20 August 2011 – The Aleph Blog

That’s Mister Buffett to You, Lady!

Posted on 20 August 201121 August 2011 by David Merkel

In my e-mail, I received this tawdry message:

Hi David,

Why is every so in love with Warren Buffett and his financial advice? He used to be a great investor. Not anymore.

Here’s a good article I saw on it from a newspaper in Oregon while I was on vacation there.

http://www.salem-news.com/articles/may182011/warren-buffett-bg.php

That’s Mister Buffett to you, lady.? The garbage article you cited doesn’t have the faintest idea of what Warren Buffett does.? Warren Buffett is not a mutual fund manager, he runs a conglomerate with a real balance sheet and real profitability.? With his friend Charlie Munger, they are wiser than 99% of all the investment advisers out there.? I have my criticisms of Mr. Buffett, but they regard ethics, rather than talent.? Warren needs to repent, he doesn’t need more talent.? There is a difference.

But as for the lousy article, what has the S&P 500 earned over the last ten years — around 1%.? Guess what, of all the big stocks that BRK owns, they have done better than that.? It is irrelevant to cite companies so small that it would not make a difference to BRK if they took a position at favorable prices.

The greater problem is that the article does not understand what Berkshire Hathaway is.? It is an insurance company that owns a lot of businesses.? Whole businesses, not parts of them.? That is 80% of what he does, the rest is like managing a huge mutual fund.

Think of Buffett as a private equity manager with a reputation for not intruding on acquired company cultures.? He is the best place to sell a profitable business to where you want to leave the people you employed intact.

That is a clever niche strategy for private equity.? Give the Buffster some props!

Warren Buffett is deservedly one of the greatest investors of all time.? He made the transition from hedge fund manager, to CEO, but really an investment manager, to CEO of a conglomerate.

Those are three different skills, and Buffett has proved adequate to meet all of the challenges, even after reaching “retirement age.”

I tell you, avoid the envy of articles that want to downplay the results that Buffett has achieved.? He is a master, together with his team, and more than able to manage his company well.? Ignore the naysayers who don’t get it.? Listen to value investors.

The Folly of Large Acquisitions

Posted on 20 August 201121 August 2011 by David Merkel

One of my portfolio management rules deals with use of free cash flow.? I have a hierarchy of how I would like managements to use cash and free cash flow:

Pay down debt; eliminate preferred stock.
Grow existing business organically.
Do small acquisitions adjacent to what the firm is doing, that improve marketing efforts, technology, lower costs, add new geographic markets, add complementary products and services, etc., and then grow those organically.
Buy back stock when it is under the conservative estimate of what the company is worth.
Pay dividends at a level where you can grow them in the future at a reasonable growth rate.
Do a large acquisition that does not materially change the business model, at a fair price.
Do a large acquisition that does not materially change the business model, at a sugar daddy price.
Buy back stock at the current market price regardless of valuation.
Do a large acquisition that materially changes the business model, at a fair price.
Do a large acquisition that materially changes the business model, at a sugar daddy price.

In one sense, aside from step one, this list goes from hardest to easiest.? There are many who think they can add value easily through financial engineering.? Financial engineering means more debt, and that is what led us into this crisis.? I like the companies I own to run with a reasonable margin of safety, but not a huge margin of safety.? Financial engineering is the easiest strategy around, and the rewards of using it are limited.

It’s hard to grow a business organically, particularly in an environment like this where demand is not growing.? The best managers still find ways to grow, without resorting to huge mergers.

Small acquisitions can be very wise for large companies, if they can use the new resources to improve their overall organic growth.

But that’s not the way that lazy, self-aggrandizing CEOs think.? “We need more scale.”? So overpay for a competitor.? For similar companies, there are always cost savings, perhaps some market power, but rarely any other advantages.? Realize the government will be watching more closely, and that there will be some intra-firm rivalry for a few years.? I’ve been there, and I know.

What’s worse is when the CEO decides for a large change in strategy in order to grow faster, and pays a sugar daddy price for a rapidly growing company in a very different business, where the synergies with the existing business are questionable.

I avoid companies that do big acquisitions, unless it is like Buffett, where he does not overpay, or like Exxon/Mobil, where the companies are so similar the it does not matter.

Thus the foolishness of Hewlett Packard.? They had a great culture, and lost confidence in their ability to innovate.? They brought in a series of poor managers — Fiorina, Hurd, Apotheker… it would have been better for the company to sell their PC division to Compaq, rather than buying Compaq.? Hurd manipulated the accounting results.? Apotheker has scores to settle, and wants to beat Oracle, though beating Oracle might have been core for SAP, it should not be for HPQ.

Avoid buying companies that are acquisitive; it is a road to losing money.

Full Disclosure: long ORCL

The Predictions of Michael Pettis

Posted on 20 August 2011 by David Merkel

I learned a lot when I read the book, “The Volatility Machine.”? You will too.? You can buy the book here.? Sorry, it is expensive, because there are few copies relative to demand.

In his weekly e-mail, he decided to highlight twelve questions where he would offer predictions.? Here they are:

BRICS and other developing countries have not decoupled in any meaningful sense, and once the current liquidity-driven investment boom subsides the developing world will be hit hard by the global crisis.

Over the next two years Chinese household consumption will continue declining as a share of GDP.

Chinese debt levels will continue to rise quickly over the rest of this year and next.

Chinese growth will begin to slow sharply by 2013-14 and will hit an average of 3% well before the end of the decade.

Any decline in GDP growth will disproportionately affect investment and so the demand for non-food commodities.

If the PBoC resists interest rate cuts as inflation declines, China may even begin slowing in 2012.

Much slower growth in China will not lead to social unrest if China meaningfully rebalances.

Within three years Beijing will be seriously examining large-scale privatization as part of its adjustment policy.

European politics will continue to deteriorate rapidly and the major political parties will either become increasingly radicalized or marginalized.

Spain and several countries, perhaps even Italy (but probably not France) will be forced to leave the euro and restructure their debt with significant debt forgiveness.

Germany will stubbornly (and foolishly) refuse to bear its share of the burden of the European adjustment, and the subsequent retaliation by the deficit countries will cause German growth to drop to zero or negative for many years.

Trade protection sentiment in the US will rise inexorably and unemployment stays high for a few more years.

I agree with these, and then some.? I do not fear the actions of China.? In debt crises, the debtor is usually favored.