Thursday, August 23, 2007

The Effect of Discount Rates on Intrinsic Value

The discount rate you use in a discounted cash flow valuation can have a big effect on an intrinsic value calculation. To illustrate, let's use an example based on the following assumptions:
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Earnings Per Share Year 0: \$1.00
Growth Years 1-5: 12%
Growth Years 6-10: 10%
Growth Years 11-15: 8%
Growth Years 16-20: 6%
Growth Years 21-25: 4%
Growth Years 26-30: 2%
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Under this scenario, the net present value of those 30 years worth of earnings is \$45.65 using the current risk free rate of 6% (even though the current risk free rate is lower, it is prudent to use 6% as a minimum) as our discount rate.
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However, if we change the discount rate to 10%, the value of that earnings stream is now only worth \$26.43. Furthermore, if we bump the rate up to 15%, the net present value is knocked down to \$15.40.
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So, discount rates have a big effect on valuation and that means that interest rates (which help determine appropriate discount rates) have a big effect on valuation. And as if that doesn't make things difficult enough, here's another fact: you can't predict interest rates over time.
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This is just further proof of the importance of only purchasing a security (or entire business) when you have a LARGE Margin of Safety between current price and intrinsic value, and it also stresses the fact that one should wait for a fat pitch before taking a swing while investing.

Monday, August 20, 2007

The Effect that Buying with a Margin of Safety has on Your Returns

A little math for a Monday morning:

Buy a stock at 50 percent (1/2) of intrinsic value, sell at 90 percent of initial intrinsic value:
IRR if it takes 2 years: 34.16%
IRR if it takes 3 years: 21.64%

Buy a stock at 67 percent (2/3) of intrinsic value, sell at 90 percent of initial intrinsic value:
IRR if it takes 2 years: 16.19%
IRR if it takes 3 years: 10.52%

Buy a stock at 50 percent (1/2) of intrinsic value, sell at 120 percent of initial intrinsic value (value increased):
IRR if it takes 2 years: 54.92%
IRR if it takes 3 years: 33.89%

Buy a stock at 67 percent (2/3) of intrinsic value, sell at 120 percent of initial intrinsic value (value increased):
IRR if it takes 2 years: 34.16%
IRR if it takes 3 years: 21.64%

It is interesting to note that buying a dollar's worth of value for \$0.50 and selling it for \$0.90 after 2-3 years, is the equivalent (on a return basis) of buying a dollar's worth of value for \$0.67 and selling it for \$1.20 after 2-3 years. This a good illustration of why you should require a larger margin of safety for a business that is not growing its intrinsic value, and be willing to pay a little more for a business that is growing its intrinsic value.

Monday, August 13, 2007

Warren Buffett on Diversification - 1966

(from Buffett’s 1965 letter to Partners)

Diversification

Last year in commenting on the inability of the overwhelming majority of investment managers to achieve performance superior to that of pure chance, I ascribed it primarily to the product of: "(1) group decisions - my perhaps jaundiced view is that it is close to impossible for outstanding investment management to come from a group of any size with all parties really participating in decisions; (2) a desire to conform to the policies and (to an extent) the portfolios of other large well-regarded organizations; (3) an institutional framework whereby average is "safe" and the personal rewards for independent action are in no way commensurate with the general risk attached to such action; (4) an adherence to certain diversification practices which are irrational; and finally and importantly, (5) inertia.”

This year in the material which went out in November, I specifically called your attention to a new Ground Rule reading, "7. We diversify substantially less than most investment operations. We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could drastically change the underlying value of the investment."

We are obviously following a policy regarding diversification which differs markedly from that of practically all public investment operations. Frankly, there is nothing I would like better than to have 50 different investment opportunities, all of which have a mathematical expectation (this term reflects the range of all possible relative performances, including negative ones, adjusted for the probability of each - no yawning, please) of achieving performance surpassing the Dow by, say, fifteen percentage points per annum. If the fifty individual expectations were not intercorrelated (what happens to one is associated with what happens to the other) I could put 2% of our capital into each one and sit back with a very high degree of certainty that our overall results would be very close to such a fifteen percentage point advantage.

It doesn't work that way.

We have to work extremely hard to find just a very few attractive investment situations. Such a situation by definition is one where my expectation (defined as above) of performance is at least ten percentage points per annum superior to the Dow. Among the few we do find, the expectations vary substantially. The question always is, “How much do I put in number one (ranked by expectation of relative performance) and how much do I put in number eight?" This depends to a great degree on the wideness of the spread between the mathematical expectation of number one versus number eight.” It also depends upon the probability that number one could turn in a really poor relative performance. Two securities could have equal mathematical expectations, but one might have .05 chance of performing fifteen percentage points or more worse than the Dow, and the second might have only .01 chance of such performance. The wider range of expectation in the first case reduces the desirability of heavy concentration in it.

The above may make the whole operation sound very precise. It isn't. Nevertheless, our business is that of ascertaining facts and then applying experience and reason to such facts to reach expectations. Imprecise and emotionally influenced as our attempts may be, that is what the business is all about. The results of many years of decision-making in securities will demonstrate how well you are doing on making such calculations - whether you consciously realize you are making the calculations or not. I believe the investor operates at a distinct advantage when he is aware of what path his thought process is following.

There is one thing of which I can assure you. If good performance of the fund is even a minor objective, any portfolio encompassing one hundred stocks (whether the manager is handling one thousand dollars or one billion dollars) is not being operated logically. The addition of the one hundredth stock simply can't reduce the potential variance in portfolio performance sufficiently to compensate for the negative effect its inclusion has on the overall portfolio expectation.

Anyone owning such numbers of securities after presumably studying their investment merit (and I don't care how prestigious their labels) is following what I call the Noah School of Investing - two of everything. Such investors should be piloting arks. While Noah may have been acting in accord with certain time-tested biological principles, the investors have left the track regarding mathematical principles. (I only made it through plane geometry, but with one exception, I have carefully screened out the mathematicians from our Partnership.)

Of course, the fact that someone else is behaving illogically in owning one hundred securities doesn't prove our case. While they may be wrong in overdiversifying, we have to affirmatively reason through a proper diversification policy in terms of our objectives.

The optimum portfolio depends on the various expectations of choices available and the degree of variance in performance which is tolerable. The greater the number of selections, the less will be the average year-to-year variation in actual versus expected results. Also, the lower will be the expected results, assuming different choices have different expectations of performance.

I am willing to give up quite a bit in terms of leveling of year-to-year results (remember when I talk of “results,” I am talking of performance relative to the Dow) in order to achieve better overall long-term performance. Simply stated, this means I am willing to concentrate quite heavily in what I believe to be the best investment opportunities recognizing very well that this may cause an occasional very sour year - one somewhat more sour, probably, than if I had diversified more. While this means our results will bounce around more, I think it also means that our long-term margin of superiority should be greater.

Friday, August 10, 2007

Ben Franklin's 13 Virtues

1. Temperance: Eat not to dullness and drink not to elevation.
2. Silence: Speak not but what may benefit others or yourself. Avoid trifling conversation.
3. Order: Let all your things have their places. Let each part of your business have its time.
4. Resolution: Resolve to perform what you ought. Perform without fail what you resolve.
5. Frugality: Make no expense but to do good to others or yourself: i.e. Waste nothing.
6. Industry: Lose no time. Be always employed in something useful. Cut off all unnecessary actions.
7. Sincerity: Use no hurtful deceit. Think innocently and justly; and, if you speak, speak accordingly.
8. Justice: Wrong none, by doing injuries or omitting the benefits that are your duty.
9. Moderation: Avoid extremes. Forebear resenting injuries so much as you think they deserve.
10. Cleanliness: Tolerate no uncleanness in body, clothes or habitation.
11. Chastity: Rarely use venery but for health or offspring; Never to dullness, weakness, or the injury of your own or another's peace or reputation.
12. Tranquility: Be not disturbed at trifles, or at accidents common or unavoidable.
13. Humility: Imitate Jesus and Socrates.

He committed to giving strict attention to one virtue each week so after 13 weeks he moved through all 13. After 13 weeks he would start the process over again so in one year he would complete the course a total of 4 times.

He tracked his progress by using a little book of 13 charts. At the top of each chart was one of the virtues. The charts had a column for each day of the week and thirteen rows marked with the first letter of each of the 13 virtues. Every evening he would review the day and put a mark (dot) next to each virtue for each fault committed with respect to that virtue for that day.

Naturally, his goal was to live his days and weeks without having to put any marks on his chart. Initially he found himself putting more marks on these pages than he ever imagined, but in time he enjoyed seeing them diminish. After awhile he went through the series only once per year and then only once in several years until finally omitting them entirely. But he always carried the little book with him as a reminder.
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Battle at Kruger

What do lions, a buffalo, and a crocodile have to do with investing and business? Pretty much nothing, but it is a good reminder that things aren't always as they seem.

Tuesday, August 7, 2007

“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful” - Warren Buffett

Where is there fear? Banks and mortgage-related companies are certainly two areas. Like USG and the quote above, it may again be fruitful to look to the Oracle of Omaha for ideas on where to look for mispriced opportunities.

Unlike other community banks, Bank of Granite has generated profits for more than 50 consecutive years. Famed investor Warren Buffett once called it the “most profitable community bank in America,” drawing worldwide attention to the Caldwell County bank.

After Buffet’s praise, “I had calls from England, Singapore and Tokyo wanting our published financial statements, and we had to hurriedly publish some more because we didn’t have enough,” Forlines recalls

Company Profile: http://www.bankofgranite.com/company_profile.php

*This is not a recommendation to buy or sell a security. Please do your own research before making an investment decision.

Drywall Maker in Pain as Housing Suffers

When a business is trading at a lower price than several proven value investors (including Mr. Buffett) last bought shares, it is usually a good place to start your research.

USG is such a company and the NY Times recently wrote an short article about the company.

“Business is tough,” said William C. Foote, chairman and chief executive of USG. “The housing recession is entering the second year of what is likely to be a multiyear downturn.”

*This is not a recommendation to buy or sell a security. Please do your own research before making an investment decision.