Archive for the ‘Warren buffett’ Category.

 

As an armchair investor, I usually analyze companies and their economic models through their annual reports and other published documents. This is a top down approach and does not involve any grass roots analysis or any kind of investigation at the ground level. At the end of the day, it has a virtual feel to it.

I recently met a distant relative, who is in the transportation business – mainly long distance trucking and started talking with him about the economics of his business. He mentioned a few key points of his business

          The pricing in the business is very volatile in nature. He was able to get good pricing (rate per tonne) during the 2004-2008 period. The rates collapsed during the 2008 -2009 period. Rates have recovered since then, but are still not anywhere near the peak levels.

          The current rates are slightly above break even. He is able to make good profits in a few months, but ends up giving back (looses money) part of it in the other months.

          He had contracted with large companies via fixed rate contracts and got killed by these contracts during the downturn due to low utilization (A truck under a fixed rate contract cannot be hired out). At present, he has inflation related pricing clauses, but is unable to enforce them due to severe competition.

          The trucking business is driven by vehicle finance from banks and NBFCs. Large companies like TCI are able to negotiate rates and payment terms with them. However as a small operator, he is unable to do so.

          The current ROC in the business is an anemic 10-13% of capital. At the same time there is a lot of stress. Due to these factors a lot of small operators are exiting the business and he is planning to do the same.

I started thinking about the economics of the business and did a mental exercise of applying the porter’s five factor model to the business to see how the facts fit the model

  1. Entry barriers: This business has low to nonexistent barriers to entry. A typical truck costs around 22-29 lacs (total cost) and one can easily get a loan of around 20 lacs. So anyone can enter this business with a starting capital of 7 lacs. In addition, one does not need any specialized skills in this business (beyond a driver’s license and a transport permit). Finally, there is an open market for trucking service (via brokers) and any operator can contract out his vehicle (if he accepts the offered price)
  2. Buyer power: Buyer power is quite high in this industry, especially with large companies. A large cement or steel companies drives a hard bargain with the transport operator as trucking, atleast at the small scale is a commodity product.
  3. Supplier power: Supplier power is quite high too. A small transport operator has to deal with large banks or NBFC for finance and with Tata motors or Ashok Leyland for the trucks. It is easy to see the lack of leverage in this unequal relationship. Fuel is the biggest variable cost, which also is priced by the government.
  4. Substitute product: Although there is not much substitution for road transport, multi-modal transport is now becoming a viable alternative. Large operators like GATI, concor or gateway distriparks now offer a combination of road and rail transport and thus provide a cheaper option. This has now started to hurt the smaller operators
  5. Competitive intensity: This is very high in the industry. As it is easy to add capacity (does not take much to buy trucks or divert it to a more profitable routes), pricing is driven by demand and supply. Due to the highly fragmented nature of the industry, most of the small operators are price takers and are not able to earn an attractive return on capital

It is also clear that the industry is now consolidating with the exit of the smaller players. In a commodity industry, the pricing is driven by the lowest cost operator. In the trucking industry the large operators (especially multi-modal transporters) have some leverage with the suppliers and are able to drive costs down (due to scale) and thus earn an attractive return on capital.

One added reason for doing this mental exercise is that I did a short project with Tata motors in their heavy vehicle business as a management student in the late 90s. The economics for the small operator had started deteriorating then and has now become worse due to the entry of multi-modal transport operators.

At the end of the conversation, I did not want to advise my relative that he should exit this business as it would seem presumptuous (what would an armchair investor know?). However, I am guessing that he has arrived at the same conclusion without using the fancy models and would be exiting it soon.

In the end, I think it was a good learning experience for me. The trucking business reminds me of the following quote by warren buffett

‘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’

 
 

Warren buffett as most of you must be aware is considered as one of the foremost investors. He is the chairman of Berkshire Hathaway and publishes an annual letter to shareholders which is a must read for any aspiring or seasoned value investor. You can access his letters here. The 2008 letters was published more than a week ago and I downloaded it the moment it was posted and read through it immediately (yes I am a complete fan !).

Some thoughts –
 
The options bet

One of most discussed topic about buffett is the options bet he has taken. The argument goes like this – Buffett has claimed that derivatives are a weapon of financial mass destruction and yet he has gone ahead and invested in the same instruments. He is being irresponsible and has doomed his company by this bet

Those who write the above are highlighting two points of their own ignorance

–        Derivatives are dangerous for those who don’t know what they are doing. This is similar to giving a knife in the hands of a child. I don’t think any journalist, no matter how anti – buffett would consider him to be a novice investor. He has clearly spelled out what kind of bet he has taken in the letter and what are the risks associated with these instruments.

Following is the comment by buffett on the same above point in a recent CNBC interview
JOE: Those are derivatives. You don’t like derivatives, but you used them in that case, right?

BUFFETT: I–well, we’ve used derivatives for many, many years. I don’t think derivatives are evil, per se, I think they are dangerous. I’ve always said they’re dangerous. I said they were financial weapons of mass destruction. But uranium is dangerous, and I just went through a nuclear electric plant about two weeks ago. Cars are dangerous.
 
JOE: Yeah

BUFFETT: But I mean, every American wants to have one. You know, the–a lot of things can be dangerous, but generally we regulate how they’re used. I mean, there was a–there was some guard up there with a machine gun on me, you know, when I was at the nuclear plant the other day. So we use lots of things daily that are dangerous, but we generally pay some attention to how they’re used.

–        They are getting confused between the possible and the probable. Let me explain – It is possible I will become a billonaire in the next 10 years and will have a personal jet . The probability of that happening is 0.0000001%. Buffett’s option bet stands to lose 37 billion dollars if the 4 indices on which he has written the puts go to zero. Let me tell you this – If these four main markets go to 0 in the next 10-15 years, money would be least of our worries. I for one be forced to work on a farm or forage for food as the markets as we know would not exist.

When I first read of these puts, my thought process was that these were akin to an insurance contract based on a long term event with the premium paid upfront (similar for CAT insurance written by Berkshire hathaway). Buffett has explained it in a similar manner in detail in the annual report. I would recommend you to read the explaination in detail.

In addition, the option bet is equivalent to taking a long term loan where the interest rate of the loan can vary depending on the final payout.
 
Drop in profits
Most of headlines are screaming a major drop in profits. Buffett in clear, uncertain language has written that the profits of his company are very lumpy and will vary depending on the sale of investments. In certain years, buffett sells off overvalued investments and those gains are realised in the net profit. In the subsequent years, in absence of any such gain the year on year comparison looks bad (look at page 28 of the annual report and the explainatory note at the bottom)

The company’s operating business had a approximate cash flow of 9 bn. However various write offs and other change has result in a drop in the quarter’s net profit. The bad economy has definitely affected the company, but the results are not as bad as they appear on the face of it.
 
Mea culpa
Buffett has admitted to two mistakes – his timing on purchasing Conco phillips and two irish banks. I have been reading and following buffett over a decade and have seen his mistakes to be sometime more profitable than most of the successes of other people. In any case, these could be genuine mistakes and could cost Berkshire 1-2 % of their networth in the worst case scenario.

Looking closely
If you look closely at the results and compare across the years, you will see that the insurance subs and utilities are doing well. Float continue to increase at a steady rate with cost of the float being below zero (which is more important than premium growth) . Both these subs which form a major portion of Berkshire’s business have actually done well compared to the overall economic environment.

The other business are doing quite fine considering the horrible economic environment (see pg 61 of the 2008 annual report)
 
But the price has dropped ?

Yes the price has dropped and the CDS spreads have widened. Do you always believe the market to be right and the price to be aribiter of value ? Well then we are speaking different language. The markets are often but not always right.

Berkshire CDS spreads are at record levels signally liquidity or credit issues. To validate that, look at the balance sheet of the company and you will find that the company has 25 billion of cash and equivalents (after all the investment which buffett has done last year). Do you really think a company with 11Bn+ cash flow and huge cash reserves will go bankrupt ?
 
Buffett fan ?
You can rightly accuse me of being a Buffett fan. However to that name, please add the names of Seth klarman, Phil fischer, Charlie munger, Marty whitman, Bill miller, eddie lampart, Rakesh jhunjhunwala and Chandrakant sampat.

I am follower of all great value investors and try to use every opportunity to learn from them. I have never blindly followed their picks or tried to imitate any of these investors, but I always try to learn from each one of them, even if they have been wrong a few times.

Let me ask you this – If you wanted to learn how to play cricket or golf or tennis, would you learn it from sachin tendulkar or Tiger woods or Roger federer (if they were ready to teach someone) ? Sure these players make mistakes and lose matches, but does that take away the fact that these players are the one of the greatest sportsmen in their fields?

It is easy for armchair players or armchair investors to critize from the comfort of their seats, especially after the event with a 20/20 hindsight. Majority of the criticism I have read about buffett and the other investors lacks rigrious detail and analysis and is usually along the lines – The stock price has dropped and hence he is doing something wrong !!.

 
 

I was recently chatting with sandesh and he asked me a question – Why don’t you invest in US based companies? Is it due to the fact that you consider them outside your circle of competence or some other reason ?

My response was – As an indian resident, I cannot invest out of india and that is the main reason for not looking at US companies.

So much for due diligence ! It seems one can invest abroad through ICICI direct and this facility has been available for some time. I do not know if there are some restrictions on the type of stocks one can buy and so would appreciate if some one can leave a comment on it.

I have been following a few companies in the US, mainly out of curiosity and as a learning experience. The one company I would like to own is Berkshire hathaway. This company is run by warren buffett and as most of the readers of this blog would know, I am a Buffett fan.

Warren buffett has been the chairman and CEO of this company since 1967 or 68 (don’t have the exact date). The company stock price and intrsinic value has grown by 20%+ since he took over the management of the company (you do the math of what 1000$ invested then would be worth now after almost 40 years of compounding at 20%+ per annum).

The core business of the company is insurance. In addition Buffett has invested capital by accquiring a collection of good companies or by investing in stocks. The company is a major shareholder in companies such as Cocacola, Amex, washington post etc and a 100% owner of companies such as See’s candies, DQ, GIECO etc.

It is diffcult to analyse the company in a short post and I will do a detailed post later if I can confirm that an Indian investor can invest in this company. However irrespective of the outcome, I would recommend everyone to read Buffett’s letter to shareholders (download here) and analyse the company. I have read these letters multiple times and I can tell you from personal experience that these letters are the best education in economics, finance and investing.

I have analysed the company to understand the economics of an insurance company and also to see the disclosure a shareholder friendly management (Buffett is known for his shareholder orientation and ‘really’ considers them as partners).

I am uploading the valuation of the company (BRK valuation.xls) in google groups (see here). The company is undervalued from my perspective. I would encourage you to download the annual report and read through it. It is a big report and takes effort to understand it, but it is worth it.

Caution: The company is undervalued, but the stock is not cheap. The ‘A’ stock is worth around 100000 usd (50 lacs per share) and the ‘B’ stock (which is 1/30 of A stock) is worth around 3200 usd (1.6-1.7 lacs per share). The reason for this high price is that buffett has not split the stock for the last 40 years (read the owners manual in the AR for the reason).