Reaction to my last report on Seeking Alpha

After giving a few days to subscribers before making my research public, I offered the last report on my website and on Seeking Alpha.

Here's an exchange between me and a reader regarding one of the companies in the report, special situation Cal-Maine (CALM):

Feckless191

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Author needs to update his information... re: "My estimate of intrinsic value for CALM is $41.40 based on a free cash flow value of $50 per share and a value based on dividend yield of $32.80 per share."

There is no "dividend yield", currently, nor will there be a "dividend yield" for CALM shares, in the near future. Please check the company's own web site, which clearly explains the dividend policy. CALM dividend is a function of "cumulative earnings", and no dividend will be paid until past losses are recovered and a "net positive" in earnings, over time, occurs.

In the previous 3 reporting periods, CALM reported losses of ($376,000, $30,936,000, and $23,010,000). That's ~ $54.4 Million in accumulated losses that must be recovered before any dividend can be paid by CALM. This coming Monday. CALM will report the most recent quarter, and with the price of shell eggs not much above the $0.971 / dozen shown as the primary factor for losses in the last reported quarter, I am thinking CALM will again report a "net loss", which only digs them into a deeper hole, as far as any potential future dividend is concerned.

Roderick MacIver, Contributor

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Thank you Feckless. My information is actually correct but as you point out, could have been explained better. I use four approaches to value:

- free cash flow, which assuming no major changes in liquidity (unusually high receivables or inventory) is based on earnings plus depreciation minus capital expenditures.
- earnings
- earnings growth
- long term (15 year if available) dividend yield divided by trailing 12 month dividend, if any.

If a company has no earnings, or earnings growth, and no dividend yield, but does have free cash flow, I rely solely on free cash flow. If it has none of the above, it is automatically excluded from my analytical process, although I do recognize that many if not most of these companies will ultimately recover.

To be more specific as far as my analytical process applies to CALM, based on TTM dividend (which of course, of necessity needs to be based on trailing twelve months dividend as reported, not as projected) of $1.19 divided by the 15 year average yield (to encompass at least one complete business cycle, particularly in highly-cyclical companies such as CALM) of 1.73% indicates a value of $68.93 per share, which I discounted to $32.80 per share for the reasons you point out.

Ultimately, you will be correct that my value is high if CALM does not pay a dividend in the next several years. However, the weakness I see in my report, after having a couple of weeks to mull it over is the opposite. Of all of the companies my report reviews, CALM may be the best long term investment based on quality of management, quality of balance sheet, quality of market position, long term return on capital, long term dividend yield, long term growth.

My mistake may have been not selecting it as the holding with the best long term investment potential, rather than PMD. I find it helps, often, to have the perspective of time after doing research, to reach a conclusion.

Long term, I certainly believe that CALM offers the lowest risk (at current prices) in relation to the potential upside, although PMD does offer the potential of truly explosive growth.

Thank you again for your comment. I review hundreds of companies in the portfolios of master investors each week, and so my process sometimes lacks depth in a particular company, as you obviously have in CALM. I appreciate your well-informed input. I'm not just saying that -- if you read my other comments here on Seeking Alpha you will see I have no problem dismissing poorly-thought out reactions to my research in a blunt and undiplomatic way.  I value your perspective and hope you will offer your thoughts on my research should you come across it here on Seeking Alpha in the future.

Thoughts After Reading Warren Buffett’s Annual Report Letter

The complete letter: http://www.berkshirehathaway.com/letters/2016ltr.pdf

• The letter opens with a chart showing the power of compound returns.

	Book Value	BRK.A Stock	S&P 500, Including Dividends
Compounded Annual Gain – 1965-2016	19.0%	20.8%	9.7%
Overall Gain - 1964-2016	884,319%	1,972,595%	12,717%

Note the difference between book value compounded at 19% versus 20.8% (stock appreciation). Over decades, a roughly 10% difference in annual rate of return results in overall returns well over two times as high.

Buffett seems to have decided early on that compounded returns are best achieved by investing long term in high quality companies, companies that themselves have the ability to compound earnings based on a competitive advantage or “moat.”

• The amount of capital that Berkshire Hathaway has to deploy:

As for Berkshire, our size precludes a brilliant result: Prospective returns fall as assets increase. Nonetheless, Berkshire’s collection of good businesses, along with the company’s impregnable financial strength and owner-oriented culture, should deliver decent results. We won’t be satisfied with less.

. . . almost the entire $15.5 billion we carry for goodwill in our insurance business was already on our books in 2000 when float was $28 billion. Yet we have subsequently increased our float by $64 billion, a gain that in no way is reflected in our book value.

(I think this means that Berkshire Hathaway’s insurance operations provide about $92 billion in investable assets).

Finally, there are three connected realities that cause investing success to breed failure. First, a good record quickly attracts a torrent of money. Second, huge sums invariably act as an anchor on investment performance: What is easy with millions, struggles with billions (sob!).

If the problem is that Berkshire Hathaway has so much money that results are penalized, the easiest solution might be to (1) stop borrowing money (about 26% of Berkshire Hathaway’s fixed capital is funded debt), and (2) exit the insurance business. I imagine he enjoys the challenge of the huge amounts of cash now at his disposal, enjoys being the Master of his chosen profession. And his investment strategy over the last several decades seems to include investing in low-volatility businesses and then levering the positions up.

However, he’s also said this:

Stay away from leverage. A long, long time ago a friend said to me about leverage, “If you’re smart you don’t need it. If you’re dumb you got no business using it.”
– Warren Buffett

There seems to be a contradiction there.

• The report contains an interesting review of the depreciation versus capital expenditure expense, including the write-off of goodwill in the insurance division.

On page 54 we itemize $15.4 billion of intangibles that are yet to be amortized by annual charges to earnings. (More intangibles to be amortized will be created as we make new acquisitions.)  . . . the 2016 amortization charge to GAAP earnings was $1.5 billion, up $384 million from 2015. My judgment is that about 20% of the 2016 charge is a “real” cost.

At BNSF, to get down to particulars, our GAAP depreciation charge last year was $2.1 billion. But were we to spend that sum and no more annually, our railroad would soon deteriorate and become less competitive. The reality is that – simply to hold our own – we need to spend far more than the cost we show for depreciation. Moreover, a wide disparity will prevail for decades.

All that said, Charlie and I love our railroad, which was one of our better purchases.

The insurance business does better than it appears and the railroad worse in terms of actual earnings. The relationship between depreciation and maintenance capital expenditures is a key consideration in the analysis of the quality of a business. It is interesting that Buffett likes the railroad business, which appears to have little or no competitive advantage or moat, and low-quality earnings.                                      

Does A Highly Creative or Artistic Personality Help Or Hurt In Investing?

This blog was inspired by Sean Iddings' article "Investing Is An Art, Not A Science" published this morning on the MicroCapClub website. You can read the article here.

The article opens with the Peter Lynch quote:

"Investing in stocks is an art, not a science, and people who’ve been trained to rigidly quantify everything have a big disadvantage."

I was a full time artist and writer for twenty-five years and pretty successful at it. In my peak year I sold over $1 million in my art and related poetry and prose. I've slowly made a transition to full time investing over the last five years. I’ve often wondered if there was a connection between artistic inclination and investing. I’ve known some extremely successful investors and none seem to have the slightest artistic inclination or imagination. I’ve wondered to what extent I need to guard against my creative impulses in investing.

My conclusion: other than to a minor extent, my artistic inclinations are more a hindrance than a help in investing. I have developed computer software that crunches the numbers on hundreds of companies a week, a project that took me years to develop, and the process of experimentation with what to emphasize, for instance latest quarter versus prior year quarter, or latest twelve months versus prior twelve months, or last five years versus prior five, well, I think there was an artistic element to that. Much of art is about emphasis in a unique way.

But in general the artistic mentality is one of constant experimentation and evolution, and investing is a business of cold analysis, and stability. I’m very good at analysis; I’m not particularly stable. So I’ve tried to develop habits and an analytical approach that protects me from myself, that makes 90% of the decision based on the numbers. And forces me to stick with the outcome of my research, that doesn’t allow me to trade based on a whim, because I get whims every single day.

As far as the Peter Lynch quote, my take is that some companies led themselves to analysis based on the numbers, and some don’t. Coca Cola does. Visa does. Amazon does not. The more stable, the more profound the competitive advantage of a company, the more that analysis based on the numbers is valid. The more volatile, uncertain, the weaker the competitive advantage or “moat,” the more a company is in transition to becoming something else, the less valid the current numbers. 

Amazon, for instance, takes most of its money and invests it in projects that won’t generate real returns for years, often many years, down the road. And they have a lot of debt, exposing them to macro developments that are essentially unpredictable. I recently ran the numbers on it, and I think the average PE over the last ten years was something like 500. In other words, to take a long term position in Amazon (as opposed to trade in and out) based on research you need to have an opinion on how worthwhile those investments in the distant future will be. That’s qualitative, not quantitative, analysis. Number crunching doesn’t help.

Sustainable competitive advantage is actually very rare. No more than five percent of public companies have them, and no more than one percent have a true advantage that results in extremely high, sustainable profitability. Number crunching can help you find competitive advantage, assess competitive advantage where it exists. It can't help you figure out where a company is going that doesn't have one, and it is of questionable value in the analysis of a company with a competitive advantage in the early stages of formation, which is what my computer model originally was designed to uncover.

Investing in Quality

Is the price required for quality -- the price in relation to earnings and yield -- worth it in investing? Would you rather own a $3,000 racehorse or one tenth of one percent of a $3 million racehorse? It depends.

Value investors pay a lot less per pound of horse than do quality investors.

With the $3,000 race horse you are investing, in part, in change. You are hoping that the win/loss ratio will improve. (He had a bum knee, but he now appears to be fine. And his great-great-great-grandfather won the Kentucky Derby thirty years ago). With the $3 million horse, you are investing in no change -- that current trends continue.

In the $3,000 racehorse business, qualitative factors are key -- your ability to see, or find through research, factors and information pointing to a happier future. In the $3 million racehorse business, you can run the numbers, calculate the likely future earnings, and then calculate likely breeding income. Assuming nothing changes.

Another difference is numbers of horses, or companies. There are a lot more $3,000 racehorses around than $3 million horses. If you are an analyst who studies the top one percent of low or no-debt, high long-term return on equity companies, you follow about 80 companies because of the huge number of companies with no revenue. That's quite manageable for an analyst.

There are two primary issues following those 80-100 companies. (1) Relative value based on earnings, earnings growth and free cash flow. To specialize in this area, you need to know the historic ratios to value, and buy the highest-quality companies when they are reasonably priced. Out of the one hundred, there are of course a cheapest ten and a most expensive ten. That difference is often driven by recent growth, and (2) You need to believe that in the case of a specific security,  its competitive advantage is sustainable ("moat") and basic market won't change or become obsolete (ie Buffett's investment in dominant city newspapers before the age of Craigslist. It's hard to compete with free).

The top one percent are the kinds of companies you can buy and hold for ten years, the companies Warren Buffett says he can buy and hold comfortably if the market shuts down for ten years. If, after careful research, you buy ten of them, one or two will perform poorly, one or two will be outstanding performers, and the rest will roughly track their return on capital over a long period of time (or return on equity for banks and insurance companies).

And the top one percent tend to be low volatility stocks. In the following two excellent articles, analysts advance the proposition that Buffett made his fortune levering up low-volatility, high-quality companies:

http://seekingalpha.com/article/4049808-buffett-low-volatility-investing

http://www.econ.yale.edu/~af227/pdf/Buffett%27s%20Alpha%20-%20Frazzini,%20Kabiller%20and%20Pedersen.pdf

_____
* There are roughly 4,333 actively traded on exchanges in the US, and another 9,800 OTC (including Pink Sheet) traded stocks. A few OTC companies are substantial, highly-profitable companies that are closely-held with only a small percentage of the outstanding stock traded publicly.

Follow Up Thoughts On Interview Of Jerry Dodson, Founder of the Parnassus Funds

Where Jerry and I differed in our opinion of a company, it was about value. My "rate of fundamental change" analysis extrapolates recent trends, in particular trailing twelve month trends. As he points out, in cyclical companies this can be dangerous. In fact, it can be dangerous in any company that is volatile up one quarter, and down the next or even up one year and down the next.

Years ago a client of mine offered this thought on the classic business mistake: "Expansion at the top of the cycle with borrowed money."

Basing one's analysis on trailing twelve month financial statement analysis (versus the prior twelve months) allows an investor to capitalize on emerging trends.

Basing one's analysis on average earnings, average price to book and average P/E ratio over the entire business cycle -- ten to fifteen years in most cases -- allows an investor to capitalize on cyclical swings in results and stock price.

The more predictable a company, the more stable, the higher its average return on capital, the lower its debt -- in all, the more significant its competitive advantage over competitors -- the greater the reliability of recent trends.

Studying Master Investor portfolios, I've noticed that ninety percent or more of positions are bets on improvement, on change. Today the company is X, and six months or a year from now it will be 2X.

Warren Buffett made a fortune betting on no or minimal change -- paying a reasonable price for quality.  That's one of the key differences between his strategy and most investors, including Master Investors.