vinod1

The moat of the consumer packaged goods (CPG) companies is being weakened due to many technological changes. For one, entry barriers for new firms has been lowered. Now it is easy for a company to do many of the basic functions: 1) Easy to startup a new company with low capital. Use AWS for your IT infrastructure. Outsource manufacturing to a Chinese company. 2) Lower cost to promote the company. Use YouTube to distribute the video at low cost. Use Facebook to promote the product. 3) Sell directly online. These small companies have much lower cost structures. What this does is enable small companies to develop either niche products or lower cost products and strip away users from the big CPG companies at the margins. Some of these niche products might even make it big. A second factor is that at least in developed countries, there is little quality difference between many of the branded CPG products and generic store label products. These factors are going to be a headwind for the CPG companies. This is what I think is happening to P&G as well. Vinod

Not using paper anymore. Organize folders by Sector and then sub-sectors and then one folder per company. I use specific naming conventions for folders and documents and it makes it easy to get to what I am looking for. Each company folder has 1) A valuation document that follows a template. I update it periodically. 2) A "Notes" document where I gather all the notes about the company. 3) A "Conf Call" document where I copy paste important parts of quarterly conference call transcripts. 4) Sometimes, if there is data that I need to analyze, then I have a "Data" excel spreadsheet. 5) A Data folder where I put all the documents I gather about the company. This is sometimes broken down into subsections. Have a google spreadsheet of key things about all the companies I track organized into "Compounders", "Wide Moat", "Low Quality". This is mainly for me to check daily to see if anything is in the buy range. Have an Investment Dairy where I document what I researched, what I bought or sold, my rationale, etc. Vinod

Thanks KCLarkin for the excellent analysis. Broadly, the way I am thinking about this, is that technology is eroding the competitive advantage of many of these businesses. To be viable businesses, they must be providing a compelling value proposition to the customers. In retail that means (a) price (b) convenience and © selection. The most important of these is price. If a business can consistently deliver on low prices, it is highlly likely to be a viable business. Coming to Best Buy. To me the main reason for the successful turnaround has been the introduction of "Low Price Guarantee". Of course, to deliver on this they have to do lot of heavy lifting in terms of store redesign, productivity improvements, etc. So one way of generalizing this to other businesses is to ask the question: Can the business offer a low price guarantee or something close to that? Or does it rely on some friction or gimmick to make the customer pay a higher price? Others factors might be more important in some cases. Say parts availability for auto retailers. But even in this case, I think they cannot just get away with charging high prices like they do now. Vinod

I think where I'm not following is that you are willing to pay for the float. If Berkshire has it and you would buy the float for face value, then not only is the float not a liability for Berkshire, it is an asset (since they can sell it). Thus, the logic seems to me to tilt to more than calling the float zero liability. My thought experiment is not very "thoughtfull" :) I mean it more as discounting the liability that is going to be paid out over a very long time. Vinod

This would only add about $90 billion in float value which the float amount at end of 2016. Part of this float value shows up in the goodwill so you have to account for that. Part is always held in cash equivalents always. This part would not have full face value. If you make these adjustments, I think the market is valuing BRK in this manner, at least implicitly from the P/BV multiple. When you estimate value of BRK from various methods they tend to cluster together closely. So float based valuation does not radically increase BRK valuation. Vinod Perhaps I'm being dense here, but if we take $90 billion in float liability and then call it $50 billion in asset (after your adjustments above), it would have well over $100 billion effect in value change from book value, wouldn't it? In other words, it isn't just discounting it as a liability if you would be willing to pay someone to get it, so it seems like it would be a big swing. I probably did not explain well. Float can be considered as equivalent to debt. Unlike debt, however, float is never really paid back unless the company liquidates or shrinks its insurance business. So we are discounting the debt to a near zero value. Not adding another asset. Vinod

This would only add about $90 billion in float value which the float amount at end of 2016. Part of this float value shows up in the goodwill so you have to account for that. Part is always held in cash equivalents always. This part would not have full face value. If you make these adjustments, I think the market is valuing BRK in this manner, at least implicitly from the P/BV multiple. When you estimate value of BRK from various methods they tend to cluster together closely. So float based valuation does not radically increase BRK valuation. Vinod

To put it more concisely, if you are given $100 today and every year going forward you would be given another $3 to $4 for the next 100 years with the caveat that you might also have to give back $3 to $5 once every 10 years (to simulate underwriting loss), what would you pay for that privilege? I would pay $100 for that. Note that, you would get that $100 back immediately to be paid back in 100 years. Vinod

“[if] I were offered $7 billion for [$7 billion of] float and did not have to pay tax on the gain, but would thereafter have to stay out of the insurance business forever—a perpetual noncompete in any kind of insurance—would I accept that? The answer is no. That’s not because I’d rather have $7 billion of float than have $7 billion of free money. It’s because I expect the $7 billion to grow.” —Warren Buffett, 1996 Annual Shareholders’ Meeting, as quoted in Outstanding Investor Digest. “If you could see our float for the next 20 years and you could make an estimate as to the amount and the cost of it, and you took the difference between its cost and the returns available on governments, you could discount it back to a net present value.” —Warren Buffett, 1992 Annual Shareholders’ Meeting, as quoted in Outstanding Investor Digest. I wrote up BRK in 2010, here is the extract related to the float valuation: The key question concerns the value of float. Float is money an insurance company holds but does not own. Float arises because premiums are received before losses are paid and this interval can be of several years. During this interval, the insurer can invest the money for its own gain. The premiums are often not sufficient to cover all the costs and insurance company has to part with some of the returns generated out of float to make up for the shortfall. To get an understanding of the theoretical basis for assigning value to float, let us take an example. Assume you are offered the following proposition: You are offered $100 to be paid back after the end of 50 years. You do not have to pay any interest and also get to keep all the money earned in the interim from investing the $100. The only restriction is that you can only invest in high quality investment grade bonds and treasuries. How much would a smart business man be willing to pay for such an offer? If you can estimate the market rates of interest for long term bonds are going to be about 4% then the business man should be willing to pay about $86. (The business man can invest $14 at 4% for the 50 year period to end up with $100.) Of course, the business man would not go through the trouble of investing to end up with no profit so he is going to offer something a little lower to make relatively low risk profit. Insurance float for Berkshire is a lot like this example with few additional benefits. First, the $100 amount is likely to grow around the nominal GDP growth rate of 4-5%. Second, as long as the business is not wound up there is no need to pay back the $100. The effective length of the investment is longer than 50 years. Third, there is a strong possibility of getting paid something like 1-2% for the privilege of holding the money. So what would a business man offered this proposition pay for this? It should be obvious that it would be at least $100 without even performing any complicated math. A conservative value of this float can be calculated mathematically with a few assumptions. Assuming no growth in float in the future; that float earns at the treasury bond rate (4%); discounted at the treasury bond rate; and that the insurance segment would not liquidated in the foreseeable future; the present value of the float is simply the amount of float i.e. $100 using the constant growth dividend model. There are two caveats to this calculation of the value of float. (1) Shareholder incurs an additional cost for the float through an insurer due to tax penalty. This cost has been estimated at around 1% by Buffett. (2) There is uncertainty in the true cost of float as it a near certainty that there would be periods of underwriting losses. Both these complications however should not alter the final value in the above calculation as it would be possible to conservatively earn enough above the Treasury bond rate on the float to mitigate this additional cost. Vinod

In the annual meeting he elaborated on this. Why did Buffett advise his wife to invest in index funds versus into Berkshire Hathaway? She won’t be selling to buy an index fund - every single share of Berkshire Hathaway will be going to philanthropy - so far 40% has been distributed - for someone who’s not an investment professional, what’s the best investment where there’s less worry than anything - big thing is money to not be a problem – there’s no way that there will be an issue absent a nuclear attack if she invested in the S&P; Buffett’s aunt Katy, whose husband used to employ Charlie and Warren, worked all her life and died at 97 with a few hundred million dollars, because she was in Berkshire Hathaway. She’d write Buffett and say she hated to be a bother but was curious if she would ever run out of money. Buffett told her that she’d run out only if she lived 986 more years. There will be people who come around with various suggestions on what to do with the money he leaves his wife, and there’s a chance she won’t have as much peace of mind only owning one stock as owning the index. Vinod

Agreed. Lots of gems throughout. I really liked his description of failure of cleantech companies that is applicable in general: Most cleantech companies crashed because they neglected one or more of the seven questions that every business must answer: 1. The Engineering Question Can you create breakthrough technology instead of incremental improvements? A great technology company should have proprietary technology an order of magnitude better than its nearest substitute. 2. The Timing Question Is now the right time to start your particular business? 3. The Monopoly Question Are you starting with a big share of a small market? Customers won’t care about any particular technology unless it solves a particular problem in a superior way. And if you can’t monopolize a unique solution for a small market, you’ll be stuck with vicious competition. But what if the U.S. solar energy market isn’t the relevant market? They would rhetorically shrink their market in order to seem differentiated, only to turn around and ask to be valued based on huge, supposedly lucrative markets. 4. The People Question Do you have the right team? You’d be wrong: the ones that failed were run by shockingly nontechnical teams. These salesman-executives were good at raising capital and securing government subsidies, but they were less good at building products that customers wanted to buy. 5. The Distribution Question Do you have a way to not just create but deliver your product? 6. The Durability Question Will your market position be defensible 10 and 20 years into the future? Every entrepreneur should plan to be the last mover in her particular market. That starts with asking yourself: what will the world look like 10 and 20 years from now, and how will my business fit in? Cleantech entrepreneurs would have done well to rephrase the durability question and ask: what will stop China from wiping out my business? Without an answer, the result shouldn’t have come as a surprise. 7. The Secret Question Have you identified a unique opportunity that others don’t see? Every cleantech company justified itself with conventional truths about the need for a cleaner world. They deluded themselves into believing that an overwhelming social need for alternative energy solutions implied an overwhelming business opportunity for cleantech companies of all kinds. Each of the casualties had described their bright futures using broad conventions on which everybody agreed. Great companies have secrets: specific reasons for success that other people don’t see. We’ve discussed these elements before. Whatever your industry, any great business plan must address every one of them. If you don’t have good answers to these questions, you’ll run into lots of “bad luck” and your business will fail. If you nail all seven, you’ll master fortune and succeed. Even getting five or six correct might work. The 1990s had one big idea: the internet is going to be big. But too many internet companies had exactly that same idea and no others. An entrepreneur can’t benefit from macro-scale insight unless his own plans begin at the micro-scale. Cleantech companies faced the same problem: no matter how much the world needs energy, only a firm that offers a superior solution for a specific energy problem can make money. No sector will ever be so important that merely participating in it will be enough to build a great company. Vinod

As others have mentioned, the degree to which you pay attention depends on the situation. For example in Valeant, the proxy for one of the years talked about how the CEO specifically asked for a performance hurdle for a 60% increase in adjusted cash earnings or whatever they used to call their earnings. I thought it is one of the most useful pieces of info providing insight into the CEO's personality and how aggressive they are. Vinod

That's a little harsh. Anyways I can think of examples, I was just hoping DYOW would give me more of them. Related party transactions comes to mind...where they give some loan to an executive with overly generous terms. Stock option grants where they lower the exercise price because the stock does badly. This all gives an indication that management is not to be trusted. In the Multibagger speculative thread, valcont brought up the fact that the fulcrum debt on Bri-Chem had an interest rate of 21%. I probably would not have caught that. So my checklist would be: 1) Check terms of the debt, interest rate, maturity, convenants, currency of debt vs currency of revenue 2) Compensation, option grants and related party transactions. Anyways to dyow I would say that if you are going to read all the disclosures you should be investing a great deal of time/money/effort into XBRL and much better visualizations. A good XBRL tool could show you all the related party transactions by date side by side or the MD&A by year on a single page. This would be order of magnitude more powerful than reading the disclosures as documents. The disclosures will be much more powerful if you can compare them across multiple years and you have a search engine that can quickly find information. Technology is your friend. Come on! I was just trying to prod dyow to post an example to prove me wrong. Thank you for the examples. dyow - I sincerely apologize. I am very curious to see any examples. Hope you can share some. Vinod

I mostly do this. Great. Do you have examples...more is better. No. Examples or evidence won't change your mind, you will block it out and look for evidence that aligns with your view. A bunch of bullshit. You do not have an example to share.

Many differences with the Great Depression. The dividend yield on Dow I think is in double digits at its lows at that time. So at a 4% withdrawal at that time you are actually investing more into the market at its lows. Vinod

I think that's excessive. 1.5 M for just living? A 4% return on 1.5M will give you 60K a year without touching principle. Social Security will kick in another 30k. Maybe in some cases one would also get some sort of pension from the employer. Assuming you have your house paid off, 90k per year just for living expenses excluding healthcare? Then on top of that 1-1.5M for healthcare? I don't know exactly how expensive services are in the US but again it the amount seems large considering that you have Medicare and Medicare-D coverage. I'm sure some people do use the amounts you've stated but that's definitely not how much you would "need". Further proof is that few people in the US have those kinds of amounts when they retire and somehow they manage to live. I'm not gonna argue with you or Liberty. I fully expected the responses (especially the one from Liberty). Have fun. Just couple notes: - 4% is risky as I said - Social security is nearly BK. I would not expect anything from it - There are no pensions from employers - Medicare is mostly a joke, does not cover a lot of things, and also possibly BK 50M is a good goal. Might not cover all basics though. Gotta go start working on it, you guys can continue the thread. ::) +1 I tend to agree with Jurgis, but there is no mention of the age at which retirement is being planned. A $1 million portfolio at age 70 is going to be quite different from $1 million at age 40. - There is a thing called "Volatility Drag". Which means that you cannot withdraw at your expected rate of return. So if your portfolio returns 5% annually, you cannot withdraw 5% without eating into your principal. This drag depends upon the volatility experienced and ranges from 1% for a 60/40 stock/bond portfolio to nearly 2% for an all stock portfolio. - We are exposed to very asymmetrical risk in retirement. Running out of money at age 80 is so much more horrible than working a few more years in your 30s or 40s. So it makes sense to have a very large margin of safety in your portfolio. - You are more likely to underestimate your actual costs for several reasons - anyone who has run a business or overseen projects would know this. So you need some buffer beyond what you think you need. Any surprises to expenses are likely to be negative rather than positive. Vinod

SD, You have a wonderful way of looking at the broader picture. Invariably I have to re-read your posts - because they are packed with wisdom. Vinod

Really terrific posts BG. Really appreciate sharing all the details. Very informative and eye opening for me. Thank you! Vinod

I think the dominant factor is the increase in number and size of competitively advantaged companies. If there were no competitively advantaged firms, lower interest rates would not have much impact on profit margins, because they would be competed away and the benefits passed on to consumers. Think retailers as an example. Profit margins have been high even before the 2008 crisis, when the economy is robust and employment levels are very high. So your argument that a stagnating economy leading to employees not demanding high wages contributing to higher margins does not hold water. Vinod

http://www.berkshirehathaway.com/letters/2016ltr.pdf

You say, Trump's policies might cause a depression. A depression!! But somehow a depression would only cause a garden variety stock market correction of 20-30%. I do not think depression means what you think it means. Vinod Perhaps I did not write clearly enough. A depression - causing a 90% drawdown - is what they have been hedging against. Trump's deregulatory policies reduce this risk. However they still see clear risks. One is that Trump's protectionist policies cause a depression. Another is a 20-30% drawdown in the normal course of business (i.e. not in a depression). This is my reading of what they said on the call. This comment was in response to the idea that since Trump they do not see risks. They do. That is why they are at high cash levels and duration down to 1. With that positioning, they no longer need the hedges. I am just dumbfounded. I had a rule before: Never debate with a Trump supporter. Now I am going to add one more: Never debate with a Fairfax diehard. Vinod

No it is not. There is difference between "hedging" and "insurance". Vinod

You say, Trump's policies might cause a depression. A depression!! But somehow a depression would only cause a garden variety stock market correction of 20-30%. I do not think depression means what you think it means. Vinod

Prem is a genuinely nice guy. I like him. I learned a lot from him and Fairfax has been a very profitable investment for me. So I am rooting for him and Fairfax. I have been critical of him but that is because I hold him in higher regard that the vast majority of the other CEO's. All I am asking is a bit of consistency and respect for the intelligence of its shareholder base. I understand that Fairfax had much success in the past by taking a point of view about the future, presenting pretty good reasons for that and optimizing the portfolio to take advantage of it. Just admit that this time it did not work out. That is the nature of macro bets. This inability to admit to mistakes has been a recurring theme the past few years on other things as well. Vinod

Included in realized losses in 2016 was a loss of $2,663.9 million realized in the fourth quarter when the company, recognizing fundamental changes in the U.S. which obviated the need for defensive equity hedges, discontinued its economic equity hedging strategy, closing all of its short positions in the Russell 2000, S&P 500 and S&P/TSX 60 equity indexes effected through total return swaps. Donald Trump wins, Tails risks, 1 in 100 year storms, all vanish!! Debt deleveraging? All done. "worried about the speculation in financial markets and the potential for a 50-100 year financial storm"? No more. "However, we have warned you many times in our Annual Reports of the many risks that we see and the great disconnect between the markets and the economic fundamentals." No more. "Most investors consider the 2008/2009 recession and crash to be a once in a generation event – and it’s over! We differ because we think we escaped the serious adverse consequences of that recession as a result of huge fiscal stimulus from the U.S., even greater fiscal stimulus from China and the reduction in interest rates to 0% with massive monetary stimulus in the U.S., Europe and Japan through QE programs. There is nothing to fall back on now if the U.S. and Europe slip back into recession." Now we have Trump! "The potential for unintended consequences, and therefore of pain, is huge." There can be no pain with Trump as president. Vinod

If the goal is diversification, then making sure that he has all the right asset classes like large cap, small cap, developed markets, emerging markets, REIT's, etc. have a much larger impact than selecting a single stock to add to an already diversified portfolio. Also this suggests that he is likely not too interested or inclined to put in the effort to study inddividual stocks, so it would be far better to avoid picking stocks. A single stock exposes him to many risks that I think he might not be prepared for - a temporary downturn in its prospects, or some such factor that depresses its price, not knowing the rationale for the stock, he is likely to panic or make a poor decision. Just adding one stock, does not add much to returns but exposes him to all the other psychological issues associated with owning an individual company. If he wants to invest in individual stocks, let him do it in a more systematic way with a group of stocks. The very best thing he can do is to focus on expenses which is likely to do a lot more than any individual stock can. Vinod