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Month: March 2012

Notes – Value Investing: Earnings Power Value (#valueinvesting)

Notes – Value Investing: Earnings Power Value (#valueinvesting)

Notes derived from Chapter 6 of Value Investing: From Graham to Buffett and Beyond

The search for distributable cash flows

The objective of earnings power value (income statement) analysis is to arrive at a reliable estimate of the no-growth average earnings power of the business in terms of cash flows which are free to be distributed to the owners.

The basic steps are as follows:

  1. Start with operating income (EBIT)
  2. Calculate taxes to be paid on operating income
  3. Adjust for one-time charges/gains
  4. Adjust for cyclicality
  5. Adjust for depreciation and amortization
  6. Adjust for maintenance capex
  7. Subtract taxes and interest

Calculating maintenance capex

There is generally a stable relationship within a firm between PP&E (net) and sales volumes.

Maintenance capex can be calculated by taking the ratio of PP&E to sales for each of five years and then taking the average. This is the dollars of PP&E required to support each dollar of sales. This ratio is then multiplied by the growth (or decrease) in sales for the current year to get growth capex. This number is subtracted from total capex and the remaining value is maintenance capex.

Calculating WACC

In order to calculate EPV, you need to be able to calculate the firm’s Weighted Average Cost of Capital, or WACC. You can approximate a WACC through the following steps:

  1. Establish the appropriate ratio between debt and equity financing for the firm.
  2. Estimate the after tax interest costs on the firm’s debt by comparing it with other firms.
  3. Estimate the cost of equity. For value investors not versed in CAPM, the best way to accomplish this is to make assumptions about what a firm would have to offer in returns to attract equity financing by surveying other fund-raisers (such as PE or venture capital firms). Another approach is to estimate total returns (dividends plus projected capital gains) that investors might earn from similar firms.

As the authors state,

The riskier the investment, the higher the cost of capital should be, but to say a great deal more with both confidence and precision is presumptuous.

Another shortcut would be to look at the interest rate on “risk free money” like a US bond and then add an appropriate premium compared to what other firms might be charged (in other words, is the company a better or worse risk than a US bond and if so, is it a little worse, a lot worse, etc.)

One final adjustment is necessary. The EPV assumes full equity financing of the capital structure. It should therefore be adjusted by subtracting the net debt (or adding the net cash) of the firm to the EPV.

Notes – Value Investing: Valuing The Assets (#valueinvesting)

Notes – Value Investing: Valuing The Assets (#valueinvesting)

Notes derived from Chapter 4 of Value Investing: From Graham to Buffett and Beyond

The first step in analyzing a company’s assets (balance sheet) is to determine whether or not it is operating in an economically viable industry. If the industry is in decline, the assets should be valued on a liquidation basis, which assumes that most of the specialized capital goods will be sold for scrap having no other easily-converted use to other businesses. If the industry is stable or growing, assets should be valued based upon their reproduction cost.

Liquidation basis

The following rule-of-thumb discounts should be considered when valuing assets on a liquidation basis:

  • Cash and marketable securities – 100% of value
  • A/R – 85% of value
  • Inventory – 50%- of value; the more commodity-like the inventory, the lower the discount
  • PP&E – 45% of value; RE holdings may sell for more, specialized plant and equipment may sell for substantially less, an appraiser can be hired if this valuation is critical
  • Goodwill – 0% of value; goodwill represents excess over cost paid for acquired businesses and customers, which are unluckily to hold significant value in a dying industry

Often the resulting discounted asset values may result in a deficit for equity holders, especially in light of large amounts of debt in the capital structure. It may even be possible that the debt holders’ claims are in deficit. In this case, the going price of the firm’s debt securities should be compared to this adjusted book value to determine if there is a distressed debt opportunity present.

Going-concern basis

Most businesses analyzed will be looked at as viable going-concerns.

The following are some rule-of-thumb adjustments that should be made for various current asset entries on the balance sheet:

  • Cash and marketable securities – no adjustment, these are assumed to be highly liquid and worth their stated book values
  • A/R – the assumption is that a smaller, start-up competitor might get stuck by its borrowers more often than an established firm, so you can add back in the bad debt allowance, or an average of similar firms
  • Inventory – the average inventory in terms of number of days worth of COGS should be examined against the current inventory; an excess accumulation should be subtracted from the current inventory value on the assumption it is unsaleable; if using LIFO and prices are rising, add back the LIFO reserve because last year’s inventory must be rebuilt at this year’s prices
  • Prepaid expenses – generally require no adjustment as they’re small and realistic
  • Deferred taxes – should be adjusted using a present value calculation if long-term in nature

There are a number of adjustments that may be made to long-term assets, as well:

  • Property/land – land may have been purchased long ago at much lower prices than it is worth today; similarly, land may have been acquired at the height of a recent bubble and its capital value may have since fallen
  • Plant – due to depreciation schedules, real, productive assets with significant economic life or increasing market value may be written down to zero; similarly, the company may have been under-expensing due to inflation; whatever the case, a present competitor would have to pay today’s prices for equivalent plant and the adjusted balance sheet should reflect that
  • Equipment – may be higher or lower and is industry specific
  • Goodwill – arises due to acquisitions of businesses, customers, brands or other intangible items of value; if the acquisition was a poor one, goodwill may be significantly impaired, or worthless; other times, goodwill might be a paltry amount of the total economic value acquired

Recreating hidden assets – R&D, brand images, special licenses

There are many hidden assets that are not found on the balance sheets of most firms but which nonetheless would have to be recreated by their potential competitors and therefore are a real source of value to the company, such as technology created through R&D, brand images or market share-of-mind and/or special licenses or privileges from the government.

  • R&D – the average length of a product cycle can be used as a multiple of average R&D expenses to recreate the “technology asset”
  • SG&A – some multiple of average SG&A expenses, usually 1-3 years worth, are necessary to replicate the brand awareness, book of clients, etc. of an existing firm in the industry
  • License or franchise – look for the price of recent sales of these assets in the market, usually in terms of a “per” number, such as “per subscriber”, “per population”, “per seat”, etc.
  • Subsidiaries – again, look for private market or wholesale transactions, usually in terms of a multiple of cash flow such as EBITDA

 

Review – Value Investing: From Graham To Buffett And Beyond (#valueinvesting)

Review – Value Investing: From Graham To Buffett And Beyond (#valueinvesting)

Value Investing: From Graham to Buffett and Beyond

by Bruce Greenwald, Judd Kahn, Paul Sonkin and Michael van Biena, published 2001

Three valuation approaches

In the world of value investing, there are three essential ways to value a business: studying the balance sheet (asset values), studying the income statement (earnings power) or studying the value of growth.

Greenwald and company recommend using each approach contingent upon the type of company being analyzed.

The asset value (balance sheet) approach

The virtue of balance sheet analysis is that it requires little extrapolation and anticipation of future values as the balance sheet ostensibly represents values which exist today. (Note: technically, for balance sheet values to be accurate they must have a meaningful connection to future cash flows and earnings which can be generated from them, but that is beside the present point.) Additionally, the balance sheet is arranged in such a way that the items at the top are items whose present value as stated on the balance sheet is more certain because they are closer to being converted into cash (or requiring immediate cash payment), whereas those toward the bottom are less certain. The implication here is that companies trading closer to the value of net assets nearer to the top of the balance sheet are more likely undervalued than those trading closer to the value of net assets nearer to the bottom of the balance sheet.

Putting these principles into practice, when using the balance sheet method, companies which are not economically viable or are experiencing terminal decline should be valued on a liquidation basis, looking at net current asset values and severely discounting long-term fixed assets (and perhaps completely writing off the accounting value of goodwill and certain intangible items). On the other hand, companies whose viability as going concerns is fairly certain should be valued on a reproduction cost basis when using the balance sheet method, meaning calculating a value for replacing the present assets using current technology and efficiencies.

In an industry with free-entry, a company trading for substantially more than $1 per $1 of asset reproduction costs will invite competition until the market value of that company falls. Similarly, a company trading for substantially less than $1 per $1 of asset reproduction costs will find competitors exiting the industry until the market value of the company rises back to the reproduction cost of the assets. Without barriers to entry which protect the profitability of these assets, the assets are essentially worth reproduction cost as they deserve no earnings power premium.

For these firms, the intrinsic value is the asset value.

The earnings power (income statement) approach

Whereas the asset value approach relies more strongly on present market values, the earnings power valuation approach begins to introduce more estimation of the relationship between present and future earnings, as well as the cost of capital. These are decidedly less certain valuations than the asset value method as they rest on more assumption of future phenomena.

The primary assumptions are that,

  1. current earnings, properly adjusted, correspond to sustainable levels of distributable cash flow, and,
  2. that this earnings level will remain approximately constant into the indefinite future.

Based upon those assumptions, the general equation for calculating earnings power value (EPV) is:

EPV = Adjusted Earnings x 1/R

Where “R” is the current cost of capital.

Earnings adjustments, where necessary, should be made on the following basis:

  1. rectifying accounting misrepresentations; the ratio of average recurring “one-time charges” to unadjusted reported earnings should be used to make a proportional adjustment to current earnings
  2. depreciation and amortization adjustments; reported earnings need to be adjusted by the difference between stated D&A charges and what the firm actually requires to restore its assets at the end of the year to the same level they were at at the beginning of the year
  3. business cycle adjustments; companies in the trough of their business cycle should have an addition to earnings in the amount of the difference between present earnings and average earnings, while companies at the peak of their cycle should have earnings adjusted by the difference between average earnings and present earnings (a negative number)

There is a connection between the EPV of a firm and its competitive position. In consideration of economically viable industries:

  1. EPV < asset reproduction cost; management is not fully utilizing the economic potential of its assets and the solution is for management to change what it’s doing, or for management to be replaced if it refuses to do so or proves incapable of doing so
  2. EPV = asset reproduction cost; this is the norm for firms in industries with no competitive advantage, and the proximity of these two values to one another reinforces our confidence that they have been properly calculated
  3. EPV > asset reproduction cost; this is a sign of an industry with high barriers to entry, with firms inside the barriers earning more on their assets than firms outside of them. For EPV to hold up, the barriers to entry must be sustainable into the indefinite future

The difference between the EPV and the asset value of the firm in question in the third scenario is the value of the franchise of the firm with barriers to entry. In other words, the firm’s intrinsic value should equal the value of its assets plus the value of its franchise.

Similarly, in the second scenario, no premium is granted for the value of growth because with no competitive advantages, growth has no value (the cost of growth will inevitably fully consume all additional earnings power created by growth in an industry characterized by free-entry competition).

The value of growth

The value of growth is the hardest to estimate because it relies the most on assumptions and projections about the future, which is highly uncertain.

Additionally, growth has little value outside the context of competitive advantage. Growing sales typically need to be supported by growing assets: more receivables, more inventory, more plant and equipment. Those assets not offset by greater spontaneous liabilities (accounts payable, etc.) must be funded somehow, through retained earnings, larger borrowings or the sale of additional shares, reducing the amount of distributable cash and therefore lowering the value of the firm.

For firms operating at a competitive disadvantage, growth actually destroys value. Otherwise, growth only creates value within the confines of a competitive advantage. This uncertainty of growth and the competitive context of it leads the value investor to be least willing to pay for it in consideration of the other potential sources of value (assets and EPV).

3/5

Notes – Competition Demystified: Chapter 5 (#competitiveadvantage, $WMT)

Notes – Competition Demystified: Chapter 5 (#competitiveadvantage, $WMT)

Reading notes to Competition Demystified, by Bruce Greenwald and Judd Kahn

Looking for competitive advantages through industry analysis

One way to approach competitive analysis is by critically examining two key measures of performance:

  • operating margins; most useful when comparing firms within an industry
  • return on invested capital; useful for comparing between industries and within

These ratios are both driven by operating profit so they should track one another; when they do not, changes in how the business is financed may be the cause.

As the authors state,

Though the entries on the income statement are the consequences, not the cause, of the differences in operations, they tell us where to look for explanations of superior performance.

Learning by example: the Wal-Mart (WMT) case study

The explanations for Wal-Mart’s success have been numerous and diverse:

  1. WMT was tough on its vendors
  2. WMT monopolized business in small towns
  3. WMT had superior management and business systems
  4. WMT operated in “cheaper” territories in the Southern US
  5. WMT obtained advantages through regional dominance

Let’s examine these claims in order.

The first explanation fails the sniff test because WMT in fact had a higher Cost of Goods Sold (COGS) than it’s competitors. Additionally, its gross profit margins did not increase as it grew larger, implying it was not getting better and better economies of scale with suppliers by buying in bulk.

And while Wal-Mart did manage to generate additional income from higher prices charged in monopoly markets, this advantage was more than offset by its policy of “everyday low prices” in more diverse markets where WMT did higher volumes.

Technologically, WMT was a buyer of logistics and distribution technologies, not a developer of them. Anything it used, its competitors could use as well. Managerially, WMT appeared to have no advantage when it expanded its retailing into hardware, drug and arts and crafts stores. Why would WMT’s superior management be effective at discount general merchandise retailing but not add additional value in these markets?

The fourth explanation fails because Wal-Mart’s opportunities for expansion in the home markets of the South were not very large. Much of Wal-Mart’s growth and success took place in larger markets outside the South.

Wal-Mart’s secret sauce was regional dominance

Competitive advantages occur in numerous, often complementary ways. In the case of WMT, the initial competitive advantage was centered around a concentrated, regional dominance. Though smaller than its competitor Kmart, by focusing on one local region WMT was able to create a number of other competitive advantages for itself, including local economies of scale, that were not available to its competitor:

  • lower inbound logistics due to density of Wal-Mart stores, distribution facilities and vendor warehouses
  • lower advertising costs due to concentration of stores and customer base in target markets
  • concentrated territories which allowed managers to spend more time visiting stores rather than traveling to and from

Looking at Wal-Mart’s activities within the relevant boundaries in which it competed, it was far larger than its competition.

Eventually, economic law won out and growth took its toll on WMT’s great business,

it was unable to replicate the most significant competitive advantage it enjoyed in these early years: local economies of scale combined with enough customer loyalty to make it difficult for competitors to cut into this base.

WMT’s margins and return on capital both began to fall during the 1980s as it began its aggressive growth into the national market. Until then, WMT enjoyed the absence of established competitors.

What could WMT have done if it wanted to grow but maintain its competitive advantages?

If it had wanted to replicate its early experience, Wal-Mart might have targeted a foreign country that was in the process of economic development but that had not yet attracted much attention from established retailers.

Lessons learned from the WMT case study

The WMT case study leaves several general impressions:

  1. Efficiency always matters
  2. Competitive advantages matter more
  3. Competitive advantages can enhance good management
  4. Competitive advantages need to be defended
Learning by example: the Coors case study

From 1945 to 1985, the brewing industry experienced significant consolidation due to the following factors:

  • demographic trends, as home beer consumption rose at the expense of tavern consumption
  • technological disruption, as the size of an efficient plant grew from 100,000 bbl/y to 5M bbl/y, leaving many smaller brewers in a position where they could not afford to keep up
  • advertising trends, as the advent of television meant national brewers could spread fixed advertising costs over a larger revenue base
  • growth in brands, the market segmentation of which did not lead to growth in consumption but did result in larger advertising burdens for smaller brewers
The organization of Coors business

Coors’ business operations were characterized by a few fundamental structures:

  1. vertical integration, Coors produced its own strain of barley, designed its own cans, had its own bottle supplier and even had its own source of water, none of which produced a meaningful cost advantage
  2. operated a single brewery, which required it to transport all its product to national markets at great cost rather than producing within each market and shortening transportation routes
  3. non-pasteurization, which led to shorter shelf life than its rivals, adding to spoilage costs
  4. a celebrity aura, which, like most product differentiation strategies, did not result in a meaningful premium charged for a barrel of Coors compared to its rivals
For Coors, geographic expansion brought with it higher costs and reduced competitive advantage as these business organization decisions interacted with the wider distribution network in unforeseen ways:
  • longer shipping distances from the central plant in Golden, CO, resulted in higher costs that could not be passed on to consumers
  • the smaller share of new local markets it expanded to meant it had to work with weaker wholesalers
  • higher marketing expenses were incurred as Coors tried to establish itself in new markets and then keep up with the efforts of AB and Miller
The net result was that Coors was “spending more to accomplish less.”

Why Coors expansion was so costly

First, although Anheuscher-Busch, the dominant firm in the brewing industry, spent almost three times as much in total on advertising compared to Coors, it spent $4/bbl less due an economy of scale derived from larger total beer output.

Second, Coors experienced higher distribution costs because distribution has a fixed regional component which allows firms with a larger local share of the market to drive shorter truck routes and utilize warehouse space more intensively.

Third, advertising costs are fixed on a regional basis. Again, the larger your share of the market in a given region, the lower your advertising costs per unit. Coors never held substantial market share in any of the national markets it expanded into.

If Coors had “gone local” (or rather, stayed local), all of its competitive disadvantages could’ve been turned into competitive advantages. Advertising expenses would’ve been concentrated on dominant markets instead of being spread across the country. Freight costs would’ve been considerably lower as it would not have been transporting product so many thousands of miles away from its central plant. With a larger share of the market it could’ve used stronger wholesalers who might have been willing to carry Coors exclusively because it was so popular in local markets.

Additionally, Coors sold its beer for less in its home regions, allowing it to win customers from its competitors by lowering prices, offering promotions and advertising more heavily. Expansion, when and if it occurred, should’ve worked from the periphery outward.

The Internet and competitive advantages

Greenwald and Kahn are skeptical of the virtues of combining the Internet with traditional competitive advantages:

The main sources of competitive advantages are customer captivity, production advantages and economies of scale, especially on a local level. None of them is readily compatible with Internet commerce, except in special circumstances. [emphasis added]

With the Internet,

competition is a click away,

and furthermore,

economies of scale entail substantial fixed costs that can then be spread over a large customer base

a state of affairs which often doesn’t exist with virtual, e-businesses.

The Internet is great for customers, but its value to businesses as a promoter of profits is questionable. The Internet doesn’t provide a strong barrier to entry because it is relatively inexpensive to set up an e-commerce subsidiary. Additionally, there are no easily discernible local boundaries to limit the territory  in which a firm competes which is another essential element of the economies of scale advantage.

In other words,

the information superhighway provided myriad on-ramps for anyone who wanted access.

Questions from the reading

  1. Greenwald and Kahn argue that management time is the scarcest resource any company has. Is this true? Why can’t companies solve this simply by hiring more managers and increasing the manager-employee ratio?
  2. In the case study with WMT, why couldn’t Kmart at least match WMT’s efforts in establishing critical infrastructure organization and technology and compete on that basis?
  3. What were the sources of WMT’s customer loyalty?
  4. Which publicly-listed firms have regional dominance as a specific strategy they follow? Do these companies’ financial performance seem to suggest they derive a competitive advantage from this strategy?
  5. In the case study with Coors, what were the industry conditions in beer brewing that made national competition more efficient than local competition?
  6. Standard Oil, another producer and distributor of “valuable liquids” was vertically integrated. Why was vertical integration beneficial in the oil industry but not in the brewing industry for Coors?

Review – The Predator’s Ball: The Inside Story Of Drexel Burnham And The Rise Of The Junk Bond Raiders

Review – The Predator’s Ball: The Inside Story Of Drexel Burnham And The Rise Of The Junk Bond Raiders

The Predator’s Ball: The Inside Story of Drexel Burnham and the Rise of the Junk Bond Raiders

by Connie Bruck, published 1988

This review is going to be brief because, full disclosure, I’ve only read (as of this writing) 180 pages of this book. And honestly, that might be about all I’ll end up reading. Here’s why:

There are great Wall Street/business biography books (The First Tycoon by TJ Stiles, for example, which I will write a review of when I eventually re-read), good Wall Street/business biography books (much of what Michael Lewis has written qualifies, even though I find the author as a person to be a bit nauseating) and bad Wall Street/business biography books, a category of which Connie Bruck’s effort is a member.

Great books in this genre are exciting to read, they’re deeply researched and place major developments and character traits into a meaningful context and they leave the reader feeling like he’s gained some knowledge which is general and timeless in nature. The good books largely accomplish the same but a little less efficiently and with a little less objectivity, the author coming across as being taken by his subject matter.

The bad books offer none of the benefits (historical context, depth of mechanical understanding, deconstruction of character) and come chock full of pointless and irrelevant trivia– lots of dates, tons of deal size data and a mountain of dropped names. The writing is sycophantic and lap-dogish, the tone is that of a hyperkinetic cheerleader and the message is one of ignorant, drooling, envious amazement.

“The Predator’s Ball” is hard to read because it seems like it was hard for Bruck to write. She flings a lot of facts and figures at you but you never get the sense she understands the qualitative significance of any of it. The book is too self-conscious and self-aware– whereas in a Michael Lewis book you can easily lose yourself in the story and feel as though you’re a fly on the wall watching everything happen, Bruck’s book comes across as a series of poorly stitched together self-referential interviews where the illusion and pacing are constantly broken by the author willingly neglecting her editorial duty and allowing herself to be used as a mouthpiece by her interviewee.

And it gets worse.

Bruck spends page after page gushing about the… gushers… of money that were pouring forth on Wall Street during the junk bond-backed buyout boom of the early 80s. But in 180 pages she has yet to stop and ask herself (and then answer) where in the hell all this money is coming from? And the book is purposefully about Michael Milken and his comrades but she makes it seem like they were the only players in the entire world of finance doing any of this stuff when more likely they had competitors not only in the US but around the world. There’s no consideration of monetary policy and little discussion of the regulatory climate. It’s like this drama is unfolding in a vacuum.

It’s not only confusing but so arbitrary as to seem pointless.

By Connie Bruck’s telling, Wall Street drama is a lot like the drama of high school social politics. The book speaks of many parties, hangouts (meetings), liaisons and shenanigans and tries to convince the reader that he should care what all these “popular” kids are doing. It’s all supposed to be extremely interesting, who slept with who, who did a deal with who and for how much and how mad it made someone else. You keep turning the page under the assumption it’s all going to add up to something, that the story is going somewhere and the meaning of all of these interactions will be summarized and revealed.

It never does. That’s when you might feel compelled, as I was, to set the book down in frustration and walk away.

I bought the book because I wanted to understand the LBO world– who were the players, how did it work, why did it happen when it did and what were the major lessons? I highlighted a few things, but mostly I just want my money back.

2/5

 

Do You Know What The NSA’s True Purpose Is?

Do You Know What The NSA’s True Purpose Is?

A friend sent me a chilling article from Wired magazine about a new, gargantuan spy center being built by the NSA in Utah. The article started with this short background on the genesis, and current evolution, of the NSA:

For the NSA, overflowing with tens of billions of dollars in post-9/11 budget awards, the cryptanalysis breakthrough came at a time of explosive growth, in size as well as in power. Established as an arm of the Department of Defense following Pearl Harbor, with the primary purpose of preventing another surprise assault, the NSA suffered a series of humiliations in the post-Cold War years. Caught off guard by an escalating series of terrorist attacks—the first World Trade Center bombing, the blowing up of US embassies in East Africa, the attack on the USS Cole in Yemen, and finally the devastation of 9/11—some began questioning the agency’s very reason for being. In response, the NSA has quietly been reborn. And while there is little indication that its actual effectiveness has improved—after all, despite numerous pieces of evidence and intelligence-gathering opportunities, it missed the near-disastrous attempted attacks by the underwear bomber on a flight to Detroit in 2009 and by the car bomber in Times Square in 2010—there is no doubt that it has transformed itself into the largest, most covert, and potentially most intrusive intelligence agency ever created.

I want to channel G Edward Griffin a little bit here. Griffin is the author of The Creature From Jekyll Island, and in this book he put forth the notion that if the results of a policy consistently and widely diverge over time from the stated intentions, one has a sound basis upon which to question the stated intentions of the policy being observed.

In “Creature”, Griffin was discussing the Federal Reserve System and its “dual mandate”– to maintain stable prices and low unemployment. Of course, the Fed has never managed to achieve either one of its objectives since it was founded, leading a skeptical observer to wonder if the Fed was perpetually failing at its stated objective, or consistently succeeding on an unstated one.

Proponents of the NSA will argue that there are many successes we might never know about due to matters of secrecy. We can’t critically examine the veracity of these arguments because we’re not deemed worthy of the trust necessary to obtain the information required to evaluate these claims, so they must be ignored.

What we are sure of, as the paragraph above points out, is that there have been numerous “surprise assaults” that the NSA has done nothing to stop.

And yet, it only grows larger.

Maybe the NSA is succeeding wildly at its true purpose despite appearing to fail at its stated purpose. The construction of this massive, $2 billion facility in Utah is alarming.

But we should be even more alarmed that we do not know what is the true purpose of this multi-billion dollar agency.

Thoughts On Mergers, Acquisitions And Conglomeration From Rothbard And Buffett (@AlephBlog, $BRK)

Thoughts On Mergers, Acquisitions And Conglomeration From Rothbard And Buffett (@AlephBlog, $BRK)

In reading David Merkel’s third posting on Warren Buffett’s latest shareholder letter, I came across the following:

it should be no surprise that as BRK grew, given Buffett’s desire for owning as much of great businesses as he could, that BRK became a conglomerate, albeit one dominated by its leading insurance businesses.

David’s making a particular point using the language of “conglomerate” in a specific way– the idea of a company operating in multiple industries, none of which are necessarily related or complimentary to the other businesses in the portfolio. He’s observing Buffett’s behavior from the standpoint of acquisitions and trying to arrive at a meaningful interpretation of why and how Buffett has acquired as he has, resulting in his business representing a conglomerate.

It’s a worthwhile consideration but I want to try standing Merkel’s perspective on its proverbial head with the help of my friend Murray Rothbard, and see if some new insights aren’t arrived at. This is from chapter ten of his opus, Man, Economy and State, discussing “Cartels, Mergers and Corporations“:

What happens when a partnership or corporation is formed? Individuals agree to pool their assets into a central management, this central direction to set the policies for the owners and to allocate the monetary gains among them. In both cases, the pool­ing, lines of authority, and allocation of monetary gain take place according to rules agreed upon by all from the beginning. There is therefore no essential difference between a cartel and an or­dinary corporation or partnership.

Before you start getting upset (you who are having your worldview challenged here), read on:

Yet clearly the only difference between a merger and the original forming of a single corporation is that the merger pools existing capital ­goods assets, while the original birth of a corporation pools money assets. It is clear that, economically, there is little difference be­tween the two. A merger is the action of individuals with a certain quantity of already produced capital goods, adjusting themselves to their present and expected future conditions by cooperative pooling of assets.

I think this can be taken a step further, even, by saying that mergers don’t actually exist, there are only acquisitions. The reason I say this is because after every merger, “of equals” or otherwise, someone is left with de facto, if not technical or legal, control over the combined entity.

When two public corporations “merge”, the minority capital owners can de-merge (or escape acquisition) by liquidating their shares in the market. Their financial capital is freed to be placed elsewhere but their physical assets (the property of the merged corporation) remain. In this sense, clearly what has occurred is an acquisition of real capital goods, not a “merger”.

Does this logic apply to liquid investment partnerships, such as hedge funds, as well? By my definition, a hedge fund is not a “merger” (temporary, at that) because mergers don’t exist… it’s an acquisition by the portfolio manager. But there is no physical capital involved at this level, it is all liquid financial assets which represent claims to real, physical capital. And if the “merged” partner decides to de-merge, the portfolio manager has to sell a corresponding number of securities and financial assets to liquidate him, the control of which he does not hold onto going forward, unlike the corporation in which investors are made liquid not by the corporation but by outside investors.

I’ll have to think about that one a bit more. In the meantime, I’ve got another Rothbard quote on the subject, from the same chapter:

a merger and the original forma­tion of a corporation do not, as we have seen, essentially differ. The former is an adaptation of the size and number of firms in an industry to new conditions or is the correction of a previous error in forecasting. The latter is a de novo attempt to adapt to present and future market conditions.

Why mention this? What does any of this have to do with David Merkel’s article, Buffett and corporate conglomeration?

Merkel notes that Buffett has talked a lot about acquisitions over the years for a good reason: all investors are acquirers. Great investors are great acquirers (and tend to be extremely acquisitive, as well as extremely conscious of their status as acquirers). Buffett, as arguably the greatest investor of all time, is also one of the greatest acquirers of all time.

Many people talk about the investment process as one of efficiently and profitably allocating capital, and they talk of Buffett as an especially talented capital allocator. Few of these people realize how close they are to the profound, in this sense. Acquisitions and mergers are part of the capital allocation process. Acquisitions decide who will make future capital allocations with regards to a current pool of capital as well as its anticipated future capital yield.

Before Buffett was the head of a big time corporate conglomerate, he was a small investor. But even then, he was still an acquirer and involved in constant corporate acquisition, just like you, me and anyone else who makes small investments periodically. Every time we purchase a security, even if it is a fractional interest in an enterprise, we are acquiring that real capital and adding it to our own enterprise, corporate or otherwise. We are expanding our own personal domain as it pertains to the total pool of capital in the economy (local, national, global) and simultaneously someone else is either transferring their domain or relinquishing it in favor of consumption.

The corporate conglomeration is the natural, logical outcome of a track record of successful, long-term serial acquisitiveness, aka “investing”. In fact, it would be extremely odd to find a successful investor who hadn’t assembled a conglomerate. No, it would be impossible!

“What about a Buffett-contemporary like Walter Schloss?” you might be asking. He didn’t assemble a corporate conglomerate.

True, Schloss did not possess the precise econo-legal structure of the corporate holding company that Buffett did. But he was still a conglomerator– he acquired small pieces of many different businesses and essentially pooled their assets under his control.

Even a person who has concentrated their investing into ONE firm over their entire career is essentially an acquirer and a conglomerater, assuming this firm grows profitably. Through profitable growth, the firm generates retained earnings which are essentially internal corporate savings that the firm can use to ACQUIRE new capital goods and assets. Cornelius Vanderbilt, the steamboat and railroad magnate of the 1800s, is a good example of this. Even though he did not acquire a number of other firms, he acquired additional assets such as steamships, railroad cars, raillines, etc., from suppliers and thereby put these capital goods under his direct control. John D. Rockefeller is an extreme example of the acquisitional behavior of an investor-entrepreneur– he acquired into his oil empire not only oil equipment and oil reserves but entire capital good suppliers related to his business, such as railroads, warehouses and service stations.

Returning to Buffett, as Merkel says:

Once BRK got big, that meant becoming a conglomerate, albeit a special one, was the logical outcome.  And I could be wrong, but that is the final corporate form for BRK.  There may come a day in a post-Buffett era when it may do many things, such as spin off companies, or centralize functions.

I don’t think conglomeration had anything to do with hitting a size threshold. I think it is related to Buffett’s long-term success as a capital allocator, which is dependent upon his ability to acquire the right assets over time. I think Merkel is correct that this will be the final corporate form of BRK.

And, I think Merkel is onto something when he says there could come a day when BRK spins off companies or otherwise transforms itself, particularly in the post-Buffett era. As we learned in our reading of Value: The Four Cornerstones of Corporate Finance, a particular asset will have numerous “best owners” over its entire lifetime. Looking at a collection of assets in the form of a contiguous business, this business will have numerous “best owners” over time, as well. From start-up, to growth, to maturity and eventually decline, ownership of the business will naturally transfer to those who are best positioned to maximize value (that is, future cash flows) from the business in its present form and at that particular stage of its lifecycle. The general trend is increasing acquisition of assets until the terminal point is reached at which point assets are divested and spun-off as the business declines and ultimately fails or disappears via merger/acquisition into the total control of another enterprise.

Merkel makes an important observation about the above-average ownership period of the average Buffett investment:

BRK is the acquirer of choice for those that want to cash out, but don’t want the unique character of their organizations to change, which Buffett points at in the present Shareholders’ Letter as a unique competitive advantage.

Buffett finds himself to be the “best owner” of various assets he has acquired for periods that seem much longer than most others because he has determined that committing himself to this role gives him a competitive advantage in convincing the previous owners to allow him to acquire the assets in the first place. Although Buffett as a capital allocator (acquirer) may have no particular advantage in managing businesses and assets involved in any particular late-phase lifecycle such as maturity and decline, by creating a credible belief that Buffett will preserve a business he aims to acquire, he is granted opportunities to acquire that might not exist for anybody else due to non-financial (such as emotional or prestige) reasons.

So far, this strategy has proven to be a good one, and a unique one for the most part. But it remains to be seen how this strategy will hold up when Buffett himself is no longer around, and many more of his businesses have entered the maturity/decline phases. After all, Buffett eventually sold off his textile mills, albeit for pennies on the dollar, though, it could be argued, not before extracting from them substantial free cash flows he was able to allocate into better businesses.

As investors, we’re all in the acquisition game. Like Buffett, whether we’re buying public or private companies, whole businesses or tiny slivers, we’re constantly acquiring (and sometimes divesting) pools of real capital.

How does acknowledging this fact change your perspective, and your behavior?

Post-script

There is nothing inherently efficient about the corporate conglomeration as an entrepreneurial structure. In fact, the conglomerate form (in the more traditional sense in which Merkel uses it) is generally found to be less efficient because it causes management to make decisions about business activities it may have substantially less expertise in, while simultaneously dividing total management attention and thereby causing distractions.

Frankly, there is no reason why a company like BRK, which owns candy confectioners, insurance companies and railroads, should necessarily have any special ability to compound wealth merely because of the corporate combination of these assets and businesses. If it were true that the corporate conglomeration was inherently more efficient and profitable, this business form would be vastly more prevalent than it currently is, if not entirely dominant.

The reality, however, is that most conglomerates are not specially profitable. They are not specially efficient. They suffer from bureaucratic operation, distracted management and huge internal calculational problems as they grow in size.

In that sense, Buffett (and Munger, to some extent) is the unique competitive advantage that BRK as a corporate conglomerate is blessed with. And it is for this reason that I believe the death of Buffett will be devastating to BRK’s market value and will most likely result in massive divestitures and the eventual break-up of the entity.

One final note, which I couldn’t help but to mention: the totalitarian state is the penultimate corporate conglomeration. And it suffers mightily as an economic entity, as a result.