholesalers, resellers, and value-added resellers.

Apple also sells and delivers digital content and applications through the iTunes Store®, App StoreSM, iBookstoreSM, and Mac App Store. In addition, the Company sells a variety of third-party iPhone, iPad, Mac and iPod compatible products, including application software, and various accessories, through its online and retail stores. Its reportable operating segments consist of the Americas, Europe, Japan, Asia-Pacific and Retail. The Europe segment includes European countries, as well as the Middle East and Africa. The Asia-Pacific segment includes Australia and Asian countries. Apple’s success has been in creating appealing devices that attract loyal customers who are willing to pay premium prices to own this brand.

Next, Google Incorporated became the most popular internet search service. This global technology company is engaged in improving the ways people connect with information.  It is now focused around the key areas of: search, advertising, operating systems and platforms, enterprise and hardware products. It integrates innovative features into its search service and offer specialized search services to help users tailor their search.

In January 2012, the Company launched Search plus Your World. When a user performs a signed-in search on Google, the user’s results page may include Google+ content from people that the user is close to. Advertising includes Google Search, Google Display, Google Mobile and Google Local. AdWords is the Company’s auction-based advertising program delivering ads relevant to search queries or Web content.

The Company, along with Open Handset Alliance has developed Android mobile software platform that any developer can use to create applications for mobile devices and any handset manufacturer can install on a device.

Google Chrome OS is an open source operating system with the Google Chrome Web browser as its foundation. The Chrome browser runs on Windows, Mac, and Linux computers. Google TV is a platform that enables the consumers to experience television and the Internet on a single screen, with the ability to search and find the content they want to watch. It is based on the Android operating system and runs the Google Chrome browser.

Google’s enterprise products provide Google Apps. These include Gmail, Google Docs, Google Calendar, and Google Sites. The Company provides hosted, Web-based applications that people use on any device with a browser and an Internet connection.

The Company also provides versions of its Google Maps Application Programming Interface (API) for businesses, as well as Google Earth Enterprise (a behind-the-company-firewall software solution for imagery and data visualization).

Google competes with Yahoo! Inc., Microsoft Corporation’s Bing, YouTube, Facebook, Twitter, WebMD for health queries, Kayak for travel queries, Monster.com for job queries, and Amazon.com and eBay for e-commerce. Google’s success has been in creating an appealing and useful search service and the Android operating system that attract customers.

This next business was a bit of a surprise to me. I did not realize how much the fertilizer industry has grown until I viewed an insightful PBS documentary called “America Revealed.”

With only 2,600 employees, CF Industries Holdings, founded in 1946, manufactures and distributes nitrogen and phosphate fertilizer products around the world. The business of the Company is divided into two operating segments, the nitrogen segment and the phosphate segment. The Nitrogen segment includes the manufacture and sale of ammonia, urea, and UAN. The Company’s principal products in the nitrogen segment are ammonia, granular urea, urea ammonium nitrate solution, or UAN, and ammonium nitrate, or AN. The Company’s other nitrogen products include urea liquor, diesel exhaust fluid, or DEF, and aqua ammonia, which are sold primarily to its industrial customers. The Company operates seven nitrogen fertilizer production facilities in North America.

The phosphate segment includes the manufacture and sale of DAP and MAP. The Company’s principal products in the phosphate segment are diammonium phosphate, or DAP, and monoammonium phosphate, or MAP. The Company’s core market and distribution facilities are concentrated in the Midwestern United States and other major agricultural areas of the U.S. and Canada.

CF Industries Holdings also exports nitrogen fertilizer products from its Donaldsonville, Louisiana manufacturing facilities and phosphate fertilizer products from its Florida phosphate operations through its Tampa port facility. In the nitrogen segment, the Company’s primary North American-based competitors include Agrium and Koch Nitrogen Fertilizers. In the phosphate segment, the Company’s primary North American-based competitors include Agrium, Mosaic, Potash Corp. and Simplot.

CF Industries’ success has been in creating a large and efficient producer and distributor of nitrogen and phosphate based fertilizers around the world.

Next, is Priceline.com Incorporated. It shows us that customers took their bargain hunting practices online and found Priceline appealing. Priceline.com is an online travel company that offers its customers a range of travel services, including hotel rooms, car rentals, airline tickets, vacation packages, cruises and destination services.

Priceline also operates a retail, price-disclosed hotel reservation service in the United States, which enables its customers to select the exact hotel they want to book. Then, the price of the reservation is disclosed prior to booking. It offers such reservations through a merchant model, as well as through an agency model for hotel room night reservations sourced through Booking.com

Booking.com is the internet hotel reservation service, with offices worldwide. Booking.com works with over 185,000 hotels and accommodations in over 160 countries offering hotel reservations on various websites and in 41 languages. In May 2010, it acquired the rentalcars.com business, a United Kingdom-based international rental car reservation service formerly known as TravelJigsaw.

Rentalcars.com offers its car hire services in more than 4,000 locations throughout the world, with customer support provided in 38 languages.

Priceline competes with both online and traditional sellers of the services it offers. The market for the services it offers is intensely competitive, and current and new competitors can launch new sites at a relatively low cost. However, over the past five years, customers found Priceline to be the appealing leader in this space.

Next, Blackrock Incorporated made my list because it showed tremendous growth and profitability during this period. BlackRock, Inc. is the publicly traded investment management firm. BlackRock along with its subsidiaries provides investment management and securities lending services to institutional clients and to individual investors through various investment vehicles.

Investment management services mainly consist of the management of fixed income, cash management and equity client accounts, the management of a number of open-end and closed-end mutual fund families, exchange traded funds and other non-U.S. equivalent retail products serving the institutional and retail markets, and the management of other investments funds, including common trusts and alternative funds, developed to serve various customer needs.

BlackRock also provides market risk management, financial markets advisory and enterprise investment system services to a base of clients. Financial markets advisory services include valuation services relating to illiquid securities, dispositions and workout assignments, risk management and strategic planning and execution.

BlackRock’s clients include taxable, tax-exempt and official institutions, high net worth individuals and retail investors. On December 1, 2009, BlackRock acquired Barclays Global Investors (“BGI”) from Barclays Bank PLC (“Barclays”), referred to as the “BGI Transaction”, adding investment and risk management capabilities and more than 3,500 new colleagues to the combined organization.

BlackRock’s BGI Products include equity, Fixed income, Multi-Asset Class, Alternative Investments, Alternative Investments, Cash Management, BlackRock Solutions and Advisory, Transition Management Services and Product Performance Notes. BGI has long been recognized for product innovation in indexed and scientific investing, including pioneering iShares, the industry’s ETF platform, sophisticated retirement solutions and liability-driven investment strategies. These strengths complement BlackRock’s active fundamental portfolio management capabilities, global mutual fund platform, customized solutions, risk management and advisory services.

BlackRock operates in a global marketplace characterized by a high degree of market volatility and economic uncertainty, factors that can significantly affect earnings and stockholder returns in any given period. The Company’s product offerings, which enhance its ability to offer a variety of traditional and alternative investment products across the risk spectrum and to tailor single- and multi- asset class investment solutions to address specific client needs. In addition, through BlackRock Solutions, the Company offers a broad spectrum of investment management and risk management products and services.

Investment management offerings include single- and multi-asset class portfolios, which might be structured to focus on a particular investment style, capitalization range, region or market sector; credit or maturity profile; or liability structure. It uses Aladdin and other state-of-the-art tools and work closely with BlackRock’s trading cost research team to manage four dimensions of risk throughout the transition: exposure, execution, process and operational risk.

BlackRock manages money for institutional and retail investors worldwide. Its client base is by both geography and client type. The Company serves clients through 74 offices across four regions: United States and Canada, EMEA, Asia Pacific and Latin America and Iberia.

BlackRock clients include tax-exempt institutions, such as defined benefit and defined contribution pension plans, charities, foundations and endowments; official institutions, such as central banks, sovereign wealth funds, supranationals and other government entities; taxable institutions, including insurance companies, financial institutions, corporations and third party fund sponsors; and retail and high net worth investors. Since customers found Blackrock managers to be able and trustworthy, it grew and profited mightily during this period.

 

Finally, I mention the giant energy company ExxonMobil. I read that Berkshire Hathaway's portfolio has recently shown a new position of 40.1 million shares valued at $3.4 billion.

ExxonMobil (NYSE: XOM) is the largest of the vertically integrated oil companies. It is also the second largest publicly-traded corporation in the world by market cap and revenue. With a market value of $417 billion, and smart strategic investments, ExxonMobil has longevity. It also pays a 2.7% dividend yield.

In his 2011 shareholder letter, Buffett wrote: “A century from now... ExxonMobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions...”

Recent investments in shale and natural gas production indicate that ExxonMobil will be earning cash for its shareholders for the next several decades. It has invested more in natural gas. ExxonMobil completed a $30 billion project to develop the world's largest natural gas field. This field is located in the Persian Gulf state of Qatar. It is expected to boost the company's gas production and make ExxonMobil the world's largest natural gas producer. The North Field is expected to contain 900 trillion feet of natural gas. ExxonMobil also agreed to a joint venture with Royal Dutch Shell and Chevron to construct a liquefied natural gas facility on Barrow Island off the coast of Australia. Chevron will own 50% of the facility while Shell and Exxon will each have 25%.

Exxon strengthened itself in Natural Gas by the acquisition of XTO Energy (shale). XTO has a strong hold in shale, including the Marcellus, Haynesville and the Bakken basins.

XTO drove a surge in U.S. fuel output by exploiting fracking. XTO Energy’s resource was reported to consist of 45 trillion cubic feet of gas. The XTO acquisition complimented Exxon’s presence in other shale areas such as the Piceance Basin in Colorado. The company has been producing natural gas from the basin for more than 50 years and it has a reported estimate of 1.5 trillion barrels of in-place oil shale resources.

So, what about an estimate of ExxonMobil’s stock value? Here, I propose that ExxonMobil has created a sustainable competitive advantage that I did not appreciate prior to reading about Buffett and Berkshire’s recent investment. Its moves to secure future sources of oil, shale, and natural gas has secured more years of future cash flows for its shareholders.

If we do a simple one or two stage DCF valuation estimation based on 10 to 15 years, a big piece of value may be missed. I argue that ExxonMobil has created a valuable advantage for itself and its shareholders that stretch the Excess Return Period (yrs) to at least 20 years, and maybe even more years. So, here is my argument simplified. For the sake of simplicity and estimation, let’s first take a look at the DCF estimate posted at Valupro.net  Is it reasonable? Did Buffett and Berkshire get a good bargain?

http://www.valuepro.net/cgi/valuate.pl?required=stock_symbol&stock_symbol=XOM

Here is one view to consider. For the sake of conservatism, we may drop the growth rate to 5% at their model. However, I argue that, in view of long rage planning and investments in shale and natural gas, you may also conservatively extend the Excess Return Period (yrs) to 20 years. This would result in an estimated intrinsic value of about $135 per share. And, if Buffett and Berkshire purchased XOM at an average cost of $85, they got a bargain of around 37% in a large business leader.

Over time, the world economies will demand more energy production.  In consideration of ExxonMobil‘s added durable competitive advantages, the “Yield On Cost” of this investment may prove to be even more profitable.

In summary, how do we tie all these good stories together? Think of the times when customers are pleased by the terms of supply and demand. As Ben Franklin wisely said, “No nation was ever ruined by trade.”

* * * *

Bud Labitan is the author and editor of “MOATS : The Competitive Advantages of Buffett & Munger Businesses.” Moats discusses the competitive advantages of 70 Berkshire Hathaway businesses and it is targeted towards business school students, investors, and business managers. He is also the author of other books on investment decision framing and decision making. These include the “1988 Valuation of Coca-Cola”, “Price To Value”, “Valuations”, and “The Four Filters Invention of Warren Buffett and Charlie Munger.”

Yield on Cost Is Warren Buffett’s Coca-Cola Magic

A nagging feeling came over me while finishing this latest book with the help of my friend Scott Thompson. While I was happy with our new book "1988 valuation of Coca-Cola: Estimated Intrinsic Value," I felt like we did not fully explain the importance, value and power of that bargain purchase. How could a man who wrote a book on Buffett and Munger’s “Four Filters Invention” investing process, “Price to Value” and "MOATS," fail to understand the power of this purchase?

I started emailing friends and doing simple, somewhat crazy math estimations to see if I could find the truth myself. I am even embarrassed to say that I sent an email to Mr. Buffett with flawed math. Friends, with their good intentions, would tell me to return to “Time Value of Money” calculations, and learn those well. They would say something like, "Coca-Cola is a great company with nice rate of returns and steadily increasing dividends, but it only gives you a range of 9% to 11% returns."



I would think, “How can that be? My investing heroes, Warren Buffett and Charlie Munger” always smile and resist cries from shareholders to sell the the Coca-Cola (KO) shares. What I rediscovered is that the magic of Warren Buffett’s and Charlie Munger’s 1988 purchase of Coca-Cola stock is: yield on cost.

Think of yield on cost” as “yield relative to my cost” or “the yield received per share cost” or "yield/per share cost." It can be described as “yield/cost per share.”

I sort of backed into finding that bond concept. My initial thinking went something like this: Think of it as getting an average of a $570 million dividend every single year from that principal investment cost of $1.299 billion in Coca-Cola. If you multiply $570 million x 24 years, we get $13.15 billion. Add this $13.15 billion to the $1.29 billion principal, and we get very, very close to the current value of $14.44 billion in BRK's ownership of Coca-Cola.

Bear with me on this basic "non-compounding" math below and you will see how Buffett received about $570 million for every year of that his principal investment of $1.299 billion in Coca-Cola. Keep in mind, I was trying to stay with simple math. Look at their cost of $1.299 billion, 0.44 rate of average annual return, and 0.57, which represents my assumption of $570 million.

0.57 x 23 (23 because of end-of-year adjustment), plus one-half of year of approximately 0.29, so 1.299 + 13.43 = 14.73, is darn close.

I found an old 2010 article that said: When Buffett began purchasing stock in Coca Cola in 1988, many Wall Street analysts were skeptical because it seemed only a matter of time before other beverage companies would take away its market share. In addition, Coca-Cola had reported earnings down 2 percent from the previous year, and had an unimpressive P/E ratio of between 14 to 19. At the time, shares of KO were worth between $35 and $45. The stock has split three times since then, and is now priced in the $60 range. By 1995, Buffett owned 100,000 shares of the company with a cost basis of roughly $1.2 billion. As of September 2010, Buffett’s unrealized gains on KO were $10.4 billion. This comes out to a 766 percent increase in value. This is one of Buffett’s greatest investing triumphs.

Using the same simple logic... When $2 grows into $6, no matter the duration, we say 6/2=3 and 3*100 = a 300% increase in value, no matter if it takes 1 or 900 years. In this simple math, duration is irrelevant.

Now, by 2013, KO stock had split 4 times and BRK has 400 million shares with a cost basis of $1.299 billion, and a market value of $14.5 billion. Forget for a moment that it took about 24.5 years to get there. Furthermore, suspend the idea of splits because we know the cost and the present dollar value that is already split-adjusted.

When $1.299 billion grows to $14.500 billion, we say 14.500/1.299=11.16 and *100 is a 1,116% increase in value. Again, in simple math, how much can we allocate to each year? Let us use a simple average and make it even. Now, a simple rough average of 1116/24.5 years=45.55% approximate gain per year, and this does not even count the value of the dividends.

(Next, I get a little theoretical.) Let us add in the low-ball but fair figure of $5 billion for all the dividends (with no major time value of money adjustments). When $1.299 grows to $19.500, we say 19.500/1.299=15.01 and *100 is a 1,501% increase in value. Now, a simple rough average of 1501/24.5 years=61.27% gain in value (on top of the $1.29 billion) per year, or around $570 million each year.

Now, I felt like I was getting close to why Buffett's 1988 bargain purchase of KO is so powerful and important. Next, I got a nice email from Richard Griebe. Griebe said he was starting to see the way I was looking at this investment in KO. “Rather than looking at the compounding of value over time, you are looking at the average annual increase in value against the original $1.299 billion invested. So, if I think of the original stock purchase as buying a bond instead, that “bond” has paid a continuously increasing interest rate over time. Following your computations to where you included dividends to calculate an average 61.27% gain per year or, in my bond model, Buffett bought a bond for $1.299 billion that has paid on average coupon of 61.27% annually. This is a feat that would make gangsters jealous. Thanks for patiently discussing this fascinating case study with me.

With Griebe’s positive words, I felt encouraged and I thanked him. Next, I kept searching the Internet for this “yield” concept that I was looking for. I was looking for Buffett’s effective yield per share compared to my yield per share. I stumbled upon the concept of yield on cost.

WOW! That is it! Yield per “share cost.”

Did I realize that 1.299 billion/400 million shares = Buffett's $3.25 per share cost per share of KO? Did you?

From the website Investopedia, Yield on cost (YOC) is defined as: “The annual dividend rate of a security divided by the average cost basis of the investments. It shows the dividend yield of the original investment. If the number of shares owned by the investor does not change, the yield on cost will increase if the company increases the dividend it pays to shareholders; otherwise it will remain the same."

To calculate yield on cost for a stock, an investor must divide the stock's annual dividend by the average cost basis per share and multiple the resulting number by 100 (to get a percentage). For example, an investor who purchased 10 shares of stock at $15 and 20 shares at $18 would have an average cost basis of $17 per share ($15*10 + $18*20)/(10 + 20). If the annual dividend is $0.90 per share, the yield on cost would be 5.29% ($0.90/$17 * 100).

Using this information, and knowing that Buffett's cost per share of KO is $3.25, can I calculate his yield on cost for 2012? The 2012 dividends per share were: March 13, 2013 $0.28, Nov. 28, 2012 $0.26, Sept. 12, 2012 $0.26, June 13, 2012 $0.26, March 13, 2012 $0.26, and the sum is $1.30

So, $1.30 / $3.25 = 0.40 and 0.40 * 100 = 40%. Buffett and Berkshire Hathaway received a 40% yield on cost just for the year 2012 dividends alone!

Alternatively, and again thinking in bond-like thoughts, if we believe the $570 million average return per year on top of the $1.299 billion principal. $570 million / 400 million shares is 1.43, and that is like a gain of 43% each year over the initial investment.

Prediction: Since 45% + 40% = 85%, I predict that the total yearly return will soon surpass the initial $1.29 billion cost basis of this Coca-Cola investment.

Coca Cola's Valuation, Warren Buffett's 1988 Purchase

For years, we have wondered how Warren Buffett valued Coca-Cola ( NYSE: KO ) stock at such a deep bargain in 1988. In this book, we estimate the intrinsic value of each Coca-Cola share when Warren Buffett purchased 7% of the company that year. This book describes a simple two stage discounted cash flow model that delivers a close approximation of the stock’s intrinsic value at that point in time.

In 1987, Coca-Cola was refocusing on its core business and sold its Columbia Pictures subsidiary. The “New Coke” fiasco of 1985 was past. The company was repurchasing common stock. So, how did the business look in the eyes of Buffett and Munger?

As some of you know, “The Four Filters Invention of Warren Buffett and Charlie Munger” book explored their investment decision making process.” We believe that Buffett and Munger made a major contribution to the field of Behavioral Finance by applying these four sequential filter steps:

Filter #1: Look for a business you understand, within your “circle of competence.”
Filter #2: Look for a Durable Competitive Advantage
Filter #3: Insist on Able & Trustworthy Managers
Filter #4: Insist on Ben Graham’s Margin of Safety where your purchase price is significantly below the intrinsic value.

Coca-Cola passed these filters. Consider the significance of each filter like this. Filter #1: Understanding means finding an understandable business with good economics. Filter #2: Look for a Durable Competitive Advantage. This means having repeat customers. Filter #3: Insist on Able & Trustworthy Managers because management must have both qualities. Why? The able but untrustworthy manager can lead to disaster.

Filter #4: Insist on a Margin of Safety where your purchase price is significantly below the intrinsic value. This is Ben Graham’s quest: to buy a business at a significant bargain so that the risk of capital loss is minimized; and, the probability of capital appreciation is maximized. Therefore, let us look at Coca-Cola’s intrinsic value per share in 1988. Coca-Cola is a business with a differentiated and continuing competitive advantage. Its economic moat is deep and wide. It has a combination of a special brand advantage, a large-scale “cost of production” advantage, and a global network distribution advantage. We could say that it has three moats around its economic castle. In addition, its managers work to build this moat bigger every day.

A customer generally asks for a Coke by name. Customers do not buy a ‘cola’. Charlie Munger said, “The social proof phenomenon which comes right out of psychology gives huge advantages to scale—for example, with a very wide distribution, which of course is hard to get. One advantage of Coca-Cola is that it's available almost everywhere in the world.”

In 1988, Warren Buffett and Charlie Munger began buying stock in the Coca-Cola Company for the Berkshire Hathaway portfolio. They purchased about 7% of the company for $1.02 billion. This turned out to be one of Berkshire's most lucrative investments. Berkshire Hathaway now owns 8.9 percent or 400 million shares of Coca-Cola.

Buffett and Munger knew that commodity companies sell products or services that can be reproduced. In 1982, Buffett said this about commodity companies: “Businesses in industries with both substantial over-capacity and a "commodity" product (undifferentiated in any customer-important way by factors such as performance, appearance, service support etc.) are prime candidates for profit troubles.” There are also companies that market commodity products so well that they distinguish their commodity product from that of their competitors. These put their own special ‘brand’ upon their product. They can achieve this by the marketing mix of price, product, placement, and promotions. In addition, continuous improvement in terms of higher quality production and service is always a plus.

In 1993, Warren Buffett said this about companies with competitive advantages: ‘Is it really so difficult to conclude that Coca-Cola and Gillette possess far less business risk over the long term than, say, any computer company or retailer? Worldwide, Coke sells about 44% of all soft drinks, and Gillette has more than a 60% share (in value) of the blade market.’ Leaving aside chewing gum, in which Wrigley is dominant, I know of no other significant businesses in which the leading company has long enjoyed such global power.’
Coca-Cola has a strong brand identity in the global market and it has pricing power. It is one of most respected brands in the world. Coca-Cola utilizes a great amount of positive advertising to maintain the Coke brand. The amount of advertising is also a barrier to entry; it makes it impossible for brands with low capital to gain a comparable amount of brand awareness. This creates an expensive barrier to entry.

Recently, Coca-Cola’s 5Yr Gross Margin (5-Year Avg.) is approximately 62%. Its Net Profit Margin (5-Year Avg.) is approximately 22%, while the industry Net Profit Margin (5-Year Avg.) is 18.0%. Coca-Cola also has better earning power efficiency in term of Free Cash Flow per unit of sale.

As of 2012, Coca-Cola has a 5-Year Average Return on Equity (ROE) of 29.9%. Its worldwide distribution system is also major competitive advantage.

Are these advantages sustainable for the next 10 years? Yes. However, Coca-Cola has recently dropped out of the top ten brand value list for the first time. This may be underpinned by a consumer trend towards healthier, non-carbonated drinks. Coca-Cola recognized “obesity and health concerns” as potential risks for the company in the 2010 annual report. However, there is little doubt that Coca-Cola’s loyal brand following will sustain its competitive advantage. Coca-Cola recognizes the need to sustain marketing and increase innovation.

In its 2010 annual report, they acknowledged the need to continue to selectively expand into other profitable segments of the nonalcoholic beverages segment.

From the 2012 annual report: “Obesity and other health concerns may reduce demand for some of our products. Consumers, public health officials and government officials are highly concerned about the public health consequences associated with obesity, particularly among young people. In addition, some researchers, health advocates and dietary guidelines are encouraging consumers to reduce consumption of sugar-sweetened beverages, including those sweetened with HFCS (High-Fructose Corn Syrup) or other nutritive sweeteners. Increasing public concern about these issues; possible new taxes on sugar-sweetened beverages; additional governmental regulations concerning the marketing, labeling, packaging or sale of our beverages; and negative publicity resulting from actual or threatened legal actions against us or other companies in our industry relating to the marketing, labeling or sale of sugar-sweetened beverages may reduce demand for our beverages, which could adversely affect our profitability.”

A historically wonderful business, Coca-Cola’s able and trustworthy managers are motivated to invest in its supply chain network to “leverage the size and scale of the Coca-Cola system to gain a competitive advantage.” With this “moat building” in mind, we believe that that Coca-Cola will be successful in maintaining its economic franchise and current barriers to entry.

On October 18, 2012, Coca-Cola announced that it planned to purchase up to 500 million shares of the company's common stock. Such actions add value to the “intrinsic value” of each remaining share outstanding.

Consider why the Coca-Cola Company is such a good business from an investor’s point of view. Both Coke and Pepsi make products we enjoy. As an investor, we prefer the Coca-Cola Company. One reason is the amount of Free Cash Flow generated for every sale. Another reason is the amount of Free Cash Flow generated after expenses.

Charlie Munger once stated: "Warren often talks about these discounted cash flows, but I've never seen him do one." Warren Buffett responded: "It’s sort of automatic... It ought to just kind of scream at you that you've got this huge margin of safety." Buffett went on to state: "We define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life. Anyone calculating intrinsic value necessarily comes up with a highly subjective figure. This figure will change both as estimates of future cash flows are revised and as interest rates move. Despite its fuzziness, however, intrinsic value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses."

This exercise is our quantitative estimation of Coca-Cola's Intrinsic Value Per Share in 1988. First, we describe our 2-stage "discounted cash flow" valuation model. This estimating model is strict. It assumes a good business will only "live" for 20 years. Within this model, we apply compounding growth to the first 10 years. Then, we assume a lower growth rate for years 11 until the end of year 20. This restriction of lesser growth in years 11 thru 20 means that this restriction imposes a degree of conservatism on top of the estimator’s optimism during the model’s early growth years. Then, after we sum up all the individual end of year cash, we should apply a discount rate and bring that sum back to present value. At this point, we divide by the number of shares outstanding.

First, keep in mind, Warren Buffett said: "Intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life. Anyone calculating intrinsic value necessarily comes up with a highly subjective figure. This figure will change both as estimates of future cash flows are revised and as interest rates move. Despite its fuzziness, however, intrinsic value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses."

Again, we emphasize that our model is an "estimation method" that imposes conservatism by limiting growth in the final ten years. It is just a model for 1988. At that time, KO stock traded between $35 and $45.25. From 1987 to 1988, the net income grew 14% and the net income per common share grew 17.3%. The number of shares outstanding in 1988 was 364,612,000 shares. We used a discount rate of 6.0% because that is the approximate 20-year average from 1988 to 2008. (see below)

Average: 10-Year US Treasury Rates from 1988–2008

1988 8.50% 1998 5.26%
1989 8.50% 1999 5.64%
1990 8.55% 2000 6.03%
1991 7.86% 2001 5.02%
1992 7.01% 2002 4.61%
1993 5.87% 2003 4.02%
1994 7.08% 2004 4.27%
1995 6.58% 2005 4.29%
1996 6.44% 2006 4.79%
1997 6.35% 2007 4.63%
2008 3.67%
AVERAGE: 5.95%



Coca-Cola’s 1988 Annual Report does not show Free Cash Flows. We can calculate FCFs below using available information from its 1988 financial statements like this:

The formula for calculating Free Cash Flow (FCF) is:
Free Cash Flow = Operating Cash Flow – Capital Expenditures

Free Cash Flow = (EBIT x (1–Tax Rate)) + (Depreciation & Amortization) – (Changes in Working Capital) – Capital Expenditure

Remember that Operating Income is referred to as EBIT or (Earnings Before Interest & Taxes, shown on the Income Statement.

Working Capital = (Current Assets) – (Current Liabilities)

EBIT is also known as Operating Income = $1,598,300,000
EBIT = Earnings Before Interest & Taxes

Tax Rate in 1988 = .34 or 34%

Depreciation & Amortization = $169,768,000

Changes in Working Capital = $227,993,000

1988’s Working Capital = 1988 Total Current Assets – 1988 Total Current Liabilities
$376,535,000 = $3,245,432,000 – $2,868,897,000

1987 Working Capital = 1987 Total Current Assets – 1987 Total Current Liabilities
$148,542,000 = $4,231,921,000 – $4,083,379,000

Capital Expenditures = $387,000,000

(EBIT x (1–Tax Rate)) + (Depreciation & Amortization) – (Changes in Working Capital) – Capital Expenditure = Free Cash Flow
($1,598,300,000 x (1– .34)) + $169,768,000 – $227,993,000 – $387,000,000 = FCF
($1,598,300,000 x (.66)) + $169,768,000 – $227,993,000 – $387,000,000 = FCF
$1,054,878,000 + $169,768,000 – $227,993,000 – $387,000,000 = FCF
$1,054,878,000 + $169,768,000 – $227,993,000 – $387,000,000 = $609,653,000

We used an assumed FCF annual growth of 15 percent for the first 10 years; and we assume 12 percent growth from years 11 to the end of year 20. Keep in mind that this is how our estimating model was designed. In the real world, you should adjust your model to better fit a superior or inferior business’ longevity.

In fact, for a great company like Coca-Cola, you could lengthen the second stage of your model out to another 5-20 years. For the purpose of conservatism, we chose to stay with our 20 year two-stage model with the compounding growth set at 15% and 12% respectively. These are reasonable expectations for that period, based on Warren Buffett’s 1990 letter where he wrote: “we hope to have look-through earnings grow about 15% annually.”

In our model, the resulting estimated intrinsic value per share (after discounting the sum back to the present) is approximately $78.67. If Warren Buffett bought at or around the Market Price of $40, he obtained a margin of safety of around 49%.

At this point, it is important to remember that Intrinsic Value is not a precise number. It is an estimated range. It is better to be approximately right than precisely wrong. As you can see below, both valuation models have estimated valuations that are fairly close to one another. The DCF/FCF model inspired by John Burr Williams estimates Coca-Cola's intrinsic value at around $79. Alternatively, Benjamin Graham's classic formula estimates the value of Coca-Cola to be approximately $87.48.

We believe that it is better to go with the more conservative estimation, and examine the business qualities within the Four Filters Process. The Four Filters are a search for: “Understandable first-class businesses, with enduring competitive advantages, accompanied by first-class managements, available at a bargain price.” This is discussed in the next chapter.

Here is the Ben Graham formula: V = EPS = (8.5 + 2g)
Where V = Intrinsic Value
EPS = Earnings Per Share for ttm (trailing twelve months)
8.5 = Price/Earnings (P/E) ratio for a no-growth business
G = reasonable expected 7–10 year growth rate

For our 1988 Coca-Cola valuation:
V = $2.43 x (8.5 + (2x14))
V = $2.43 x (8.5 + 28)
V = $2.43 x 36.5
V = $88.70

Alternatively, if we imagine Buffett performing this calculation in his head, his modified Graham formula might resemble something like this:
V = EPS = (8 + 2g)
V = $2.43 x (8 + (2x14))
V = $2.43 x (8 + 28)
V = $2.43 x 36
V = $87.48



WARNING

Remember that intrinsic value estimations comprise Filter #4 of Buffett & Munger's Four Filters investment process. Be sure to consider all four filters during your investment research & analysis.

No matter which estimation method you adopt, keep in mind that Warren Buffett bought an understandable business with sustainable competitive advantages, able trustworthy managers, and a significant bargain relative to its intrinsic value. These four filter factors describe the wonderfulness or magic of a business.


*****

MOATS : Competitive Advantages of 70 Buffett and Munger Businesses

MOATS : The Competitive Advantages of Buffett and Munger Businesses discusses the "competitive advantages" of 70 selected businesses purchased by Warren Buffett and Charlie Munger for Berkshire Hathaway Incorporated. This is a very useful resource for investors, managers, students of business around the world. It also looks at the sustainability of these competitive advantages in each of the 70 chapters.

find it here: http://www.lulu.com/spotlight/4filters

The MOATS book introduction audio mp3 file: http://www.frips.com/moats.mp3

audio file of Wells Fargo, WFC chapter from MOATS book:
http://www.frips.com/wfc.mp3

audio file of the Johnson and Johnson chapter from MOATS:
http://www.frips.com/jnj.mp3

audio file of the Costco chapter in MOATS http://www.frips.com/costco.mp3

audio file of the American Express chapter: http://www.frips.com/axp.mp3

The IBM Chapter from MOATS. Why did Buffett buy into a technology services
company after so many years? http://www.frips.com/ibm.mp3

Here is a 1 min : 32 sec audio file of Warren Buffett talking about an
economic castle and its moat http://www.frips.com/wbmoat.mp3

Herman Cain May Change World View On Taxes

Who ever thought that a conservative man from Georgia running for President of The United States could affect taxation and democracy debates around the world?

Herman Cain's 9-9-9 Plan is a Vision for Economic Renewal that can be good for America and the world's economies. He believes that the natural state of our economy is prosperity. Freedom from excessive regulation and excessive taxation ensures that.

Cain believes that in order to return to prosperity, Government must get off our backs, out of our pockets and out of our way.

His Economic Guiding Principles include:

1. Production drives the economy, not spending. Production is the engine, consumption is the caboose. We can not spend our way to prosperity. Government spending is like taking a bucket of water from the deep end of the pool, pouring it in the shallow end. Then they HOPE that the water level will CHANGE.

2. Risk taking drives growth. Business formation and job creation are dependent on entrepreneurs taking risks. Investors who fund those entrepreneurs likewise take risks.

3. Measurements must be dependable. A dollar must always be a dollar just as an hour is always 60 minutes. Sound money is crucial for prosperity.

UNITE, never DIVIDE; UNITED around ECONOMIC GROWTH

Cain states that when one party is so focused on spending so that the other must focus on cutting, we must unite around economic growth. Unite income tax payers with payroll taxpayers so we all pull for low rates Unite those wanting to eliminate deductions with those seeking lower rates. Unite the Flat-Taxers with the Fair-Taxers.  

Price To Value - Chapter Seven: Phil Carret’s Ideas

Price To Value - Chapter Seven: Phil Carret’s Ideas


CHAPTER SEVEN: Phil Carret’s Ideas
from the new book Price To Value (Acalmix)


Philip Carret founded Pioneer Fund in 1928, six years before Ben Graham wrote the 1st edition of Security Analysis. Carret also wrote a useful and enlightening book called “The Art of Speculation.” And, Warren Buffett stated that Philip Carret “had the best truly longterm investment record of anyone I know."

What made Carret so successful in investing? I asked Frank Betz, of Carret Zane Capital Management, a similar question. Frank shared a partner's desk with Phil Carret as his personal assistant from the mid-eighties until Phil's death in 1998. Carret was then over age 101, and he was still commuting most days from his Scarsdale home to the mid-town NYC office of Carret and Company that he founded in 1962. There he was still functioning fully in the management of client portfolios. Betz recalled that Phil was a voracious reader not only of dozens of corporate annual reports and daily newspapers, but of an eclectic variety of books ranging from philosophy, history, biography and economic subjects. Phil Carret always claimed the most useful information he gleaned from this was from his concentration on the detailed footnotes appended to annual reports.


While Frank was already a long experienced money center banker, analyst, and investor when he was recruited to work for Carret by Phil's son Donald, I wanted to know how this interaction affected his own approach to investing. Frank believes that “working with Phil Carret, significantly sharpened my senses.”

Frank Betz also remembers that Carret would warn others against following fads in investing, and he often cited one of the most important characteristics of successful investors is patience. In the preface of his book, Phil Carret wrote, “The man who looks upon speculation as a possible means of avoiding work will get little benefit from this book. It is written rather for the man who is fascinated by the complexity of the forces which produce the ceaseless ebb and flow of security prices, who wishes to get a better understanding of them.”


“Successful speculation requires capital, courage and judgment. The speculator himself must supply all three. Natural good judgment is not enough. The speculator’s judgment must be trained to understand the multitudinous facts of finance.” Like mine, it was Carret’s hope that his book would assist his readers.


At the 1996 Berkshire Hathaway Annual Meeting, Warren Buffett said: "The main thing is to find wonderful businesses, like Phil Carret, who's here today, always did. He's one of my heroes, and that's an approach he's used. If you've never met Phil, don't miss the opportunity. You'll learn more talking with him for fifteen minutes than by listening to me here all day."


Let us take a brief look at Carret’s somewhat contrarian view on oil. “Oil is produced in thousands of oil fields on every continent in the world. The temporary absence from the market of a single country - even a country as important to oil as Iraq or Kuwait - will have only a temporary effect. Other oil producers can boost their output quickly. And in the United States, we have abundant supplies of natural gas, which can serve as a substitute for oil to a considerable extent.”


More importantly, take a look at Phil Carret's "12 Commandments of Investing":


1. Never hold fewer than 10 different securities covering five different fields of business;


2. At least once every six months, reappraise every security held;


3. Keep at least half the total fund in income producing securities;


4. Consider (dividend) yield the least important factor in analyzing any stock;


5. Be quick to take losses and reluctant to take profits;


6. Never put more than 25% of a given fund into securities about which detailed information is not readily and regularly available;


7. Avoid inside information as you would the plague;


8. Seek facts diligently, advice never;

9. Ignore mechanical formulas for value in securities;


10. When stocks are high, money rates rising and business prosperous, at least half a given fund should be placed in short-term bonds;


11. Borrow money sparingly and only when stocks are low, money rates low and falling and business depressed;


12. Set aside a moderate proportion of available funds for the purchase of long-term options on stocks in promising companies whenever available.


We see that Phil Carret exercised safety-based commandments. And, the last one appears to be targeted towards “intelligent speculation.” There, he advised setting aside a proportion of available funds for long-term options on stocks in promising companies whenever available. With careful study and patience, Carret knew he could predict good outcomes. Philip Carret died on May 28, 1998, at age 101.




- - - - - - -

“Price To Value” is about Intelligent Speculation and Decision Framing. Readers will benefit from this book if it stimulates better thinking into the most important factors crucial to decision making. These decision framing ideas can be applied across different asset classes. First, the book presents the four investing decision filters in simplified terms. Then, it extends these ideas by looking into the intelligent speculation ideal described by Benjamin Graham in his tenth lecture of 1946.



Bud Labitan's books are available on Amazon.com and Lulu.com

http://stores.lulu.com/4filters

 

The Book

What we view as tough times may soon be viewed as "buying opportunities" for Warren Buffett and other value investors. After all, some of their best purchases were made during the stagflationary period of the 1970's.
I think Buffett and Munger invented an amazing Behavioral Finance Formula or Process that is underappreciated by the business and academic communities. On paper as early as the 1977 BRK annual letter, their work in designing a mixed qualitative + quantitative formula may be worthy of a Nobel Prize in Economics and Behavioral Finance. So, in my new self-published book "The Four Filters Invention of Warren Buffett and Charlie Munger" ( www.frips.com ) I examine each of the basic steps they perform in "framing and making" an investment decision. I made this book a small and focused look into this amazing invention within "Behavioral Finance."Buffett mentions the Four Filters this way: "Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag."

In my view, the genius of Buffett and Munger's four filters process was to "capture all the important stakeholders" in one "multi-variable" equation. Imagine...Products, Enduring Customers, Managers, and Margin-of-Safety... all the important stakeholders for business success in one mixed "qual + quant" formula...The genius of the Munger and Buffett collaboration. And, quality bargains at 50 cents on the dollar may soon appear; Use the Four Filters!

Thanks for your interest in my book and helping to promote awareness of my book. Here is a 10 minute audio book summary: http://www.frips.com/4fsummary.mp3

Behavioral Finance

A handful of readers have looked at my book as a reiteration of ideas. So, I wrote some these words to a reviewer of my book. Then, I realized that it helps to explain "the essence" I tried to express in my book:

Thanks for your positive words and review of my book. I appreciate yours and all the feedback I get. If possible, kindly mention to your readers that I intended to make this book a small and highly distilled look into this amazing invention within "Behavioral Finance."In my view, the genius of Buffett and Munger's for filters process was to capture all the important stakeholders in a "multi-variable" equation or formula. Imagine... Products, Enduring Customers, Managers, and Margin-of-Safety... all in one mixed "qual + quant" formula. In my view, that is the real genius of the Munger and Buffett collaboration.

Perhaps Munger does not get enough credit for this amazing formula because he enjoyed some of the profits and distributed some to family and charities along the way. However, their record speaks for itself. And, Buffett is always ready to mention that "Time is the friend of the wonderful business, the enemy of the mediocre. You might think this principle is obvious, but I had to learn it the hard way. In fact, I had to learn it several times over... It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner."

So, my book, "The Four Filters Invention of Warren Buffett and Charlie Munger" is really a subtle tribute to their collaborative genius in Behavioral Finance. And, let me be the first in line to nominate both men for a Nobel Prize in Economics.

However, the significance of their ideas in Behavioral Finance will most probably be eventually recognized like the ideas of Rev. Thomas Bayes. Posthumously. As Bill Gates is keenly aware, "Bayesian Probability" is vitally important to Microsoft Windows software. ( http://en.wikipedia.org/wiki/Thomas_Bayes )

CHAPTER ONE OF FIVE: UNDERSTANDING

The Four Filters.

What I Learned from Warren Buffett.
By Bud Labitan


CHAPTER ONE OF FIVE: UNDERSTANDING

Over the years, I have read most of the books about Warren Buffett, his teacher Benjamin Graham, and his business partner Charlie Munger. I have also listened to many hours of audio lectures and interviews. During this time, I have been consistently interested in how Warren Buffett frames an investment decision and how he arrives at a winning investment prospect.

Warren Buffett has talked about the Four Filters in several ways, but the sequence is always the same: “Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag.” Buffett has also phrased the four filter process in this way: “When buying companies or common stocks, we look for understandable first-class businesses, with enduring competitive advantages, accompanied by first-class managements, available at a bargain price.”

These ideas sound so simple. Many people hear them at the Berkshire Hathaway annual meeting in Omaha each year. Yet, few people have stopped to think about the importance and effectiveness of each individual filter.

This is a small and valuable book that concentrates on the four sequential filters that will make anyone a better and more skillful investment decision maker. It is dedicated to Janine Rueth and Victoria Labitan. In this book, I squeeze “all the lean beef” into five chapters: “the Four Filter chapters and a summary chapter.” The final summary chapter will tie the filters together and demonstrate, with enthusiastic attitude, why these filters work to maximize the probability of investing success from both a mathematical and a practical point of view.

In developing understanding of a company and its products, Buffett framed the diligent mental process this way: “If I were looking at a company, I would put myself in the frame of mind that I had just inherited that company, and it was the only asset my family was ever going to own. What would I do with it? What am I thinking about? What am I worried about? Who are my customers? Go out and talk to them. Find out the strengths and weaknesses of this particular company versus other ones.”

Like a detective, he begins by asking himself basic questions. He looks for simple things that he can count. He looks for companies run by able and owner-oriented people.
Said Mr. Buffett, “Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag.”

I have played with the four filters and twisted them into 4 clusters this way:
1. Products 2. Customers 3. Management 4. Margin of Safety

Why do the filters work? I will give you a hint - Elaboration and Elimination.
In terms of mathematical probabilities, think of each stop along the four filters as a mutually exclusive and additive event. If a company passes a couple of filters, it is, by the process of elimination, farther to the right on a normal distribution curve, from an “investment prospect” point of view. If this were a field of racing horses, movement along each step of the Four Filters path, the prospect or suspect enters a subset of “better than average” horse. In my view, practicing these steps will make you a better thinker.

The majority of Berkshire Haathaway companies have important competitive advantages that will endure over time. For Warren Buffett and his shareholders, it is comforting to be in businesses where some mistakes can be made and yet satisfactory overall performance can be achieved.

How were these four filters developed? Over the course of their investing experiences, Warren Buffett and Charlie Munger have had many discussions about the qualities of both bad and good businesses. Warren Buffett’s advantage is passion and attitude for sensible investing. He learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values. Sound owner-oriented business principles, along with time, training, and temperment have mabe them even better investors.

So what does Ben Graham add to filter number one, understanding? Graham, according to Buffett, added three basic ideas that can enhance our intellectual investing framework.
Graham’s ideas can help us do reasonably well in stocks.


Buffett on Graham:
His three basic ideas - and none of them are complicated or require any mathematical talent or anything of the sort - are:

1. that you should look at stocks as part ownership of a business,
2. that you should look at market fluctuations in terms of his "Mr. Market" example and make them your friend rather than your enemy by essentially profiting from folly rather than participating in it, and finally,
3. the three most important words in investing are "Margin of safety" - which Ben talked about in his last chapter of The Intelligent Investor - always building a 15,000 pound bridge if you're going to be driving 10,000 pound trucks across it.

I think those three ideas 100 years from now will still be regarded as the three cornerstones of sound investment.

In developing our understanding of a company and its products, Warren Buffett advises students to “Think for yourself.”

He reads annual reports of the company he is looking at, and he reads the annual reports of the competitors. He has said that annual reports are the main source of the study material needed or understanding. Of course, he also cautions students to focus on their own circle of competence. Notice the filtering process of his statement here: “Draw a circle around the businesses you understand and then eliminate those that fail to qualify on the basis of value, good management, and limited exposure to hard times.”

Just as a good leader has been tested by tough times and has a solid followership, a good company will have a loyal followership or customer base. The wonderful ones will have some sort of pricing power.

Charlie Munger understood the importance of thinking about the “Wonderful Business” early, while Warren Buffett was still buying cheap “Cigar-Butts.” Shortly after purchasing Berkshire, Buffett acquired a Baltimore department store called Hochschild Kohn. That was purchased through a retailing company called Diversified Retailing that later merged with Berkshire Hathaway. They now consider this, as well as the original textile company purchase an investing mistake. But, they both admit that they have learned from their mistakes. Now, when buying companies or common stocks, they look for first-class businesses accompanied by first-class managements. They look to what managements do more than what managements say.

Along with learning about GEICO’s low cost advantage from Lorimer Davidson, Warren Buffett learned some things from studying Phil Fisher, Philip Carret, and Henry Singleton. Buffett met Phil Fisher in the early Sixties, after reading his first book. Phil Fisher was a deep thinker into the nature of managements and their business growth potential. According to Buffett, “His ideas, like those of Ben Graham, were simple but powerful, and I wanted to meet the man whose teachings had such an influence on me…It's been over 40 years since I integrated Phil's thinking into my investment philosophy.”

So, part of developing your “circle of competence” is reading, learning, observing and integrating sound ideas into your investment philosophy. According to Buffett, he and Charlie Munger “just read the newspapers, think about a few of the big propositions, and go by our own sense of probabilities.”


Buffett and Munger’s Goal at BRK:
Our long-term economic goal is to maximize the average annual rate of gain in intrinsic business value on a per-share basis. We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress.


How do we develop a better frame of reference and make better investing decisions? As you now know, Filter One is to “Develop a Better Understanding” of the company and its products. I got interested in looking at how Buffett and Munger frame their decisions when I was in business school at Purdue University Calumet. This is a quick summary about my views on their “framing.”

Framing in behavioral finance is the choosing of particular words to present a given set of facts. And, framing can influence our choices. Tversky and Kahneman described "Prospect Theory" in 1979 using framed questions. Tversky and Kahneman found that contrary to expected utility theory, people placed different weights on gains and losses and on different ranges of probability. They also found that individuals are much more distressed by prospective losses than they are happy by equivalent gains. Some have concluded that investors typically consider the loss of $1 twice as painful as the pleasure received from a $1 gain. Others believe that this work helps to explain patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty. An increasing body of literature on framing supports a tendency for people to take more risks when seeking to avoid losses as opposed to securing gains.

Takemura (1992) showed that the effects of framing are likely to be lower when subjects are warned in advance that they will be required to justify their choices, and when more time is allowed for arriving at their choices. Luckily, Buffett and Munger seem to have arrived at practical use of these optimal framing ideas earlier than most.

They try to keep this simple. Notice this example from the latest 2007 annual report:

The Pritzker family decided to gradually sell or reorganize certain of its holdings, including Marmon, a company operating 125 businesses, managed through nine sectors. Marmon’s largest operation is Union Tank Car, which together with a Canadian counterpart owns 94,000 rail cars that are leased to various shippers. The original cost of this fleet is $5.1 billion. All told, Marmon has $7 billion in sales and about 20,000 employees. We will soon purchase 60% of Marmon and will acquire virtually all of the balance within six years. Our initial outlay will be $4.5 billion, and the price of our later purchases will be based on a formula tied to earnings.

A simple valuation example here will demostrate this bargain purchase in a well run company. For fun, lets do a fair "replacement cost" estimate on the 94,000 railcars alone.
94,000 x what? Made out of steel, the boxcar cost about $45000 a copy in 1980. A buddy of mine, says that $90,000 would be a fair price to pay for a mid-age mid-use rail car which can be depreciated over about 40-50 years. So, 94,000 x $90,000 = 8.46 Billion.... just in railcars alone. Furthermore, consider that the Marmon Group is composed of 125 different companies. And, I may be understating the replacement cost of a mid-age mid-use rail car.


Buffett and Munger have employed the principles taught by Dave Dodd and Ben Graham. In my view, Buffett and Munger overcome the conventional framing effects thru rational and thorough business analysis. They simply avoid getting into judgments in some fields. Warren Buffet has said: "If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter. Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter." I call their approach the compounding success theory because I imagined how their sequence of rational decisions push the probability of investment return success into the upper percentiles.

In my masters paper, I must admit that I got too wordy. I have come to realize that the Four Filters encapsulate the most important contributions of John Burr Williams, Benjamin Graham, Phillip Fisher, Warren Buffett, and Charles Munger. Each of the great investors learn from knowledgeable others.

While everyone may take a little different approach to measuring both quantitative and qualitative value; in my view, each of the Four Filters delivers something especially valuable. They help get us closer to the real "intrinsic value" of a good business.

Book: "The Four Filters"

I am working on a new book called "The Four Filters: What I learned from Warren Buffett."

Think: "Practical Best Practices in Behavioral Finance"
My book would be half the size of Charles' "Getting Started in ValueInvesting," and it would focus narrowly on the merits of the "behavioral science"aspects of Warren Buffett's approach.
It could be read on a plane trip across the country.

For sample of my writings, see:
http://www.frips.com/cst.htm

I will describe how the Four Filters relate to Behavioral Finance and how the Four Filters enhance the investment decision making process.

USG

As some of you know, I am bullish about USG. It has gotten its asbestos exposure behind it. And, it has emerged from restructuring as a new and dominant player that is building its protective moat. So, for you quantitatively inclined, some of these present numbers are opportunistically deceptive. BRK owns about 20 percent of the company, up from its initial investment into 15 % of the company.

USG Corporation (USG), through its subsidiaries, is a manufacturer and distributor of building materials, producing a range of products for use in residential, non-residential, and repair and remodel construction, as well as products used in certain industrial processes. The Company's operations are organized into three segments: North American Gypsum, Building Products Distribution and Worldwide Ceilings, the net sales of which accounted for approximately 48%, 38% and 14%, respectively, during the year ended December 31, 2007. The Home Depot, Inc. accounted for approximately 11% of USG's net sales in 2007.

USG Corporation , USG has a (5-year annual average) net income growth rate of negative 11.3 . What competitive advantages does it have? Brand, Technology, Cost of Production, Distribution Network? Are possible advantages sustainable? Does USG have a solid mix of Product, Pricing Power, Placement, and Promotions? When buying companies or common stocks, look for understandable first-class businesses, with enduring competitive advantages, accompanied by first-class managements.

USG has a current market price is 33.18 Using an assumed growth rate of -4.5 percent, the estimated Intrinsic Value is 18.67 per share from ValuePro.net, and there does not appear to be a bargain or 'margin of safety' present here. However, using an assumed growth rate of 7 percent, the estimated Intrinsic Value is 68.36 per share from ValuePro.net, and this may or may not indicate a bargain of 35 dollars. Is it a possible Value Trap? If the growth assumptions used in estimating the Intrinsic Value are accurate and sustainable, this may or may not indicate a price-to-value ratio of .49 , and a possible margin of safety of 51 percent.

The current price/earnings ratio = 42.6 It's current return on capital = 2.09. Using a debt to equity ratio of .56, USG Corporation shows a current return on equity = 4.12

Some industries have higher ROE because they require no assets, such as consulting firms. Other industries require large infrastructure builds before they generate a penny of profit, such as oil refiners. Generally, capital-intensive businesses have higher barriers to entry, which limit competition. But, high-ROE firms with small asset bases have lower barriers to entry. Thus, such firms face more business risk because competitors can replicate their success without having to obtain much outside funding. Growth benefits investors only when the business in point can invest at incremental returns that are enticing; only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor. The wonderful companies sustain a competitive advantage, produce free cash flow, and use debt wisely.

Automatic Warning, ( above 0.5 ) on this current debt to equity level of .56

Does USG Corporation make for an intelligent investment or speculation today? Time is said to be the friend of the wonderful company and the enemy of the mediocre one. Before making an investment decision, seek understanding about the company, its products, and its sustainable competitive advantages over competitors. Next, look for able and trustworthy managers who are focused more on value than just growth. Finally ask: Is there a bargain relative to its intrinsic value per share today? Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misapraised. In terms of Opportunity Cost, is USG the best place to invest our money today? What about growth in Free Cash Flow?

Excerpts, comments, and news items: http://finance.yahoo.com/q/h?s=USG
Portions of this report are generated in budlab software on 08-03-03 . Budlab software was designed to help me produce a report that emphasizes conservativism and rationality when making an investment decision.

Recession and Opportunities

Our country appears to be in an economic recession. This will be a painful time to many families and many businesses. Eventually, our country will pull out of this recessionary or stagflationary time into another growth era.

From a Value Investing point of view, quality bargains will be revealed. This will bring equity purchase opportunities because markets tend to overreact. Looking for "mispriced opportunites" is the foundation of sensible investing.

Be on the lookout for QB. Quality Bargains.

Wally Weitz

Is Wally Weitz the next Warren Buffett ?

Elimination Process and its Effects

In my last article at Gurufocus.com entitled, "Best Practice: The Elaboration Effect" I attempted to tie in concepts from the practices of Warren Buffett and Charles Munger that explain why they appear immune to the convestional framing effects. Link: http://www.gurufocus.com/news.php?id=3051 This next best practice is called "The Elimination Process and Effect" Using the process of eliminating bad and mediocre businesses from investment consideration have pushed their probability of success automatically into the higher percentiles of long term investing success.

How is this done? Chiefly by performing the four filters:

1. Understand the Business and it Products.

2. Is there a Sustainable Competitive Advantage

3. Able and Trustworthy Managers

4. A Margin of Safety if the selling price is significantly below the Intrinsic Value.

In building an A.I. interactive model of WB's Investing Brain, one approach is to use probabilities and elimination. Which words have appeared most frequently in Buffett's writings to shareholders? While this is not a complete study, this sample below shows the "word frequency" from my old compilation of the BBF, Buffett Business Factors. I will add a few comments to point out some patterns I detected.

FREQUENCY, WORD, COMMENT

386, business
No shocker here, the underlying business is always more important than stock's market price.

250, not
This one caught me by surprise at first until I remembered WEB talking about the importance of the human mind casting out less than desirable purchases. In the talk to MBA students in Tennessee, Buffett mentioned the reason why great chess champions can beat IBM's best supercomputers. An experienced chess champ has the ability to cast off a lot of information noise.

180, earnings
A lot of focus on real free cash flow

155, value
And the sustainable competitive advantage therein

146, businesses
386+146 = 532 times !

141, about
A preposition meaning connected or associated with. WEB and CM have lot of experiences to form pattern comparisons

140, capital

122, investment

99, managers
There is a lot of talk in the writings about able and trustworthy managers and numerous examples

96 , market
This is interesting mainly because the concept of market get mentioned so much further down this word frequency list.

I came to the conclusion that if a truly smart machine interpreted the essence of the discussions portion of his shareholder letters, the conclusion might read something like this:

"Mr. Buffett focused on the importance of individual businesses and what not to value. Because of the frequent use of the words business, not, earnings, value, about, and capital, we can conclude that this piece of literature is a cautionary tale about factors to avoid when making an investment."

Therefore, in addition to the Elaboration Process and Effect, another important Best Practice for investors is the Elimination Process and its Effects on your portfolio.

http://www.gurufocus.com/news.php?id=9509

A Bargain Purchase

From the 2007 BRK Annual Report...

For fun, lets do a fair "replacement cost" estimate on the 94,000 railcars alone.
94,000 x what.?

Made out of steel, the boxcar cost about $45000 a copy in 1980. A buddy of mine, says that $90,000 would be a fair price to pay for a mid-use rail car which can be depreciated over about 50 years.

94,000 x $90,000 = 8.46 Billion.... just in railcars alone. Furthermore, consider that the Marmon Group is composed of 125 different companies.

Charles Mizrahi's Book: Getting Started in Value Investing

I had the privilege of proofreading early drafts of this book, and I am happy to report that Charles Mizrahi has written a great book called Getting Started in Value Investing. It is a clear guide written by an author with many years of experience in writing newsletters and managing money intelligently.

This book serves as a clear guide from the basic beginning steps to the "things to watch out for" ending summary. I recount his rational guide path here: Chapter 1 begins with the misconceptions of Value Investing. Chapter 2 follows with the basics of sensible value investing. Chapter 3 warns us about Mr. Market. Chapter 4 covers Great Companies, and explains why they may become great investments. Then, in Chapter 5, Mizrahi explains why good managements add more value. Chapter 6 covers the issue of competition and the importance of enduring competitive advantages. Chapter 7 covers the Essential Valuation Variables that matter and Chapter 8 brings these numbers to life. Chapter 9 explains the critical issue of Price of a Stock versus the Value of the Company. Chapter 10 examines our own psychological biases. Then, in Chapter 11, Charles Mizrahi summarizes the essence of the Graham-Dodd-Buffett-Munger style of equity value investing.

While everyone may take a little different approach to measuring both quantitative and qualitative value; in my view, each of these eleven chapters delivers something especially valuable to the reader. They help to get us closer to the real "intrinsic value" of a business. When Charles first told me of his project to write an introductory book on Value Investing for the Wiley investment series that is based on the Warren Buffett value approach to stock investing, I challenged him to swing for the fences and cleverly twist it into a book that could yield enduring value like Ben Graham's classic, The Intelligent Investor.

I think that this book delivers because it gives us useful and valuable information in each chapter. The Mizrahi kids should be proud of what their dad has crafted. This book should be in every library. Since "Getting Started in Value Investing" delivers sound investing principles, and it is written in a clear paternal style, it has a good chance of becoming a bestseller. Charles Mizrahi clearly explains the core of the Graham-Dodd-Buffett-Munger style of equity value investing.

Since "Getting Started in Value Investing" delivers sound investing principles, and it is written in a clear paternal style, it has a good chance of becoming a bestseller. Charles Mizrahi clearly explains the core of the Graham-Dodd-Buffett-Munger style of equity value investing.

Why did Buffett and BRK buy stock in Kraft ?

Why did Buffett and BRK buy stock in Kraft ? Let's examine the reasons together.Brands? Costs Controls? Expanding Markets? Share Buybacks? Irene Rosenfeld?

Berkshire Hathaway, bought more than 132 million shares of food company Kraft, according to a document filed with the Securities and Exchange Commission Thursday. Kraft Foods Inc. (KFT), through its subsidiaries, is engaged in the manufacture and sale of packaged foods and beverages in the United States, Canada, Europe, Latin America, Asia Pacific, the Middle East and Africa. The Company manufactures and markets packaged food products, consisting principally of beverages, cheese, snacks, convenient meals and various packaged grocery products. The Company operates in two segments: Kraft North America Commercial and Kraft International Commercial. It has operations in 72 countries and sells its products in more than 155 countries.

Kraft Foods, KFT has a (5-year annual average) net income growth rate of negative 4.71 . The company is looking forward to a 7-9% forward growth rate. What competitive advantages does it have? Brand, Technology, Cost of Production, Distribution Network? Are possible advantages sustainable? It's current market price is 29.31

The estimated Intrinsic Value, using an assumed 7% forward growth rate, is 43.39 per share from ValuePro.net, and this may or may not indicate a bargain of 14 dollars. Is it a possible Value Trap? If the 7% growth assumptions used in estimating the Intrinsic Value are accurate and sustainable, this may or may not indicate a price-to-value ratio of .67 , and a possible margin of safety of 33 percent in a good company with good brands selling at a fair price.

The current price/earnings ratio = 18.2 It's current return on capital = 5.41 Using a debt to equity ratio of .77, Kraft Foods shows a current return on equity = 9.32 Some industries have higher ROE because they require no assets, such as consulting firms. Other industries require large infrastructure builds before they generate a penny of profit, such as oil refiners. You cannot conclude that consulting firms are better investments than refiners just because of their ROE.

Generally, capital-intensive businesses have high barriers to entry, which limit competition. But high-ROE firms with small asset bases have lower barriers to entry. Thus, such firms face more business risk because competitors can replicate their success without having to obtain much outside funding. Automatic Warning, ( above 0.5 ) on this current debt to equity level of .77

From 2007 excerpts, the company expects that revenue will grow 3% to 4% on an organic basis in 2008 and that "we'll hit our stride" by 2009, said Chief Executive Irene Rosenfeld in a written release. "We'll fully realize the financial benefits of our investments and deliver our long-term targets of at least 4% organic net revenue growth and 7% to 9% EPS growth." In addition to "rewiring" the company, Rosenfeld said Kraft intends to "reframe" its product categories to make them more relevant to consumers, to better exploit its sales abilities and to drive down costs.

One key is to expand the focus in larger, faster-growing categories. As an example, Rosenfeld cited moving away from dying sectors like processed cheese slices and into sandwich, snacking and high-end cheeses. Also important is grabbing market share away from restaurants, she said, vowing that Kraft will strive to provide "restaurant-quality food at home in the office or anywhere ... at a fraction of the cost." Frozen pizza's a case in point. With brands like Jacks' and Tombstone, Kraft has long been a major player in the $4 billion category. Then, about 10 years ago it went after the $11 billion chain business with higher-end offerings like DiGiorno. And now, Rosenfeld said, "we are setting our sights on the $20 billion local pizzeria" category.

Does Kraft Foods make for an intelligent investment or speculation today? Time is said to be the friend of the wonderful company and the enemy of the mediocre one. Before making an investment decision, seek understanding about the company, its products, and its sustainable competitive advantages over competitors. Next, look for able and trustworthy managers who are focused more on value than just growth.

Finally ask: Is there a bargain relative to its intrinsic value per share today? In terms of Opportunity Cost, is KFT the best place to invest your money today? I do not know enough about KFT, but, I am open to talking and discussing Kraft.

Buffett Answers Questions

Bank of America

Why did Buffett and BRK buy 8,700,000 shares of BAC between $48.34 - $50.14 per share?

BAC also buying Countrywide Financial. While Countrywide reported one in three of its subprime mortgages were delinquent at the end of 2007, and the company lost $422 million in the fourth quarter, BofA chief executive officer Kenneth Lewis has said Countrywide's financial results were consistent with the bank's due diligence and agreed-upon purchase price of $4 billion. The purchase will make Charlotte, N.C.-based BofA (NYSE: BAC) the nation's largest mortgage lender and loan servicer. The deal is slated to close in the third quarter.

Perhaps, my generated report below will also help you better understand this purchase.

Bank of America Corporation (Bank of America) is a bank holding company. Bank of America provides a range of banking and non-banking financial services and products through three business segments: Global Consumer and Small Business Banking, Global Corporate and Investment Banking, and Global Wealth and Investment Management. In December 2006, the Company sold its retail and commercial business in Hong Kong and Macau (Asia Commercial Banking business) to China Construction Bank. In October 2006, BentleyForbes, a commercial real estate investment and operations company, acquired Bank of America Plaza in Atlanta from CSC Associates, a partnership of Cousins Properties Incorporated and the Company. In June 2007, the Company acquired the reverse mortgage business of Seattle Mortgage Company, an indirect subsidiary of Seattle Financial Group, Inc.

Bank of America, BAC has a (5-year annual average) net income growth rate of 9.87 . What competitive advantages does it have? Brand, Technology, Cost of Production, Distribution Network? Are possible advantages sustainable? Does BAC have a solid mix of Product, Pricing Power, Placement, and Promotions? When buying companies or common stocks, look for understandable first-class businesses, with enduring competitive advantages, accompanied by first-class managements.

BAC has a current market price is 38.84 Using an assumed growth rate of 7 percent, the estimated Intrinsic Value is 92.89 per share from ValuePro.net, and this may or may not indicate a bargain of 54 dollars. Is it a possible Value Trap? If the growth assumptions used in estimating the Intrinsic Value are accurate and sustainable, this may or may not indicate a price-to-value ratio of .42 , and a possible margin of safety of 58 percent.

The current price/earnings ratio = 12.It's current return on capital = UnavailableUsing a debt to equity ratio of 4.16, Bank of America shows a current return on equity = 10.8

Some industries have higher ROE because they require no assets, such as consulting firms. Other industries require large infrastructure builds before they generate a penny of profit, such as oil refiners. Generally, capital-intensive businesses have higher barriers to entry, which limit competition. But, high-ROE firms with small asset bases have lower barriers to entry. Thus, such firms face more business risk because competitors can replicate their success without having to obtain much outside funding. Growth benefits investors only when the business in point can invest at incremental returns that are enticing; only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor. The wonderful companies sustain a competitive advantage, produce free cash flow, and use debt wisely.

Automatic Warning, ( above 0.5 ) on this current debt to equity level of 4.16

Does Bank of America make for an intelligent investment or speculation today? Time is said to be the friend of the wonderful company and the enemy of the mediocre one. Before making an investment decision, seek understanding about the company, its products, and its sustainable competitive advantages over competitors. Next, look for able and trustworthy managers who are focused more on value than just growth. Finally ask: Is there a bargain relative to its intrinsic value per share today? Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misapraised. In terms of Opportunity Cost, is BAC the best place to invest our money today?

What about growth in Free Cash Flow?
Excerpts, comments, and news items: http://finance.yahoo.com/q/h?s=BAC

Portions of this report are generated in budlab software on 08-03-03 . Budlab software was designed to help me produce a report that emphasizes conservativism and rationality when making an investment decision.