Loews 2012 Annual Report

So the 2012 annual report is up on the website.  They revamped it and Loews even has a new logo.

Here is the new logo:

I'm not an art major or anything like that so I don't know anything about it but my first impression was that this looks a little retro, even Art Deco-ish.  Loews is going for a more contemporary look with this, apparently, but it looks more retro than modern.  But then again, what do I know.  I'm sure they paid good money to a well-schooled designer to create it so it must be good.

For reference, here is the old logo:



Not to complain too much, but many of the materials on the website including the ones updated in 2013 still has the old logo.  That sort of spoiled the 'freshness' of the new website.  

Anyway, what the heck am I talking about?  Who cares.   Let's look at some stuff in the annual report.   This is not a summary by any means, but just random comments that came to mind as I read through the report.

There is really nothing new here, just stuff we already know.  In this year's annual report, they put in the stock price performance versus the S&P 500 index for 10, 20, 30, 40 and 50 years:

...and the usual shares outstanding comparison.   They are very good allocators of capital and they do buy back a lot of stock.  Share count is down by 2/3 since 1971 which is very reassuring; these guys aren't going to go on a buying binge just to get bigger or use up excess capital.




They explain their approach to investing.  I think investors are antsy that L is sitting on so much cash; they wonder when they will do a big deal that might get the market excited about L.  So this is their response to that, I suppose.

Substantial Investments
Tisch did say that although they haven't done any large acquisitions, they have been investing actively at the subsidiary level.  L has spent or committed $6.5 billion since 2010 through their subs. 


Sum of the Parts Valuation

And as usual, here is the sum of the parts valuation of L they include in their annual reports and presentations (stock price data as of Feb 1, 2013).   I haven't talked about the numbers in this post at all since I already did some work on the 10-k in my previous posts:  Loews Adjusted Book Value Update and More Adjustment to Loews Book Value.

Hedge Funds
L mentioned hedge funds in the annual report, that they invest 5% of CNA's investments in limited partnerships.  People are always asking who they allocate capital to, or what the performance is like.  In the annual, they said that in the past 15 years the partnerships have earned 11%/year.  In a recent interview, Tisch said that the hedge funds over time have earned 5-10% more than the 3 month treasury rate.

Also, at the website on the annual report page is a presentation called "Company Overview" which is worth reading.

From there is a little more about L.  I won't summarize everything that's in there but here are some interesting things I'll cut and paste here.

First is how well Diamond Offshore and Boardwalk has done for L.  People criticize Diamond Offshore as having an old fleet, but Tisch explains in the annual report that the age of the fleet might be old, but they have spent a lot of money building new rigs and rebuilding old ones and these rigs do get contracted out at good rates so that's what counts.  Diamond's returns over time is shown in a table below.  Also, L has taken a lot of cash out of Diamond over the years.  Boardwalk has also done well and even though they just invested in 2003, they have already gotten back their total investment (invested a total of $3.2 billion and got it all back already and they still own a bunch). 

That's pretty good.

The company overview presentation shows some promising trends in their subsidiaries.  Here's one that Tisch has been talking about; the firming of pricing in P&C insurance:

If this continues, obviously it would be good for CNA, which accounts for a large part of L's value. 

 



Contrary to what you would imagine, ultra-deepwater day rates are trending nicely, getting back up to the 2007-2008 highs.  This is good for DO, of course, since they have some new rigs coming online soon.

 DO has performed well over time:

And they think that natural gas demand will rise over time:

Lotta Value: Investment Hunter
And I don't know if this is desperation, but they put up on the website a comic book, oops, sorry, I meant graphic novel (this makes it OK for adults to read, I suppose) to tell the Loews value story.  I know they have been frustrated for years that L doesn't trade at or above the sum of the parts.  Tisch believes that L is worth more than the sum of the parts, and it has been frustrating for him for many years.

So this is where they go.  They turn to a comic book!  Oops, I mean graphic novel.  I suppose it's OK.  There's nothing wrong with having some fun.  But I would be shocked (and scared) if Lotta Value helped narrow the discount between stock price and intrinsic value. 

I know Warren Buffett has been frustrated too with the stock price of Berkshire Hathaway, pounding the table recently in his annual reports insisting that BRK is worth far more than book value. 

If Buffett did a comic book, maybe he would borrow some talent from Iger (Disney) and do a better one.   Who knows.

This one certainly won't appeal to the younger crowd... but then again, the younger crowd is not the ones with the money, I suppose.

 

 

This is just the first page.  You can download the whole thing at the L website.
For people who are too lazy to even read a comic book, they did a video so you can watch that instead.

Lotta Value book and video

I suppose it's good that they are trying new things to get the word out and try to narrow the discount.

Conclusion
The new website is nice.  Simple and fresh, with some new stuff on there.  It would be really great if they put more meat in the history section.  I'm sure there is a lot of interesting stuff they can put there.  The new logo to me is nice even though it doesn't seem contemporary to me.  But what do I know, and why am I even talking about it?  What difference does it make to an investor?

Flipping through the annual report and company overview, I get the sense that L is really on top of things and are working hard to create value.  There does seem to be a lot of potential in their various areas of investment.  If the CNA turnaround really works and they get their combined ratios down, premiums go up and rates keep firming, there can be some real upside in the stock as CNA is still trading cheap.  Interest rates might have to go higher, though.  

Diamond Offshore looks good too in the longer term as it does look harder and harder to find cheap oil and oil companies will need to keep drilling. 

I'm actually surprised at how well Boardwalk is doing despite low natural gas prices and L sees a lot more growth ahead which is good. 

Loews Hotels too seems to be more active.  For a long time, it seemed to me that it was just there.  They owned some nice hotels but it just didn't really do anything.  Now it seems like there is some activity going on, so we'll see how that goes.

Anyway, other parts look interesting too.  Have a look for yourself.

 

Markel 2012 Annual Report

The Markel (MKL) results have been out, but I just noticed that the annual report is out too (I don't check so it may have been out for a while).  The MKL annual report is a very good read of you have the time to check it out.

We know this from the earnings release, but MKL grew book value a nice +14.7% in 2012 (despite Sandy) and had a 97% combined ratio.   They had a $399 million reserve release last year, but that's because they tend to be conservative in their reserving (they explain it in the annual report).  Some may complain that the combined ratio in recent years is phoney due to these releases, but that's like saying AIG isn't really as bad as it looks because they are just taking hits on past policies they wrote that were bad.  If we can penalize some for under-reserving, why should we penalize others for being conservative?

Anyway, the investment portfolio at Markel did quite well too with the equity portfolio rising +20% and fixed income portfolio earning 5%.

There was a nice explanation in the report about their approach to equity investing.  Their equity portfolio has returned +9%/year in the past ten years (versus +7%/year for the S&P 500 index) and +10%/year in the past twenty years (versus +8%/year for the S&P 500 index).  I wonder if there are any mutual funds or even hedge funds out there with 20 year returns like this?   Probably not too many.

The book value per share (BPS) at MKL also increased nicely over the long term rising +13%/year over  ten years (versus +7%/year for the S&P 500 index) and +16%/year over twenty years (versus +8%/year for the S&P 500 index).

This is how they explained what they do in their equity portfolio (this should be boringly familiar to regular readers here):

MKL's underwriting continues to do well (MKL combined ratio):

And here is an updated table on their investment portfolio:

There's a lot more in the annual report so check it out.  

Anyway, all of these five, ten and twenty year figures got me curious.  I do follow a lot of these "Berkshire-like" entities and have been updating their performance so I figured, why not put all of this stuff into a table?   The annual reports of these entities are starting to dribble out (Y and FRFHF are out too).  How are these guys doing compared to the S&P 500 index and Berkshire Hathaway over time?  

                          2012           5 year          10 year        20 year
MKL                +14.7%        +8.8%         +13.1%      +16.1%   
Y                     +10.8%          +6.1%           +8.8%            na
FRFHF              +6.5%       +10.6%          +11.6%      +16.2%
L                        +5.1%         +9.6%         +10.0%        +11.2%        
LUK                  +9.6%          +2.0%        +12.4%        +10.6%
GLRE                +1.9%          +5.8%

BRK                 +14.4%        +7.9%         +10.6%       +14.4%
S&P 500          +16.0%        +1.6%           +7.1%         +8.2%

(All of the above include dividends except LUK and FRFHF.  FRFHF 2012 return includes dividends, but historical BPS growth does not)

What's pretty amazing is that not only did MKL beat the S&P 500 index in most time periods, it also beat BRK in all of the above time periods.  Of course, it's not in the nature of the MKL folks to mention that in their annual report, but there it is.

MKL is trading now at $504/share versus 2012 year-end BPS of $403.85/share, around 1.3x book.  MKL is certainly not dirt cheap but with performance figures like the above it may well be worth the premium.    

(Update after the fact:  The above $403.85/share BPS doesn't take into account the Alterra merger which will be about 4% accretive to BPS.  Plus a strong stock market, up 10%, would push up pro-forma BPS by another 3% or so, so the BPS would be 7% higher (the equity portfolio would be 30% or so of pro-forma shareholders' equity))

More Adjustment to Loews Book Value

So I made a post about the adjusted book value per share of Loews (L) and someone kindly responded that there are publicly listed MLP general partnership (GP) interests that I can use to value L's GP interest and IDR (incentive distribution rights) in Boardwalk Pipeline (BWP).

The thing to do, of course, would be to calculate the implied valuation of the GP/IDR from these listed entities at current prices and I may actually do that at a later date.

But for now, I just wanted to get a sense of the valuation of these things so I did some googling first (to avoid too much work!).  Keep in mind I'm not the best googler in the world, but I did find something interesting. 

There are some presentations and reports out there that value these GP/IDR interests very highly.  One report analyzed the implied values of GP interests (as a ratio of total GP cash flow (including IDR) based on acquisitions between 2007 and 2010.  The low was around 12x and the high was almost 60x with a median of 24x and average of around 28x cash flow.

Even Kinder Morgan (KMI), when it IPO'ed, came out at 25x cash flow (IPO enterprise value / total GP cash flow).  This valuation would include income from their limited partnership interest too.

For some clean numbers, I looked at the merger proxy of the Kinder Morgan - El Paso merger.  Merger proxies are great because of the valuation work included in there (even though we spend time laughing at investment bankers, sometimes that stuff comes in handy).

Anyway,  according to the proxy filed in October 2011, the peer group valuation of the general partnership interest that KMI owns as a ratio enterprise value (EV) of only the GP portion / GP distribution (including IDR) was valued using this peer group:

Alliance Holdings, L.P.
Atlas Energy, L.P.
Crosstex Energy
Energy Transfer Equity
NuStar GP Holdings
Targa Resources Corp

The valuations (EV of GP only / GP distribution including IDR) were:

                 mean             median            high           low
2011e        20.9x             19.4x               29.5x        15.5x
2012e        17.7x             17.2x               21.7x        14.5x

Since we know the 2012 cash flows for BWP, let's just use the 2011 estimated valuation of 19.4x median or 20.9x mean.  We can just use 20x because it's a simple round number.

There was also a historical transaction analysis done by Barclays of GP transactions between 2003 and 2010.  The valuation ranged from:

           low         median            high
           12.7x      18.8x               26.1x

Barclays added to this EV valuation KMI's holdings in the LP's, so the above 18.8x figure is for the GP-IDR cash flows alone.   The deal universe was:

Sellers:
Penn Virginia GP Holdings, LP
Enterprise GP Holdings, LP
Inergy Holdings, LP
Buckeye GP Holdings, LP
Magellan Midsteam Holdings, LP
Markwest Hydrocarbon, Inc.
Kaneb Pipeline Partners, LP & Kaneb Services LLC
Plains Resources, Inc.


Again, this points to a valuation in the 19-20x range, far higher than the 10x multiple I put on the cash flow in my L valuation post.

Loews Adjusted BPS Updated
So, adjusting the prices of DO, CNA and BWP as I did in my last post to current prices, we get an adjusted BPS of $52.21/share for L now.  This figure does not include the 2% GP interest and the IDR.

Here is the cash flow from the 2% partnership interest and IDR paid to L in the past four quarters:

Amount Paid to GP (including IDR, millions)
February 2012:     $9.1
May 2012:            $9.6
August 2012:      $10.2
November 2012: $10.8
Total:                   $39.7

Using the above figure of 20x, that comes to  $794 million for the value of the BWP GP, and with 392 million shares outstanding, that comes to around $2.00/L share.  

Add this to the $52.21 above and we get a total adjusted book value of $54.21/share.   With L now trading at around $44/share, that's a 19% discount to adjusted book value.

This is just a quick look at this piece of L.  I don't think people spend too much time on it as it doesn't take up a large percentage of the value, but if BWP keeps growing, this can get big enough to really make a difference.

I don't follow MLP/GPs at all so there is probably a lot more that can be done here in terms of fine tuning the valuation (or more recent proxy/valuation tables), but for now, I think the above look is a little better than just randomly throwing a 10 multiple on the GP cash flows.  Good enough for me (for now). 

Value of Investments per Share (Berkshire Hathaway)

So I explained in my most recent post (Buffett Letter 2012) on Berkshire Hathaway (BRK) why investments per share is not worth investment per share to me.  I know this makes no sense to many, and even Buffett would say it makes no sense.  Cash is worth what it's worth.  No more, no less.

I don't have a problem with that, really.  But I just have another way to look at it, so I thought I'd clarify a little bit more.  Someone posted a comment that I should value investments at market value, and I responded there but then realized I should make my response a full post.  I know there have been debates about this all over the internet for years.

So anyway, here are my thoughts.

Investments are Often Worth Market Value
First of all, investments are worth their market value if they are realizable.  If it can be distributed to shareholders in some way (spin-off, liquidated and cash distributed etc.) without disrupting the business operations, then I believe you can value it at market (less taxes or whatever adjustments that need to be made).

On the other hand, if the investments are part of a business, like in an insurance company, then this is not freely distributable, and therefore it may not be worth market value (not to mention that float becomes an obligation on liquidation).

To keep things really simple, I'll talk about a hypothetical insurance company instead of plugging in the real figures for BRK.  I am going to make up all of these figures so bear with me.

Hypothetical Insurance Company:  Berkaway Hathshire
First of all, let's assume that this amazing insurance company, Berkaway, has an incredible underwriting staff that always breaks even (at least) in the underwriting operations.  Let's say that it's pretty much a sure thing that the cost of float will be free.

Second, let's assume that the investment leverage is 2.5x (much higher than BRK), and this company invests it's float in only fixed income securities.   After-tax return on fixed income securities these days come to around 2% (Don't argue! Let's just say it is true).

Let's also say that the shareholders equity of Berkaway is $1 million.

So here are the figures:

Shareholders equity:        $ 1 million
Float:                                $ 1.5 million
Investments:                     $ 2.5 million (2.5x investment leverage)
Net earnings:                    $ 50,000
ROE:                                 5%

This is what Berkaway looks like.  You see that the ROE comes to 5% despite 2.5x investment leverage.

Now, this is what we are arguing about:  What is the value of this insurance company?

If you believe that an insurance company with zero cost float is worth the investments it owns, then you are saying that Berkaway is worth $2.5 million.

OK.  No problem.  That's one way to look at it.

Some say that the investments is worth market value because that is what you can get if you sell it.  But does the $2.5 million really represent liquidation value?  Let's see what happens if you sold all the investments, paid back the float and distributed the rest to shareholders.  What do you get?  Exactly.  You get $1 million, not $2.5 million.  In liquidation, the float becomes an obligation even if it's as good as equity in a going concern.   That's the paradox of this situation (like trying to catch your own thumb); float is as good as equity and investments are worth market value, but if investments are worth market value in liquidation, then float is not equity anymore).


Equity Investor
Here is how an equity investor might look at it.  I don't want to get into theoretical stuff too much, but let's just say that the cost of equity is 10%.  In other words, when investors invest in stocks, they typically want to earn around 10%. 

If that is the case, then Berkaway is clearly not worth $2.5 million.

As is common in valuing financial companies, the usual way to look at this (and I admit the usual way is not always the right way) is that if a financial company can't earn 10% ROE, then it's not worth book value, and if it can earn more than 10%, then it's worth more than book value.

Buffett Agrees with This
So before we dismiss this notion that firms that earn an ROE below 10% isn't worth book value as being silly, let's think about what Warrren Buffett himself just said on CNBC the other day.

In talking about banks, someone asked him about the cheap banks; banks that trade for less than tangible book.  Wells Fargo trades above book value.  Buffett said that book value doesn't matter in valuing banks, it's the earnings that count.  Now, that sounds odd coming from Buffett who advocates ROE as an important measure of capital efficiency or management competence.

What I realize now when he said that is that he just means that looking at P/B ratios is not that meaningful in evaluating banks.

He clarified that by saying that if a bank can earn return on tangible assets above 1.0%, then it can trade above tangible book value.  If it can't earn 1.0% on tangible assets, then it is worth less than tangible book value.  Banks like Citigroup have ROA below 1% so isn't worth more than tangible book.

By the way, I think Buffett uses 10x leverage for a typical bank, so 1% ROA translates into 10% ROE.

So he is saying the same thing I am saying about financials:  If a financial can earn an ROE above 10%, it is worth more than book, and if it can't, then it's worth less than book.

Another way of saying that is that Buffett thinks the cost of equity for financial companies is around 10%  (But don't use that phrase, cost of equity, in front of Buffett!).

Back to Berkaway Hathshire
So, going back to Berkaway, the ROE in the above example would imply that it is only worth 50% of book value.  On a 5% ROE, you have to pay 50% of book to make a 10% return.   Book value of Berkaway was $1 million, so it's only actually worth $500,000 (at 50% of book).

So how does that compare to total investments?  Total investments are $2.5 million, so at $500,000, Berkaway is actually only worth 20% of total investments.

Other Insurance Companies
So if you still believe that BRK's investments per share are worth the total value, then why not look at other insurance companies?  I would imagine that other insurance companies are very cheap too using this metric (investments per share of Markel, for example, far exceeds it's share price).

The common argument (which is fair) is that BRK doesn't lose money in underwriting (unlike most other insurance companies).  In fact, it has earned $18 billion in the last ten years or some such thing.  I don't know if I would want to bake that into any valuation (opinion here differs, but I don't have a strong feeling either way.  I just sort of not include it.  All valuation measures to me are just ballpark things to think about, not concrete, absolute things).

But underwriting profits and losses can easily be incorporated in valuations.  If cost of float is positive for some companies, you can just deduct from the valuation of the company (if it tends to lose, on average, $1 billion a year, just knock off $10 billion from the valuation).  Conversely, if a company has a negative cost of float, then just capitalize that (if it tends to earn $1 billion in underwriting profits over time, then just add $10 billion to the valuation).

I don't think there is a need to value one insurance company at investments per share because they have a zero or negative cost of float, and then value every other insurance company on the planet at book value or according to ROE.

That sort of seems unreasonable to me.

So, either look at BRK like other insurance companies (using book value, ROE etc...) or look at the other insurance companies using investments per share (and then making adjustments for underwriting losses/cost of float etc.).

I don't think everything should be valued the same way, but in this case, I think it's reasonable as it's a pretty straightforward model we are talking about (ROE, P/B ratios etc...).

But anyway, this is just my opinion.  I'm just clarifying my thoughts on the subject.  I know that the opinions on this stuff differs dramatically and that's totally fine.

   

Loews Adjusted Book Value Update

I may be jumping the gun here as Loews (L) annual report hasn't come out yet, but since the 10-K is out I figured I would just update some numbers.

Last year I made a post about adjusting L's book value by adding or subtracting the difference between the market value of publicly listed holdings of L instead of adding up the sum of the parts. The problem with summing the parts for me was trying to figure out what the rest of L was worth, and figuring out what tax rate (if any) to apply to the market value of the listed holdings.

I figured that if I just adjust the equity of the listed holdings on L's balance sheet by the price-to-book ratio on the subsidiary's listed stock, that would reflect them at current market value.  Plus, I would know how much gain or loss there would be if the positions were sold.  I thought it was an elegant solution (and a very simple one).   For example, if L carried something on it's book at $1.00 and the stock traded at 1.5x book, I can just adjust the $1.00 by multiplying it by 1.5x.

This year, I noticed some problems with this approach (the equity on the L's balance sheet and on the subsidiaries balance sheet sometimes don't match;  Boardwalk Partner's (BWP) equity is much smaller on L's balance sheet than on BWP's own because of deferred taxes and other things).  

Also, it tends to be quite sloppy.

So I completely redid my calculations, but this time simply took the number of shares owned by L, multiplied by the stock price and then looked at the difference between that and what was on L's balance sheet (the assets, liabilites, total equity, minority interest etc. for each of the subsidiaries can be found at the back of the 10-K).   In the case of CNA, I had to add back the preferred shares it sometimes owned as that is included in the equity on L's balance sheet, but wouldn't be reflected in a market value calculation if you took the number of CNA shares held and multiplied it by CNA's stock price.

Anyway, enough boring details.  (I also did find one error, but it doesn't really change the gist of the story much).

Book Value
In 2012, BPS grew +4.6%, and +5.12% if you include dividends paid.  Dividends paid reduces book value, so looking at BPS growth alone doesn't tell us how well management did.  So I often look at BPS change including dividends (add dividends paid to the year-end BPS and then calculate change in BPS; this would be sort of a comprehensive ROE.  Keep in mind that this may not be a figure that an investor can compound at because dividends will be taxed and reinvestment may not occur at book value).

So using this BPS plus dividends figure, here is how L has done over time:

                                                     S&P 500
                              Loews             Index               BRK
5 year                      +9.6%          +1.6%                +7.9%            
10 year                  +10.0%          +7.1%              +10.6%
Since 1989            +11.2%          +8.5%              +15.3%
Since 1999            +10.0%          +1.6%                +8.8%

So L has grown at a pretty consistent 10% or so, beating the S&P 500 index by a good margin and comparable to Berkshire Hathaway.  1999 is when James Tisch became CEO, so the performance since 1999 reflects his performance.

As we saw in the table, L's book value per share has grown at a faster pace than the S&P 500 index. It lagged in the bubble years of the 1990s, but has been going straight up since 2000:







Loews BPS versus S&P 500 (Total return)

And here's the L stock price versus BPS:

Loews Book Value Per Share versus Stock Price

This chart shows the spike in 2007 caused by the Diamond Offshore (DO) rally.  It seems like L has traded near book value most of the time and is now trading below it.

Long Term Performance
Since I don't have data going all the way back, I just look at stock price performance over time for long term comparisons.

Here is a chart of Loews stock (including dividends) over time compared to the total return of the S&P 500 index.

Since 1970:

Loews versus S&P 500 Index (both include dividends)

The blue line is L, and the red is the S&P 500 index.  Since 1970, Loews has returned 12.2%/year (including dividends) versus +10.1%/year for the S&P 500 index (including dividends).  The spike in 2007 was due to Diamond Offshore going up dramatically during the oil bubble.  L traded at over 1.5x book back then.


Adjusted Book Value
So getting back to adjusted book values, below is the table I posted last year but the figures for adjusted book values are all recalculated.  These should be much more accurate than last year's, even though it doesn't really change the story at all.



The listed subsidiaries that were 'adjusted' in this table are CNA, DO and Boardwalk Partners (BWP).  There was a tracking stock for the Carolina Group and that would have an impact on adjusting the book value, but that was spun off so I didn't bother; it might change values in some periods, but wouldn't change the end result over time (the tabacco business value was realized when they did the exchange offering swapping Lorillard shares for L shares in 2008).

I didn't include the 2% general partner interest of BWP in the adjustment.  The GP interest is on the L balance sheet, but my market cap adjustment only takes into account the common and class B units.

On an adjusted book value basis, L grew book value +6.4% in 2012 and +11.34%/year over the past ten years.  The five year figure is flat, again, due to the DO rally/spike in 2007.

Notice, too, that the p/b ratio on an adjusted basis seems much more stable than the unadjusted p/b ratio.  On an adjusted basis, L has traded at between 0.8-0.9x book.

Current Adjusted Book Value?
Assuming all else unchanged and just updating the current stock prices of DO, CNA and BWP, the current adjusted BPS comes to $51.70/share compared to L trading now at $43.22, a 16% discount. 

But Wait!  More Adjustments: Incentive Distribution Rights (IDR)
As I said, in the above adjustments I excluded the 2% GP interest in the market value adjustment, so that actually has to be added back.   The market cap of BWP is now $6.2 billion, so the GP interest would be worth around $127 million (market cap only includes common and class B units).   With 392 million L shares outstanding, that comes to $0.32/L share.

That's not that much but the real value here is in the incentive distribution rights (IDR) that the GP owns.  Over a certain amount of cash distributions to the common unit holders, the GP is entitled to an escalating percentage of distributable cash. 

The terms are laid out in the BWP 10-K.  Here it is:

So the more distributable cash they can create per unit, the more the GP will get paid.  In the last four quarters, BWP has already been paying $0.53/share so anything above that the GP gets 50% of it which is kind of insane when you think about it; it only represents 2% ownership but will get 50% of cash distributable above $0.5250.   That's pretty sweet.

I haven't looked at BWP closely so I have no idea what their prospects are and how much they can grow distributable cash per share, but I assume there is plenty of growth potential (or else why would L be involved?).

Without knowing anything about BWP, it's hard to put a value on what this IDR is worth.  It sort of reminds me of LUK's Fortescue notes in that way.

Anyway, even if I don't know anything about BWP (I will take a closer look later and I'll let you know if I learn anything worth posting about) I do know what they have earned up to now.

The payments made to L by BWP for this IDR were:

           IDR payments
2010   $18.2 million
2011   $22.3 million
2012   $30.1 million

So this has been growing.  I don't know enough to make any projections and am too dumb to come up with anything else, so let's just put a 10x multiple on this cash flow.

That would make this IDR worth $300 million.  Again, that's assuming no growth but we notice these payments have been growing.  And don't forget, above a certain threshold, the GP gets 50% of incremental cash distributions.  If someone wants to say it will keep growing, I won't argue with them.

So with 392 million L shares outstanding, this IDR is worth $0.77/share.   Add the 2% GP interest of $0.32/share and we get a total value of $1.09/share.

Add this to the current adjusted book value of $51.70 and we get a total adjusted book value of $52.79/share.  At $43.22, L is then trading at an 18% discount.

Keep in mind that the 2% GP interest is on the L balance sheet; I just had to add it back to my adjusted book value since I used the current value of common and class B units (and excluded the 2% GP interest) in making my BV adjustment.  The IDR value, I don't think, is on the L balance sheet.

Taxes
Oh yeah, and I haven't assumed any taxes on the above calculations.  In recent years, unrealized gains seems to be offset by losses (note the deep discount to book value of CNA).  So it would be a wash.  Plus, these folks tend not to pay taxes.  I think any monetization will come through spinoffs, exchanges and other tax efficient means.    Part of the discount in L stock might be due to people applying 20% discounts to the value of publicly listed holdings for tax and liquidity.  It may be the correct way to look at things, but I'm not convinced enough to put it in my valuations.

Conclusion
Anyway, this is a really boring stock, I know.  Not much ever happens there; conference calls usually end in 30-40 minutes after the same questions.  I bet if they just picked a random conference call recording from the past and played them (instead of holding real conference calls), nobody would notice.

But I still think it's a solid holding and they are very, very conservative.  Boring doesn't mean it's not a good investment.  If you want excitement, go bunjee jumping.

I wouldn't worry too much that they aren't shooting the lights out in recent years.  They have been very cautious and conservative deliberately and that's their choice.  Sure, they aren't doing mega-deals like the unworried Buffett, but L has proven that they can do well even with their cautious stance.

Anyway, I'm sure I'll have something to say once their annual report comes out. 



Buffett Letter 2012

OK, so there are a lot of comments about the Berkshire Hathaway letter to shareholders all over the place and I really don't have too much to add, but I thought I'd post some comments for the people I tell to read these every year (and I know they don't).

So consider this just a quick takeaway sort of thing that may not be of much value to the folks who wisely took the time to read it.  And by no means is this a summary.  I'm only writing about certain things that came to mind.  I don't mention most subjects that was in the letter.

Anyway, here goes.

Good return!
First of all, Berkshire Hathaway (BRK) grew book value per share (BPS) +14.4% in 2012 compared to +16.0% for the S&P 500 index.  Buffett called this return subpar, but that's only because it underperformed the S&P 500 index (total return which includes dividends).  Aside from that, +14.4% is a very good, decent return.  BRK tends to not do well on a relative basis in strong market years, but does much better in not-so-good market years.  So we shouldn't be too worried about BRK underperforming in big up years.  In fact, Buffett says that  BRK only underperformed in 9 out of 48 years, but that in 8 of those 9 years the market was up 15% or more.

Buffett says, "We do better when the wind is in our face".

Just one year doesn't really tell you much, so let's take a quick look at the longer term.   

                                     BRK growth in book           S&P 500 total return
Since 1965                    +19.7%                                +9.4%
Last 10 years                +10.6%                                 +7.1%
Last 5 years                  +7.9%                                   +1.7%

BRK has grown an astonishing +19.7%/year since 1965 versus +9.4% for the S&P 500 index.

Please note that despite all that has happened since 1965 (Vietnam war, dollar devaluation/70's inflation, disco, black monday, internet bubble, financial crisis, gungnam style etc...) the market has returned +9.4%/year.  Can you imagine telling Buffett in 1965 all of the horrible things that will happen in the next 47 years so he should consider another line of work?

The five and ten year rates are also favorable compared to the S&P 500 index.
  
Interestingly, he said:

Charlie and I believe the gain in Berkshire's intrinsic value will over time likely surpass the S&P returns by a small margin.  (emphasis mine)
 

I've suspected that for a while now so that doesn't surprise me, but I don't remember him actually saying that this way before.  Of course, he has said many times in the past that BRK's growth will be nowhere near what it has been in the past.   Anyway, that is not really a big concern for conservative investors who own BRK.  It's a solid stock to own.

Don't Worry So Much
I know this is a recurring theme on this blog and it's beating a dead horse.  But other than "what do you think of Apple/Facebook (or whatever stock is hot or cold on that day) the most common question I tend to get when people realize I deal with the stock market is, "What's going to happen with the fiscal cliff?" or "I got out of the market because I'm worried about xxxxx".  Some say, "you better get out of the market because I heard some guy on TV say that the Dow can get down to 6000!".

So here is Buffett again on the topic:

This is in sharp contrast to many shareholder letters these days that spend so much time talking about the many problems that we have.  This is not to make light of the many real problems that we face.  It's also not prudent to be overexposed, leveraged or anything like that where if another crisis happened you might blow up.

Granted, the reason why mutual fund and hedge fund managers have a different mindset than Buffett on this issue is partly due to the flakey nature of their capital.  Buffett manages real permanent capital.  Mutual fund and hedge fund managers manage hot money.   If they act like Buffett, they will get killed when the market tanks and they have to face redemptions.  Buffett never has to worry about investor redemptions!  This is a key difference.  This is also why individual investors should act more like Buffett than the ever-so-worried mutual fund and hedge fund managers.

New Investment Managers
As we know, Buffett hired two portfolio managers to invest BRK's capital.  We don't have a whole lot of detail on their performance since they only just started, but Buffett says that both of them have outperformed the S&P 500 index by double-digit margins.  That means each of them returned more than 26% (the S&P 500 index returned 16%) in 2012.  Look through your year-end mutual fund statements; how many of your funds have a 26% return?

Of course, it's too soon to say whether these managers are any good (well, you can say they are good because they had good track records before joining BRK) but it's not a bad start!

Wells Fargo (WFC)
As of year-end, Wells Fargo is the largest stockholding at BRK.  This may come as a shock to many who don't like banks, but there it is.  WFC is a larger position than Coke, and the interesting thing is that it is big not because it has gained the most (like Coke) but because Buffett has been buying a lot of it lately.  Only IBM is larger on a cost basis.  On CNBC the other day, Buffett said he has bought WFC this year too and said it's cheaper than Coke.

I looked at WFC in this Wells Fargo is cheap post; the fact that he has still been buying supports the view that it is still a cheap stock.  (Buffett also mentioned in the letter that WFC's earnings is understated by $1.5 billion due to an amortization charge that doesn't make sense).

Dividends
At the end of the letter to shareholders, Buffett explains why a dividend doesn't make sense right now for BRK, and how people can create their own dividend by selling a little bit of BRK every year.  It's a great explanation of why it would be better to do this than have BRK actually pay a cash dividend.   If you don't understand how selling 4% or so of your holdings every year is actually better than BRK paying a 4% dividend, read this section of the letter.  It is very clear.

Books
Buffett often recommends books, especially the Graham books, but I don't remember him recommending books in his letter to shareholders.  You would be a fool not to read books he recommends (if you have any interest in Buffett and his ways, that is).

Here are the books he recommends.  I haven't even read them yet, but I put them in the store anyway.

Of course, he has to push the new book out by Carol Loomis.

Tap Dancing to Work by Carol Loomis
The Outsiders by William Thorndike Jr, a book about CEOs that were good at capital allocation and includes a chapter on Tom Murphy.
The Clash of the Cultures by Jack Bogle about investment versus speculation
Investing Between the Lines by Laura Rittenhouse


The following section gets into some valuation issues for BRK.  It's a hint to friends and relatives who are not particularly interested in financial stuff to skip the rest. 

BRK Valuation
One big parlor game on the internet is to figure out what BRK is actually worth.  You can find all sorts of models and estimates all over the place.  Buffett, in recent years, has gone out of his way to tell us that book value per share way understates the intrinsic value of BRK.  In this year's letter, he again says, "we use book value as a significantly understated proxy " of intrinsic value (emphasis is Buffett's!).

So as in last year's letter, he is telling us that BRK is worth way more than stated book value, which by the way comes to around $114,214/share (from the annual report).

I will probably make some posts about BRK's valuation in the future, but for now I just wanted to make a quick comment on the two-column method BRK valuation that Buffett seems to endorse.

Let's take a quick look at this.

Buffett's idea is to look at BRK as two separate businesses; the operating business and the insurance business.  The insurance business is where the stock and other investments are held (roughly speaking) and the operating businesses are the wholly owned (or consolidated) subsidiaries that include things like See's Candies, Nebraska Furniture Mart, Dairy Queen etc...

So what Buffett does is he looks at a single metric for each part:  For the operating business he looks at the pretax earnings per share of businesses other than insurance and investments.  For the insurance business, he looks at the per share total investments held by BRK.

The per share pre-tax profit of the operating businesses was $8,085.  Since Buffett says he likes to pay 9-10x pretax profits, I will value the operating businesses at $81,000/share (around 10x pretax profit).

Investments per share comes to $113,786/share.  So according to this method of valuation, BRK is worth $81,000 + $113,786 = $194,785/share.  By the way, this comes to 1.7x book value.  According to this methodology, BRK is indeed worth far more than stated book value.

This is a good, simple model and it's hard to argue against.  There is no question that the investments per share are worth what it is on the books for.  $1.00 of cash is worth $1.00 of cash.  $1.00 of bonds is worth $1.00 of bonds.  $1.00 of stocks is worth $1.00 of stocks.  So what's the problem?

Nothing, really.

Another Way to Look at It
I don't want to argue what is the right way or wrong way to look at these things.  Valuation is a tricky business and people will have different ways of looking at this and that's totally fine.

My own personal reservation with this valuation is that to me, investments per share may not be worth investments per share.

Why?  Let's just say, for example, that all of the investments were in bonds yielding 1% and that there is no real prospect of this changing in the near or far future.  There is no plan to distribute this or to sell the bonds and invest the proceeds in higher return assets.

In this case, if my required rate of return is 10%, then the investments per share is only worth 10% of face value to me.  A business is only worth the future cash flows it generates, right?  So if the future cash flows are low, then it's not worth much.

Some will argue that bond funds don't trade at such steep discounts.  I think that is different.  Money market funds and bond funds are valued differently; people don't expect 10% returns from a money market fund; just safety and stability of principle and some interest.  This is the same with bonds. A bond is a bond, not a business.

If all of the BRK investments per share was invested in stocks managed by Buffett, then as an equity investor, it would obviously be worth investments per share dollar for dollar.   It may even be worth more if we expect Buffett to outpeform the stock market.

If half of the assets is invested in low yielding bonds and cash, then to me it would be worth quite a bit less.

So what is the investments per share worth to me?  I will look at this in detail in a later post but for now I'll keep it really simple. 

First of all, I need to know what the expected return on the investments per share is.  If the expected return is 10%, then of course the investments per share would be worth the whole amount as that is the same as my required rate of return (or discount rate).  If the expected return is 5%, then the investments per share would be worth 50% of the amount.

Expected Return on Investments
I noticed that the expected long term rate of return on BRK's pension plan assets is 6.6%.  I also see that the asset allocation for the plan assets is roughly 50% equities and 50% fixed income and cash.  I actually don't know how the outside managed assets are invested but I assume it is not listed equities as most of what is in there is not Level 1 asset (assets with quoted prices); so I assume they are some sort of corporate and other fixed income investments.

Interestingly, BRK's investments per share is also close to 50% equities and 50% fixed income and cash.

Buffett has said many times that pension funds that have expected returns of 8-9% is pure fantasy; they will never achieve that sort of return in this environment.

Note, also, that this is the expected return on plan assets for the long term.

So you see where this is going.  With investments per share of $113,786, the return on this amount may be 6.6%.   If that is the case, then to me, the investments per share is only worth 66% of that or around $75,000/share.   (If float can grow, then of course the increase in investments per share would be higher than 6.6%, but Buffett has been hinting that float may not grow all that much in the future and may even decline (but no more than 2%/year)).

Add this number to the operating businesses value of $81,000/share and I get a total value of $156,000/share.   BRK closed today at $154,425/share so it is trading right around fair value using these assumptions.

The portion allocated to equities in the investments per share may rise, but I have established in my previous post So What is BRK Really Worth?  that the fixed income and cash portions of BRK's total investments typically don't go below the float amount (which is currently $73 billion).   This makes sense; float is an insurance liability so it is held in liquid securities.

It's fair to argue that BRK currently has way more cash than usual.  There seems to be $47 billion cash and Buffett said he would like to keep it at no less than $20 billion.  So maybe we should give full credit to the $27 billion excess cash because that can actually be deployed into high return equities or acquisitions.  So we can take that excess cash out and value it at 100% and then keep the 34% discount for the rest of the investments.  This would bump up the value of the investments to $80,000/share, so the total value of BRK would come to $161,000/share.

Either way, from this point of view, it looks like BRK to me is worth around $156,000 - $161,000/share. 

Anyway, I do have more thoughts on valuation but I'll post those later. 

Oh, and I do own BRK in my long term account and plan to keep it there a long time, but have sold out most of it in my more active account (it was a pretty big, levered (LEAPed) position so...).

JPM Investor Day 2013

So I listened to the JPM investor day via the internet today.  My internet connection, or the PC or something somewhere kept dropping out so I missed a lot, but that's OK.

Anyway, I know I do talk an awful lot about financials and banks.  That's partly because I do tend to have a sort of comfort level with financials (having been in the industry), they seem to still be hated (financially (many still believe financials are dangerous black boxes) and culturally (this popular hatred of banks seemed to have peaked out with Occupy Wall Street, but it's still pretty thick out there)), and they still seem cheap to me.  Not as cheap as in the fall of 2011 or at some points last year, but still cheap.

So that's why I talk a lot about them. If these things were trading at 3x book, I wouldn't talk about them (or maybe I would be looking for shorts).

This is not really a summary or recap of the investor day at all, but just some random thoughts that came to mind while I was listening.

Stock Price Performance
Anyway, there is one chart that I don't believe I've seen before.  Maybe it was in another presentation somewhere.  But I don't remember seeing it.  I do remember recently that Dimon said something about JPM stock; that even if you go back to the Bank One years JPM stock has outperformed other banks and even the S&P 500 index over time.

I sort of always wondered about this as I did own Bank One stock from way back when he first joined.  But this was never a 'hot' stock so my impression wasn't that it performed particularly well (of course, not bad considering how many banks lost most of their value).

So it was very interesting for me to see this page in their presentation:

This is pretty impressive.  It may be hard to see; you can go to the JPM website and actually look at the presentation slides if you want.   In the above charts, the blue line (I'm sure it's Chase blue) is JPM.  The little table at the top shows the annualized returns during the different periods.  I want you to see this so I'm going to actually retype this stuff out:

Annualized Returns

 

                        3/26/00 -            1/13/04 -              1/1/08 -              1/1/12-
                        2/19/13              2/19/13                 2/19/13              2/19/13
JPM*               +9.4%               +5.4%                 +4.8%                +46.5%
BKX                 -0.1%                 -3.3%                    -6.6%                +38.2%
S5FINL            -0.3%                 -2.6%                    -7.0%                +35.4%
SPX                 +1.9%                +5.6%                   +3.1%                +21.7%

*includes Bank One for 3/26/00 - 2/19/13 period

BKX is the KBW Bank Index, S5FINL is the S&P 500 Financials index, and SPX is of course the S&P 500 index.

March 26, 2000 is the day before Dimon became CEO of Bank One and January 13, 2004 is the day before JPM agreed to take over Bank One.

This is pretty impressive.  In March 2000, the S&P 500 index was close to it's high, so since then if you invested with Dimon, you would have outperformed the S&P 500 index by 7.5%/year.  That's a pretty big outperformance.  And you would have done even better against other bank stocks.

You know, this blog is getting very boring and predictable.  Any time I see a table like the above, I get tempted to do something. You know where this is going.  I have to add one more comp to the above table:

Annualized Returns

                              3/26/00 -             1/13/04 -             1/1/08 -             1/1/12-
                              2/19/13               2/19/13                2/19/13             2/19/13
JPM*                    +9.4%              +5.4%                  +4.8%               +46.5%
BRK-A                 +8.8%              +6.5%                  +2.6%                +28.2%
BKX                       -0.1%                -3.3%                   -6.6%                +38.2%
S5FINL                  -0.3%                 -2.6%                  -7.0%                +35.4%
SPX                       +1.9%                +5.6%                 +3.1%                +21.7%

Since March 2000, JPM has actually outperformed even Berkshire Hathaway!  That really is astounding.  Of course, we can argue about reinvested dividends (which may not be reinvested pretax, even though you can in an IRA) or some other factors.  But still, this is pretty crazy.  Even starting from right before the financial crisis in 2008, JPM has outperformed BRK +4.8%/year versus +2.6%/year.   I don't think anyone would have been able to predict that, given that it was a financial crisis driven by all the insane stuff that JPM was involved in (to a lesser extent than the less fortunate, or rather, less competent banks).

I don't mean to say JPM is a superior investment to BRK.  This comparison is just for fun.  They are different beasts with different risk profiles.  But then again, it's not hard to understand why even Buffett personally owns (or at least until recently) a million shares of JPM.


The Usual Chart
And here is the usual chart that I like showing the growth of book value of JPM:

Bank Value per Share and Tangible Book Value per Share Growth

Tangible book value per share has grown 15% in 2012, an average of 12%/year over five years and 9%/year over 10 years.

JPM closed today at $47.60/share, so it's still trading at 1.2x tangible book value.  This is still very attractive.  Of course, 1.0x tangible book is Dimon's "very conservative" valuation for JPM where it's a no-brainer to buy back stock.  He feels that JPM can earn at least 15% return on tangible book, so that makes perfect sense.  With a 15% return on tangible book being what they can do "at least", then 1.5x tangible book is not an aggressive valuation at all, I don't think.

How to Make 40% by Year-end 2013 (or 23%/year in Three Years)
So even today, JPM is easily worth $58/share ($38.75 x 1.5).  That's 22% higher than the current price.  If tangible book grows 15% again this year, then 1.5x year-end tangible book would take the stock price up to $67.   That would be a 41% return through the end of 2013.

If JPM keeps earning 15% on tangible equity over the next three years, TBPS grows 12%/year (less than tangible ROE due to dividends paid) and the stock price gets up to 1.5x tangible book, JPM would be a $82/share stock.  That's 20%/year over the next three years and with dividends at the current dividend yield, that would come to 23%/year.  Not too bad. 

And keep in mind that this is based on the "at least 15% return on tangible equity", so this may be conservative. It is certainly possible that things can get much better as the world 'normalizes'.    How many large cap stocks project 20%+ returns?

Line of Business ROE
Here's a table of the through-the-cycle ROE targets for the various business lines.  As they have been saying, if current elevated expenses (legal expense etc...) normalize, they can earn $24 billion net as is (without assuming growth or improvement in the environment).

The $24 billion net income is before preferred divideds and other distributions to participating securities, and that comes to around $1.4 billion, so net to common would come to $22.6 billion.  With 3.8 billion shares outstanding, that's around $6.00/share in EPS, and 10x that is $60/share.

Not surprisingly, that comes to 1.5x tangible book value per share.

Anyway, the earnings walk below shows how JPM can get to $27.5 billion in net earnings just from certain items normalizing.

You will notice that if you take out the $3.5 billion in growth initiatives, you will get the $24 billion that has often been mentioned.  I think that is what they would earn when things settle down.  I notice in this chart, though, that there is $1.3 billion earnings improvement on an assumed 100 bps increase in interest rates.  My impression was that the $24 billion they used to talk about didn't assume any increase in rates.  The forward curve does imply rising rates, so that may be where that comes from. 

There is no timetable set for this $27.5 billion to be achieved.  This 'significant' items are expected to go down over time (as well as the litigation expense), and the growth intitiatives will kick in over time too. 

But during the Q&A when someone asked about this $27.5 billion figure, Dimon said that there is no time-table but it can come soon too; he noted that the investment bank is doing better than expected, so other areas might too.

The key is that the earnings power of $27.5 billion is there now (or will soon be in place with ongoing growth intitiatives).  And this doesn't include any growth over time from improvement in the environment.

For example, Dimon said that the investment banking business will see demand double in the next ten years and triple in emerging markets (or something like that).  If JPM just keeps up, they can really grow.

If you flip through the slides, you'll realize that JPM really is a growth business.  This may not really be recognized.

Don't Break Us Up!
OK, nobody said that.  But there were some slides today that sort of focused on synergies/cross sell to show the benefit of JPM being a large diversified business that it is.  This is obviously on the minds of senior management at JPM, and they seem to be getting ready for the debate (where shareholders and/or regulators/government might demand they be broken up). 

Here are some slides.

This is from the overview presentation:

...and this is from the Asset Management presentation:

 

 

...and this from the Commercial Banking:

Conclusion
Anyway, I thought it was a good presentation.  JPM seems to be doing well and growing in many areas.  A lot of this doesn't show up yet due to all sorts of recent events, but it seems like it will soon when things turn.

Even without a turn in the environment, they have been doing very well earning record profits.  You don't need heroic assumptions to get 20%/year out of this stock (12% tangible BPS growth, 1.5x tangible BPS valuation etc...), so it looks like a solid stock to own.

Like WFC, this is a company that has grown and benefitted from bad times, so I wouldn't worry too much about bad times.  Maybe we want bad times so they can grow even more.

The stock seems to have done well over time, even outperforming Berkshire Hathaway, and it's still pretty cheap.  That's kind of rare.

(But then again, this is a bank stock so be aware that even if the business does well and benefits from another crisis, the stock market will probably not agree; this can get volatile so beware!  I tend to like highly focused portfolios, like Greenblatt, Buffett and Munger advocate. But remember, even Greenblatt said that if you own 5-8 stocks, they have to be different industries.  Owning 8 banks stocks as your whole portfolio is not going to work.)