In Defence of Warren Buffett

Currently the press is slamming Warren Buffett and Berkshire Hathaway for the sudden resignation of David Sokol and his questionable involvement with Lubrizol before the Berkshire deal. For more background please read Buffett Misses Chance to Show Moral Courage

I think it likely that an SEC investigation (already announced) and further questioning of Sokol will lead to more answers, but in my view, Buffett's reputation is being unnecessarily damaged. A true contrarian/value investor would look at this news, compare it to Buffett's (and Berkshire's) history, and realize that the street is wrong once again. Lets look at some facts:

• Berkshire's compounded annual gain (from 1965-2010) is 20.2%

• Buffett's annual base salary is $100,000
• Supported Barack Obama and advocates for taxing the rich 

• Convinced Sokol to stay at Berkshire twice
• "Lose money and I will forgive you, but lose even a shred of reputation and I will be ruthless" is taken out of context

The first point is just to reiterate that we are in fact discussing the most successful investor of all time. His performance is in a league of its own, and I think this puts the onus on his detractors to prove anything contrary to his sterling reputation.

The importance of the next two points cannot be understated. Warren Buffett is perhaps one of the most humble and honest people in the investment business today. His philanthropy, his views on social justice, and his 'walking the talk' all contribute to a person that can't be described as greedy or above the law.

The final two points support Buffett's innocence in the Sokol affair. If Buffett respected Sokol enough to convince him to stay at Berkshire twice, how can we possibly expect him to have been aware or even suspicious of wrongdoing on Sokol's part. Also, how can one expect Buffett to be ruthless with an employee that has already resigned? Are we realistically expecting the 80 year old man to publicly bash a good friend and employee of over a decade? Is this rational?

The press is holding the Oracle of Omaha to a much higher moral standard than the rest of the industry, and very soon people will realize this. The street is merely channeling bearish sentiment from one likely insignificant issue (who historically cared about Libyan oil?) to another. If anything, I take this 'Buffett Bashing' as another indicator of the small correction we're having in the midst of an extraordinary bull run. Sokol's mistake is not a "credit negative" for Berkshire and the issue is being blown out of proportion.

Value vs. Growth

For the average person a bull market is a fantastic thing. Those with jobs outside the financial sector aren't following the markets daily and have portfolios filled mostly with mutual funds, etfs, and maybe a few bonds. For the average investor, bull markets are strange. Obviously when the index is skyrocketing there is a greater chance that any individual stock will rise, but it also makes it much harder to outperform - the goal of all fund managers.

The value investing method, historically, provides the greatest rate of return. This is not arguable, it is fact. When in a bull market, however, investors are often tempted to seek growth instead of value. This is perhaps the single greatest mistake an investor can make, and I'd like to show why.

Book Value + Future Retained Earnings + Dividends = Stock Price

This is the bare bones way to value a business. Ben Graham's defensive investor focuses on the net book value and dividends portion of the equation, while the majority of investors today are consumed with forecasting earnings growth. The logic here is wrong.

When looking at a company's balance sheet, it is very easy to decipher what the assets are worth. Without oversimplifying it, generally the more liquid an asset is, the more favourable it is. Cash can be used to buy new businesses, buy equipment and land, and can also be returned to investors as dividends and stock buybacks. This is why I prefer to spend my time focusing on the assets of a company. If a company sits on a mountain of cash: that is a huge check mark. It also means that companies with massive inventories and slow turnover are a big red flag. The other side of the equation is the liabilities section. Even if a company reports low total liabilities (giving a higher book value), we can still look to see what proportion is short-term versus long-term debt. If a retailer has a higher proportion of long-term debt at a high interest rate, then the business may need to re-finance to stay competitive. If all of a company's debt is short-term and you know the company's earnings are questionable, this would be a potentially deadly situation as well.

Doing this analysis is easy, not time-consuming, and with some common sense can provide insightful investment opportunities. Here the hope is that the market realizes that the assets are undervalued or the liabilities are not an issue, and raises the stock price as a result (often called mean-reversion).

The problem with focusing only on forecasting future earnings is that it is extremely hard to do. Here is just a short list of some of the problems:

1. For companies with diverse operations, it is often difficult to make predictions on multiple business divisions (for conglomerates, it may be impossible)
2. For global companies impacted by various economies it is almost impossible to predict how currencies/population trends/product trends will go when the company operates in several countries
3. Although it may be easy to say a product or service will increase in demand, the effects on the bottom line are very hard to tell and in some cases revenue really does go through a corporate 'blackbox' before it ends up being reported as earnings per share
4. Even if the company has a stated plan to grow earnings, there is always the possibility that a failure to execute means earnings those are not realized

These problems increase with the size and complexity of the company. For example, it would be much harder for me to predict EPS for General Electric (GE) than for Avalon Rare Metals (AVL), a Canadian small cap with a few mines.

The problems associated with value investing are not nearly as bad as with growth investing. It is my belief that the value method provides a more accurate appraisal the of a company's worth, and involves less assumptions and consequently less risk.

The chart above shows what a dollar invested in 1927 would be worth in 2006. For picking value stocks it identifies low p/e, low p/fcf, low p/b, low p/s, and high dividend yields. For growth it uses high p/e, high profit margin, high roe, and high sales growth.

There is a reason you never hear Warren Buffet or Ben Graham talk about growth: they don't believe in it. The logic is all there, and I hope you'll see it to.

Rethinking Diversification and My Top Pick

It's probably the toughest question you can ask yourself, but if you can't answer it (or even attempt to) then you need to reevaluate your investment criteria.

Question: If you could invest in one thing, what would it be?

Now by 'thing' I mean as specific as possible; not just asset class, you have to pick the individual stock/bond/commodity. Many people would no doubt find this difficult, it's troubling to think about a portfolio with 0 diversity, with all your eggs in one basket. The key lesson here is simple:

If your uncomfortable making something 100% of your portfolio, then don't bother 

I'm talking more to retail investors of course but the lesson holds true even for the big players. Even the math that supports diversification says that having roughly 20-25 individual holdings is the optimal portfolio, anything greater than that adds no benefit. This number is cut down even further when considering ETFs.

With that in mind, what is my top pick?

Asset Class: Equities (historically the best)
Market Cap: Small-Mid Cap (historically the best)
Strategy: Value (historically the best)
Method: 4 metrics (Price/Free Cash Flow, PEG, Price/Sales, Price/Book)

Results

My last step is to evaluate individual balance sheets looking for large cash and low debt. The list I'm left with is usually between 10-50 companies long (this is also another simple way to judge how the market is valued). Out of what is left I usually prefer strong brands and simple businesses.

My Top Pick: GameStop (NYSE: GME)

Hugely shorted with earnings forecasts that are far too bearish for a company that consistently performed extremely well until the crash. Innovation in gaming technology (Kinect, Wii, etc.) will ensure growth opportunities for this business.

Disclosure: I do not own nor do I plan to buy shares of GameStop in the next 72 hours

Socionomics

Socionomics - Patterns in markets and nature

A great introductory video to this concept. While I generally don't agree with the premise that markets and nature follow the same underlying pattern, I do believe strongly in the concept of herding. The study of market psychology can give investors the edge in catching market reversals that take the majority by surprise. Below is the elliot wave principle or pattern for those of you who don't have time for the full video.

Brand Value and the Case for Diageo (NYSE: DEO)

I realized today that in my previous posts I talk mostly about the fundamentals of a company. I spend a lot of time on ratio analysis, discounted cash flow analysis, any method based on the principles of accounting. This constitutes 70% of my investing decision, and as such, I will not look at a company if it's books aren't suitable.

This being said, I do have other criteria. The other 30% deals with more qualitative factors. This includes assessing the economics of the industry the company is in, market sentiment, and brand value. While good marketing departments emphasize sales goals, great ones emphasize brand value. I think we all have a pretty good understanding of brands: they are the sum total of all the images, sounds, feelings, and perceptions thrown at you by marketers. This component is important, 30% of my decision important. For something this important, I'm not comfortable keeping this analysis qualitative.

Interbrand - 100 Best Global Brands of 2010

When I looked through this list it was pretty consistent with what a list of the top 100 corporations by market capitalization would look like. In certain cases however, there are powerful brands that are either owned by private companies, or are just one division in a holding company or conglomerate. Mercedes-Benz and Zara are two examples.

Who has heard of Diageo (NYSE: DEO)? If you haven't, let me give you a little tour:

Included above is the world's best selling whiskey, tequila, liquer, stout, and vodka. Three of the above are also feature in Interbrand's list of the top 100 brands. Brand value gives companies ease when looking to break into new markets, raise prices, and increase revenue in general. With this list of respected labels, investors would be fools to not at least give Diageo a look.

Fundamentals


Okay, now to the important stuff, the 70%.

I found external research that did a discounted cash flow analysis on Diageo that gave a fair value per share of $138. When looking at their numbers I consider it to be a bit liberal, but still, $138 (when it's trading at $73) is a huge margin of safety.

Price/Sales of 2.99 and PEG of 1.49 are below the industry average and very reasonable. With a net profit margin of 18% it is also the 4th most profitable in the industry. This being said, it's not a particularly fast growing company with an average of close to 8% EPS growth over the past 5 years.

It has only 16% institutional ownership which is a plus from the Peter Lynch perspective. It means the 'smart money' is ignoring it and could push it higher in the future. It's only got 3 analysts covering it which means current earnings estimates are more likely to be inaccurate and leaves room for surprise. However, the 3 analysts collectively have a target price of $85, meaning the consensus is still positive.

With a two year time horizon I am extremely confident a valuation of $95 is realistic and ideal for the more conservative investor. For those willing to wait and weather potential resistance at this level, I have a target of $108.

Disclosure: I own no shares in Diageo (NYSE: DEO) 

Gold: Will You Bet Against Buffett?

"Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head." - Warren Buffett

Commodities do not innovate; they are not ideas and the only way they increase their value is either by becoming scarce (supply) or becoming popular/more useful (demand). The reason equities, historically, are the best asset class is because companies have to adapt to their environment; they are forced to improve. Gold will never change. Google (GOOG) may be around in 50 years time, and I have no idea what it will be doing. Gold will also be around, but it won't be doing anything. 

"If you are not willing to own a stock for 10 years, do not even think about owning it for 10 minutes" - Warren Buffett 

Are we unjustified in replacing 'a stock' with gold? I'm not arguing the possibility that gold has far to run, it may, but why bet on it? 

Gold's long term average is between $700-$800/oz. As I write this it's at $1369/oz (CAD). 

In this article, HSBC fund manager Charles Morris says, "I absolutely believe it's heading into a bubble, but that's why you buy it...a bubble is good." Legendary investor George Soros agrees and has put considerable money where his mouth is. Their investment thesis: it's going up regardless, might as well hop on board. It's not a thesis, and it's not investing, it's speculating. 

A friend of mine said to me recently, "gold just keeps going up eh?" I didn't know how to respond. He then asked, "you think it'll keep going?" Again, I didn't know how to respond. My friend has no investment training, knowledge, and usually has very limited interest in the markets. If he is talking about gold, maybe it's a sign we are talking too much. 

Buying gold takes faith, and I have greater faith in the wisdom of Warren Buffett.

Bullish on China Mobile (CHL)

Disclaimers are usually put at the end of an article but I'm just going to go ahead and say it...

I Own Shares in China Mobile

Why am I a huge bull on this company? Is there one thing I know that the market doesn't?
No.

The reason I'm so confident is because of the overwhelming number of reasons to own these shares. Mainly:

1. Amazing Valuation
2. It's in China
3. Check the chart


Valuation
P/Earnings= 12.2 (five year average = 17.5)
P/Book= 2.6
P/Free Cash Flow= 6.3

That's cheap for a $212 billion company with

Profit margin: 25%
Debt/Equity: 2%
Cash: $11.6/share
ROE: 23% this year

China
It's in China! That means I don't have to participate in QE2 debate, I don't have to pay attention to foreclosures, I don't care about the republican party. Regardless of your opinions on China's future, at present it is the most competitive country in the world. I'm not an advocate of only investing in China (nor am I a bear on the US) but now is the appropriate time to think about global diversification. The reality is that some countries are now positioned to outperform in the next 10 to 20 years, and by the numbers, one of those countries is definitely China.

Chart

I look at a chart at the beginning of my analysis and at the end. The majority of the research should be based on the books; the quantitative scorecard of any business. But right here we can visually see the upside potential. Before the crash it wasn't volatile, it just consistently surged upward. It also looks like it's resumed that trend in the past year. We are effectively getting a 50% discount IF we believe that the underlying fundamentals of the business have not changed.

They haven't changed.

We would have heard about 'disappointing figures' or a 'bleak future' from analysts. Or we would recognize superior value in a smaller competitor threatening to take market share. So far neither of these have happened. Even if China Mobile has squeezed all the potential out of its market, it's still the market leader, it still provides a necessary and valuable services and products; is it really justified to cut it's value in half?

I have a price target of $80, but considering they have a 3.5% dividend yield, I'm happy to hold.


Disclaimer: The analysis made is not to encourage speculation or investment in the companies mentioned. I am currently long shares of China Mobile (CHL).