Thursday, July 26, 2012

Two Good Articles

Two Good Articles

Case Study: Berkshire Hathaway–Avoiding Value Traps

A contributor, Sid Berger, generously provided us with a concise case study. Thank you Sid.
Berkshire Hathaway, Inc. Case Study – Avoiding Value Traps
“All I want to know is where I’m going to die so I’ll never go there.” – Charlie Munger
This article is the first in a series of case studies highlighting mistakes by famous value investors. This concept was unashamedly stolen from Mohnish Pabrai. See here for the article–his-project-to-learn-from-other-successful-investors-includes-comments-on-dell-and-aig.
In 1962, Warren Buffet came across a struggling textile manufacturer named Berkshire Hathaway. By any measure, the company was cheap. He bought shares from 1962-1965 at an average price of $14.86. This price was 22% below its December 31, 1965 net working capital of $19 per share.
It looked like a classic Grahamian purchase of a company for less than liquidation value. Buffett recognized that the business was unexciting but likely to generate a couple of good quarters which would give the stock price a temporary boost. Yet, Buffett let emotion rule and held on to the business and continued to plow more money into it. He finally pulled the plug in 1985.
What was wrong with Buffet’s investment process that led him to make this mistake? Could it have been avoided?
Buffett himself did a great post-mortem analysis in his 1985 letter to shareholders I will draw upon that letter here but will expand upon some of the concepts and highlight their broader applicability.
First off, the company had absolutely no moat. That is, it had no durable competitive advantages such as brand name. To paraphrase Buffet, they couldn’t charge two cents more than their competitors because consumers had to have a Berkshire lining in their suit.
Second, textiles are an industry with no or low barriers to entry. As a result, any capex was simply wasted as all market participants countered with investments of their own. Standing on its own, Berkshire was presented with investment choices that would produce great returns. But, the investments were neutralized by each of the competitors making investments of their own. As Buffet stated, such a situation is like spectators at a parade all standing on their tiptoes to catch a better view – not much is actually accomplished.
Buffet also seems to have missed or at least minimized the threat of low-cost overseas competition. There were non-US textile mills where employees were willing to work for a fraction of Berkshire’s workers. Could Buffet have seen this coming? It’s difficult for me determine as I am not an expert on the textile industry of the mid-Sixties. He does note in his 1985 letter to Berkshire Shareholders that manufacturers in the Southern part of the US were thought to have an advantage over Berkshire because of their non-unionized workforce. So, he was at least aware that labor costs could be an issue.
More broadly, turnarounds seldom turn. Even the most gifted manager will have difficulty turning around a struggling company in a declining industry. As Buffet stated, “When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” Buffet convinced himself that new management could turn around the Berkshire business, but the secular decline in the US textile industry was too much for anyone to defeat.
Also, if you’re producing a commodity, you better be the lowest cost producer. A low-cost structure is a powerful competitive advantage in that it enables a company to generate higher profits that it can reinvest into its business and distance itself from its competition. A low-cost structure also provides a business flexibility to use price as a weapon to take market share, weakening higher cost competitors who must match price and risk potential losses.
The Berkshire episode also contributed to Buffet’s move away from anchoring valuations on the balance sheet. For one thing, appraisals of liquidation value are typically unreliable. Buffet notes that Berkshire’s assets had been acquired for $13 million, had book value (after accelerated depreciation) of $866,000 and had replacement cost of $30-50 million. At auction, they fetched $163,122 gross or less than 0 net of expenses.
What checklist items does this case study produce? 1. Can the company be killed by low-cost overseas competition? 2. Is it a turnaround situation? Is this a mere blip (Amex) or an industry in secular decline (Berkshire)? Will it take large amounts of capex to turn it around? 3. Does the company have a moat? Does the industry have barriers to entry? Does the company have pricing power? 4. If the company produces a commodity, is it the low-cost producer?
Compare Berkshire with a Buffet success, See’s Candy. See’s Candy was a high quality business with durable competitive advantages that needed little capex and drowned in cash flow. Unfortunately, some companies failed to learn these lessons – even in the same industry.
See the Munsingwear case study, There, management continued to reinvest in the textile industry even though it was losing money on every sale.
How do these lessons apply to a company like Dell, which shows up in the portfolios of a lot of prominent value investors? In 2004, IBM sold off its PC division. At the time, the IBM CEO explained that the PC had become commodity-like and returns were unlikely to exceed IBM’s cost of capital. Is the US PC business the 2011 version of the New England textile industry in 1965?

Mohnish Pabrai - His Project To Learn From Other Successful Investors (Includes Comments On Dell And AIG)

At his annual meeting with investors Mohnish described a project he had undertaken to help him improve as an investor. The project was designed to help him learn from the decision making process of successful fund managers: 

"From the period of 2004 to 2010 we scanned all the 13F filings and all the public filings for Davis Funds, Oakmark, Third Avenue, Longleaf, Fairholme, Baupost, Greenlight, ESL, Pershing, Brave Warrior, Oak Value and Wintergreen. If you track the 13F filings quarter after quarter, you can see changes that are made in the portfolios. We looked at where the company added a brand new position in a quarter which wasn't in the 13F last quarter. We then looked at the next quarter to see if there was a change in the number of shares. If the number of shares went up, then we knew they continued buying. In our analysis, we assumed that they were buying evenly throughout the quarter and came up with an average price. This probably isn't reality, they probably had more sporadic buying, but I don't think those deltas are very large. We focused on the investments where the company had completely exited the investment. They held the investment, then at some point they completely sold the investment, and the investment was no longer on the 13F filing. During the 6 year period, we went through and extracted all the data about the gains and losses over all the positions that these funds held. We could clearly see the ones that they made money on. We could also see the ones that they lost money on, and approximately how much money they made or lost. On that list of mistakes, which is a long list of mistakes, we found 363 mistakes." 

In the annual meeting Monish was asked to elaborate further: 

Question: My question is when you went through the checklist analysis looking at the mistakes of these star investors, what were some of the more like common ones or ones where you saw a lot of managers making the same mistake? And then the other part is, I know it's hard to analyze this, but what about mistakes of omission where a lot of investors say those are the big ones. From your insight and your experience what are maybe one or two things that you can think of to help us as investors. 

Answer: Those are good questions. What I'm doing with the checklist doesn't help me on the omission side because we're not able to see those. And maybe the best lessons are on the omission's side. In terms of some of the lessons, one thing I found very strange is when I look at Longleaf Partners whom I respect a lot. They're a great shop, and do great work. And then I see they make an investment in GM. When I see them invest in GM (GM) I'm saying, "Okay, so do they not see that this is unionized? And do they not see that they have no differentiated products? And do they not see that you've got a very bad, labor management relationship?" 

So I'm scratching my head about why would you go into something like GM when you know there's a whole bunch of items where any benefits from that business are unlikely to come to the shareholders. They're more likely to end up with employees and the unions. I listened to their commentary of why they invested in GM and the commentary was about how GM owns the truck business. Toyota doesn't have a place in the truck business and GM owns the truck business and that's so big and so important. 

One of the things I came out with was that sometimes you can look at the trees and miss the forest. I found that in some of these investments that Longleaf was making they would find some glimmers of a great business inside these huge companies. And of course the truck business went to hell because gas prices went up and people stopped buying SUVs and trucks. 

One of the checklist questions that comes out it is that are you missing the forest from the trees? Are you focusing too much on a few trees and not looking at the forest? Another example is with Dell. You know again Longleaf invested in Dell (DELL) and, in fact, they still have Dell. They have not exited their Dell position and they're still very bullish on Dell. One of the changes that came about with Dell was the change from desktops to laptops. When you change from desktop to laptop, you take away the advantage Dell has in assembly. The traditional Dell model was that you place an order, then they start building the computer and they ship it to you. 

Well, with laptops you really can't do that. It doesn't quite work the same way a computer does, and the whole assembly and parts and all that is somewhat different. Then you go to the next step where you're going from desktops to laptops to smart phones. And you go to iPads and that advantage continues to decline. 

Longleaf will say you have to look at their enterprise business, you have to look at their server business, and you have to look at the storage business. Those are doing well, and okay maybe in the end it works out. But count me as a skeptic. What I found is that sometimes there was an emphasis on the trees. Another example is with Davis Funds. 

There was a question asked by one of the investors to Mr. Davis after Hank Greenberg left AIG (AIG). "Is this a meaningful event that this person who built this amazing company is no longer here?" And their response was completely relevant. This is a great set of assets and brand set, and of course one of the problems we know very well with levered financial institutions is that you have to be very careful in how they're run. 

In hindsight what we can see with AIG is clearly no one was minding the store too carefully, where one group in London takes the whole thing down. One of the things I focused on with the checklist was to know what data was visible before the investment was made that would stop you from making the investment. 

The important thing about the checklist is that it's not data that comes out later. It's data that's with you today. So what was visible about AIG is that Hank had left. You can handicap that in whatever way you want to. The second thing that was absolutely clearly visible about AIG is that it's a levered financial institution in insurance and there are very, very few insurance companies that in the long run are decent businesses. I don't know whether that would have been enough to stop it but those are the data points that come out.

I'm still going through and flushing through these. Sometimes when you see these very large losses being made by very smart investors, I find that sometimes they've fixated on the wrong variables. They really should have fixated on some different ones and that would have created maybe a different outcome.

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