“Good Enough” with Ken Fisher

 

Ken Fisher, love him or hate him, but without a doubt you should admire him.  Admire him for his business building ability, or as I do his candid and public disclosure of his thoughts and recommendations.  For over 20 years Mr. Fisher has published his views in his Forbes Magazine column.  This opens Mr. Fisher up to a problem; the public disclosure of recommendations gives any and all the fodder for criticism based on passed results.   All of us professing to be professional investors know that all of our recommendations will not result in positive or exceptional rates of return for ourselves or our clients.  It is one of the deep dark secretes of the professional investor.  Very few will openly admit to this, but even fewer will put themselves at risk by publically disclosing their portfolio decisions.  Mr. Fisher is not one of these.

 

It is in one of his Forbes articles that we find a reference to the “Good Enough” approach to the investment process.  Mr. Fisher’s column on December 26, 2005 was titled “The Integrity Premium.” In it he discusses the change in the number and quality of national auditing firms in the post-Enron, post-WorldCom era.  Because of this mistrust of audited financial numbers, Mr. Fisher recommend that all investors “should focus on stocks that are good enough and cheap enough that you can be comfortable with them despite zero ability to believe in audited profit-and-loss and asset–and-liability accounts”.

 

“Good Enough” with Marty Whitman

 

Good enough and cheap enough - these are simple words, but over the years it has been the theme song of many great investors.   I was first introduced to this concept many years ago, during my first few years in the investment business.  Inflation was rampant and investing in common stocks was considered by most to be “irrational.”  Young, and without the training of financial analysis, I stumbled across an article referencing Marty Whitman.  At the time, Mr. Whitman was not a household name, which has changed since the launch of his Third Avenue Value Fund on November 1, 1990.  If you are still unfamiliar with Mr. Whitman, his stewardship of the Third Avenue portfolio has earned him the right to say that over the past twenty years, he has been one of the best, if not the best, stock managers in the world.  His Third Avenue Value Fund was recognized by Morningstar as the number one world stock fund for the 20-year period ending November 1, 2010.

The article referenced his book The Aggressive Conservative Investor, co-written with Martin Shubik.  It was published in 1979, but was not a big success and quickly went out of print.  I gave up trying to find a copy. Instead, I took a chance and called Mr. Whitman’s office.  He was kind enough to send me a copy free of charge.  Even better, he paid the postage himself.   With the success of Third Avenue, his book is readily available at most book outlets; however, you will not be able to obtain your copy at the same bargain price as my own.  On page 20 you will find these words:

 

When purchasing equity securities, an outside investor using our approach will not acquire a position for his portfolio unless he believes that the value represented by the particular security is good enough, based on the four essential elements.  He does not consciously try to outperform the market over the short run.  Thus, investigation in areas other than financial integrity will tend to be emphasized less than it would be if the investor was striving for more immediate performance.  First, little or no time is spent attempting to gauge the general market outlook, examining technical positions or making business-cycle predictions.  Put simply, there is no attempt to hold off buying until the investor believes stock prices are near bottom.  Rather, the primary motivation for purchases is that values are good enough.

 

It is quite easy for us all to forget that the concepts of “good enough” and “cheap enough” have produced such consistent long term returns, at least for those who have had the fortitude to apply this theme.  True, it takes training to determine what is good enough and what is cheap enough.  But for many of us, our greatest failure is not paying any attention to it at all.  In today’s investment world the majority of investors are making their investment decisions based on their general market outlook and their desire to obtain immediate gratification. 

 

“Good Enough” with Warren Buffett

Bill Miler, the great manager of the Legg Mason Value Trust, introduces our third and most famous “good enough” investor, Warren Buffett.   Mr. Miller has also felt the public ridicule because of these past few years, but even Mr. Buffett is not immune to public criticism.  He is currently the toast of the town, but whenever his performance drops below the market’s return, every few years or so, the negative comments begin to flood.  Mr. Miller, in his most recent market commentary “The 70% Solution”, has this to say about Mr. Buffett:

 

One of the most remarkable things about the investing world is how (correctly) venerated Warren Buffett is and how completely people ignore his investing advice.  Since Mr. Buffett has made more money than anyone in the history of the planet solely through investing, one would think that when he says quite clearly what to invest in, people would pay attention.  I guess they do pay attention, they just do the opposite.  In 1974, near the bottom of the market, he said stocks were so cheap he felt like an over-sexed guy in a harem.  In 1999, near the top, he opined that stocks would see returns way below those experienced in the bull market up to that time.  From the time of his comments in November 1999 to the end of October 2008, stocks fell over 2% per year.  In October 2008, again near the bottom, Buffett published an op-ed in The New York Times entitled, “Buy American.  I Am.” Telling people to buy American stocks.  They promptly accelerated their selling.  On October 5^th of this year, he said the following:  “It is quite clear stocks are cheaper than bonds.  I can’t imagine anybody having bonds in their portfolio when they can own equities.”  The result:  people pour money into bond funds in record amounts, and sell their holdings in funds that invest in U.S. stocks.  Why investors persist in doing the opposite of what the greatest investor of all time does, is a greater mystery than the problem of consciousness, or the origin of life, or free will and determinism.  Those at least are hard problems.”

 

Mr. Buffett has been just as open and candid with his thoughts as Mr. Fisher, Mr. Whitman and Mr. Miller have been.  However, he has not shared with the public as freely as the others just what his methods in determining “good enough” or “cheap enough” are.  So we have to draw our conclusions based on the public disclosure of his holdings.  Even then, reviewing his ownership in various public companies doesn’t fully explain his reasoning for purchasing or selling individual positions.  The annual Value Investing Conference, created by John Schwartz and Whitney Tilson, was held last year at the University of Virginia’s Darden School of Business.  One of the speakers at the conference was Alice Schroeder, the author of the authorized biography of Warren Buffett titled The Snowball.  In her presentation she discussed an investment made by Mr. Buffett in 1959.  The investment was in a company called Mid-Continent Tab Card Company.  The facts surrounding this investment are quite interesting and would be worthy of your review, but that is not our point today.  The most important part of Ms. Schroeder’s presentation is some short comments she made at the end of her discussion on Mid-Continent.  It seems that Mr. Buffett did not project revenues or profits based on some model like most analyst .  His main consideration was if Mid-Continent was capable of earning a 15% return on his investment.  In other words, his “good enough and cheap enough” price to pay was an investment capable of earning a 15% return on his investment, based on his interpretation of the current state of the company and the price he would have to pay for an ownership interest in that company.  Is this all there is to Mr. Buffett’s success - earning a 15% return on his investment?  Are there any other public investments that can shed a little more light on this required rate of return?  There is, but first I wanted you to know the results of Mr. Buffett’s investment in Mid-Continent.  He owned his interest in the company for 18 years earning a 33% compounded annual return.

 

In the fall of 2008, during the depths of the financial crisis, Mr. Buffett’s Berkshire Hathaway, full of cash and willing to make investments, struck a private deal with Goldman Sachs.  A short time later he lent $2.6 Billion to Swiss Re followed by a $600 Million loan to Harley-Davidson.  If 15% is Mr. Buffett’s good enough criteria, looking into these loans can be quite revealing. 

 

Goldman Sachs, in return for $5 Billion, issued Berkshire a perpetual preferred stock.  The fixed cost of this cash infusion was a promised dividend payment equal to 10%.  Most of us would be very happy with a guaranteed 10% return, yet Mr. Buffett was not satisfied.  If his requirement was 15%, then there had to be a little kicker to the fixed return.  In Goldman’s case it was the right to buy $5 billion of common stock at $115.00 a share anytime in the next 5 years.  Mr. Buffett commented on the transaction during an interview on CNBC.  He stated, “The price was right, the terms were right, and the people were right”.   If 5% in addition to the 10% fixed payment is “good enough” then the stock price of Goldman Sachs would have to reach the following per year; $120.75 - $126.79 – $133.12 – $139.78 - $146.77.  The closing price on November 19^th was $166.67.

 

Mr. Buffett, through Berkshire, lent a little over $2.6 Billion to Swiss Reinsurance Co.  In return for the loan, SwissRe agreed to a 12% coupon rate.  As before, Mr. Buffett required a kicker.  The loan had a conversion feature into Swiss Re shares at a price of 25 Swiss francs.  Once again, 12% would be acceptable to most, yet it would not be if your required “good enough” return is 15%.  Swiss Re plans on repaying Berkshire in January.  The payment, besides the principle amount of the loan and interest, will include an extra payment of over $600 Million for his kicker.  More than enough to exceed a 15% threshold.

 

And what of Berkshire’s loan to Harley-Davidson?  In February of 2009 Berkshire, along with Davis Selected Advisers, L.P., lent the company $600 Million for 5 years.   The cost to Harley was a straight interest payment of 15% per year.   There was no kicker in this deal. Is this verification that Mr. Buffett’s “good enough” return is 15%.  I would have to say, no, just some anecdotal evidence emphasized by yours truly. 

 

A Good Enough Example – Bank of New York Mellon

 

All of us like positive reinforcement of our work.  I can think of no greater compliment than to have the greatest investor of all time reinforcing our ownership of a company held by many of you as well as myself.  During the past July through September quarter Mr. Buffet through Berkshire purchased 1,992,759 shares of Bank of New York Mellon.  By all accounts, this was a new purchase for the company, even though it is a relatively small position for Berkshire, with an end of quarter market value of approximately $52,070,000 or $26.13 per share.  Given that we have no actual purchase price we will assume that his cost is an average of $25.41 which is the average price during the third quarter.  I know that many of you are doing the math in your head, so instead of letting you continue let’s just do the math first to see what the share price of Bank New York Mellon (BK) would have to be in order for the market value to reflect a 15% compounded rate of return.  Currently the company’s dividend is $0.36 per share or 1.4%.  Deducting this from a required 15% return will mean the share price would need to grow at a compounded rate of 13.6% per year.  Over the next five years, this is the result:  $28.87 – $32.79 - $37.25 – $42.31 - $48.07.

I cannot draw any conclusion that Mr. Buffett thinks in terms of “terminal value” as we have just done.  I would think that he is more concerned with the company’s ability to earn a 15% return on investment within the business, letting the future market value take care of itself.  As he stated in the Goldman transaction, the price is right, the terms are right and the people are right.  An equity ownership in any company is not the same as a loan.  When it comes to owning a business, the terms are based and dependent upon management’s (the peoples) capability to earn a reasonable rate of return on the current and future level of capital deployed by the firm.  What is received through the equity purchase is partial ownership of the net assets of the firm and a share of all the future earnings generated on those assets.

This is not the time or place to discuss accounting and the elements of determining net assets of a company.  Given that, we will simply substitute Value Line’s (I have heard, one of Mr. Buffett’s favorites) estimation of book value per share as the present net asset value of the firm.  Their estimate is $25.15 per share.  If it is close to accurate, then Mr. Buffett has paid a zero premium for these assets, which is a bargain by itself.

The Bank is currently the largest global custodian; entrusted with over $24 Trillion of other peoples’ money.  It is one of the 10 largest asset managers in the world with over $1 Trillion of discretionary money management.  It is the largest global trustee of funds borrowed by others, servicing over $12 Trillion in outstanding debt.  This alone should give us some confidence in the quality of the firm and its people.   Even though their clients have given them a seal of approval, it is nice to know that they have earned the highest credit rating among U.S. banks by third party rating agencies and have received numerous awards as the top-ranked client service organization in the world.

 

This is nice, but it does nothing to indicate that a 15% return on investment is possible.  This has to do with operation of the business, and the Bank of New York Mellon is a wonderful business.  It makes its money by providing a service at a price that is less than the cost of doing it yourself.  For each $ of asset in custody the firm receives a storage payment.  For each $ the company manages, they receive a small fee based on the current market value of the amount managed, and for each $ of assets held in trust they receive a small service fee for processing payments and redemptions.  Because each of these services are open ended, meaning the bank could be fired at any time, the future cash flow the firm will generate is subject to individual interpretation.   For a “good enough” investor the question is only if the business is sound and that the company can earn a similar return as the past.  In BK’s case, the bank is currently generating over $800 Million of new capital per quarter not needed for servicing debt.  This $3.2 Billion per year is available to increase dividends, buy back shares, or expand their operations through both organic growth and acquisitions. 

The bank’s shareholder equity at the end of 2009 was approximately $29 Billion.  Once again I will do a little math for you.  If Bank of New York is generating $3.2 Billion of capital on a $29 Billion book value, the return on this book value is 11.03%.  This return is not quite 15%.  However, it is not hard to imagine there’s a high probability that the earnings power of this capital will compound and produce a “good enough” return, rewarding all current shareholders, including us, well over 15%.

Thanksgiving is upon and us we would like to thank each and every one of you for the great honor you have given us by allowing us to help in the managing of your assets. 

Until next time,

Kendall J. Anderson, CFA

 

(c) Anderson Griggs

www.andersongriggs.com