“Chapters 8 and 20 have been the bedrock of my investing activities for more than 60 years,”
- Warren Buffett, speaking about The Intelligent Investor
The quote above is by Warren ‘The Oracle’ Buffett. Chapter 8 of the Intelligent Investor is about Mr. Market – a fellow I assume you all know too well. Let’s focus on Chapter 20, which is is titled, “Margin of Safety as the Central Concept of Investment”. Although experienced readers may snore at the thought of reading another such post – I urge you to resist for the time being; I think I’ve found a different take on this often repeated ‘value investment’ buzzword (you can snore at the end).
The most recent Berkshire letter contains two illustrative case studies on Buffett’s private real estate purchases (the abridged version – for those few who didn’t drop everything over the weekend to read this year’s sermon: ‘What you can learn from my real estate investments (click to read)’).
These two cases allude to a pattern that not many seem to focus on. What caught my eye in both cases was the fact that Buffett didn’t compile a detailed valuation model in order to estimate rental yields 20 years out. His thinking behind the valuation of his farm purchase, for example, was breath-takingly simple:
“I calculated the normalised return from the farm to then be about 10%. I also thought it was likely that productivity would improve over time and that crop prices would move higher as well”.
Put in other words, going into the investment, Buffett got a 10% yield on his purchase price and he was sure that this ‘coupon’ would grow. Amazingly, this simple statement encapsulates every value investing tenant: (1) to know what the true ”normalised return” of an asset is, an investor must operate within their circle of competence (2) by demanding a “10%” return going into the investment an investor has a huge margin of safety over other comparable interest rates/opportunity costs and, lastly, (3) by making an educated estimate about the future (quite simply, “will the future be better or worse?”), an investor must think like a true business (or real estate) owner. For step (3), Buffett simply calculated the two factors that would impact his farm’s future profitability the most – “corn prices and productivity” – and determined, with the bare minimum of research, that these would increase over time (he was right about both too – surprise!). Stated differently, his 10% yield was only going to get better going forward.
Keep It Simple, Stupid.
I know what you’re thinking: “this is brain-drainingly simple and so far I have feel I’ve wasted time reading this blog”. Ok, I agree: it is simple. But what got my juices flowing was how frequently Buffett seems to apply this ’10% growing yield on purchase’ formula throughout his entire career.
Firstly (and most obviously) Buffett repeated this ‘magic formula’ of 10% (growing) yield on purchase price with his New York apartment investment too:
“As had been the case with the farm, the unleveraged current yield from the property was about 10%. But the property had been undermanaged by the RTC, and its income would increase when several vacant stores were leased. Even more important, the largest tenant — who occupied around 20% of the project’s space — was paying rent of about $5 per foot, whereas other tenants averaged $70″.
Still not sensing an interesting pattern? Well, in 1999 at the height of the tech bubble, a student asked Buffett what he thought about the tech company Cisco, which at that (crazy) time had a market cap of $500 Billion (yes – you read right: Billion). It doesn’t require a tremendous amount of intellect to dismiss a 100x P/E ratio for a half-a-trillion-dollar company (with the benefit of hindsight at least). What is interesting is the way Buffett dismissed Cisco’s frothy price tag. Here was his reply when asked about Cisco’s valuation:
“Think about a company with a market cap of $500 billion. To justify paying this price, you would have to earn $50 billion every year until perpetuity, assuming a 10% discount rate. And if the business doesn’t begin this payout for a year, the figure rises to $55 billion annually, and if you wait three years $66.5 billion. Think about how many businesses today earn $50 billion, or $40 billion, or $30 billion. It would require a rather extraordinary change in profitability to justify that price.”
Rephrasing the quote above, when Mr. Market offered the whole of Cisco to potential business partners at a $500 Billion price-tag, Buffett first thought: ‘to yield me 10% on my investment (assuming I could buy the whole business), Cisco would need to earn me $50 Billion today – which doesn’t look like it will happen for a long time’. This simple hurdle of 10% unleveraged current yield informed him that Cisco (1) didn’t have a margin of safety versus other alternatives, (2) would require him to stray from his circle of competence in order to begin guessing how their normalized income would get to $50 Billion and (3) was very un-businesslike!
Now do I at least some of your attention?
A Worked Example
Consider this investment case. Let’s imagine it’s 1987 and you are an investor during this other stock market bubble (for some – that may not require much imagination). Let’s apply the same rules. Here is a quick financial summary of a company from 1987 (during a period of stock market excess) which will remain anonymous for now. Study the figures below (don’t worry – there won’t be any tests):
Click picture to enlarge:
This whole company was selling for roughly $14 Billion in market cap ($38.13 * 377 shares outstanding). It’s enterprise value was roughly $12 Billion (once you include some long-term stakes in public companies not included in the figures above). It’s revenues were $7.6 billion and it’s book value was a paltry $3.2 billion
Applying the “Buffett formula”, would you buy it or would you pass?
Clearly for Buffet, what matters is not how high revenues are or how high book value is. Rather, it all comes down to earnings power – after all, earnings (/’owner earnings’) is what gets him his 10% hurdle; not book value. For this $12 Billion investment to make some basic financial sense, you would need at least $1.2 Billion in operating income over the next year to get a 10% yield on investment (lets use operating income as a proxy for ‘unleveraged yield’). Is this possible over the next year? Most likely. For one, this mystery company has already earned $1.3 Billion this year in operating income, plus sales seem to have grown every year before that. Further, it looks like margins have been improving every year and returns on capital have rocketed over the last 3 years too. This could be either a fluke/one-off year or, perhaps, the company’s fortune’s are strengthening – thereby juicing our 10% requirement well into the future.
Next, to normalize earnings and to make assessments about the future, we’d have to think like a business owner. But, alas, to think like a business owner, you’d have to know the business – and I don’t want to reveal it to you just yet. So, let’s keep it vague (and keep some of you guessing). Play along and pretend this is what you uncovered about the company:
(1) The company’s main product has low technological requirements – so threats from new entrants with better ‘know-how’ or R&D capabilities are nil
(2) It was once a family owned company and was in operation for a long period of time before 1987 (by the way, the business still exists today)
(3) In 1987, it was still under-penetrated in a few markets.
(4) For those hawk-eye readers: capital expenditures exceeded depreciation in the past because the business was once more capital intensive. However, after a period of rapid strategic change, permanent moves were made by management to make the business ‘asset light’ and, hence, future depreciation expenses should approximate maintenance capital expenditures.
(5) It sells a differentiated product, so threats from ‘low-cost’ entrants domestically and internationally aren’t significant in the long-run (although they sometimes influence prices over the short term).
(6) The business is inflation resistant.
Additionally, it looks like margins can remain constant, returns on capital will (at the very least) stay the same and, so far, a 10% required yield looks like a low bar to cross.
In reality, facts indicate that this 10% yield should grow drastically over time. Moreover, it appears the shares outstanding have shrunk every year – juicing returns further and potentially indicating a shrewd management team is at the helm. Putting everything together, the ultimate yield on investment 5 years out might be 13%, or it might be 30% – whatever the number, some basic mathematics and some basic investigations into the underlying economics of the business (conducted by me on your behalf) seem to indicate that 10% is all but guaranteed. This 10%+ normalized return also offers a more attractive return than 1987 Government bonds which at the time paid a 7% interest rate – particularly because we can be just as sure of this 10% rising as we can of the 7% Government coupon staying roughly the same (or dropping).
So… do you think Buffett would have invested?
Hiding In Plain Sight
Many of you have probably long-guessed what the company is. But for those a bit slower, the company ‘s name is… *drum roll*: Coca-Cola.
Your $14 Billion hypothetical 1987 dollars, would now be worth a cool, yet still hypothetical $170 Billion (unadjusted for dividends). Oh yeah, I forgot to mention: Buffett invested.
To close this ‘current yield’ valuation loop, let me also reveal the origins of Buffett’s ‘magic formula’ (/common sense): I’m nearly a 100% sure that Buffett adopted this method after reading a particular investment book. That investment book’s name is *drum roll again*: The Intelligent Investor.
Specifically, from a passage found in *last drum roll*… Chapter 20!!!:
“In the ordinary common stock, bought for investment under normal conditions, the margin of safety lies in an expected earning power considerably above the going rate for bonds. Assume in a typical case that the earning power is 9% on the price and that the bond rate is 4%; then the stockbuyer will have an average annual margin of 5% accruing in his favor… Over a ten year period, the typical excess of stock earning power over bond interest may aggregate 50% of the price paid. This figure is sufficient to provide a very real margin of safety – which, under favourable conditions, will prevent or minimize a loss“.
- Benjamin Graham, The Intelligent Investor
‘You don’t need to measure the precise weight of someone to know if they are fat’.
Disclosure: This post is in no way intended to be taken as investment advice. I have no position in any asset discussed.