Value Investing – Page 21

Managing Berkshire Hathaway by Committee?

Posted on 25 March 2014 by David Merkel

While reading about portfolio companies today, I ended up reading this piece about Berkshire Hathaway. ?Not that great of an article, and it got worse when I read this:

Then there is the big question, “Who will replace Warren Buffett (Trades, Portfolio)?” He is now 83 years old. There is no official word on who will take over, but in his letters to shareholders he takes time to praise many of the investment managers working for him. The current consensus seems to be that Berkshire will be run by committee. The company has plenty of assets and superior management, so it should continue to operate efficiently. [emphasis mine]

That’s not the way BRK works. ?BRK is a group of businesses, run by men (male & female) who love their businesses, and would rather be running their businesses than taking a vacation. ?When Buffett dies, and he *will* die one day, much as shareholders might like to hope otherwise, BRK will likely be managed much as it is today. ?BRK relies on self-motivated managers that do their part to ?make the company work. ?Given the level of independence, it is the only way it can work, absent the possibility of considerable centralization after Buffett’s death.

The same applies to the management of the small central office. ?Public stock portfolio management is separate from the purchase of private companies (with some informal overlap). ?Operational management is limited, aside from efforts to fix lagging subsidiaries (think of Tracy Britt Cool). ?The next CEO of BRK will have to have multiple skills, but he won’t have to “do it all” as Buffett does. ?He will have to delegate yet further.

Think: how many people can understand all of the following:

The economics of a wide number of industrial businesses
The economics of one of the biggest insurers & reinsurers of the world
The quantitative aspects of Buffett’s derivative bets
Clever investing in public equities
Ability to acquire attractive public and private companies and on attractive terms
Minimizing tax impacts in the process
How to continually motivate the managers of a spread-out empire of companies

The successor to Buffett will likely be little different than Buffett — a capital allocator who motivates his many managers. ?At the size of BRK, private equity skills may be more valuable than public equity skills. ?BRK is a conglomerate, with considerable diversification. ?Even a passing look at the corporate org chart screams “Big!”

You want a sharp delegator/decision-maker at the head of BRK. ?He will hand off many responsibilities to others, but hold onto the core jobs of allocating capital, and evaluating/rewarding managers.

Anything else is suicide for BRK. ?That said, it’s not impossible that a future CEO would radically streamline BRK, and turn it into something more like GE. ?That would be a big mistake, but it would look like low hanging fruit, because of the many similar businesses that could be combined. ?Purchasing and central office services could be combined as well. ?That might improve profits in the short-run, but it would destroy the unique corporate culture that Buffett has created.

Far better to have a “fixer” correcting the edges of the corporation like Tracy Britt Cool, or David Sokol, than to wholly change the healthy culture of a corporation, with uncertain rewards.

Full Disclosure: Long BRK/B for myself and clients

Classic: Ways to Cut Risk

Posted on 23 March 201423 March 2014 by David Merkel

This was published in late 2007 at RealMoney. ?I don’t know exactly when.

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I came into the investment business through the back door as an actuary and a risk manager. For more than a decade, I worked inside several large life insurance companies creating investment products. My team?s dirty secret? We just wanted to clip a smallish profit on the assets, without taking much risk ourselves. If we could do that, and produce a reliable investment result for our clients, we were happy.

That was my job then; in a different sense, it is my job now.? My goal as a writer, commentator, and independent money manager is to take much of the risk out of personal investing while retaining most of the profit potential.

Nobody can avoid every up and down in the market. What you can do, however, is to ensure that you don?t get crushed when the market rolls over. My own portfolio is a case in point. Over the last seven years, starting in September of 2000, my investment process has yielded an annualized return of 20% a year.? I manage to a long horizon, so I don?t try to cut losses in the short run.? I am willing to take pain if I feel that the underlying fundamentals are intact.? I had only one losing year in that time, but it was a doozy. During four months in 2002, my portfolio lost 32% of its value.? I was shaken, but I scraped together my spare cash and invested. Over the next 16 months, my portfolio rallied 86%, which I found about as astounding as the 32% loss.?

The experience taught me that risk control works. Oddly enough, though, risk control doesn?t get a lot of attention. The most popular books and websites on investing spend nearly all their time focusing on the prospect of big returns; they rush over the matter of how to avoid big losses or how to deal with these losses when they happen. The result? Many people sour on investing because they take risks they don?t intend and lose a lot of money. They conclude that the investment game is rigged against them and they leave investing.

It doesn?t have to be that way. Let me suggest five simple ways you can control your worst tendencies, reduce your risk and become a happier investor.

Spread your bets around. The most basic rule of risk control is to diversify your investments. It is also the most neglected rule.

Perhaps the neglect is because most people don?t understand what diversification means. For starters, it means building a buffer against all the stuff you would prefer not to think about?unemployment, sickness, a horrible bear market, etc. Before you start investing, you need three to six months of living expenses set aside in bank deposits, money market funds and short-term bond funds. Having this cushion protects you from having to sell investments in an emergency, which in turn allows you to take risk with your remaining assets.

On top of your emergency funds, your portfolio should include a dollop of high quality bonds that mature in anywhere from two to 10 years. For older people, bonds cushion the downside of the total portfolio and ensure that you can?t be devastated by a stock market downturn. For younger people, bonds provide an additional benefit?you can sell them to buy stocks or other investments if the market plunges and you spot tempting bargains. So how much of your portfolio should you devote to bonds? As little as 20% of your portfolio if you?re in your twenties and a risk taker; 50% or more if you?re above 65 or naturally cautious.

Once you?ve got your emergency funds and your bonds stowed away, it?s time for stocks?and, once again, diversification should be your starting point. You don?t want to bet your entire future on a handful of stocks or on one industry or even on a single country. The easiest way to ensure that you?re widely diversified among many different stocks is to invest in a mutual fund or exchange-traded fund that holds scores of individual stocks, representing a multitude of different industries.

If, like me, you prefer to buy individual stocks, you have to balance your desire to be widely diversified against how much money you have to invest and?just as important?how much time you have to spend researching companies. My minimum for reasonable diversification is 15 stocks. When I started investing as a serious amateur back in 1992, I started with 15 stocks in my portfolio, and I bought $2,000 of each of them. Since then I?ve made maybe a dozen serious investing mistakes, but because I had my money diversified among many companies, none of my mistakes ever cost me more than 2% of my total capital.

These days I?m even more diversified: I run with 35 stocks, which is close to the maximum an individual can hope to track and research. Generally I devote an equal amount of money to each of my stocks?an equal weight, in investment jargon?because usually I can?t tell what my best ideas are. When a position gets more than 20% away from its target weight, I consider whether I should bring it back to equal weight or sell the whole thing.? Occasionally I deviate from equal weighting, but only when I have a very safe stock that is grossly undervalued. I never go above a double weight, which means that a single stock rarely accounts for even 6% of my overall portfolio.

The final way I diversify my portfolio is intellectually. I try to listen to as many viewpoints from as many different people as I can. I do this because the ideas of all but the most careful investors are internally correlated. They reflect some idea of what the economy is likely to do in the future, and they lean toward companies that fit that view. Some investors love companies with high P/E multiples and incredible growth stories. Other investors?and I?m one of them?love companies in distressed industries that are going for a song. You should listen to both camps. Doing so insures that you learn to think about investments from a wide number of perspectives. It makes investing more businesslike.

Here?s one trick you might find handy. As I gather my ideas from a wide number of sources, I print them out, and place them in a pile next to my computer.? I try to forget who gave me the idea, which forces me to look at the idea fresh, without the biases that come from trusting an authority figure.

Follow the cash. Most investors pay a lot of attention to how much a company earns; few investors realize how easily management can manipulate those earnings with fancy accounting. To reduce risk in the stocks you buy, keep an eye on a company?s cash flow as well as its earnings.

Your first step should be to look with a questioning eye at the non-cash, or accrual items, on the company?s financial statements. These include entries for such things as depreciation, inventory adjustments, or bad debt allowances. Cash is certain, but non-cash items such as these are anything but. Earnings can be thrown up or down by how quickly management decides to write down the value of a new factory or by how much it estimates its inventory of rotary-dial phones is really worth. The accounting industry tries to set guidelines for accruals, but management still has a lot of leeway.

For non-accountants, the easiest way to sniff out possible trouble is to compare the earnings statement with the cash flow statement?specifically the top segment of the cash flow statement, which shows ?cash flow from operations.? This is the amount of cold hard cash the company?s operations are generating, before making any payouts to lenders or shareholders, or investing in new equipment. In most cases, if a company?s earnings are growing, its cash flow from operations should also be going up, since higher earnings just about always mean more cash going through the business. So what if a company says its earnings are growing, but its cash flow isn?t?? You should be very, very wary. The financial statements aren?t necessarily bogus, but you have to puzzle out how a company?s earnings can be rising without throwing off more cash.

Sometimes there is no good answer to this puzzle. Remember Sunbeam, the small-appliance maker that hired ?Chainsaw Al? Dunlap to goose its business? I owned the stock in 1996 when Dunlap came on the scene. But after two earnings reports I became suspicious. ?All of these restructuring efforts are improving earnings, but they?re not producing cash from operations,? I thought. ?What gives?? I concluded something fishy was going on, so I sold for a nice gain. Over the next six months, the stock rose by 60%?then plunged 90% as it became clear that most of Sunbeam?s increase in earnings was the result of accounting shenanigans, not real business gains.

Love the unloved. Most people avoid industries that are under stress.? Who can blame them?? The industry outlook is horrible; there can?t be anything good here.?

I take a different view. I believe that some of the safest plays you can make consist of buying financially strong names in weak sectors. These companies are usually cheap in comparison to their earnings and to their book values. You can find out more about how to spot undervalued companies by visiting the website of Tweedy Browne, the famous value-investing firm, and reading their excellent paper on What Has Worked In Investing (http://www.tweedy.com/library_docs/papers/what_has_worked_all.pdf).

In addition to the standard measures, I look for companies with good bond ratings.? The ratings agencies are out of favor now, because of the current furor over securitization, but they produce the best single measure of a company?s creditworthiness. The raters award the best ratings to companies that can generate cash well in excess of what is needed to pay all their creditors and that possess a low ratio of debt to assets.

Once I?ve bought a stock, I try to be patient, because the payoff is usually not instantaneous. In 2001, when steel stocks looked horrible, I bought Nucor, the soundest company in the industry. Steel companies dropped like flies in 2002 and the stock did nothing?until the end of the year, when enough steel-making capacity had been closed down that steel prices began to rise. Nucor flew, and I made a nice profit.

The key to making this contrarian strategy work is to not overdo it. Some industries?newspapers, say, or fixed-line telecom companies?truly do have questionable futures. You have to analyze each situation on its own merits.? At present, my favorite industries are insurance, energy, agriculture/food processing, cement, and chemicals.

My value-hunting approach means that most of the stuff I buy is not popular. I veer away from firms that are pioneering new technologies or markets. Such companies are easy to get enthusiastic about, but difficult to value because there are so many unknowns.

When I talk about the companies I own, the response is often, ?You invest in obscure stuff.? What do you think about Google?? I don?t have an opinion on Google.? I can?t tell you whether it will produce enough profits over the years to justify its current price or not.? So much depends on future tastes and competition. I?d rather own cement companies; they are very difficult to make obsolete.

Take emotion out of it You should look over your portfolio two to four times a year. In my own case, I follow a very structured process. I take all of the investment ideas that I have gathered up since my last portfolio pruning, and rate them on valuation, momentum, and accounting quality to arrive at a composite measure of their overall desirability. I compare these ideas to the companies that are already in my portfolio.

This sounds complicated and so it is. But exactly how you do your ranking is less important than having a system for comparing the stocks in your existing portfolio to the alternatives that the market is offering you. Your goal should to take some of the emotion out of investing. You don?t want to fall in love with the companies that you already own. To avoid this, I try to pinpoint what companies in my ideas list are better than the median idea in my portfolio.? These become purchase candidates and I do further research on them.

I also look at the companies in my portfolio that are below the median in desirability, and I ask why I?m keeping them. In many cases, the companies are less desirable because they?ve gone up in price and are no longer as cheap as the once were. In other cases, they?re less desirable for the opposite reason? the company?s business has deteriorated and shows no signs of turning around. Every three to four months, I typically sell two or three companies from my 35-stock list and replace them with more promising companies from the ideas list. I typically hold a stock for three years.? Many of my ideas go against me at first, but often turn and make money for me later.

Smart money is slow money. If a stockbroker or financial planner tells you that you?ll miss a huge opportunity if you don?t buy right now, ignore them. A smart investor moves at his or her own pace.

To make sure that you don?t get pressured into buying something, it?s nearly always a good rule to avoid salespeople. Stockbrokers, financial planners, mutual fund salespeople and even the experts on the television all have financial incentives that can pull them in directions opposite to what?s in your best interest. Before buying any stock or any financial product, you should do a bit of background reading so that you understand what you?re buying and how much rival products cost. In many cases?insurance is a good example?you?ll find that the simplest product is your best buy. Complexity in insurance, and many other investments, is usually a cover for increased fees.

Especially when it comes to buying stocks, patience is your best friend. If an idea seems like a sure thing, sit on it for a month.? If the idea is still a good one, you will usually still have time to act on it.? If the idea is a bad one, the extra time will help you do further research and may make its problems evident.

One of the best ways to make money is to avoid losing it. When I approach new ideas, I try to ask how likely it is that I will lose money, and how much I could lose if I am wrong. I lose about 20% of the time. Six times in the last 15 years, I have lost half my money on an investment. Those are actually pretty good numbers. I can?t avoid all losses, but if I wait, take my time and do my research, I can limit my losses, and make money on the rest of my ideas.

As Light As Hydrogen

Posted on 19 March 201419 March 2014 by David Merkel

Okay let?s roll the promoted stocks scoreboard:

Ticker	Date of Article	Price @ Article	Price @ 3/18/13	Decline	Annualized	Splits
GTXO	5/27/2008	2.45	0.040	-98.4%	-50.8%
BONZ	10/22/2009	0.35	0.001	-99.7%	-73.0%
BONU	10/22/2009	0.89	0.001	-99.9%	-79.1%
UTOG	3/30/2011	1.55	0.000	-100.0%	-95.1%
OBJE	4/29/2011	116.00	0.167	-99.9%	-89.7%	1:40
LSTG	10/5/2011	1.12	0.010	-99.1%	-85.7%
AERN	10/5/2011	0.0770	0.0001	-99.9%	-93.4%
IRYS	3/15/2012	0.261	0.000	-100.0%	-100.0%	Dead
RCGP	3/22/2012	1.47	0.300	-79.6%	-55.1%
STVF	3/28/2012	3.24	0.420	-87.0%	-64.5%
CRCL	5/1/2012	2.22	0.026	-98.8%	-90.6%
ORYN	5/30/2012	0.93	0.110	-88.2%	-69.5%
BRFH	5/30/2012	1.16	0.515	-55.6%	-36.3%
LUXR	6/12/2012	1.59	0.009	-99.4%	-94.7%
IMSC	7/9/2012	1.5	0.900	-40.0%	-26.1%
DIDG	7/18/2012	0.65	0.042	-93.5%	-80.7%
GRPH	11/30/2012	0.8715	0.085	-90.3%	-83.5%
IMNG	12/4/2012	0.76	0.045	-94.1%	-88.9%
ECAU	1/24/2013	1.42	0.240	-83.1%	-78.8%
DPHS	6/3/2013	0.59	0.010	-98.3%	-99.4%
POLR	6/10/2013	5.75	0.070	-98.8%	-99.7%
NORX	6/11/2013	0.91	0.210	-76.9%	-85.2%
ARTH	7/11/2013	1.24	0.360	-71.0%	-83.6%
NAMG	7/25/2013	0.85	0.164	-80.7%	-92.2%
MDDD	12/9/2013	0.79	0.320	-59.5%	-96.4%
TGRO	12/30/2013	1.2	0.220	-81.7%	-100.0%
VEND	2/4/2014	4.34	4.900	12.9%	187.3%

	3/18/2014		Median	-93.5%	-85.2%

Tonight’s loser-in-waiting is HydroPhi Technologies [HPTG]. ?This one can’t even get basic science right. ?It claims to be able to split water into hydrogen and oxygen, and then recombine them to create energy. ?Circular processes in general lose energy, otherwise we would have perpetual motion machines.

And behind the vapid analysis is an uber-loser. ?His analyses never pan out over one year. ?A clever speculator might make money occasionally, but not regularly, because the stocks he pumps are like this one. ?Little revenues, negative earnings, negative net worth. ?This is a recipe for disaster.

Think about it — if you had a miracle energy technology, would you merge your company with a failed internet advertising company “BigClix?” ?I would think not. ?You would keep your company private and enjoy the significant profits.

As it is, there are no profits, so where is this great energy technology? ?This is a scam, and laws should be revised to allow prosecution of those who write such promotional garbage as we have seen. ?It is no good to have the 4-point type disclaimers telling some of the truth, while the big type says “Buy, buy BUYYY!!!” ?Also, as far as the web version of this promotion goes, the promoters pour in half a million. ?As it says in the 4-point type:

Third Party Advertiser IMPORTANT NOTICE: Esquire Media Services Inc (EMS) has managed up to a $500,000 USD advertising production budget as of January 21, 2014 in an effort to build industry and investor awareness for HydroPhi Technology Group Inc (ticker symbol: HPTG).?

It’s easy to affect the price of a company that has bad fundamentals. ?It’s overvalued to start; it will only be more overvalued at the crest of the promotion. ?If you attract a bunch of people to the pump-and-dump who want to play the momentum, some may think they will be clever enough to scalp a quick profit along with the insiders. ?Some of them win, and others lose. ?Others believe the advertising, and stay to lose a ton.

Seth Klarman recently said,??It might not look like it now, but markets don?t exist simply to enrich people.? ?This needs to be remembered by all. ?Markets are for trading, and trading is a negative-sum game. ?Those who buy & hold valuable businesses for a span — that is a positive-sum game, because the underlying asset is appreciating.

To close: don’t buy promoted stocks. ?Never. ?Those who are paid directly or indirectly to encourage you to buy are at best sub-agents for the seller — they aren’t on your side. ?In buying promoted stocks, it’s like going to Vegas, minus the fun. ?You will lose. ?You will lose a lot. ? The house edge is fixed — it’s only a question of how much you will lose.

Avoid promoted stocks. ?As I often say: “Don’t buy what someone else wants to sell you, buy what you have researched and know has value.”

“Different from the Consensus”

Posted on 16 March 2014 by David Merkel

At a recent investment competition that I attended, one of the judges asked the question to all teams, in a somewhat long-winded way, “How is your opinion different than the consensus?” ?Perhaps because I have heard it for too many years, I got a little tired of it.

So what is the consensus? ?There is no “consensus” document that is publicly available.

The consensus could be any collection of factors that justifies the current market price.
The consensus could be generally agreed upon ideas of a large majority of “sell side” analysts.
The consensus could be a few critical factors that are widely agreed on.

A correct insight that is different from that of the majority is valuable. ?But the majority is often right, at least in the short run. ?I often found as a buy side analyst that some sub-industry sectors were rationally priced and there were no plays to be made.

Therefore I would say don’t force yourself to be different from the consensus. ?If you have good reasons to be different from the consensus, pursue those views.

Sometimes the best answer is, “I don’t know,” or “This seems fairly priced to me.”

You don’t always have to make a decision. ?Even Buffett has a “Too Hard” pile for documents. ?As an aside, he tossed Assurant into the “too hard” pile, while I immediately embraced the IPO. ?And yes, I did have a view that was different than the seeming consensus.

Some say, “Not to Decide is to Decide.” ?Well, yeah, but as investors, we have to guard against false certainty. ?We will be hurt more by wrong actions we take than by right actions that we miss. ?There’s more than one fish in the sea. ?If you can’t find a good opportunity, well, keep looking. ?Peruse 13Fs of clever investors for ideas. ?Look for good companies in bad industries. ?Those will make you different than the consensus.

Don’t ever feel forced into making an investment decision. ?If it is not compelling, pass it up and wait. ?Yes, time is money, but haste makes waste. ?Particularly where fear or greed is involved, there are real risks of making bad decisions. ?Channel your inner Vulcan, and be as dispassionate as possible.

There is a consensus in investing, but it is an abstract thing, and not easily measured. ?Don’t aim to be different than the consensus; aim to be right, because often the consensus is right, and there is no reason to invest in a given company.

Full Disclosure: Long AIZ BRK/B

On the Structure of Berkshire Hathaway, Part 2, the Harney Investment Trust

Posted on 14 March 201414 March 2014 by David Merkel

In Omaha, there is Farnam Street. ?Among value investors, it is well-known, because the small main office of Berkshire Hathaway [BRK] is located there. ?Less well known is Harney Street, but from an insurance standpoint it is important, because Berkshire Hathaway’s largest insurance subsidiary, National Indemnity, is located there. ?One of the major assets of National Indemnity is the Harney Investment Trust, of which National Indemnity is the sole beneficiary.

Before I go further, I want to say there is a lot I don’t know about what I am going to write. ?Let me tell you what sources I have looked at:

SEC filings of companies where the Harney Investment Trust was a greater than 5% shareholder.
Legal documents from Bankruptcies and other corporate legal events where Harney Investment Trust was a party.
All of the statutory filings for Berkshire Hathaway’s primary insurance companies in 2012.
All of National Indemnity’s statutory filings on assets 2002-2013.
All of National Indemity’s statutory audits, 2002-2012.

Now, if you read through BRK’s filings to the SEC, you won’t find many mentions of the Harney Investment Trust. ?You have to read the insurance regulatory documents to find it, and even if you do that, you will still be puzzled. ?Why?

Over the last 12 years, the National Association of Insurance Commissioners does not require “Other Assets” on Schedule BA to provide enough data so that an external user can make the change in book value or market value make sense. ?It has gotten better over time, but it is still not enough. ?You want to have enough data such that it explains the change in market and book value to the nearest thousand dollars.
There are a few errors that are obvious. ?Some easy calculations don’t add. ?Current year starting values are not the same as last year’s ending values.
A few numbers between the statutory filings and audits don’t agree.

Now, some of that is due to bad regulation. ?The data reported for schedule BA assets could be streamlined such that it reports the change in the balance sheet for each asset on a book and fair market value basis.

But more of it is due to BRK’s lack of willingness to discuss/mention the Harney Investment Trust. ?I did a lot of digging on this, and found ?little that was definitive. ?One seemingly intelligent opinion I found here. ?I will quote the most relevant portion from “globalfinancepartners”:

Regarding the large surplus at Berkshire – it is largely because many subsidiaries are owned inside the insurance companies – especially within National Indemnity.? 100% of the stock of BNSF, for example, valued at BRK’s cost of $34 Billion – is owned by National Indemnity and counts towards the statutory surplus.? Also, National Indemnity owns 100% of the shares of GEICO.? Then in addition there are the securities, of course.

GEICO, in turn, owns 100% of the shares of Clayton, McLane, TTI, as well the marketable securities.

I’ll attach an NAIC filing if you really want to geek out.? But unfortunately, the mystery stock Buffett has been accumulating and receiving confidential status on through the SEC is hidden like always inside the “Harney Investment Trust” – Buffett’s go-to vehicle for keeping stock trading hidden from regulatory filings.? (Harney Street is in Omaha)

He gets it, mostly, and concludes that Buffett uses the Harney Investment Trust to hide his buying and selling of positions. ?Assets inside the Trust do not get reported one-by-one on the insurance Schedule D.

Now, before I close, I want to share the data that I have harvested from the Statutory statements, and make a few more comments.

Year	2001	2002	2003	2004	2005
Cost		?? 8,063,249,239	?? 6,098,184,425	??? 4,345,049,427	????? 7,566,419,887
Addl Investment					????? 4,314,851,219
Fair Value					?? 10,532,124,694
Book	?? 9,814,864,000	?? 9,325,481,908	?? 8,326,636,998	??? 5,326,049,532	????? 9,524,818,329
Change		???? (220,350,768)	?????? 859,931,290	? (1,141,017,994)	????? 1,958,398,441
Accretion
OTTI
FX Change
Inv Income					????????? 455,078,969
Book Sold		?? 5,405,086,442	?? 4,640,112,416	??? 2,934,268,712	????? 1,121,718,176
Change					?????????? (40,084,139)
Consideration		?? 6,156,977,208	?? 5,492,507,843	?? ?3,827,449,032	????? 1,561,718,363
Gain		?????? 751,890,766	?????? 852,395,427	???????? 893,180,320	????????? 399,916,048
income
% Assets		25.77%	18.33%	10.45%	15.36%
Am Cost	?? 8,355,067,000	?? 8,063,249,000	?? 6,098,184,000	??? 4,345,049,000	????? 7,566,420,000
URGC	?? 1,459,797,000	?? 1,711,427,000	?? 3,810,157,000	??? 2,316,272,000	????? 2,965,705,000
URCL	????????????????????????????????? –	?????? 144,894,000	????????????????????????????????? –	?????????????????????????????????? –	???????????????????????????????????? –
Fair Value	?? 9,814,864,000	?? 9,629,782,000	?? 9,908,341,000	??? 6,661,321,000	?? 10,532,125,000
Comments		Disagreeing figs

Year	2006	2007	2008	2009
Cost	????? 6,964,633,697	?? 20,139,079,483	????? 5,921,482,114	????? 5,786,018,179
Addl Investment	????????? 982,768,239	?? 15,783,905,450	????? 9,781,668,840	?? 10,865,269,974
Fair Value	?? 12,117,706,779	?? 21,921,621,265	????? 4,923,093,676	????? 6,769,046,868
Book	?? 11,123,440,646	?? 21,921,621,265	????? 4,801,843,191	????? 5,800,502,260
Change	????? 3,098,256,653	????? 1,751,436,622	??? (2,840,908,667)	????? 1,108,867,879
Accretion			????????? 119,595,243	????????? 197,707,597
OTTI			????????? 288,188,143	????? 2,590,146,282
FX Change			?????????? (57,873,620)	???????????? 36,966,246
Inv Income	????? 1,261,755,231	????????? 663,463,512	????????? 987,469,687	????????? 826,207,723
Book Sold	?? ???1,746,959,239	????? 2,653,395,647	?? 24,830,673,311	????? 8,645,957,509
Change	??????? (100,447,051)		????????????? (3,398,147)	???????????? 37,662,286
Consideration	????? 1,999,993,027	????? 6,522,527,452	?? 24,010,303,351	????? 9,017,341,154
Gain	????????? 353,480,839	????? 3,869,131,805	????????? 179,640,040	????????? 371,383,645
income			??????????????? 3,658,670	???????????? 62,505,008
% Assets	16.56%	29.56%	7.78%	7.39%
Am Cost	????? 6,964,634,000	?? 20,139,079,000	????? 5,921,482,000	????? 5,786,018,000
URGC	????? 5,153,073,000	????? 1,782,542,000	???????????????????????????????????? –	????????? 983,029,000
URCL	????????????????????????? ???????????-	???????????????????????????????????? –	????????? 998,388,000	???????????????????????????????????? –
Fair Value	?? 12,117,707,000	?? 21,921,621,000	????? 4,923,094,000	????? 6,769,047,000
Comments		Bought out other trusts	Cleaned House

Year	2010	2011	2012	2013
Cost	????? 9,457,498,340	????? 7,464,877,852	?? 7,064,639,865	?? 5,004,510,446
Addl Investment	????? 7,068,414,613	?? 12,784,563,299	?? 4,186,877,510	?? 3,254,233,606
Fair Value	?? 11,700,226,848	????? 7,807,366,099	?? 9,066,610,408	?? 7,675,070,719
Book	?? 10,720,330,531	????? 7,450,894,712	?? 8,417,129,742	?? 7,511,081,043
Change	????? 1,271,863,576	??? (1,276,652,476)	?? 1,332,026,027	?? 1,163,420,948
Accretion	???????????? 17,914,824	?????????? (25,309,149)	???????????? 2,759,586	???????????? 2,810,400
OTTI	????????? 476,659,635	????????? 190,142,457	?? ????115,680,863
FX Change	????????????? (5,766,223)	?????????????????? (911,734)	???????????? 1,296,067	????????????????? 659,774
Inv Income	????????? 554,369,500	????????? 719,996,080	?????? 389,469,312	?????? 403,093,171
Book Sold	????? 2,944,738,747	?? 14,566,437,847	?? 4,479,185,215	?? 5,214,644,823
Change	??????????????? 7,728,019	??????????????? 4,705,665	???????????? 4,970,996	???? (102,528,623)
Consideration	????? 3,576,396,272	? ?14,738,706,689	?? 4,833,798,698	?? 5,785,003,373
Gain	????????? 631,657,525	????????? 141,268,842	?????? 354,613,478	?????? 570,358,551
income	???????????? 76,920,680	???????????? 25,137,655	????????? 11,091,687	?????? 118,147,838
% Assets	9.60%	6.45%	6.59%
Am Cost	????? 9,457,498,000	????? 7,464,878,000	?? 7,064,640,000
URGC	????? 2,343,171,000	????????? 866,984,000	?? 2,083,717,000
URCL	????????? 100,442,000	????????? 524,226,000	????????? 81,747,000
Fair Value	?? 11,700,227,000	????? 7,807,636,000	?? 9,066,610,000

Notes: OTTI: other than temporary impairments. ?URCG: Unrealized Capital Gains. URCL: Unrealized Capital Losses. ?Other categories are hard to define, though I am sure the NAIC has definitions, though they don’t give complete changes in balance sheets.

Another thing that I could not make to match from the statutory statements was the securities that went in and out of the trust. ?Aside from some Treasury bonds ?in 2002, here are all of the reported transactions where securities moved from National Indemnity to the Trust, and vice-versa.

Year	Action	Ticker	Shares	Value	Consideration	Capital Gain (loss)
2003	In	MTB	???????? 927,760	????????????? 3,655,241
2003	In	WFC	???? 6,138,800	???????? 127,795,056
2003	In	AXP	???? 5,308,500	???????? 101,902,002
2003	In	MCO	?? 16,140,300	???????? 340,631,841
2003	Poof	LVLT	?? 32,691,065	???????? 100,000,000
2004	In	TMK	???????? 872,200	?????????? 20,268,837
2004	In	HRB	?? 14,350,600	???????? 222,546,836
2004	In	CDO	???? 1,195,274	????????????????????????????? 1
2004	In	COST	???? 5,254,000	???????? 146,595,428
2004	In	GCI	???? 3,447,600	?????????? 81,873,173
2004	In	MLI	???? 1,361,900	?????????? 30,408,193
2004	In	SEE	???? 1,113,300	?????????? 32,102,292
2004	In	USG	???? 6,500,000	?????????? 37,180,000
2005	Out	TMK	???????? 872,200	?????????? 20,268,837	???????? 49,826,080	?????????????? 29,557,243
2005	Out	HRB	?? 14,350,600	???????? 222,546,836	?????? 703,179,400	???????????? 480,632,564
2005	Out	CDO	???? 1,195,274	????????????????????????????? 1	???????? 26,666,563	?????????????? 26,666,562
2005	Out	COST	???? 5,254,000	???????? 146,595,428	?????? 254,346,140	???????????? 107,750,712
2005	Out	GCI	???? 3,447,600	?????????? 81,873,173	?????? 281,668,800	???????????? 199,795,627
2005	Out	MLI	???? 1,361,900	?????????? 30,408,193	???????? 43,853,180	?????????????? 13,444,987
2005	Out	SEE	???? 1,113,300	?????????? 32,102,292	???????? 59,305,491	?????????????? 27,203,199
2005	Out	USG	???? 6,500,000	?????????? 37,180,000	?????? 261,755,000	???????????? 224,575,000
2008	In	USB	?? 20,768,728	???????? 657,202,698
2008	In	WFC	?? 52,372,788	???? 1,819,017,267
2008	In	COP	?? 71,896,273	?? ??5,878,643,401
2008	In	COST	???? 5,264,000	???????? 146,595,428
2008	In	KFT	?? 89,222,400	???? 2,957,096,963
2008	In	PG	?? 17,200,318	???? 1,026,726,674
2008	In	USG	?? 10,102,918	??????? ?202,419,056
2008	In	WMT	?? 18,998,300	???????? 901,731,797
2008	Out	PG	?? 20,000,000	???? 1,193,846,154	?? 1,468,400,000	?????????? (274,553,846)
2009	In	COP	?? 29,711,330	???? 1,163,495,683
2009	In	MTB	???????????? 6,300	???????????????? 447,467
2009	In	PG	?? 14,328,093	???????? 855,276,936
2009	In	TMK	???? 1,656,900	?????????? 60,572,017
2009	In	WMT	?? 14,892,842	???????? 746,046,432
2009	In	WFC	?? 21,030,680	???????? 473,941,080
2009	In	GSK	???? 1,510,500	?????????? 78,918,016
2009	In	PKX	???? 1,087,000	?????????? 44,260,228
2009	In	SNY	???? 2,896,133	???????? 119,233,280
2009	Out	COP	?? 71,896,273	???? 5,690,321,498	?? 3,724,226,941	???????? 1,966,094,557
2009	Out	MCO	?? 15,000,000	???????? 163,880,137	?????? 284,850,000	?????????? (120,969,863)
2009	Out	PG	? ?26,000,000	???? 1,552,000,000	?? 1,607,320,000	???????????? (55,320,000)
2010	In	JNJ	?? 13,274,736	???????? 851,173,066
2010	Out	COP	?? 25,227,450	???????? 987,906,942	?? 1,288,365,871	?????????? (300,458,929)
2010	Out	KFT	?? 57,684,645	???? 1,885,271,843	?? 1,567,868,651	???????????? 317,403,192
2010	Out	MTB	???? 4,680,322	?????????? 36,930,716	?????? 216,105,603	???????????? 179,174,887
2010	Out	PG	?? 15,000,000	???????? 895,384,615	?????? 909,450,000	?????????????? 14,065,385
2011	In	COP	?? 21,109,637	???????? 826,653,385
2011	In	GCI	???? 1,740,231	?????????? 13,921,848
2011	In	IBM	?? 63,905,931	?? 10,856,339,550
2011	In	MTB	???? 4,671,245	?????????? 38,003,193
2011	In	PG	?? 12,669,252	???????? 756,256,889
2011	In	WFC	?? 28,446,437	???????? 718,140,133
2011	Out	JNJ	?? 12,951,761	??? ?????829,897,088	?????? 801,466,418	?????????????? 28,830,670
2012	In	WFC	?? 32,872,641	???? 1,090,916,624
2012	Out	PG	?? 29,754,036	???? 1,776,087,072	?? 1,984,891,742	???????????? 208,804,670

In means assets came into National Indemnity, and out means the reverse. ?Poof means something came into National Indemnity, and left in the same calendar year.

Notably, in 2008, Buffett had most of the assets exit the trust into National Indemnity, when they were in a position of unrealized capital loss. ?I don’t fully understand the tax and capital effects here, but it seems that Buffett found it to his advantage to move assets out of the trust, and into National Indemnity once the assets were unrealized capital losses.

I think the guy I quoted is correct. ?Buffett uses the Harney Investment Trust to hide his acquisitions and dispositions of stock. ?The NAIC should end this, and make Schedule BA assets that are easily separable appear on Schedule D, where they belong. ?Schedule BA should be for assets that are not publicly traded. ?Partnerships with assets that would fit on Schedule D should ?be on Schedule D.

Summary

Buffett tries to take an ethical stance in investing, and makes many statements about the way investing ought to be done. ?Using a trust to avoid disclosure of holdings and transactions is not in the spirit of GAAP or statutory accounting/disclosures. ? This practice should be ended. ?Warren, step up your game before you have to and end the Harney Investment Trust. ?I write this as a fan who owns BRK/B shares.

And, to my dedicated readers, if you have more data, or a better means of analysis of the data I have gathered, by all means offer your help. ?Thanks, David

Full disclosure: long BRK/B for clients and me

On the Structure of Berkshire Hathaway

Posted on 12 March 201413 March 2014 by David Merkel

Berkshire Hathaway [BRK] is a unique company. ?You have a property-casualty insurance giant owning many businesses directly through insurance subsidiaries, including huge businesses like a Class 1 Railroad — BNSF.

Yes, National Indemnity owns BNSF in entire, and many other businesses as well. ?I thought the pre-crisis org chart of AIG was complex — because of the many industries that it covers, BRK is far more complex. ? In the 2012 statutory statements, it runs for 22 pages. ?Let me list the top-level subsidiaries, and any significant lower level subsidiaries they own.

Affordable Housing Partners (common for reducing taxes w/ section 42 housing)
Albecca (Larson-Juhl)
AU Holding Company (Applied Underwriters
Ben Bridge Corporation
Benjamin Moore
Berkshire Hathaway Credit Corp (BH Media — all the little newspapers)
Berkshire Hathaway Finance Corp
BH Columbia Inc (Columbia Insurance, Medical Protective Corp [which owns Lubrizol debt])
BH Housing LLC
BH Shoe Holdings, Inc.
BH-IMC Holdings B.V. (“Iscar”)
BHSF (SF = Scott Fetzer)
Blue Chip Stamps, Inc. ?(Really, still around?)
Borsheim Jewelry Company
Brookwood Insurance Company
Business Wire, Inc.
Central States of Omaha Companies, Inc.
CORT Business Services Corp
CTB International Corp.
Cypress Insurance Company
Forest River, Inc.
Fruit of the Loom, Inc.
Garan, Inc.
Gateway Underwriters Agency
General Re Corporation (seems to own much of Fruit of the Loom)
Helzberg’s Diamond Shops
International Dairy Queen
Johns Manville Corp
Jordan’s Furniture
Justin Brands (Acme Brick)
Marmon Holdings
MidAmerican Energy Holdings (CalEnergy, HomeServices of America, Magma Power, NV Energy, Pacificorp)
MiTek Industries
MS Property
National Fire & Marine Insurance Company
National Indemnity (Flightsafety, BNSF, CLAL, GEICO, Clayton Homes, McLane, TTI)
National Liability & Fire Insurance Company
Nebraska Furniture Mart
NetJets, Inc.
Northern States Agency, Inc.
OTC Worldwide Holdings (Oriental Trading Company)
Precision Steel Warehouse, Inc.
R. C. Willey Home Furnishings
Richline Group, Inc.
See’s Candy Shops
Shaw Industries Group
Star Furniture Company
The Buffalo News, Inc.
The Fechheimer Brothers Company
The Lubrizol Corp
The Pampered Chef, Lrd.
US Investment Corporation
Wesco-Financial Insurance Company
XTRA Corp

BRK is huge, and Buffett prefers owning whole companies to portions of companies, because then the entire free cash flow is available to him, not just the dividends.

The first question to answer is why does Buffett have some industrial companies inside his insurers, and some not? ?That has to do with risk-based capital. ?P&C insurers have to put up capital equal to 22.5% on equity of affiliated insurers, and 15% on non-affiliated common stocks, and 20% on Schedule BA investments that are similar to stocks. ?These are more liberal than the standards for life companies, which ?have a 30% charge on stocks. ? (Which doesn’t make sense, because life insurers have longer balance sheets, and have a better ability to hold equities, but I digress…)

But even if they have to put up capital to own the companies, BRK has a negative cost of capital inside its insurers, because they make underwriting profits. ?What a business — make money on insurance, and on businesses owned by the insurance subsidiary.

One more thing about BRK’s insurance subsidiaries — in general, because they have so much asset risk, they don’t write as much insurance as other companies of their size would.

Tomorrow, I will write part 2 on this, regarding the one anomaly I found going through BRK’s statutory books, the Harney Investment Trust. ?Till then.

Full disclosure: long BRK/B for clients and me

The Rules, Part LXI (The End… of the Past)

Posted on 11 March 2014 by David Merkel

Rule: every rule has exceptions, including this one

In the long-run, and with hindsight, most actions of the market make sense. ?Sadly, we live in the short run, and our lives may only see one to 1.5 full macro-cycles of the market in our lives. ?We live in a haze, and wonder what useful economic and financial rules are persistently valid?

We live in a tension between imitation and thought, between momentum and valuation, between crowds and lonely reasoning, between short-term thinking and long-term thinking.

It would be nice to be like Buffett, who has no constraint on his time horizon, managing to the infinite horizon, because he has so much that setbacks would mean little to him. ?But most of us have retirements to fund, college expenses, a mortgage, and many other things that make us far more subject to risk.

Does valuation matter? ?You bet it does. ?When will it matter next? ?Uh, we can’t answer that. ?When we come up with a good measure of that, people begin using it, and the system changes.

My personal asset allocation for most of my life has been 75% risk assets/25% cash. ?Especially now, when bond yields are so low, I don’t see a lot of reason to extend the maturities of my bond portfolio, aside from a small position in ultra-long Treasuries, which is a hedge against deflation.

Investment reasoning is a struggle between the short-term and the long-term. ?The short-term gets the news day-by-day. ?The long term silently gains value.

If you invest long enough, you will have more than your share of situations where you say, “I don’t get this.” ?It can happen on the bull or bear sides of the market, and you may eventually be proved right, but how did you do while you were waiting?

Thus, uncertainty.

Is there a permanent return premium to investing in equities? ?I think so, but it is smaller than most imagine, particularly if compared against BBB/Baa bonds.

I’m not saying there are no rules. ?Far from it, why did I write this series?! ?What I am saying is that we have to have a firm understanding of the time horizon over which the “rules” will work, and an understanding of market valuations, sensing when valuations are high amid a surging market, and when valuations are low amid a plunging market. ?There are times to resist the trends, and times to embrace the trends.

The rules that I embrace and write about are useful. ?They reduce risk and enhance return. ?I once said to Jim Cramer before I started writing at RealMoney that the rules work 65% of the time, they don’t work 30% of the time, and 5% of the time, the opposite of the rules works. ?This is important to grasp, because any set of tools used to analyze the market will be limited — there is no perfect set of rules that can anticipate everything. ?You should expect disappointment, and even embarrassment with some degree of frequency. ?That’s the way of the market even for the best of us.

Hey, Buffett bought investment banks, textiles, shoes and airlines at the wrong times. ?But we remember the baseball players who had seasons that were better than .400, and Buffett is an example of that. ?In general, he made errors, but he rarely compounded them. ?His successes he compounded, and then some.

The rule I stated above is meant to be a paradox. ?In general, I am a long-term oriented, valuation-driven investor who seeks to maximize total return over the long haul, with significant efforts to avoid risk. ?Do I always succeed? ?No. ?Do I make significant mistakes? ?Yes. ?Have my winners more than paid for my losers over the 20+ years I have been an active investor? Yes, yes, and then some.

But this isn’t about me. ?Every investor will have days where they will have their head in their hands, like I did managing the huge corporate bond portfolio in September 2002, where I said to the high yield manager one evening as we were leaving work, “This can’t keep going on like like this, right? ?We’re close to this burning out, no?

He was a great aid to my learning, an optimist who embraced risk when it paid to do so. ?At the time, he agreed with me, but told me that you can never tell how bad it could get.

As it was, that was near the bottom, and the pains that we felt were those of the market shaking out the crud to reveal what had long lasting value. ?Or at least, value for a time, because?the modus operandi of the Fed became inflating a financial/housing bubble. ?That would not work in the long run, but it would work for a time. ?After that, I worked at a place that assumed that it would fail very soon, and was shocked at how far the financial excesses would eventually run. ?I was the one reluctant semi-bull in a bear shop that would eventually be right, but we had to survive through 4+ years of increasing leverage, waiting for the moment when the leverage had gone too far, and then some.

Being a moderate risk-taker who respects risk is a good way to approach the markets. ?I have learned from such men, and that is what I aim for in my investing. ?That means I lag when things are crazy, and that is fine with me. ?I don’t play for the last nickel — that nickel may cost many bucks. ?Respect the markets, and realize that they aren’t here to serve you; they exist to allocate capital to the wise over the long run. ?In the process, some will try to profit via imitation — it’s a simple strategy, and time honored, but when too many people imitate, rather than think, bad things happen.

The End, for Now

This post is the end of a long series, and I thank those who have read me through the series. ?I think there is a lot of wisdom here, but markets play havoc ?with wisdom in the short run, even if it wins in the long run. ?If I find something particularly profound, I will add to this series, but aside from one or two posts, all of the “rules” were generated prior to 2003. ?Thus, this is the end of the series.

The Rules, Part LVIII

Posted on 7 March 2014 by David Merkel

Can contingent claims theory for bond defaults be done on a cash flow/liquidity basis?? KMV-type models seem to fail on severely distressed bonds that have time to breathe and repair.

We’re getting close to the end of this series, and I am scraping the bottom of the barrel. ?As with most aspects of life, the best things get done first. ?After that diminishing marginal returns kick in.

Here’s the issue. ?It’s possible to model credit risk as a put option that the bondholders have sold to the stockholders. ?As such, equity implied volatility helps inform us as to how likely default will be. ?But implied volatilities are only available for at most two years out, because they don’t commonly trade options longer than that.

Here’s the scenario that I posit: there is a company in lousy shape that looks like a certain bankruptcy candidate, except that there are no significant events requiring liquidity for 3-5 years. ?In a case like this, the exercise date of the option to default is so far out, that the company can probably find ways to avoid bankruptcy, but the math may make it look unavoidable. ?Remember, the equity has the option to default, but they also control the company until they do default. ?Being the equity is valuable, because you control the assets.

Bankruptcy means choking on cash flows out that can’t be made. ?Ordinarily, that happens because of interest payments that can’t be made, rather than repayment of principal. ?If interest payments can be made, typically principal payments can be refinanced, unless credit gets tight.

The raw math of the contingent claims models do not take account of the clever distressed company manager who finds a way to avoid bankruptcy, driving deals to avoid it. ?The more time he has, the more clever he can be.

This is a reason why I distrust simple mathematical models in investing. ?The world is more complex than the math will admit. ?So be careful applying math to markets. ?Think through what the assumptions and models mean, because they may not reflect how people actually work.

On Finding Neglected Companies

Posted on 5 March 20145 March 2014 by David Merkel

While at RealMoney, I wrote a short series on data-mining. ?Copies of the articles are here: (one, two). I enjoyed writing them, and the most pleasant surprise was the favorable email from readers and fellow columnists. As a follow up, on April 13^th, 2005, I wrote an article on analyst coverage — and neglect. Today, I am writing the same article but as of today, with even more detail, and comparisons to prior analyses.

As it was, in my Finacorp years, I wrote a similar piece to this but it has been lost; I can?t find a copy of it, and Finacorp is in the ash-heap of financial firms. (Big heap, that.)

For a variety of reasons, sell-side analysts do not cover companies and sectors evenly. For one, they have biases that are related to how the sell-side analyst’s employer makes money. It is my contention that companies with less analyst coverage than would be expected offer an opportunity to profit for investors who are willing to sit down and analyze these lesser-analyzed companies and sectors.

I am a quantitative analyst, but I try to be intellectually honest about my models and not demand more from them than they can deliver. That’s why I have relatively few useful models, maybe a dozen or so, when there are hundreds of models used by quantitative analysts in the aggregate.

Why do I use so few? Many quantitative analysts re-analyze (torture) their data too many times, until they find a relationship that fits well. These same analysts then get surprised when the model doesn’t work when applied to the real markets, because of the calculated relationship being a statistical accident, or because of other forms of implementation shortfall — bid-ask spreads, market impact, commissions, etc.

This is one of the main reasons I tend not to trust most of the “advanced” quantitative research coming out of the sell side. Aside from torturing the data until it will confess to anything (re-analyzing), many sell-side quantitative analysts don’t appreciate the statistical limitations of the models they use. For instance, ordinary least squares regression is used properly less than 20% of the time in sell-side research, in my opinion.

Sell-side firms make money two ways.They can make via executing trades, so volume is a proxy for profitability.They can make money by helping companies raise capital, and they won?t hire firms that don?t cover them.Thus another proxy for profitability is market capitalization.

Thus trading volume and market capitalization are major factors influencing analyst coverage. Aside from that, I found that the sector a company belongs to has an effect on the number of analysts covering it.

I limited my inquiry to include companies that had a market capitalization of over $10 million, US companies only, and no ETFs.

I used ordinary least squares regression covering a data set of 4,604 companies. The regression explained 82% of the variation in analyst coverage. Each of the Volume and market cap variables used were significantly different from zero at probabilities of less than one in one million. As for the sector variables, they were statistically significant as a group, but not individually.Here’s a list of the variables:

*Variable*	*?Coefficients*	*?Standard Error*	*?t-Statistic*
?Logarithm of 3-month average volume	?0.57	0.04	?15.12
?Logarithm of Market Capitalization	?(2.22)	0.15	(14.69)
?Logarithm of Market Capitalization, squared	?0.36	0.01	?31.42
?Basic Materials	?(0.53)	0.53	?(1.01)
?Capital Goods	?0.39	0.54	?0.74
?Conglomerates	?(0.70)	1.95	?(0.36)
?Consumer Cyclical	?0.08	0.55	?0.14
?Consumer Non-Cyclical	?(1.40)	0.55	?(2.52)
?Energy	?2.56	0.53	?4.87
?Financial	?0.37	0.48	?0.78
?Health Care	?0.05	0.50	?0.11
?Services	?(0.30)	0.49	?(0.61)
?Technology	?0.82	0.49	?1.67
?Transportation	?2.92	0.66	?4.40
?Utilities	?(1.10)	0.60	?(1.82)

In short, the variables that I used contained data on market capitalization, volume and market sector.

An increasing market capitalization tends to attract more analysts. At a market cap of $522 million, market capitalization as a factor adds no net analysts. At the highest market cap in my study, Apple [AAPL] at $469 billion, the model indicates that 11 fewer analysts should cover the company. The smallest companies in my study would have 3.3 fewer analysts as compared with a company with a market cap of $522 million.

Market Cap	?Analyst additions
?10.00	?2.30
?30.00	?3.40
100.00	?4.61
300.00	?5.70
522.20	?6.26
?1,000.00	?6.91
?3,000.00	?8.01
10,000.00	?9.21
30,000.00	?10.31
100,000.00	?11.51
300,000.00	?12.61
469,400.30	?13.06

The intuitive reasoning behind this is that larger companies do more capital markets transactions. Capital markets transactions are highly profitable for investment banks, so they have analysts cover large companies in the hope that when a company floats more stock or debt, or engages in a merger or acquisition, the company will use that investment bank for the transaction.

Investment banks also make some money from trading. Access to sell-side research is sometimes limited to those who do enough commission volume with the investment bank. It’s not surprising that companies with high amounts of turnover in their shares have more analysts covering them. The following table gives a feel for how many additional analysts cover a company relative to its daily trading volume. A simple rule of thumb is that (on average) as trading volume quintuples, a firm gains an additional analyst, and when trading volume falls by 80%, it loses an analyst.

Daily Trading Volume (3 mo avg)	Analyst Additions
3	0.6
10	1.3
30	1.9
100	2.6
300	3.2
1,000	3.9
3,000	4.5
10,000	5.2
30,000	5.8
100,000	6.5
300,000	7.1
1,000,000	7.8
3,000,000	8.4
4,660,440	8.7

An additional bit of the intuition for why increased trading volume attracts more analysts is that volume is in one sense a measure of disagreement. Investors disagree about the value of a stock, so one buys what another sells. Sell-side analysts note this as well; stocks with high trading volumes relative to their market capitalizations are controversial stocks, and analysts often want to make their reputation by getting the analysis of a controversial stock right. Or they just might feel forced to cover the stock because it would look funny to omit a controversial company.

Analyst Neglect

The first two variables that I considered, market capitalization and volume, have intuitive stories behind them as to why the level of analysts ordinarily varies. But analyst coverage also varies by industry sector, and the reasons are less intuitive to me there.

Please note that my regression had no constant term, so the constant got embedded in the industry factors. Using the Transportation sector as a benchmark makes the analysis easier to explain. Here’s an example: On average, a Utilities company that has the same market cap and trading volume as a Transportation company would attract four fewer analysts.

Sector	?Addl Analysts	?Fewer than Transports
?Transportation	?2.92
?Energy	?2.56	?(0.37)
?Technology	?0.82	?(2.10)
?Capital Goods	?0.39	?(2.53)
?Financial	?0.37	?(2.55)
?Consumer Cyclical	?0.08	?(2.84)
?Health Care	?0.05	?(2.87)
?Services	?(0.30)	?(3.22)
?Basic Materials	?(0.53)	?(3.46)
?Conglomerates	?(0.70)	?(3.63)
?Utilities	?(1.10)	?(4.02)
?Consumer Non-Cyclical	?(1.40)	?(4.32)

Why is that? I can think of two reasons. First, the companies in the sectors at the top of my table are perceived to have better growth prospects than those at the bottom. Second, the sectors at the top of the table are more volatile than those toward the bottom (though basic materials would argue against that). As an aside, companies in the conglomerates sector get less coverage because they are hard for a specialist analyst to understand.

My summary reason is that “cooler” sectors attract more analysts than duller sectors. To the extent that this is the common factor behind the variation of analyst coverage across sectors, I would argue that sectors toward the bottom of the list are unfairly neglected by analysts and may offer better opportunities for individual investors to profit through analysis of undercovered companies in those sectors.

Malign Neglect

Now, my model did not explain 100% of the variation in analyst coverage. It explained 82%, which leaves 18% unexplained. Some of the unexplained variation is due to the fact that no model can be perfect. But the unexplained variation can be used to reveal the companies that my model predicted most poorly. Why is that useful? If my model approximates “the way the world should be,” then the degree of under- and over-coverage by analysts will reveal where too many or few analysts are looking. The following tables lists the largest company variations between reality and my model, split by market cap group.

Behemoth Stocks

Ticker	Company	Sector	Excess analysts
BRK.A	Berkshire Hathaway Inc.	07 – Financial	(25.75)
GE	General Electric Company	02 – Capital Goods	(20.47)
XOM	Exxon Mobil Corporation	06 – Energy	(19.32)
CVX	Chevron Corporation	06 – Energy	(14.64)
PFE	Pfizer Inc.	08 – Health Care	(14.57)
MRK	Merck & Co., Inc.	08 – Health Care	(12.76)
GOOG	Google Inc	10 – Technology	(11.44)
JNJ	Johnson & Johnson	08 – Health Care	(11.39)
MSFT	Microsoft Corporation	10 – Technology	(10.39)
PM	Philip Morris International In	05 – Consumer Non-Cyclical	(10.21)

Too many

Ticker	Company	Sector	Excess analysts
V	Visa Inc	09 – Services	?2.58
DIS	Walt Disney Company, The	09 – Services	?2.95
SLB	Schlumberger Limited.	06 – Energy	?4.15
CSCO	Cisco Systems, Inc.	10 – Technology	?5.22
QCOM	QUALCOMM, Inc.	10 – Technology	?5.34
ORCL	Oracle Corporation	10 – Technology	?5.98
FB	Facebook Inc	10 – Technology	?8.28
AMZN	Amazon.com, Inc.	09 – Services	?9.34
AAPL	Apple Inc.	10 – Technology	?10.57
INTC	Intel Corporation	10 – Technology	?11.85

Large Cap Stocks

Ticker	Company	Sector	Excess analysts
SPG	Simon Property Group Inc	09 – Services	(16.15)
BF.B	Brown-Forman Corporation	05 – Consumer Non-Cyclical	(16.03)
LUK	Leucadia National Corp.	07 – Financial	(15.93)
L	Loews Corporation	07 – Financial	(15.90)
EQR	Equity Residential	09 – Services	(15.87)
ARCP	American Realty Capital Proper	09 – Services	(15.75)
IEP	Icahn Enterprises LP	09 – Services	(15.50)
LVNTA	Liberty Interactive (Ventures	09 – Services	(15.36)
ABBV	AbbVie Inc	08 – Health Care	(15.01)
GOM CL	Ally Financial Inc	07 – Financial	(14.87)

Too Many

Ticker	Company	Sector	Excess analysts
UA	Under Armour Inc	04 – Consumer Cyclical	?16.68
BRCM	Broadcom Corporation	10 – Technology	?17.29
RRC	Range Resources Corp.	06 – Energy	?17.33
SWN	Southwestern Energy Company	06 – Energy	?17.70
RHT	Red Hat Inc	10 – Technology	?18.08
NTAP	NetApp Inc.	10 – Technology	?19.82
CTXS	Citrix Systems, Inc.	10 – Technology	?19.84
COH	Coach, Inc.	09 – Services	?20.87
VMW	VMware, Inc.	10 – Technology	?21.60
CRM	salesforce.com, inc.	10 – Technology	?22.64

Mid cap stocks

Ticker	Company	Sector	Excess analysts
FNMA	Federal National Mortgage Assc	07 – Financial	(13.84)
UHAL	AMERCO	11 – Transportation	(12.23)
O	Realty Income Corp	09 – Services	(12.06)
CIM	Chimera Investment Corporation	07 – Financial	(11.49)
SLG	SL Green Realty Corp	09 – Services	(11.46)
NRF	Northstar Realty Finance Corp.	09 – Services	(11.34)
FMCC	Federal Home Loan Mortgage Cor	07 – Financial	(11.14)
EXR	Extra Space Storage, Inc.	11 – Transportation	(10.97)
KMR	Kinder Morgan Management, LLC	06 – Energy	(10.94)
CWH	CommonWealth REIT	09 – Services	(10.51)

Too Many

Ticker	Company	Sector	Excess analysts
AEO	American Eagle Outfitters	09 – Services	?17.00
DRI	Darden Restaurants, Inc.	09 – Services	?17.40
RVBD	Riverbed Technology, Inc.	10 – Technology	?17.50
CMA	Comerica Incorporated	07 – Financial	?17.74
GPN	Global Payments Inc	07 – Financial	?18.30
WLL	Whiting Petroleum Corp	06 – Energy	?19.67
DO	Diamond Offshore Drilling Inc	06 – Energy	?21.57
URBN	Urban Outfitters, Inc.	09 – Services	?24.06
RDC	Rowan Companies PLC	06 – Energy	?24.48
ANF	Abercrombie & Fitch Co.	09 – Services	?26.02

Small cap stocks

Ticker	Company	Sector	Excess analysts
BALT	Baltic Trading Ltd	11 – Transportation	?(7.96)
ERA	Era Group Inc	11 – Transportation	?(7.45)
PBT	Permian Basin Royalty Trust	06 – Energy	?(7.42)
SDR	SandRidge Mississippian Trust	06 – Energy	?(7.18)
PHOT	Growlife Inc	02 – Capital Goods	?(6.79)
SBR	Sabine Royalty Trust	06 – Energy	?(6.74)
CAK	CAMAC Energy Inc	06 – Energy	?(6.64)
FITX	Creative Edge Nutrition Inc	09 – Services	?(6.57)
BLTA	Baltia Air Lines Inc	11 – Transportation	?(6.53)
VHC	VirnetX Holding Corporation	10 – Technology	?(6.49)

Too many

Ticker	Company	Sector	Excess analysts
WLT	Walter Energy, Inc.	06 – Energy	?12.19
ANGI	Angie’s List Inc	10 – Technology	?12.31
FRAN	Francesca’s Holdings Corp	09 – Services	?12.58
ZUMZ	Zumiez Inc.	09 – Services	?13.49
GDP	Goodrich Petroleum Corp	06 – Energy	?15.02
DNDN	Dendreon Corporation	08 – Health Care	?15.89
ACI	Arch Coal Inc	06 – Energy	?16.04
HERO	Hercules Offshore, Inc.	06 – Energy	?16.19
AREX	Approach Resources Inc.	06 – Energy	?17.64
ARO	Aeropostale Inc	09 – Services	?20.80

Microcap Stocks

Ticker	Company	Sector	Excess analysts
SGLB	Sigma Labs Inc	06 – Energy	?(6.18)
AEGY	Alternative Energy Partners In	10 – Technology	?(5.97)
WPWR	Well Power Inc	06 – Energy	?(5.83)
TTDZ	Triton Distribution Systems In	10 – Technology	?(5.53)
SFRX	Seafarer Exploration Corp	11 – Transportation	?(5.15)
PTRC	Petro River Oil Corp	06 – Energy	?(4.99)
UTRM	United Treatment CentersInc	08 – Health Care	?(4.82)
BIEL	Bioelectronics Corp	08 – Health Care	?(4.80)
DEWM	Dewmar International BMC Inc	01 – Basic Materials	?(4.74)
FEEC	Far East Energy Corp	06 – Energy	?(4.61)

Too many

Ticker	Company	Sector	Excess analysts
PRSS	CafePress Inc	09 – Services	?3.99
SANW	S&W Seed Company	05 – Consumer Non-Cyclical	?4.03
KIOR	KiOR Inc	01 – Basic Materials	?4.06
PRXG	Pernix Group Inc	02 – Capital Goods	?4.08
EYNON	Entergy New Orleans, Inc.	12 – Utilities	?4.17
PARF	Paradise, Inc.	05 – Consumer Non-Cyclical	?4.40
SUMR	Summer Infant, Inc.	05 – Consumer Non-Cyclical	?4.52
LAND	Gladstone Land Corp	05 – Consumer Non-Cyclical	?4.57
JRCC	James River Coal Company	06 – Energy	?6.38
GNK	Genco Shipping & Trading Limit	11 – Transportation	?7.11

My advice to readers is to consider buying companies that have fewer analysts studying them than the model would indicate.? This method is certainly not perfect but it does point out spots where Wall Street is not focusing its efforts, and might provide some opportunities.

Full disclosure: long BRK/B & CVX

On Intrinsic Value

Posted on 4 March 2014 by David Merkel

In his annual report, though not his more well-known letter, Buffett talked about intrinsic value. ?It was on pages 107-108, and here it is:

Now let?s focus on a term that I mentioned earlier and that you will encounter in future annual reports.

Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of?investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a?business during its remaining life.

The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a?precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are?revised. Two people looking at the same set of facts, moreover ? and this would apply even to Charlie and me ? will almost inevitably?come up with at least slightly different intrinsic value figures. That is one reason we never give you our estimates of intrinsic value. ?What our annual reports do supply, though, are the facts that we ourselves use to calculate this value.

Meanwhile, we regularly report our per-share book value, an easily calculable number, though one of limited use. The?limitations do not arise from our holdings of marketable securities, which are carried on our books at their current prices. Rather the?inadequacies of book value have to do with the companies we control, whose values as stated on our books may be far different from?their intrinsic values.

The disparity can go in either direction. For example, in 1964 we could state with certitude that Berkshire?s per-share book?value was $19.46. However, that figure considerably overstated the company?s intrinsic value, since all of the company?s resources?were tied up in a sub-profitable textile business. Our textile assets had neither going-concern nor liquidation values equal to their?carrying values. Today, however, Berkshire?s situation is reversed: Now, our book value far understates Berkshire?s intrinsic value, a?point true because many of the businesses we control are worth much more than their carrying value.

Inadequate though they are in telling the story, we give you Berkshire?s book-value figures because they today serve as a rough,?albeit significantly understated, tracking measure for Berkshire?s intrinsic value. In other words, the percentage change in book value?in any given year is likely to be reasonably close to that year?s change in intrinsic value.

You can gain some insight into the differences between book value and intrinsic value by looking at one form of investment, a?college education. Think of the education?s cost as its ?book value.? If this cost is to be accurate, it should include the earnings that?were foregone by the student because he chose college rather than a job.?

For this exercise, we will ignore the important non-economic benefits of an education and focus strictly on its economic value.?First, we must estimate the earnings that the graduate will receive over his lifetime and subtract from that figure an estimate of what?he would have earned had he lacked his education. That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day. The dollar result equals the intrinsic economic value of the education.

Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for?the education?didn’t?get his money?s worth. In other cases, the intrinsic value of an education will far exceed its book value, a?result?that proves capital was wisely deployed. In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value.

There are two problems with intrinsic value:

We don’t really know what future free cash flow will be, nor the willingness and ability of management to use it wisely.
We really don’t know what the cost of capital is for a firm, particularly not the cost of equity.

With simple firms, we can try to do a sum-of-the-parts analysis off of comparable companies — but often the differences are significant. ?It’s not easy.

Buffett has drawn a line in the sand, and that line has held so far — he buys back shares when the price drops below 1.2x book value. ?At present, that is his proxy for what I suspect is his minimum view of what BRK is worth.

This offers an experimental way of attempting to estimate intrinsic value, that is, if you are the CEO or CFO. ?Set up a valuation metric off of book or sales, since they don’t move as much as earnings, and then offer to buy back shares at a multiple of the metric that you think represents intrinsic value.

If you don’t buy many shares, you might want to move the multiple up. ?If shares come flooding in, move the multiple down. Oops, did I forget to mention “be conservative initially?”

I think Buffett is setting an example to other management teams on how to run an intelligent buyback. ?The main principle is this: buy back shares during a panic, or during a malaise that does not reflect future prospects. ?Don’t buy back shares all of the time. ?Wait for bargains to buy back shares.

If you set the barrier on when you buy shares such that it happens a few times a year, and cash levels never get too low, you’ve probably set up a good buyback plan, and as a bonus, you have a decent conservative idea of what the intrinsic value is for your stock.

I think it would make a lot of sense for CEOs and CFOs to imitate Buffett, and make their buybacks contingent on a certain multiple of book value or sales. ?Adapt the level to demand, and be conservative — it is far better to not make so much money, than to give away give away value by overpaying for your stock. ?You can always buy back more stock later; you can’t un-buy stock.

The side benefit of an exercise like this to a corporation is that it will understand its cost of capital well, and will be all the more able to make intelligent decisions on mergers and acquisitions, stock buybacks and issuance.

Full Disclosure: Long BRK/B for clients and me