vinod1

I envy you guys. I was at Busch Gardens today and yet managed to miss the excitement. JPM at $50! I am pissed. Vinod

This is probably a basic question to most of you. Trying to understand everything slows me down a lot in trying to figure how these stuff works. How did he get $6000? Is 10 percent cost of capital the same as the DCF discount rate in this case? Yes. Cost of capital is essentially the same as discount rate or required return. Cost of capital is from the company perspective while discount rate or required return is from investors point of view. Assuming all equity funding, they become one and the same. So $600/0.1 = $6000 Vinod

US Bancorp, M&T Bank, Credit Acceptance Corporation, Wintrust, Glacier Bancorp, JP Morgan - if you are interested in the banking industry these are must reads. Vinod

This would be too difficult to predict as there are going to be lot of 2nd order and 3rd order effects. When we have a true driverless car, it might actually increase car usage very significantly - Segments of populations that cannot drive a car (handicapped, older citizens, cannot get a driver's license, etc) would now be able to use them. - People would be more inclined to use them to drive long distances commuting to work, etc as they can be working in the car - Cars could take some of the market share away from public transport, airlines, etc as it would be more convienent The impact would also depend upon how the regulation would evolve and it might favor one industry over another. VInod

Most of my favorite books on valuation are mentioned above. The books mentioned above cater to different sets of needs and provide different perspectives. Damodaran's investment valuation is most comparable to McKinsey's book, in that they do a deep dive on the minutia of valuation. Except for the part about using beta to estimate required returns, it is useful to know almost all the other facets of valuation covered in these books. You might not actually make LIFO to FIFO adjustments or currency translation adjustments in real world valuation - it is one thing to know how these are impacting the financial statements and consciously ignore them for simplification and not knowing what is going on and if it is a positive or negative or if these effects cancel out over the long term. Even if you end up just using multiples, knowing the underlying assumptions behind them helps you to think more clearly. I found out I had been abusing the DCF method before I read Damodaran's book in depth - one of many many but this is most glaring. I personally liked Damodaran's book much better than McKinsey. Perhaps because I started with Damodaran's book and breezed through McKinsey as they cover very very similar material with a slightly different terminology. I also like Jeffrey Hooke's book and Greenwald a lot. They provide a completely different perpective, Hooke's a high level overview and how to value different types of businesses using industry specific methods. Greenwald comes about from a completely different angle based on moat vs. no moat and reinvestment opportunity. I think reading Damodaran or McKinsey's book and both Hooke's and Greenwald provides a nearly comprehensive valuation toolkit for investors. Vinod

I think Sequoia is probably the best proxy for the quality approach. +1 Sequoia is the best proxy for quality (identified both quantitatively and qualitatively) along with a concentrated portfolio and with a large dose of common sense. Quality without concentration or common sense - Jensen Fund Quality indexing (quantitatively driven) without concentration - GMO Quality Vinod

Hi longinvestor, Does this mean that your estimate of IV for BRK is 2.4x BV? Just curious, I have never been able to justify much above 2x BV even in my most optimistic scenario. Thanks Vinod Thanks! I'm not the numbers type, yet indulged because of boredom that comes with owning BRK. Playing around with assumptions (discount rate, owner earnings etc.), my IV range is between $240,000 and $340,000. The big range supports my vaguely correct posture and I'm comfortable with it. While I may be over optimistic, the market continues to under estimate BRK as the norm. Been buying more. While on the subject, I've seen many calculators / calculations using two columns, using DCF etc. But not much discussed about the "third (more subjective) element" which deals with the efficacy with which retained earnings will be deployed. WEB covers this on page 123-124 of the AR. Your thoughts on this? After all, retained earnings is the story of Berkshire since 2009. Curious as to your take on this. Thanks I think Buffett is happy to deploy capital when he can get a very high probability of 10% returns. His investments - WFC, IBM, Capex at Utilities, his various preferred investments, etc - all indicate he is happy with 10%. He might get a chance on occasion to deploy capital at higher rates but they are going to be only a few such opportunities. Some of the internal reinvestment opportunities are going to be at higher rates and he is going to pay premiums for new businesses that generate high ROIC or ROE. But I think all in all, a 10% return on retained earnings is what we can expect. So that is my estimate for "efficacy with which retained earnings will be deployed". IMO - For the really small subset of very high quality companies like Berkshire, Coke, Walmart, etc. it is more useful to estimate the growth rate of IV rather than focusing on IV itself. This would allow you to estimate what returns you are likely to get over the very long term if you just hold this investment. This way you avoid the most speculative component of valuation - changes in multiples. Vinod If IV is made up of 1. Investments/share + 2. Operating Earnings per share + 3. Incremental return on Retained Earnings Readily Calculable 1) = $140,000 2) = 10x $11,000 = $121,000 Efficacy of RE deployed - estimate of future 3) = NPV of incremental earnings from RE= $81,000 How I get to this: RE for 2012-13-14: $14B, $20B, $20B; If we held RE constant at $20B for the next 20 years (WEB has stated this "as far as the eye can see") and the retained earnings start producing a 10% return 3 years out; 10% Discount rate So 1+2+3 = $342,000; There's my 2.4x BV. Conservative enough? If you ask me, they will retain far more than what I'm assuming, earn better than 10%. Agree with you, they look for a near certain 10% return; The retained earnings is of growing significance just by sheer magnitude. A standout comment by Munger in his commentary, "BRK will do fine without ever making another acquisition" perhaps has this baked in. IMO, the multiple you put on #2 is based on "the efficacy with which retained earnings will be deployed". If you do it this way, in effect you are saying a $1 of operating earnings are worth about 27.4 times. So you are putting a PE multiple of 27.4 $121,000 + $81,000 = $202,000 value for operating businesses. These are earning pre-tax about $11,000. At a 33% tax rate, after tax earnings are $7370. PE multiple = 202,000/7370 = 27.4 You would certainly be able to justify these depending on your assumptions about expected returns, required return, retention and length of the period where expected returns exceed required returns. But to me they would not be conservative. But again, that would just be me and I have a tendency to be very conservative in my estimates. Vinod

10% after leverage. Basically ROE. Since they are likely to keep about $30 billion on average in cash and need to pay taxes on capital gains, leverage basically pays for the drag of these two. So we end up with ROE of about 10% Vinod.

Hi longinvestor, Does this mean that your estimate of IV for BRK is 2.4x BV? Just curious, I have never been able to justify much above 2x BV even in my most optimistic scenario. Thanks Vinod Thanks! I'm not the numbers type, yet indulged because of boredom that comes with owning BRK. Playing around with assumptions (discount rate, owner earnings etc.), my IV range is between $240,000 and $340,000. The big range supports my vaguely correct posture and I'm comfortable with it. While I may be over optimistic, the market continues to under estimate BRK as the norm. Been buying more. While on the subject, I've seen many calculators / calculations using two columns, using DCF etc. But not much discussed about the "third (more subjective) element" which deals with the efficacy with which retained earnings will be deployed. WEB covers this on page 123-124 of the AR. Your thoughts on this? After all, retained earnings is the story of Berkshire since 2009. Curious as to your take on this. Thanks I think Buffett is happy to deploy capital when he can get a very high probability of 10% returns. His investments - WFC, IBM, Capex at Utilities, his various preferred investments, etc - all indicate he is happy with 10%. He might get a chance on occasion to deploy capital at higher rates but they are going to be only a few such opportunities. Some of the internal reinvestment opportunities are going to be at higher rates and he is going to pay premiums for new businesses that generate high ROIC or ROE. But I think all in all, a 10% return on retained earnings is what we can expect. So that is my estimate for "efficacy with which retained earnings will be deployed". IMO - For the really small subset of very high quality companies like Berkshire, Coke, Walmart, etc. it is more useful to estimate the growth rate of IV rather than focusing on IV itself. This would allow you to estimate what returns you are likely to get over the very long term if you just hold this investment. This way you avoid the most speculative component of valuation - changes in multiples. Vinod

Hi longinvestor, Does this mean that your estimate of IV for BRK is 2.4x BV? Just curious, I have never been able to justify much above 2x BV even in my most optimistic scenario. Thanks Vinod Thanks! I'm not the numbers type, yet indulged because of boredom that comes with owning BRK. Playing around with assumptions (discount rate, owner earnings etc.), my IV range is between $240,000 and $340,000. The big range supports my vaguely correct posture and I'm comfortable with it. While I may be over optimistic, the market continues to under estimate BRK as the norm. Been buying more.

Hi longinvestor, Does this mean that your estimate of IV for BRK is 2.4x BV? Just curious, I have never been able to justify much above 2x BV even in my most optimistic scenario. Thanks Vinod

I wouldn’t call it “a very specific view of the future”… That imo is a fact! ;) Instead, how big banks are going to do very fine, if interest rates stay low and asset prices deflate, is more difficult for me to understand… But I admit I don’t follow them closely, and therefore I might be missing something important. Cheers, Gio I was probably not clear. The specific view of the future is the deflation scenario playing out in the next few years. You seem to think that as likely and having that view, I can completely understand why Fairfax would be attractive. As far as big banks are concerned, sure they would not make as much money in a deflation scenario, but they would come our alright. Their capital levels are in the best shape possible, they are furiously reducing expenses, revenues are depressed not just from interest rates but from a lots of other factors, so they have lots of room to do reasonable well come what may. Vinod

Fortunately, we can put together a “portfolio” of investments… And certainly I am not saying FFH is my only investment! But I disagree with your base scenario “because you don’t have any particular view of the world”… Instead, to be invested in big banks you must have a very clear view of how the world is going to be 10 years from now… Because in a deflationary environment big banks will suffer much! I on the contrary own both investments that I think will do well if a muddle through scenario goes on, and an investment in FFH that will do well in case of deflation. In other words, I believe FFH has a place especially in the portfolios of those who claim not to have “any particular view of the world”! ;) Cheers, Gio Gio, I am comfortable enough to hold the big banks under a variety of scenarios. So I really do not have a view on how deflation/inflation plays out in future. I understand portfolio part, but just focusing on Fairfax. I am not saying Fairfax does not make sense for you or someone else who wants part of the portfolio to do well in a deflation scenario sort of like a hedge. All I am saying is, if deflation scenario does not play out, the returns from Fairfax are likely to be unattractive. Since I do not have any particular view of the future, I see no reason to weigh the deflation scenario heavily, as you seem to be doing. You repeatedly point out how Fairfax is going to make billions in a deflation scenario that it gets to deploy when asset prices collapse. That a very specific view of the future. Vinod

I am invested in big banks and smaller positions that span the spectrum - but hardly the owner operator type you are looking. Even these I am slowly reducing my positions as they appreciated, so not super attractive right now. Vinod

Hi Vinod, Imo those are the things anyone can plainly see and agree on. As I have already told you, I think FFH’s overall strategy might be a little less evident: as asset prices will probably deflate at one time during the next 3-5 years, FFH will be best positioned to purchase productive assets very cheaply. Better positioned than anyone else I know of, actually! That might be the beginning of a transformation into a much more diversified conglomerate of high quality businesses, which will more closely resemble what Berkshire is today. If successful, certainly FFH’s stock price doesn’t reflect such a scenario. And personally I don’t know of many businesses with higher opportunities of compounding capital over the next 5-10 years (if the scenario I have described comes to pass, the best case for FFH), nor with a lower risk of permanent loss of capital (if the scenario I have described never materializes, the worst case for FFH). But, please, let me know which businesses you are investing in! So that I might look at them, and better understand what you mean! If I like them, as I have always said, I might decide to sell some FFH to buy those businesses. ;) Cheers, Gio Hi Gio, It could be we differ in our expectations. In a deflation/stock market crash scenario, I fully agree that Fairfax would be a tremendous beneficiary. This seems to be your base case. But what if this does not take place? In such a case, Fairfax would not even be compounding at high single digits. This is my base case since I do not have any particular view of the future. Vinod

It is not a chore at all. I absolutely love reading these books. Just that my interest in them does not seem to correlate very well with how much I retain and how much I actually put into practice. I think we probably differ in how we learn. For me, when I try so summarize when putting it down on paper, it forces me think through more deeply and that is how I learn most effectively. The very act of writing seems to focus my mind much more. Even if I do not read what I have written, I pretty much retain the gist of it when I write. I too assume that even if I do not remember all the details, it is somewhere in the back of my mind and that somehow my thinking improved as a result of reading those books somehow. Vinod

Vinod, I am curious to know the names of the 10 other books. For me, nothing has worked better than interspersed repetition and recall. smd123, My mention of 10 books is not really a fixed set of books. I usually write a short summary, it might even be as little as a one sentence for books that I find there is something that I should incorporate into my thinking or habits. It is on a continuum, "Security Analysis" being at one end where I spent 6 months to drill down the lessons of that book deeply into my day to day practice to "Black Swan" being at sort of the other end where I think the lesson is quite simple and direct ("random, unknownable, and unpredictable shit happens more often than we realize") so not much re-reading required. I would put "The Most Important Thing" by Howard Marks as somewhere in between. With that caveat, here are some books on which I spent quite some time trying to practice what they say 1. Seven habits of highly effective people - lot of it is fluff but it has a few things that have a big impact on me. For example, "begin with the end in mind" is something that I found very useful in making big impact decisions. 2. How to win friends and influence people. 3. Dont sweat the small stuff. 4. Investment Valuation by Damodharan. I think this is absolutely the wrong way to approach investing, but I think knowing the theory really cold and then rejecting it based on specific reasons that you believe in, goes a long way in being a better investor. 5. Understanding Michael Porter. Perhaps the best approach to understanding moats and a companies strategy that I came across. 6. A bunch of books and literature on children's eduction, emotional well being, etc. 7. Value Investing from Graham to Buffett and beyond I think these are the main ones that I spent the most time on. Vinod

Thanks for all the feedback. I am broadly in agreement with most of you and have been practicing many of the suggestions. So it looks like there are no shortcuts. Vinod

I read quite a few books and sometimes I come across a book that I really want to internalize. It could be learning a new skill, incorporating something into a habit, etc. I found that after reading a book, I would remember or practice what it says for maybe a week or two and then it is out of my mind. Even re-reading a few times, does not really seem to make it stick in my mind. The only effective way for me seems to be to prepare a high level summary and just review it daily for a week, then weekly for a little while and after that a couple of times a year. This is quite an intensive process that takes up a bit of time. So I was able to do this only for a few topics (1) Ben Graham Security Analysis - a six month effort (2) Buffett's annual letters and interviews - another 6 month effort (3) Influence and about another 10 books. Some of the books, like "How to read a book" are quite simple to retain since it is just knowing a method and being aware of it. Some like "How to win friends and influence people" are much harder since it involves changing deep rooted habits. I am constantly battling the urge to read a new book versus just re-reading books that I already have or notes that I prepared. How do you internalize books that you find helpful? What did you find most helpful? Vinod

Gio, To me the question is, is the business becoming so much better that the past does not provide a good guide to the future? To me, the answer is no. Fairfax is moving in the right direction to a better more profitable niches of the insurance market and their India investment fund is a good move, but are likely to add 1% to 2% to their ROE. As you mentioned we are looking at different things. I am looking for businesses that are likely to compound at attractive rates over the next 5 to 10 years in the base case with a low chance of permanent loss of capital. Vinod

The way Prem talks about The Great Depression, about being cautious in 1925 and waiting through 1932, suggests he is going to wait a whole lot longer than 2 or 3 years. So I think he is going to stick to deflation camp for a very long time. A couple of years of inflation would seem similar to the way he had to wait for CDS bets to come through. Vinod

bluedevil, It is strange addressing politely with a "devil" tag. :) I did think about this and agree with you to an extent, but the time frame for this to happen might be very far off. Look at the P&C industry history. The industry as a whole generates low ROE. They know they need to underwrite profitably to generate good ROE, but they do not. Industry average CR's have been above 100 for a long time. So why did the industry continue to underwrite at CR above 100 when ROE is poor? Industry structure and incentives pretty much explain why. Buffett has written about this a zillion times. I do agree CR and investment returns are not independent, but it going to take many years before you see some change in underwriting results. Vinod

Vinod was calculating the rate of book value growth. His estimate is 5-12%, with a base case of, call it, 7%. His base case calls for stock market returns of 5% (not unreasonable by any measure). His base case says Fairfax will grow at a greater rate than the market and is therefore "worth" at least book to "the market". What it is worth to frommi or Jurgis or vinod is an entirely different story. What something is worth to the market under reasonable assumptions under today's conditions is different than what something is worth to any one of us with an XX% hurdle. My takeaway from Vinod's thorough analysis is in order to own FFH today, you either must have higher compounding rate expectations (like Gio does, not trying to argue with you Gio, I just know you expect greater things from FFH than 5 or 7%) or pretty low return requirements. I have no strong opinions either way and have never owned FFH. This is exactly what I meant. Thanks for explaining it better than I could. Vinod

Agree. Investment returns are really what would drive book value growth for Fairfax. So you have to ask what rate did they earn in the past? What was their return compared to the relevant benchmark i.e. the value add? What are the benchmarks likely to yield in future? Is the value add likely to be less, more or about same as in the past? This is what I tried to do in this blog post. http://vinodp.com/blog/?p=34 Vinod So following your logic, FFH is worth ~0.7*bv? And every insurance company is worth a lot less than bookvalue because stock and bond returns are lower going forward? :) Assuming stock market returns are going to be 5% and FFH returns 7%, even adjusting for risk, why would it be worth less than book value? Vinod

Agree. Investment returns are really what would drive book value growth for Fairfax. So you have to ask what rate did they earn in the past? What was their return compared to the relevant benchmark i.e. the value add? What are the benchmarks likely to yield in future? Is the value add likely to be less, more or about same as in the past? This is what I tried to do in this blog post. http://vinodp.com/blog/?p=34 Vinod