My Triple Crown - Weekly Blog # 783

 

Mike Lipper’s Monday Morning Musings

My Triple Crown:

Berkshire, Coronation, Derby, plus analytical insights

 

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018

 

 

 

Berkshire Hathaway Annual Benefits

One of the advantages of owning shares in this unique company, both personally and professionally, is having the opportunity to learn from Warren Buffett, Charlie Munger, Greg Able, and Ajit Jain. The side conversations with a number of deeply involved investors and managers is an added benefit. For me, my wife, and my son Steve, this is truly an educational experience.

 

In terms of Berkshire, the following is a brief list of short-term (one year) comments:

1. The “float” is expected to be higher than in 2022. There should also be earnings from the railroad.
2. They have heavy property insurance exposure in Florida real estate.
3. GEICO will not be getting the full benefit of the switch to fully automate until at least 2024, possibly longer.
4. The stock is selling below “going-concern value”, suggesting it’s a good use of cash, particularly for heirs.

 

Coronation

While the coronation of King Charles III and Queen Camilla is important to many in the English-speaking world, it is also important to those of us entrenched in the investment world. King Charles produced a more modern version of the over 1,000-year-old coronation with all its pageantry and significance. Globally, he should give us hope we can remodel a financial system showing serious signs of disarray, with the inability to produce good value for all direct and indirect participants. Among which are the problems related to regional banks, commercial real estate, government sponsored inflation, inadequate education, inefficient healthcare, and getting the optimum benefits from layoffs. (More on the latter subject later in this blog.) We should learn what we can from King Charles’s discipline, especially his ability to make painful decisions with a clear view of a desirable future.

 

Kentucky Derby

The Kentucky Derby is America’s most famous horse race, which is unfortunate. The entrants in the race are 3-year-young horses with very little experience. This year’s winner, like many others in the race, had only raced 3 times and had only raced once at the Derby’s distance.  As most blog readers have learned, I believe whatever analytical talents I may have, I learned at the New York racetracks.

 

The payoff after both the tax authorities and track takes their share is important in figuring out if a particular horse is worth betting on. It’s a critical element of my handicapping skill, which I carry over to my financial analysis responsibilities. Not surprisingly, Warren Buffett also learned a great deal from attending local racetracks. One can see this when he explains the key to Berkshire’s insurance success, which is getting the right spread between the rate charged and the risk of loss.

 

One of the determents in this analysis is who you are competing against. This was an unusual Derby in that a number of horses were scratched. The betting crowd (the market) was left without a strong preference or favorite, much like one of the five largest market-caps in most sectors. At the track, the odds-on favorites are often 2 to1, or less. In this year’s race the winning odds-on favorite was 4 to 1. This should have been an alert to bettors that there was a low level of confidence in the crowd’s or the market’s choices. Somewhat similar to a number of market periods we have gone through recently. This filter might have suggested giving a more earnest look at horses with longer odds. Opening up the possibility of identifying a horse with 9 to 1 odds who finished first barely beating the second finisher, a horse with 5 to 1 odds. This type of behavior is why I often favor less popular investments, including small-caps and companies with somewhat blemished records. Particularly when there is a change of jockeys or other key managers. The keys to success in this type of thinking is not the win vs. loss ratio, but the number of dollars won or lost. Or if you prefer, Berkshire’s rate vs risk.

 

Analytical Insights

Hardly a day passes without the media reporting on a company with a new layoff. This is not newsworthy because of the number of people being laid-off, but because it’s happening during a period of high employment where there’s a surplus number of job openings relative to the number of people unemployed. Clearly there is an imbalance, or phrased another way, the people unemployed are different that those employed.

 

This condition requires careful and thoughtful analysis based on incomplete data. I suggest disaggregating the layoffs by presumed causes. The following is a list of types of layoffs and their significance:

1. LIFO (Last In, First Out) is usually directed by HR people from an easy date of employment list, without any further consideration. (I avoided one such occasion personally by going to a senior partner of an institutional brokerage firm which had 5 junior analysts. I pointed out that the likely salaries in aggregate were roughly equivalent to that of one aging but knowledgeable senior analyst. Perhaps my logic or guts worked, all five junior analysts were saved. I left the firm for another opportunity soon thereafter. Of the 4 that remained, at least 2 became productive firm partners.)
2. The opposite approach is sorting by perceived talent and keeping the best. In effect create a talent bank.
3. Friends for life. As I moved up, I recognized that some talented individuals did not fit where the firm was going. I suggested they find a better place and they became friends for life.
4. A layoff can be an essential part of a plan to move an operation, disposing of an activity that no longer fits.

 

Good analysts should try to determine which of the four alternatives most likely fits their described motivation. The LIFO layoff is only helpful in improving overall short-term productivity, as it does not make the remaining workers feel good about working for the employer. This may be unavoidable if the company is a union shop with built in official or unofficial rules governing layoffs. If so, the employer has deeper problems. 

 

In Conclusion

I had a good learning week, and I am happy to discuss my views with subscribers. Whether you agree or not, I can learn from you.

 

 

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Avoid GDP and EPS

Introduction

When the starting focus is wrong, many investors do not succeed. Though I can not judge the veracity of Socrates’ view that the unexamined life is not worth living, I believe the unexamined investment process is not worth continuing.

Starting with GDP

More supposedly learned people spend their working lives following and projecting the various Gross Domestic Product (GDP) statistics than any other measure. The academic community (within their institutions and within their satellites in business and government) start almost all of their future projections with a GDP growth rate. Yet it is rare for any annual or multi-year projection to prove to be accurate in terms of magnitude and occasionally direction. Thus most top down investment processes that start with GDP projections have not produced competitive results.

GDP traps

The basic fallacy of substantial reliance on GDP numbers is that a single number can represent the entire amount of economic activity within a geographic location. As a junior analyst at a trust bank, each of our company reviews required a comparison of revenues to a relevant generic measure. For many years the senior investment person was a well known and respected economist and the comparison was often with the GDP^*.

          ^*At the time we used Gross National Product (GNP).

As industry analysts we were meant to contribute our estimates of various industry statistics. As a budding technology analyst among other sub-segments followed, I was responsible for estimating the growth in the production of timing devices. While clocks or other timing tools were inherent in the production of numerous technological products, we did not follow a single company that provided any numbers as to their production. Not even output for industrially important punch card clocks to determine employee hours were available. There was no focus on changing specific prices (e.g., as transistors were introduced into timing mechanisms). In addition, I suspect at that point there were more clocks and other timing equipment already being used in our military and thus their production numbers were not known or were classified. Similar detailed projections were required by other analysts.

For central authorities the cost and availability of gathering complete production numbers were, and are, beyond their capability. Due to the nature of governments to tax, I presume there has always been a sizeable unreported level of business which probably changed with the taxing authorities’ levels of competency, authority and integrity. I doubt that it was ever a constant ratio of aggregate economic activity. Further, I am guessing that everyday somewhere within an economy business people, farmers, and others are finding new and different methods to produce similar goods at lower costs and perhaps increased worthiness.

A “Man-made” metric

Today we live in a global and increasingly integrated world. GDP analysts utilize export and import statistics reported to them mostly based on tax and other regulatory data provided. While this may be a good attempt, it is a monastic view of a commercial marketplace where transfer pricing is an art form, some over-invoicing occurs as a way to move currency and there is not cross-border comparison as to how the same transaction is tracked in multiple countries.

In sum total, the reliance on GDP pronouncements by government authorities and media pundits seems to me to be a weak crutch upon which to base investment decisions. They are sound bite size, and excessively simplistic answers to the complex question as to how the economy and business in general are doing. As noted in my earlier posts, some of the Chinese political leadership do not trust GDP figures as they are “man-made” and not a direct extrapolation of economic activity.

Most EPS valuations mislead

Currently it is fashionable to quote Professor Robert Shiller’s Cyclically Adjusted P/E (C.A.P.E.) as a valuation metric to determine how expensive the stock market is. Liz Ann Sonders of Charles Schwab^** recently produced a study entitled “Devil Inside: Dissecting the Most Popular Valuation Metrics,” which does a fine job pointing out the problems with this ten year average inflation-adjusted earnings per share of the S&P 500 price/earnings ratio. The problem that I have with relying on this as a tool is though it may make life easy for students and pundits,  the earnings used are only the reported earnings and it is looking backward.

            ^**Owned personally, and/or by the private financial services fund I manage

Beginning at least some 80 years ago Professors Benjamin Graham and David Dodd taught in their Securities Analysis courses that the first thing the analyst was to do in analyzing an income statement was to reconstitute it, removing all the non-recurring sources of income and expense. Eventually the accounting profession caught up and started to disclose the various reported non-recurring factors; e.g., profit and loss of investment sales by industrial companies.

In addition, to determine fundamental earnings power, one of the tasks that I did some sixty years ago was to “normalize” tax rates and where possible put all competitors on a similar rate which in effect reduced the impact of different balance sheet structures. More difficult was to model all peers on the same inventory accounting system such as LIFO vs. FIFO, etc. Most difficult was adjusting for various unusually large year- end sales and expenses that under other conditions could have appeared in the following years. To me the real benefit of this numbers crunching was to force on me that I was viewing a painting depicting someone else’s view of reality rather than reality itself.

This jaundiced view of reported earnings was reinforced years later when I had to deal with mergers & acquisitions. There were significant differences in the views of the buyers and the sellers of a company which led in part, to a dissimilar valuation that motivated each, and in many cases varied from public perceptions as to the value of the deal. In effect, the beauty of the deal was in the eyes of the beholder.

Having helped some financial organizations make acquisitions, the real focus was identifying the range of likely future earnings. The buyers were buying what they thought about the future, both without major changes and with changes that the acquirer expected to make. In almost all cases this led to a bargain purchase with a valuation below the valuation that the buyer’s stock was selling at for at the time of the purchase. Keeping the point of view of potential acquirers in mind, I estimated what I thought long-term future earnings might be in my purchases of individual securities and various funds. Thus, I am a future oriented investor along with others beyond the halls and bypasses of academia.

Three steps to take

1.  Adopt the appropriate valuation measure for each account. Some investors appear to be more comfortable in the past as they fundamentally believe that the current and future will be an extrapolation of the past. Of course the trick here is to pick which past. You could start with the Eighteenth Century, or perhaps 1926 when the first tracking services became evident, or a rolling ten year C.A.P.E. model. You could use a period since last the major peak or troth, or chart when new leadership of a company or country came to power or use another timespan.

2.  Use selection approaches that are appropriate for the timespan. For example in our four Lipper Timespan Fund Portfolios^TM, we will be much more focused on short-term GDP pronouncements and reported earning valuations in the first two portfolios, Operations and Replenishment. In both cases we recognize that a significant downturn is a matter of major concern. As the timespan lengthens we become more future earnings-focused and more interested in changes of demographics and psychographics than in GDP. Thus within our Timespan Portfolios, the shorter timespans will be much more influenced by cyclical factors,  in the intermediate timespans secular trends and in the Legacy Portfolio likely disruptions to historic extrapolations.

3.  An important advantage of investing through a portfolio of funds is that select smart managers that have well thought-out, but different investment strategies are available. This third step is critical to avoid locking into a single philosophy. The one absolute positive as to the future is that every investor and investment manager will be wrong from time to time (or if you prefer, premature). The risk when this happens to all of us is to overreact with an abrupt reconstruction of investments. By instead using a selection of sound, good managers, most of the time the total portfolio will benefit and move toward its funding responsibilities.

Question of the week:

What are the three most likely future changes that your investments can tolerate and what are the two that would force major changes to your investments?

__________   

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