Berkshire Hathaway Inc.

Here is the link to an interesting article regarding the stock of Berkshire Hathaway Inc. (BRK.A or BRK.B), the company owned by Warren Buffet… pay particular attention to the comments following the article as they provide some insight into the importance of understanding the economics of the underlying business… as well as being highly entertaining…

“Berkshire Hathaway’s Operating Businesses Currently Priced Under 2X Earnings“

Dividends and long-term investing.

Dividend distributions are an attractive proposition for many investors. As the old saying goes, “a bird in hand is worth two in the bush.” This speaks to the risk-averse nature exhibited by most people. This is rational as it makes perfect sense to prefer a certain outcome to an uncertain outcome with the same expected value.

Consider the following two scenarios:

1) You are offered $100.

2) You are offered an opportunity to flip a coin. If the coin lands on tails you win $150, but if it lands on heads you only win $50. Since there is an equal probability of the coin landing on heads or tails (ie. 0.50), the expected value of the flip is $100 ((0.5)($150) + (0.50)($50) = $75 + $25).

Which scenario would you prefer?

I would guess that most of you would gladly accept the $100 offered in scenario 1 as it offers the same expected value with less risk.

However, if scenario 2 instead offered you $155 when the coin lands on tails, and $55 when the coin lands on heads, then the expected value is now $105 ((0.5)($155) + (0.50)($55) = $77.5 + $27.5). Therefore, you are compensated slightly for accepting the additional risk.

Some people who originally chose scenario 1 would now choose scenario 2, finding the additional compensation adequate. Others would still choose scenario 1, finding the additional compensation inadequate. Either way, I believe that this illustrates the attractiveness of dividends to the risk-averse investor.

However, to me it is not logical to base my investment decision on the dividend offered by a company on their common stock.

Assuming that a company is and will continue to be a going concern, its stock can be classified as a form of perpetuity, in that it theoretically generates cash flows forever. As a result, it is subject to a high degree of uncertainty as its value today is dependent on its cash flows infinitely into the future. The further into the future we go, the more uncertainty we encounter as to the existence and/or amount of those cash flows that will be received.

Therefore, anyone interested in investing in such a high risk security must be able to withstand a high degree of volatility. This, in my opinion defines a long-term investor. By extension, a long-term investor will not require an income from his/her long-term investments. If he/she does require an income from his her long-term investments, then he/she is not really a long-term investor, but rather a short-term investor in that they need their money in the “short-term”.

Now, to clarify this point somewhat I will say this. Most people are both short-term and long-term investors. That said, there is a simple way in which to account for this. Allocate an adequate amount to cover your income requirements next year in a short-term discount bond with a maturity of one year. Allocate an adequate amount to cover your income requirements two years from now in a short-term discount bond with a maturity of two years. Continue this trend until you reach approximately 15 to 20 years in the future where you are fully able to absorb the inherent volatility associated with long-term investments.

If you happen to invest in a coupon bond that pays fixed semi-annual payments and matures in say, 8 years. Simply reinvest the coupon payments in the same security as you receive them. You will be subject to interest rate and reinvestment risk, but again, that is due to the fact that an 8 year security is a medium-term investment. Therefore, you must be able to absorb the additional volatility associated with the additional uncertainty relative to a short-term investment.

But to get back to our long-term investment, the fact that the long-term portion of your portfolio does not require any provision of income implies that any dividends distributed to shareholders will simply be reinvested in the company through the purchase of additional shares. If there is a better opportunity available to reinvest those dividends then by definition the investor should sell their existing shares in favour of the better opportunity. Therefore, there is no benefit to receiving regular dividend payments.

If the company cannot find any attractive projects with which to invest its retained earnings, then it can simply distribute those earnings back to its shareholders through a share repurchase. This reduces the number of shares outstanding, which results in each share representing a greater proportion of ownership in the company. Therefore, earnings per share (EPS) rise and the market price should follow suit. Another way of rationalizing the increase in share price would be to consider the increase in demand for the company’s shares generated by the repurchase, which will drive the market price up.

The repurchase scenario is therefore equivalent to the dividend scenario as shareholders can simply liquidate some shares, which are now worth more due to the share repurchase, placing them in the same situation they would find themselves in had the company distributed its earnings through a dividend distribution.

The Earnings Yield.

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A great deal has been made of the importance of the price earnings ratio (P/E) over the years as a way of comparing stocks within a given industry, as well as differentiating between value and growth stocks. However, I believe that intuitively it makes more sense to look at the earnings yield, which is simply the inverse of the price earnings ratio (E/P). This essentially represents the stock as a cash flow machine. While the P/E ratio is quite arbitrary in that it is restricted to relative comparison within its own asset class, the earnings yield can theoretically be used to evaluate the attractiveness of a stock across various asset classes.

A good example arises from the bond market. The yield on a coupon bond represents the expected future cash flows relative to the price. This is because the bond holder is entitled to those future cash flows (ie. the value of the bond). In exchange for these cash flows the bond holder must pay the market price (ie. the price of the bond).

In order to simplify this example we can assume that the bond in question is a perpetuity, which is simply a coupon bond that pays a fixed coupon payment forever. This assumption enables us to not only simplify the math, but it also allows us to more easily relate our bond example to our stock scenario.

Now, we can calculate the bond yield by simply dividing the fixed cash flow of the perpetuity (say, $10 per year) by the market price of the perpetuity (say, $100). From there we get a yield of 10% ($10/$100).

When we relate this bond example to our stock scenario we reach a very similar conclusion.

The earnings yield of a stock represents the expected future earnings relative to the price. This is because the stock holder is entitled to those earnings (ie. the value of the stock). In exchange for these earnings the stock holder must pay the market price (ie. the price of the stock).

In our bond example we assumed that the bond was a perpetuity. If we assume that the underlying company for which the stock issued is and will continue to be a going concern, it is then by definition a perpetuity.

Therefore, we can similarly calculate the earnings yield by simply dividing the expected earnings per share of the company (say, $1 per year) by the market price of the perpetuity (say, $10). From there we get an earnings yield of 10% ($1/$10).

What we can see from the two above scenarios is that the yield relates the cash flow to the market price. What we also see is that the cash flow represents value, while the market price obviously represents price. Therefore, the yield relates the value of the security, whether a stock or bond, to the price of the security.

Graham’s famous book “Security Analysis” demonstrates the importance of this relationship by introducing the concept of ‘intrinsic value’, while his other investment classic “The Intelligent Investor” introduces the concept of a ‘margin of safety’. These key concepts address the gap that exists between value and price.

As a result, we can then deduce that all else equal, purchasing securities with higher yields both enhance returns and reduce risk.

What is meant by “Exceptional” Investors?

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Dictionary.com defines exceptional as 1. “forming an exception or rare instance; unusual; extraordinary” or 2. “unusually excellent; superior.” This follows with the contrarian philosophy of investing, which advocates going against the trend of the overall market.

“I buy stocks when the lemmings are headed the other way.” (Warren Buffet)

“Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.” (Warren Buffet)

In order to acheive superior investment results, it is my belief that we must think independently and intelligently about each individual investment decision, without falling victim to herd mentality.

Welcome Exceptional Investors!

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I would like to begin by outlining my investment philosophy. I am a firm proponent of the value philosophy of investing developed by Benjamin Graham, and implemented by many of the most successful investors ever. A list of history’s greatest investors would have to include such value legends as Warren Buffet, Charlie Munger, John Templeton, John Neff, Walter Schloss, Jean-Marie Eveillard, Seth Klarman, David Dreman, Joel Greenblatt, and Charles Brandes. This list is by no means exhaustive, however I believe that it speaks to the merit of the value philosophy. The application of Graham’s value principles form the basis of all my investment decisions, however it is not the only consideration. It can therefore be considered a ‘necessary but not sufficient’ condition of investment. Other important philosophies that I believe have the potential to complement the value philosophy are the ‘growth at a reasonable price’ (GARP) philosophy developed by Peter Lynch, as well as the contrarian philosophy which is often seen as a branch of value investing. That said, I believe that Graham’s ‘margin of safety‘ concept must form the cornerstone of every investment decision.