I talked about how great it is that people can buy BRK and LUK at book value, and that JPM is selling at or below it's tangible book value per share even though JPM is capable of earning much more than 15% on that tangible equity.
The markets are falling apart now and financials are getting even cheaper. Again, there are tons of financials that are getting cheap. Some really cheap ones are Citigroup and Bank of America, for example. Although these banks may rally sharply over the next few years and I assume investors will make out well, they do have a history of problems and they are large institutions tied to the GDP of this country.
However, if you look at a firm like Goldman Sachs (GS), they are much more nimble than those large banks as they can typically more easily move capital to where the opportunities exist. They are not burdened by large consumer loan portfolios and large bank branch networks, for example.
Also, GS earns half of their net revenues in the non-U.S. market.
I just wanted to post this quickly as it seems like such a tremendous opportunity so I won't go into the details of this company.
But let's just say that GS is one of the best financial companies out there. They did very well through the Great Recession with very little in losses (like the other of my favorites, JPM, BRK and LUK) and have managed to grow book value in the past few years despite the worst environment in 100 years (or whatever).
Anyway, the bottom line is that the book value per share of GS at the end of June 2010 was $131.44/share and the tangible book value per share was $121.60/share.
And the stock is now trading at $93/share! That's a 30% discount to book value and a 24% discount to tangible book value per share.
Not too long ago, you had to work hard and make partner to be able to buy into GS at book value, and here it is for anyone to buy at way below book value.
If that's not an opportunity, I don't know what is.
Thursday, September 22, 2011
Wednesday, September 21, 2011
LUK: Leucadia National at Book Value
A lot about investing is about finding the right people. If you can find smart people to run your money and just give them the money, that's a good thing. This is why I like to follow companies that are run by outstanding management with a long history of outperformance. Of course, Buffett's Berkshire Hathaway (BRK) is one of those companies. There are others, although most won't have the long term track record of a Buffett.
One of my favorite companies has been Leucadia National (LUK). It is run by the duo Joe Steinberg and Ian Cumming. They have been running Leucadia National since 1978.
This is one of those companies, like BRK, where it is worth your time reading their annual reports, going back as far as you can. Reading reports by these really smart, straight shooters is very educational; you will learn a LOT.
Anyway, like BRK, they do have their performance of the company since they started running it on the first page of their annual report. You can see it here. (I love how they put all that information right up at the front. I wondered why more companies don't do that, until I realize most companies can't create a long term track record like that! Some try to do it and then stop when their numbers start to look bad, lol...)
The returns are absolutely amazing. Since 1979 through 2010, a period of 30 years, they have increased book value per share of LUK by 19.6% per year.
OK, OK, there was a big bull market from 1979-2000. It was easy to make money during that period. How have they done since 2000 when the market has been flat?
Here are the annualized returns for the five and ten year periods:
Annualized growth in book value per share:
Five years +11.0%
Ten years +14.7%
(30 years +19.6%)
So in a flat market, they were able to increase the per share value of the company by double digits. That's pretty good.
And again, as I argued in the JPM and BRK posts, these five and ten years have not been kind to businesses. They include all the things like 9/11, two wars, two historic bear markets, near-Great-Depression, huge catastrophes etc...
If you go back to the year 2000 and tell someone exactly what will happen in the next decade (starting with the popping of the internet stock bubble, a 50% decline in the S&P 500 index, 80% decline in the NASDAQ index, Both World Trade Centers collapsing due to terrorism, wars because of that, oil going up to $150/barrel, big financial crisis, housing depression, extended high unemployment etc...), and ask them what would happen to firms like LUK, BRK, or JPM, I don't think anyone would have guessed they would increase book value per share by double digits despite all that. I highly doubt that.
(This sort of goes back to my other argument about the futility of predicting things.)
Anyway, so you have a company with a great long term track record and a pretty good short term track record even in the worst environment ever run by some of the shrewdest investors around, you have to be interested.
And if you can buy into such a company at book value, with no premium at all, that is really something.
In the past 31 years, the price-to-book value ratio of LUK has averaged around 1.0: it has traded right around book. But that may be because they were largely an insurance company early on.
In the past ten years, however, and ironically in a harsh economic environment (and not the bubbly and wonderful 1980s and 1990s) the price-to-book value ratios has averaged 1.5x.
There is no reason to believe it will go right back up to 1.5x book value ratio, but if it did, that's a 50% return right there without LUK management lifting a finger.
So what does LUK actually do? At this point, they are a conglomerate. Think of LUK as a private equity fund, or a concentrated equity fund. They own large, concentrated positions in listed companies such as Jeffries Group, Fortescue Metals Group (an Australian iron ore company that has been a home run for LUK), and Inmet Mining, just to name some large positions.
They do own a bunch of privately held (not listed) businesses as well, though they tend to be smaller and to me not the real drivers of LUK's value/worth.
They have started to wind down their large position in Fortescue Metals Group and have sold their large position in Americredit, a subprime auto finance company they bought during the financial crisis.
Their investment style is typically to invest big in distressed or special situations.
Anyway, the book value of this company, currently as I estimate it is around $25.20/share and the stock price closed at $25.23/share today. You are getting this awesome management with no premium at all.
These guys are real straight shooters (notice how I tend to like those kinds of people?) so I do trust that their balance sheet is marked conservatively. Their large equity holdings are marked to market (and I did adjust for that since the market has declined since their last balance sheet date at the end of June 2011).
As usual, there are risks. Both Cumming and Steinberg are not young, so they probably will not be managing this entity for the next twenty years. I don't really understand what their endgame is going to be, but from what they have been saying in the annual meetings in the past few years, I think they are working very hard to structure LUK into a sustainable business model like BRK.
Don't just go out and buy this stock because you read a nice blog post on the internet. Read their annual reports. Do some research. Get comfortable. Only then, maybe buy some stock. I do own some but often trade in and out of it as it gets expensive or cheap.
Anyway, this is just an intial post to point out a cheap stock of high quality. Over time, I may post more about LUK in detail.
One of my favorite companies has been Leucadia National (LUK). It is run by the duo Joe Steinberg and Ian Cumming. They have been running Leucadia National since 1978.
This is one of those companies, like BRK, where it is worth your time reading their annual reports, going back as far as you can. Reading reports by these really smart, straight shooters is very educational; you will learn a LOT.
Anyway, like BRK, they do have their performance of the company since they started running it on the first page of their annual report. You can see it here. (I love how they put all that information right up at the front. I wondered why more companies don't do that, until I realize most companies can't create a long term track record like that! Some try to do it and then stop when their numbers start to look bad, lol...)
The returns are absolutely amazing. Since 1979 through 2010, a period of 30 years, they have increased book value per share of LUK by 19.6% per year.
OK, OK, there was a big bull market from 1979-2000. It was easy to make money during that period. How have they done since 2000 when the market has been flat?
Here are the annualized returns for the five and ten year periods:
Annualized growth in book value per share:
Five years +11.0%
Ten years +14.7%
(30 years +19.6%)
So in a flat market, they were able to increase the per share value of the company by double digits. That's pretty good.
And again, as I argued in the JPM and BRK posts, these five and ten years have not been kind to businesses. They include all the things like 9/11, two wars, two historic bear markets, near-Great-Depression, huge catastrophes etc...
If you go back to the year 2000 and tell someone exactly what will happen in the next decade (starting with the popping of the internet stock bubble, a 50% decline in the S&P 500 index, 80% decline in the NASDAQ index, Both World Trade Centers collapsing due to terrorism, wars because of that, oil going up to $150/barrel, big financial crisis, housing depression, extended high unemployment etc...), and ask them what would happen to firms like LUK, BRK, or JPM, I don't think anyone would have guessed they would increase book value per share by double digits despite all that. I highly doubt that.
(This sort of goes back to my other argument about the futility of predicting things.)
Anyway, so you have a company with a great long term track record and a pretty good short term track record even in the worst environment ever run by some of the shrewdest investors around, you have to be interested.
And if you can buy into such a company at book value, with no premium at all, that is really something.
In the past 31 years, the price-to-book value ratio of LUK has averaged around 1.0: it has traded right around book. But that may be because they were largely an insurance company early on.
In the past ten years, however, and ironically in a harsh economic environment (and not the bubbly and wonderful 1980s and 1990s) the price-to-book value ratios has averaged 1.5x.
There is no reason to believe it will go right back up to 1.5x book value ratio, but if it did, that's a 50% return right there without LUK management lifting a finger.
So what does LUK actually do? At this point, they are a conglomerate. Think of LUK as a private equity fund, or a concentrated equity fund. They own large, concentrated positions in listed companies such as Jeffries Group, Fortescue Metals Group (an Australian iron ore company that has been a home run for LUK), and Inmet Mining, just to name some large positions.
They do own a bunch of privately held (not listed) businesses as well, though they tend to be smaller and to me not the real drivers of LUK's value/worth.
They have started to wind down their large position in Fortescue Metals Group and have sold their large position in Americredit, a subprime auto finance company they bought during the financial crisis.
Their investment style is typically to invest big in distressed or special situations.
Anyway, the book value of this company, currently as I estimate it is around $25.20/share and the stock price closed at $25.23/share today. You are getting this awesome management with no premium at all.
These guys are real straight shooters (notice how I tend to like those kinds of people?) so I do trust that their balance sheet is marked conservatively. Their large equity holdings are marked to market (and I did adjust for that since the market has declined since their last balance sheet date at the end of June 2011).
As usual, there are risks. Both Cumming and Steinberg are not young, so they probably will not be managing this entity for the next twenty years. I don't really understand what their endgame is going to be, but from what they have been saying in the annual meetings in the past few years, I think they are working very hard to structure LUK into a sustainable business model like BRK.
Don't just go out and buy this stock because you read a nice blog post on the internet. Read their annual reports. Do some research. Get comfortable. Only then, maybe buy some stock. I do own some but often trade in and out of it as it gets expensive or cheap.
Anyway, this is just an intial post to point out a cheap stock of high quality. Over time, I may post more about LUK in detail.
Tuesday, September 20, 2011
Buffett Editorial in the New York Times from October 2008
In the midst of the financial crisis in October 2008, Buffett published this editorial in the New York Times. I keep saying this won't be a Buffett fan site or anything like that, but I do think this is an important editorial that applies today too and I thought I would post it here, 'for the record'.
BUY AMERICAN, I AM
The financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.
So ... I've been buying American stocks. This is my personal account I'm talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.
Why?
A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation's many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.
Let me be clear on one point: I can't predict the short-term movements of the stock market. I haven't the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.
A little history here: During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor's best
friend. It lets you buy a slice of America's future at a marked-down price.
Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.
You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines
made them queasy.
Today people who hold cash equivalents feel comfortable. They shouldn't. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed,
the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.
Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky's advice: "I skate to where the puck is going to be, not to where it has been."
I don't like to opine on the stock market, and again I emphasize that I have no idea what the market will do in the short term. Nevertheless, I'll follow the lead of a restaurant that opened in an
empty bank building and then advertised: "Put your mouth where your money was." Today my money and my mouth both say equities.
Warren E. Buffett is the chief executive of Berkshire Hathaway, a diversified holding company.
BUY AMERICAN, I AM
The financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.
So ... I've been buying American stocks. This is my personal account I'm talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.
Why?
A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation's many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.
Let me be clear on one point: I can't predict the short-term movements of the stock market. I haven't the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.
A little history here: During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor's best
friend. It lets you buy a slice of America's future at a marked-down price.
Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.
You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines
made them queasy.
Today people who hold cash equivalents feel comfortable. They shouldn't. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed,
the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.
Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky's advice: "I skate to where the puck is going to be, not to where it has been."
I don't like to opine on the stock market, and again I emphasize that I have no idea what the market will do in the short term. Nevertheless, I'll follow the lead of a restaurant that opened in an
empty bank building and then advertised: "Put your mouth where your money was." Today my money and my mouth both say equities.
Warren E. Buffett is the chief executive of Berkshire Hathaway, a diversified holding company.
Microsoft
Here's a just a quick note on the cheapness of Microsoft (MSFT). Microsoft is a controversial stock; some feel it has great value and others feel it is a value trap, an old dinosaur on it's way out.
David Einhorn among other notable value investors have taken a decent stake in this company.
The primary bear case, I think, is simply that PCs and laptops will be pushed out completely by iPads and smart phones, and what's left of PCs and laptops will be taken over by 'cloud' software providers.
Anyway, let's take a quick look some basic figures for MSFT.
Here are some figures for the past six years from their investor day presentation last week (materials are available at the MSFT website):
Revenues EPS
2006 $44.3 bn $1.20
2007 $51.1 bn $1.42
2008 $60.4 bn $1.87
2009 $58.4 bn $1.62
2010 $62.5 bn $2.10
2011 $69.9 bn $2.69
During this period, MSFT grew revenues at an average of 10% per year, operating earnings at 11% per year and EPS at 18% per year (EPS grew faster due to large share repurchases).
This is not a bad performance for a dinosaur business in a really awful economic environment with high unemployment and businesses not spending.
At around $27/share, MSFT is trading at a mere 10x the most recent fiscal year EPS. That is mighty cheap. EPS estimates for this year and next year are:
Year ended
June 2012: $2.86
June 2013: $3.13
So MSFT is trading at 9.4x current year and 8.6x June 2013 earnings.
This is without including the large amount of cash and short term investments on MSFT's balance sheet.
A quick look shows that MSFT has cash, cash equivalents and short term investments of $ 52.8 billion as of the end of June 2011 and $10 billion in equity investments for a total of $62.8 billion. Long term debt as $12 billion and other long term liabilities was $8.1 billion (presumably tax liabilities) so net of that, their net cash and investment position would be $42.7 billion.
With 8.4 billion shares outstanding, that comes to $5 per share. Since these investments don't generate too much income, I won't bother to adjust the eps (other income is less than 3% of pretax income, I think).
Deducting the $5/share from a $27 MSFT stock price would mean you are getting the operating business for $22/share.
At $22/share, you are getting MSFT at 8.2x last year's earnings (ended June 2011), 7.7x current year estimate and 7x 2013 estimate.
Also, MSFT has been paying dividends recently. Here are the dividends paid in the recent past:
2007 $0.40
2008 $0.44
2009 $0.52
2010 $0.52
2011 $0.64
Dividends have grown 12.5% per year recently, and again, during one of the worst periods in economic history. With a $0.64 dividend paid last year, MSFT is trading at a 2.4% dividend yield, compared to a ten year treasury yield of less than 2.0%.
That is pretty cheap and it does look like the market is pricing MSFT as a true dinosaur.
I don't have too strong a view on this, but at this price, I do think the risk/return is pretty attractive. As always, there is risk and it is difficult to project out what the technology industry will look like in five or ten years, but there is a price where things can get very interesting.
David Einhorn among other notable value investors have taken a decent stake in this company.
The primary bear case, I think, is simply that PCs and laptops will be pushed out completely by iPads and smart phones, and what's left of PCs and laptops will be taken over by 'cloud' software providers.
Anyway, let's take a quick look some basic figures for MSFT.
Here are some figures for the past six years from their investor day presentation last week (materials are available at the MSFT website):
Revenues EPS
2006 $44.3 bn $1.20
2007 $51.1 bn $1.42
2008 $60.4 bn $1.87
2009 $58.4 bn $1.62
2010 $62.5 bn $2.10
2011 $69.9 bn $2.69
During this period, MSFT grew revenues at an average of 10% per year, operating earnings at 11% per year and EPS at 18% per year (EPS grew faster due to large share repurchases).
This is not a bad performance for a dinosaur business in a really awful economic environment with high unemployment and businesses not spending.
At around $27/share, MSFT is trading at a mere 10x the most recent fiscal year EPS. That is mighty cheap. EPS estimates for this year and next year are:
Year ended
June 2012: $2.86
June 2013: $3.13
So MSFT is trading at 9.4x current year and 8.6x June 2013 earnings.
This is without including the large amount of cash and short term investments on MSFT's balance sheet.
A quick look shows that MSFT has cash, cash equivalents and short term investments of $ 52.8 billion as of the end of June 2011 and $10 billion in equity investments for a total of $62.8 billion. Long term debt as $12 billion and other long term liabilities was $8.1 billion (presumably tax liabilities) so net of that, their net cash and investment position would be $42.7 billion.
With 8.4 billion shares outstanding, that comes to $5 per share. Since these investments don't generate too much income, I won't bother to adjust the eps (other income is less than 3% of pretax income, I think).
Deducting the $5/share from a $27 MSFT stock price would mean you are getting the operating business for $22/share.
At $22/share, you are getting MSFT at 8.2x last year's earnings (ended June 2011), 7.7x current year estimate and 7x 2013 estimate.
Also, MSFT has been paying dividends recently. Here are the dividends paid in the recent past:
2007 $0.40
2008 $0.44
2009 $0.52
2010 $0.52
2011 $0.64
Dividends have grown 12.5% per year recently, and again, during one of the worst periods in economic history. With a $0.64 dividend paid last year, MSFT is trading at a 2.4% dividend yield, compared to a ten year treasury yield of less than 2.0%.
That is pretty cheap and it does look like the market is pricing MSFT as a true dinosaur.
I don't have too strong a view on this, but at this price, I do think the risk/return is pretty attractive. As always, there is risk and it is difficult to project out what the technology industry will look like in five or ten years, but there is a price where things can get very interesting.
Berkshire Hathaway at Book Value?!
OK, I really have no intention of turning this blog into a Warren Buffett fan site or a Berkshire Hathaway (BRK) information aggregation/news site or anything like that. There are tons of those things out there and many are very well done.
BUT, having said that, I can't not mention an astounding thing going on in the market right now. I don't think many people would have dreamed of this in a long time.
Anyway, as I said, there are a lot of websites/blogs that talk in detail about BRK, what it's worth and all that. Calculating the intrinsic value of BRK seems to be a miniature cottage industry on the internet. I don't intend to jump onto that bandwagon. I have my own thoughts on how to value BRK, but I am mostly content reading analysis by others.
I am only making this post because with BRK trading at where it is now, it doesn't take a whole lot of deep analysis to realize it's a darn good bargain.
To make a long story short, BRK is now trading at very close to book value per share. As of the end of the June 2011 quarter, BRK had total shareholders equity of $163 billion. Shares outstanding is 1.65 billion shares, so total book value per share is $98,790/share based on the A-shares. Book value per share would be $65.85/b-share (1,500 class b shares per class a share).
BRK-A (a-shares) is now trading at around $105,000 per share (or a slight 6.3% premium to the BPS), and BRK-B is trading at $70/share.
OK, OK, but stock prices have gone down since the end of June. At June end, the S&P 500 index was at 1,321 but is now at 1,218, a decline of around -7.8%. BRK had $66 billion in stock holdings (marked-to-market on the balance sheet every quarter net of taxes owed) as of the end of June. So if the stocks fell as much as the S&P did, that would be a $5 billion decline in the net worth of BRK, or around 3%.
Subtract that from the net worth calculations above and that still leaves the stock trading at a premium of less than 10%!
Why should we care if BRK is trading at book value?
For one, I think BRK has traded at a price-to-book-value ratio of around 1.7x over the past ten years, so this is a very rare thing. If BRK traded merely back at what it used to trade at versus book, that alone would give you a 70% return on owning this stock.
But there are reasons, of course, that it may not get back to 1.7x book. I don't want to get into the details of accounting or anything, but there is an impact from BRK's purchase of Burlington Northern, for example.
But more important may be the age of Warren Buffett. He is an old guy; he just turned 81. The past performance of BRK is largely thanks to the genius of Buffett. Can this be repeated over the next 50 years? Highly unlikely.
Another reason is that BRK is an insurance company, although they are in many other businesses. Insurance companies and financials are very, very out of favor right now. Insurance and reinurance has been in a soft market for a long, long time so it has been difficult to make money in the insurance business even though BRK has been successful even in this soft market. That's another long story that I will leave out of this post. But trust me when I say that BRK's insurance business is very different than other listed insurance and reinsurance companies.
Also, BRK is known to hold some financial stocks. He is a large holder of Wells Fargo, American Express, recently purchased a stake in Bank of America, bought preferred shares in General Electric and Goldman Sachs during the crisis etc...
So many people view BRK as a financial company, vulnerable to the same macro factors as any other bank or insurance company.
So it is not completely surprising that Mr. Market will bundle BRK with the other financials and throw it in the dumpster.
But let's get back to book value. First of all, Buffett has said many times over the years that book value per share is a very good indicator of intrinsic value. Changes in the book value per share of BRK reflects well the direction and magnitude of the change in the intrinsic value of the company.
What's the difference between book value and intrinsic value? I don't want to get into it too much right now, but let's just say that book value is an accounting measurement that has many inaccuracies and problems, and the concept of intrinsic value is a look at the true value of what a business is worth regardless of accounting rules and conventions. The purpose of having the concept of intrinsic value is to eliminate or reduce the inaccuracies of accounting book value.
Anyway, the key here is that although Buffett says repeatedly that book value per share is a good indication of how BRK is doing, he says that every year, the gap between intrinsic value and book value continues to grow, and that this gap is pretty substantial.
That means if you buy BRK at book value, or close to it, then you are getting a huge bargain according to Buffett's own view. And again, Buffett is no self-promoter type. He is as straight a shooter as you will find in the free world. If he says BRK is worth far more than stated book value, you can take that to the bank.
Does that mean BRK is worth 1.6 to 1.7x book value? I have no idea, actually. But if you are buying cheap, you don't have to worry too much about that. Maybe 1.5x book is a reasonable estimate. Who knows.
And that isn't even that important when book value is going to grow. BRK has grown book value per share by 20.2% from 1965 through 2010. That's 20.2%/year for 45 years, compared to +9.4%/year including dividends for the S&P 500 index.
OK, but this may be misleading because Buffett will not be around for the next 45 years.
But Buffett has said that he has no desire to retire. He may be with BRK for many more years to come. He has stated at the annual meeting that he is confident that BRK can grow book value at a pace that exceeds the S&P 500 index by several percentage points. This really puts to rest the notion that BRK is simply too big to outperform anymore.
Again, Buffett is no self-promoting, over-promising type. He truly feels that he can outdo the S&P 500 index by several points per year. And he and the board is putting a lot of energy into succession to make sure that BRK will be managed well going forward.
Let's go back to the growth of book value. People have been saying that Buffett is too old, or BRK is just too big to outperform since the 1990s.
Many argued even in 1999/2000 that the stock market is way overvalued and that the market will crash and that there is no way Buffett is going to make money in the next decade.
Well, let's take a look at what happened. First of all, the bears were right. The market did have a bear market and the S&P 500 went down 50% and the NASDAQ index did even worse declining a whopping, Nikkei-like 80%! And then we had the worst financial crisis since the Great Depression.
Let's look at the growth of book value per share over the past five and ten years (through the end of December 2010, which includes these 100-year flood-type events).
BRK S&P 500 index (w/dividends)
5 year annualize return: +10.0% +2.3%
10 year annualized return: + 9.0% +1.4%
Notice how BRK has outperformed the S&P 500 index by 7.7% per year in the past five, horrible years and 7.6% per year in the past ten nightmare years.
Also, I should note that this period also includes some of the largest insurance/reinsurance catastrophes in history, from 9/11 to Katrina to this year's earthquake in Japan.
BRK was able to grow book value at 9-10% per year during a time that the market was flat, and had 9/11, the worst financial crisis, internet bubble/collapse/bear market, wars in Iraq and Afghanistan etc... This sort of argues against the view that Buffett is simply a bull market genius. He is able to make money in non-bull markets too.
How many mutual funds can we name that has done this well? None. And the other interesting point is that Buffett works for a small salary and does not take 'fees' out, like 1% or 2% that equity funds like to take. Also, he doesn't take 20% of the profits as hedge funds typically do. You get this wonderful outperformance at a very, very low cost.
The other thing to point out about the long term returns is that the BRK change in book value is actually after taxes; change in book value is net of all taxes including markups of equities owned, which is marked to market net of taxes payable on the unrealized profits. The S&P 500 returns, however, are gross return figures and do not reflect taxes at all.
And you get all of this right now at something close to flat book value.
Any premium to book value that BRK might be worth is simply icing on the cake. If BRK continues to grow it's book value per share, and the market valuation returns to a more normal level above book value, that is just a nice wind at your back to help your return.
If you are wondering about the long term future of BRK, Buffett has said many times that this is a primary preoccupation of his. Most of his and his family's net worth is invested in BRK, as are many of his close friends and their families. When he thinks about the future of BRK, he thinks about those people that depend on his decisions for their well-being. He is not a hired gun CEO out to make a ton of money for himself and then just exercise their stock options and say good-bye (and leave others to clean up the mess).
He is determined to see that BRK is in good hands after his passing. Also, it is important to remember that BRK is a big collection of some outstanding businesses. It is not a mutual fund or hedge fund where the investment manager has to stay on top of the portfolio every day and make adjustments. Much of BRK operates very well without Buffett's supervision.
Having said that, it is silly to think that BRK stock won't go down if Buffett gets hit by a truck. But at this price level, you are not paying a Buffett premium at all so the downside would probably be very limited.
Anyway, I tell anyone I run into who is interested in investing to read all of Berkshire Hathaway's annual reports that are posted for free at the BRK website (all annual reports going back to 1979 is posted there). The contents of all those "letter to shareholders" is better than any book you can buy on investing or business, by far. And it's all free!
But I do know that even if I say that, only the hard core investors are going to actually do it. Most will just shrug and say, oh, and never even go to the website.
That's why I will post BRK's long term returns that is on page one of the annual report every year at the bottom of this post. Look at it carefully and see how well Buffett has done over the years. It is absolutely, mindbogglingly amazing.
As usual, these are just my thoughts on this stock and is not necessarily a stock recommendation. I would hate it if someone bought a stock I mentioned and lost money on it. Whenever you read about an investment idea on the internet, you should do your own work, try to understand it and then if you like it, only then buy it. There is nothing worse in the investing world than to just do what you read on the internet!
The figures below are:
BRK: percentage change in book value per share
SP 500 w/div: Total return of S&P 500 index including dividends
difference: difference between the two (BRK return - S&P 500 return)
The averages for the whole period for these columns are:
BRK: +20.2%
SP 500 w/div: + 9.4%
difference: +10.8%
BUT, having said that, I can't not mention an astounding thing going on in the market right now. I don't think many people would have dreamed of this in a long time.
Anyway, as I said, there are a lot of websites/blogs that talk in detail about BRK, what it's worth and all that. Calculating the intrinsic value of BRK seems to be a miniature cottage industry on the internet. I don't intend to jump onto that bandwagon. I have my own thoughts on how to value BRK, but I am mostly content reading analysis by others.
I am only making this post because with BRK trading at where it is now, it doesn't take a whole lot of deep analysis to realize it's a darn good bargain.
To make a long story short, BRK is now trading at very close to book value per share. As of the end of the June 2011 quarter, BRK had total shareholders equity of $163 billion. Shares outstanding is 1.65 billion shares, so total book value per share is $98,790/share based on the A-shares. Book value per share would be $65.85/b-share (1,500 class b shares per class a share).
BRK-A (a-shares) is now trading at around $105,000 per share (or a slight 6.3% premium to the BPS), and BRK-B is trading at $70/share.
OK, OK, but stock prices have gone down since the end of June. At June end, the S&P 500 index was at 1,321 but is now at 1,218, a decline of around -7.8%. BRK had $66 billion in stock holdings (marked-to-market on the balance sheet every quarter net of taxes owed) as of the end of June. So if the stocks fell as much as the S&P did, that would be a $5 billion decline in the net worth of BRK, or around 3%.
Subtract that from the net worth calculations above and that still leaves the stock trading at a premium of less than 10%!
Why should we care if BRK is trading at book value?
For one, I think BRK has traded at a price-to-book-value ratio of around 1.7x over the past ten years, so this is a very rare thing. If BRK traded merely back at what it used to trade at versus book, that alone would give you a 70% return on owning this stock.
But there are reasons, of course, that it may not get back to 1.7x book. I don't want to get into the details of accounting or anything, but there is an impact from BRK's purchase of Burlington Northern, for example.
But more important may be the age of Warren Buffett. He is an old guy; he just turned 81. The past performance of BRK is largely thanks to the genius of Buffett. Can this be repeated over the next 50 years? Highly unlikely.
Another reason is that BRK is an insurance company, although they are in many other businesses. Insurance companies and financials are very, very out of favor right now. Insurance and reinurance has been in a soft market for a long, long time so it has been difficult to make money in the insurance business even though BRK has been successful even in this soft market. That's another long story that I will leave out of this post. But trust me when I say that BRK's insurance business is very different than other listed insurance and reinsurance companies.
Also, BRK is known to hold some financial stocks. He is a large holder of Wells Fargo, American Express, recently purchased a stake in Bank of America, bought preferred shares in General Electric and Goldman Sachs during the crisis etc...
So many people view BRK as a financial company, vulnerable to the same macro factors as any other bank or insurance company.
So it is not completely surprising that Mr. Market will bundle BRK with the other financials and throw it in the dumpster.
But let's get back to book value. First of all, Buffett has said many times over the years that book value per share is a very good indicator of intrinsic value. Changes in the book value per share of BRK reflects well the direction and magnitude of the change in the intrinsic value of the company.
What's the difference between book value and intrinsic value? I don't want to get into it too much right now, but let's just say that book value is an accounting measurement that has many inaccuracies and problems, and the concept of intrinsic value is a look at the true value of what a business is worth regardless of accounting rules and conventions. The purpose of having the concept of intrinsic value is to eliminate or reduce the inaccuracies of accounting book value.
Anyway, the key here is that although Buffett says repeatedly that book value per share is a good indication of how BRK is doing, he says that every year, the gap between intrinsic value and book value continues to grow, and that this gap is pretty substantial.
That means if you buy BRK at book value, or close to it, then you are getting a huge bargain according to Buffett's own view. And again, Buffett is no self-promoter type. He is as straight a shooter as you will find in the free world. If he says BRK is worth far more than stated book value, you can take that to the bank.
Does that mean BRK is worth 1.6 to 1.7x book value? I have no idea, actually. But if you are buying cheap, you don't have to worry too much about that. Maybe 1.5x book is a reasonable estimate. Who knows.
And that isn't even that important when book value is going to grow. BRK has grown book value per share by 20.2% from 1965 through 2010. That's 20.2%/year for 45 years, compared to +9.4%/year including dividends for the S&P 500 index.
OK, but this may be misleading because Buffett will not be around for the next 45 years.
But Buffett has said that he has no desire to retire. He may be with BRK for many more years to come. He has stated at the annual meeting that he is confident that BRK can grow book value at a pace that exceeds the S&P 500 index by several percentage points. This really puts to rest the notion that BRK is simply too big to outperform anymore.
Again, Buffett is no self-promoting, over-promising type. He truly feels that he can outdo the S&P 500 index by several points per year. And he and the board is putting a lot of energy into succession to make sure that BRK will be managed well going forward.
Let's go back to the growth of book value. People have been saying that Buffett is too old, or BRK is just too big to outperform since the 1990s.
Many argued even in 1999/2000 that the stock market is way overvalued and that the market will crash and that there is no way Buffett is going to make money in the next decade.
Well, let's take a look at what happened. First of all, the bears were right. The market did have a bear market and the S&P 500 went down 50% and the NASDAQ index did even worse declining a whopping, Nikkei-like 80%! And then we had the worst financial crisis since the Great Depression.
Let's look at the growth of book value per share over the past five and ten years (through the end of December 2010, which includes these 100-year flood-type events).
BRK S&P 500 index (w/dividends)
5 year annualize return: +10.0% +2.3%
10 year annualized return: + 9.0% +1.4%
Notice how BRK has outperformed the S&P 500 index by 7.7% per year in the past five, horrible years and 7.6% per year in the past ten nightmare years.
Also, I should note that this period also includes some of the largest insurance/reinsurance catastrophes in history, from 9/11 to Katrina to this year's earthquake in Japan.
BRK was able to grow book value at 9-10% per year during a time that the market was flat, and had 9/11, the worst financial crisis, internet bubble/collapse/bear market, wars in Iraq and Afghanistan etc... This sort of argues against the view that Buffett is simply a bull market genius. He is able to make money in non-bull markets too.
How many mutual funds can we name that has done this well? None. And the other interesting point is that Buffett works for a small salary and does not take 'fees' out, like 1% or 2% that equity funds like to take. Also, he doesn't take 20% of the profits as hedge funds typically do. You get this wonderful outperformance at a very, very low cost.
The other thing to point out about the long term returns is that the BRK change in book value is actually after taxes; change in book value is net of all taxes including markups of equities owned, which is marked to market net of taxes payable on the unrealized profits. The S&P 500 returns, however, are gross return figures and do not reflect taxes at all.
And you get all of this right now at something close to flat book value.
Any premium to book value that BRK might be worth is simply icing on the cake. If BRK continues to grow it's book value per share, and the market valuation returns to a more normal level above book value, that is just a nice wind at your back to help your return.
If you are wondering about the long term future of BRK, Buffett has said many times that this is a primary preoccupation of his. Most of his and his family's net worth is invested in BRK, as are many of his close friends and their families. When he thinks about the future of BRK, he thinks about those people that depend on his decisions for their well-being. He is not a hired gun CEO out to make a ton of money for himself and then just exercise their stock options and say good-bye (and leave others to clean up the mess).
He is determined to see that BRK is in good hands after his passing. Also, it is important to remember that BRK is a big collection of some outstanding businesses. It is not a mutual fund or hedge fund where the investment manager has to stay on top of the portfolio every day and make adjustments. Much of BRK operates very well without Buffett's supervision.
Having said that, it is silly to think that BRK stock won't go down if Buffett gets hit by a truck. But at this price level, you are not paying a Buffett premium at all so the downside would probably be very limited.
Anyway, I tell anyone I run into who is interested in investing to read all of Berkshire Hathaway's annual reports that are posted for free at the BRK website (all annual reports going back to 1979 is posted there). The contents of all those "letter to shareholders" is better than any book you can buy on investing or business, by far. And it's all free!
But I do know that even if I say that, only the hard core investors are going to actually do it. Most will just shrug and say, oh, and never even go to the website.
That's why I will post BRK's long term returns that is on page one of the annual report every year at the bottom of this post. Look at it carefully and see how well Buffett has done over the years. It is absolutely, mindbogglingly amazing.
As usual, these are just my thoughts on this stock and is not necessarily a stock recommendation. I would hate it if someone bought a stock I mentioned and lost money on it. Whenever you read about an investment idea on the internet, you should do your own work, try to understand it and then if you like it, only then buy it. There is nothing worse in the investing world than to just do what you read on the internet!
The figures below are:
BRK: percentage change in book value per share
SP 500 w/div: Total return of S&P 500 index including dividends
difference: difference between the two (BRK return - S&P 500 return)
The averages for the whole period for these columns are:
BRK: +20.2%
SP 500 w/div: + 9.4%
difference: +10.8%
| BRK | SP 500 w/dvd | difference | |
| 1965 | 23.80% | 10.00% | 13.80% |
| 1966 | 20.30% | -11.70% | 32.00% |
| 1967 | 11.00% | 30.90% | -19.90% |
| 1968 | 19.00% | 11.00% | 8.00% |
| 1969 | 16.20% | -8.40% | 24.60% |
| 1970 | 12.00% | 3.90% | 8.10% |
| 1971 | 16.40% | 14.60% | 1.80% |
| 1972 | 21.70% | 18.90% | 2.80% |
| 1973 | 4.70% | -14.80% | 19.50% |
| 1974 | 5.50% | -26.40% | 31.90% |
| 1975 | 21.90% | 37.20% | -15.30% |
| 1976 | 59.30% | 23.60% | 35.70% |
| 1977 | 31.90% | -7.40% | 39.30% |
| 1978 | 24.00% | 6.40% | 17.60% |
| 1979 | 35.70% | 18.20% | 17.50% |
| 1980 | 19.30% | 32.30% | -13.00% |
| 1981 | 31.40% | -5.00% | 36.40% |
| 1982 | 40.00% | 21.40% | 18.60% |
| 1983 | 32.30% | 22.40% | 9.90% |
| 1984 | 13.60% | 6.10% | 7.50% |
| 1985 | 48.20% | 31.60% | 16.60% |
| 1986 | 26.10% | 18.60% | 7.50% |
| 1987 | 19.50% | 5.10% | 14.40% |
| 1988 | 20.10% | 16.60% | 3.50% |
| 1989 | 44.40% | 31.70% | 12.70% |
| 1990 | 7.40% | -3.10% | 10.50% |
| 1991 | 39.60% | 30.50% | 9.10% |
| 1992 | 20.30% | 7.60% | 12.70% |
| 1993 | 14.30% | 10.10% | 4.20% |
| 1994 | 13.90% | 1.30% | 12.60% |
| 1995 | 43.10% | 37.60% | 5.50% |
| 1996 | 31.80% | 23.00% | 8.80% |
| 1997 | 34.10% | 33.40% | 0.70% |
| 1998 | 48.30% | 28.60% | 19.70% |
| 1999 | 0.50% | 21.00% | -20.50% |
| 2000 | 6.50% | -9.10% | 15.60% |
| 2001 | -6.20% | -11.90% | 5.70% |
| 2002 | 10.00% | -22.10% | 32.10% |
| 2003 | 21.00% | 28.70% | -7.70% |
| 2004 | 10.50% | 10.90% | -0.40% |
| 2005 | 6.40% | 4.90% | 1.50% |
| 2006 | 18.40% | 15.80% | 2.60% |
| 2007 | 11.00% | 5.50% | 5.50% |
| 2008 | -9.60% | -37.00% | 27.40% |
| 2009 | 19.80% | 26.50% | -6.70% |
| 2010 | 13.00% | 15.10% | -2.10% |
Monday, September 19, 2011
J.P. Morgan at Tangible Book
I was reading a recent issue of Grant's (August 12, 2011) and he reminds us that J.P. Morgan Chase (JPM) is trading at close to tangible book value per share.
He also quotes Jamie Dimon, one of my favorite CEOs as saying in April, "Your company earned a record $17 billion in 2010, up 48% from $12 billion in 2009. As points of reference: In 2008 - which, as you know, was a year filled with unprecendented challenges - we earned $6 billion, and the year before, we earned $15 billion, a then record for us.... Our return on tangible equity for 2010 was 15%. Given your company's earnings power, these returns should be higher. In a more normal environment, we believe that we can earn approximately $22 billion to $24 billion..."
$22 to $24 billion in earnings equates to $5.64 - $6.15 in EPS. With the current stock price at around $32/share, J.P. Morgan, what I think is the best managed bank in the world with one of the best CEO's is trading at 5.2 - 5.7x eps. That is really, really cheap. If banks trade in a more normal, non-panic range of 10-15x eps (not a stretch at all), then JPM could be trading in the range of $56.40 - $92/share (10 times the low end of the eps estimate range or 15x the high end. Taking the mid point of the eps of $5.90/share, that would be a range of $59 - $89/share)
Now wait, you say. JPM is a bank. Banks aren't supposed to make a lot of money going forward due to Dodd-Frank. The Volcker rule will also restrict the amount of money they can make, right? Also, European debt problems can really spiral out of control and take global financial insitutions down.
Yes, new laws will put a damper on bank earnings going forward, but the Volcker rule will apparently have little impact on JPM as they didn't have much in the way of pure proprietary trading, and the Dodd-Frank rules will just cause a shift in pricing across products so it won't lead to a straight decline in revenues. Dimon has said that if you restrict how much you can charge for milk, a supermarket will find a way to charge more for the olive oil, or some such thing. They will find other services to provide that can be profitable.
Tangible Equity
From the above comment by Dimon it is clear that he thinks even with all the new laws, restrictions and European problems, JPM can earn much more than 15% return on tangible equity. That is good information. Jamie Dimon is no flakey promoter and he is not the salesman/hyping type of CEO. He is just about the smartest, most conservative manager in finance. So if he says JPM should be able to earn much more than 15% return on tangible equity in a more 'normal' environment, then I really believe that they can do it.
Given that piece of information, it really is amazing that you can buy shares in J.P. Morgan at around tangible book value per share. That's pretty much saying that you are buying into a business at a price that can earn 15%, at least, over time. How many investments can you say that about? If you bought an S&P 500 index fund, I think the best that you can expect over time is 10%/year.
Stock prices historically has traded at around 15-16x p/e since 1870 or so. That's an earnings yield of about 6.5%.
And here you have an investment where the prospective earnings (if you buy at this price) is at least 15%.
Recent Trends in Return on Equity and Return on Tangible Equity
JPM's return on equity (ROE) and return on tangible common equity (ROTCE) for the years 2005 through 2010 were as follows:
ROE ROTCE
2005 8% 14%
2006 12% 22%
2007 13% 21%
2008 4% 6%
2009 7% 11%
2010 10% 15%
The average ROTCE over the past six years is 14.8%. Note that this 14.8% includes the worst financial crisis since the great depression, and includes massive losses in mortgages, CDOs, credit cards and everything else.
JPM did not produce a loss in any single quarter throughout this crisis.
Yes, yes, critics say that this is because JPM didn't mark their books correctly. But anyone who knows Jamie Dimon knows that he is very conservative and hates bogus accounting. And besides, if phony accounting is all it takes to survive a financial hurricane, how come Bear Stearns, Washington Mutual, AIG, Citigroup, Fannie Mae, Freddie Mac and many others didn't use the same phoney accounting to avoid losses?
I don't think it was phoney accounting. I think it was just good management.
The government had to bail them out? Yes, it's true that if the financial system did collapse, JPM would have been in trouble too. But Dimon was preparing JPM for a 15% unemployment rate. He said they would have been ready for a more severe recession/crisis. Again, I believe him.
In any case, the above ROTCE is very impressive and it is not a stretch to believe that they can do better in the future as the economy normalizes.
Dividends
A quick comment on dividends; banks have not really boosted dividends yet as they have stopped dividends during the crisis to preserve and increase capital.
But from JPM's presentation this past spring, we see that analysts expect dividends of $5 billion in 2012 and $6 billion in 2013. Assuming 3.9 billion shares outstanding (which may decrease due to share repurchases), that would be $1.28 and $1.54 per share. On a $32 stock price, those are forward dividend yields of 4% an 4.8% respectively. This compares to a 10 year treasury yield of below 2%.
Even under the 'stressed' scenario where the environment gets worse, dividends per share for 2011, 2012 and 2013 are expected to be $0.63, $1.28 and $1.56 (these are higher than the above base-case figures probably because I just took $5 billion and $6 billion (rounded figures) divided by 3.9 billion shares, whereas per share dividends are from the JPM presentation as stated per share).
Stress Test?
In the April presentation to shareholders, JPM included projections for earnings, capital, dividends etc... based on a stressed analysis; how would the bank do if things got materially worse?
The assumptions for the stress scenario, I think, was that unemployment would get worse and peak out at 12% in the fourth quarter of 2013, the Housing Price Index would have a peak-to-trough decline of 45% by the first quarter of 2012, the S&P 500 index would dcline to 850 in the first half of 2011 and stay there through the fourth quarter of 2013 and the Fed Funds rate would stay at 20 basis points (0.20%) through 2013.
Of course, things can get much worse than that, but it is a good 'bad case' scenario to evaluate to see how JPM would do.
The analysts projections under this 'stressed' scenario would be:
2011 2012 2013
Net Income $12 bn $13 bn $14 bn
Total Common Dividends $2 bn $ 5 bn $ 6 bn
Basel I Tier 1 Common Ratio 10% 11% 12%
Basel III Tier 1 Common Ratio 8% 9% 10%
So even under harsh economic conditions, JPM will be able to pay out good dividends and even manage to increase capital ratios, even under the new, much stricter Basel III.
Risks
Many banks and financials are trading very cheaply now including Bank of America (BAC), which Warren Buffett bought preferred shares of (with warrants). He has endorsed the business model and management of BAC and has put his money where his mouth is. If he thinks BAC can't survive over the next few years, he would not have done so as he really hates to lose money.
Citigroup and other banks are also trading pretty cheaply; much cheaper than JPM.
But I wanted to highlight JPM due not just the cheapness of the stock, but because of it's high quality management and incredible track record even through this crisis. Of course, BAC and other banks may go up MORE in a normalizing global market environment; I am not proposing that JPM will go up the most in that scenario. But one could only dream of being able to buy into a bank like this at tangible book value in a normal environment.
Also, there are risks. Market volatility will probably continue for some time and there is no telling if the European situation will completely melt down. There is no reason for me to believe that J.P. Morgan won't survive this under current management. We can see how well they did in the financial crisis where the meltdown occured here in the U.S. J.P. Morgan does not have a lot of exposure in Europe. I imagine much of their exposure is in the derivatives book, and Dimon is known to be very conservative in that area. I find it highly unlikely that the derivatives book will blow up under Dimon.
A double dip recession in the U.S. will most likely hurt the stock price, but I see no reason JPM can't get through that either. Their capital position is better, balance sheets stronger, loan qualities higher than before the last crisis.
As far as I am concerned, the biggest risks is a more severely flattening yield curve. This will hurt all the banks. The Fed's operation "twist", switching it's QE2 holdings into longer maturity treasuries to push long term yields down may hurt the net interest margin of all banks. This would put downward pressure on profits going forward.
Many banks here earn 3-4% interest spreads, while the big banks in Japan earn slightly more than 1%. If interest spreads come down to below 2%, this could be problematic for many banks.
The other is what happens after Jamie Dimon. Dimon shows no signs of leaving yet, but much of my faith in JPM is based on my trust of Dimon. I am confident JPM will do well going forward even without Dimon as long as the succession is done well. Citigroup was a total disaster because Weill left Citigroup to a lawyer with very little financial and/or operational experience. He was clueless, basically. I think this was also the case with AIG; Sullivan was an insurance guy but really had no idea about other aspects of AIG's business.
It is highly unlikely that Dimon would pull off such a sloppy, reckless succession. But it is a risk.
Having said all that, all financials are highly unfavored and hated. This is one area where value investors should be hunting. Although JPM is not the cheapest financial stock around (there are many), this is one of the most solid companies with the best managements.
He also quotes Jamie Dimon, one of my favorite CEOs as saying in April, "Your company earned a record $17 billion in 2010, up 48% from $12 billion in 2009. As points of reference: In 2008 - which, as you know, was a year filled with unprecendented challenges - we earned $6 billion, and the year before, we earned $15 billion, a then record for us.... Our return on tangible equity for 2010 was 15%. Given your company's earnings power, these returns should be higher. In a more normal environment, we believe that we can earn approximately $22 billion to $24 billion..."
$22 to $24 billion in earnings equates to $5.64 - $6.15 in EPS. With the current stock price at around $32/share, J.P. Morgan, what I think is the best managed bank in the world with one of the best CEO's is trading at 5.2 - 5.7x eps. That is really, really cheap. If banks trade in a more normal, non-panic range of 10-15x eps (not a stretch at all), then JPM could be trading in the range of $56.40 - $92/share (10 times the low end of the eps estimate range or 15x the high end. Taking the mid point of the eps of $5.90/share, that would be a range of $59 - $89/share)
Now wait, you say. JPM is a bank. Banks aren't supposed to make a lot of money going forward due to Dodd-Frank. The Volcker rule will also restrict the amount of money they can make, right? Also, European debt problems can really spiral out of control and take global financial insitutions down.
Yes, new laws will put a damper on bank earnings going forward, but the Volcker rule will apparently have little impact on JPM as they didn't have much in the way of pure proprietary trading, and the Dodd-Frank rules will just cause a shift in pricing across products so it won't lead to a straight decline in revenues. Dimon has said that if you restrict how much you can charge for milk, a supermarket will find a way to charge more for the olive oil, or some such thing. They will find other services to provide that can be profitable.
Tangible Equity
From the above comment by Dimon it is clear that he thinks even with all the new laws, restrictions and European problems, JPM can earn much more than 15% return on tangible equity. That is good information. Jamie Dimon is no flakey promoter and he is not the salesman/hyping type of CEO. He is just about the smartest, most conservative manager in finance. So if he says JPM should be able to earn much more than 15% return on tangible equity in a more 'normal' environment, then I really believe that they can do it.
Given that piece of information, it really is amazing that you can buy shares in J.P. Morgan at around tangible book value per share. That's pretty much saying that you are buying into a business at a price that can earn 15%, at least, over time. How many investments can you say that about? If you bought an S&P 500 index fund, I think the best that you can expect over time is 10%/year.
Stock prices historically has traded at around 15-16x p/e since 1870 or so. That's an earnings yield of about 6.5%.
And here you have an investment where the prospective earnings (if you buy at this price) is at least 15%.
Recent Trends in Return on Equity and Return on Tangible Equity
JPM's return on equity (ROE) and return on tangible common equity (ROTCE) for the years 2005 through 2010 were as follows:
ROE ROTCE
2005 8% 14%
2006 12% 22%
2007 13% 21%
2008 4% 6%
2009 7% 11%
2010 10% 15%
The average ROTCE over the past six years is 14.8%. Note that this 14.8% includes the worst financial crisis since the great depression, and includes massive losses in mortgages, CDOs, credit cards and everything else.
JPM did not produce a loss in any single quarter throughout this crisis.
Yes, yes, critics say that this is because JPM didn't mark their books correctly. But anyone who knows Jamie Dimon knows that he is very conservative and hates bogus accounting. And besides, if phony accounting is all it takes to survive a financial hurricane, how come Bear Stearns, Washington Mutual, AIG, Citigroup, Fannie Mae, Freddie Mac and many others didn't use the same phoney accounting to avoid losses?
I don't think it was phoney accounting. I think it was just good management.
The government had to bail them out? Yes, it's true that if the financial system did collapse, JPM would have been in trouble too. But Dimon was preparing JPM for a 15% unemployment rate. He said they would have been ready for a more severe recession/crisis. Again, I believe him.
In any case, the above ROTCE is very impressive and it is not a stretch to believe that they can do better in the future as the economy normalizes.
Dividends
A quick comment on dividends; banks have not really boosted dividends yet as they have stopped dividends during the crisis to preserve and increase capital.
But from JPM's presentation this past spring, we see that analysts expect dividends of $5 billion in 2012 and $6 billion in 2013. Assuming 3.9 billion shares outstanding (which may decrease due to share repurchases), that would be $1.28 and $1.54 per share. On a $32 stock price, those are forward dividend yields of 4% an 4.8% respectively. This compares to a 10 year treasury yield of below 2%.
Even under the 'stressed' scenario where the environment gets worse, dividends per share for 2011, 2012 and 2013 are expected to be $0.63, $1.28 and $1.56 (these are higher than the above base-case figures probably because I just took $5 billion and $6 billion (rounded figures) divided by 3.9 billion shares, whereas per share dividends are from the JPM presentation as stated per share).
Stress Test?
In the April presentation to shareholders, JPM included projections for earnings, capital, dividends etc... based on a stressed analysis; how would the bank do if things got materially worse?
The assumptions for the stress scenario, I think, was that unemployment would get worse and peak out at 12% in the fourth quarter of 2013, the Housing Price Index would have a peak-to-trough decline of 45% by the first quarter of 2012, the S&P 500 index would dcline to 850 in the first half of 2011 and stay there through the fourth quarter of 2013 and the Fed Funds rate would stay at 20 basis points (0.20%) through 2013.
Of course, things can get much worse than that, but it is a good 'bad case' scenario to evaluate to see how JPM would do.
The analysts projections under this 'stressed' scenario would be:
2011 2012 2013
Net Income $12 bn $13 bn $14 bn
Total Common Dividends $2 bn $ 5 bn $ 6 bn
Basel I Tier 1 Common Ratio 10% 11% 12%
Basel III Tier 1 Common Ratio 8% 9% 10%
So even under harsh economic conditions, JPM will be able to pay out good dividends and even manage to increase capital ratios, even under the new, much stricter Basel III.
Risks
Many banks and financials are trading very cheaply now including Bank of America (BAC), which Warren Buffett bought preferred shares of (with warrants). He has endorsed the business model and management of BAC and has put his money where his mouth is. If he thinks BAC can't survive over the next few years, he would not have done so as he really hates to lose money.
Citigroup and other banks are also trading pretty cheaply; much cheaper than JPM.
But I wanted to highlight JPM due not just the cheapness of the stock, but because of it's high quality management and incredible track record even through this crisis. Of course, BAC and other banks may go up MORE in a normalizing global market environment; I am not proposing that JPM will go up the most in that scenario. But one could only dream of being able to buy into a bank like this at tangible book value in a normal environment.
Also, there are risks. Market volatility will probably continue for some time and there is no telling if the European situation will completely melt down. There is no reason for me to believe that J.P. Morgan won't survive this under current management. We can see how well they did in the financial crisis where the meltdown occured here in the U.S. J.P. Morgan does not have a lot of exposure in Europe. I imagine much of their exposure is in the derivatives book, and Dimon is known to be very conservative in that area. I find it highly unlikely that the derivatives book will blow up under Dimon.
A double dip recession in the U.S. will most likely hurt the stock price, but I see no reason JPM can't get through that either. Their capital position is better, balance sheets stronger, loan qualities higher than before the last crisis.
As far as I am concerned, the biggest risks is a more severely flattening yield curve. This will hurt all the banks. The Fed's operation "twist", switching it's QE2 holdings into longer maturity treasuries to push long term yields down may hurt the net interest margin of all banks. This would put downward pressure on profits going forward.
Many banks here earn 3-4% interest spreads, while the big banks in Japan earn slightly more than 1%. If interest spreads come down to below 2%, this could be problematic for many banks.
The other is what happens after Jamie Dimon. Dimon shows no signs of leaving yet, but much of my faith in JPM is based on my trust of Dimon. I am confident JPM will do well going forward even without Dimon as long as the succession is done well. Citigroup was a total disaster because Weill left Citigroup to a lawyer with very little financial and/or operational experience. He was clueless, basically. I think this was also the case with AIG; Sullivan was an insurance guy but really had no idea about other aspects of AIG's business.
It is highly unlikely that Dimon would pull off such a sloppy, reckless succession. But it is a risk.
Having said all that, all financials are highly unfavored and hated. This is one area where value investors should be hunting. Although JPM is not the cheapest financial stock around (there are many), this is one of the most solid companies with the best managements.
Friday, September 16, 2011
Theme Investing, Good Idea?
When you have been in the investment world for a long time, you realize that every era, people get caught up in all sorts of 'themes' and 'stories'. Back in the early 80s, it was technology. There was a technology boom that ended in a bust. This happened in the 60s too, with many companies coming out with names that ended in '-tech' or '-tron' or some such indicative thing.
Of course this happened in the late 90s too with the internet; many companies coming out with names ending in ".com". The early 90s saw biotech stocks boom on the promise of biotechnology. The Japan bubble was partly based on the limited supply of land in the tiny island nation, and those 'hidden' assets the Tokyo Stock Exchange-listed companies owned.
Oftentimes, the 'story' or 'theme' will prove to be correct. But the accuracy, or correctness of the story does not often lead to good investment results. In the 1800s, British investors rushed to buy into hundreds of railway companies starting up in the U.S. The story was that railways across America will change the country. It did. But how many of those British investors made money? Of the hundreds of railway companies that were started, only a few were left by 1900.
The same happened with automobiles early this century. Autos was the future. It will change the country. Every household will own their own car at some point etc... Sure, it was a big thing. But there too, many automobile companies were started. How many survived? As far as I know, only GM, Ford and Chrysler survived and the rest went under.
This is the same story that we repeated back in the early 1980s. Computers will change the world! But out of the hot computer stocks back in the early 1980s, how many are still around today? Disk drive makers?
The internet bubble. The story was that the internet will change the world. Yes, it did change the world. Those prediction came true, pretty much as people expected. But how many people made money by buying internet stocks back in 1999/2000? How many picked the winners, and were smart enough to get out at the top? Not many.
A similar thing may be happening in natural resource and commodity stocks. China's growth is deemed inevitable, and that means more demand for just about everything.
Another 'theme' these days is green energy, solar and things like that.
I think these predictions will come true, about the growth of China and the increase in use of renewable energy sources.
But as usual, I am highly skeptical of people's ability to pick the winners.
This doesn't mean, of course, that people shouldn't invest in the area. It's just that it is a hard game to play, to invest in themes/stories as I showed above with historical examples.
One great example of green energy is Pacific Ethanol. Pacific Ethanol was a great story. They were a pure play on ethanol, which was a bio-fuel to help reduce our dependence on imported crude oil. The government supported this industry with incentives. The stock price soared to $300 or so (actually more like $40 or so since there was a recent 1:7 reverse split).
Corn was cheap and abundant in the U.S., and crude oil was expensive. What's not to like about turning cheap, abundant corn into something you can put into your gas tank? And it burns cleaner than gasoline too, and the government is offering incentives. This is a layup. How can you lose money? It kills two birds with one stone (reduce dependence on foreign oil and help the environment at the same time!)
And then on top of that, you had Bill Gates' investment company owning a large stake. This is the richest and smartest guy in the world with an investment in Pacific Ethanol.
What a really great story. If I was a retail broker pushing stocks, this would have been an easy one to sell for sure. What's not to like? How can you not understand it?
So what happened? From a high of $300 or so (I'm just eyeballing the chart on Yahoo Finance; ticker symbol is PEIX), it is now trading at $0.38. That's not a typo. It is trading for less than one dollar. And they didn't even make subprime loans or buy CDO squareds! (see chart here)
Another one is Ballard Power Sources. Check out this chart. This too is an alternative energy play. For as long as I have been in the business, Ballard has occasionally been promoted as the answer to the country's energy problem. They develop and manufacture batteries, and will presumably be suppying many of the batteries that will go into the future electric cars.
I have been hearing this story over and over for many years, particularly when oil prices go up and people start talking about electric cars.
Nobody really knows who will dominate the electric vehicle battery market. Nissan, Toyota and many other companies are putting a lot of money into R&D to develop a good battery that would work well in an electric car.
Here too, I think the 'prediction' will come true. Some day, most of our cars, buses and maybe trucks will run on electricity. But who will profit from that? That's a very different and very difficult question to answer.
My guess is that the winners will be a complete surprise.
So what matters, then?
At the end of the day, all investments come right back to the two simple questions:
1. Is it a good business?
2. Is it priced reasonably?
If the answer to the above two is yes, then it's a good buy and if the answer is no for either one of them, then it's not a good buy.
If someone can find a good business with a good story, that is great too. But the above two questions should come before the story or theme.
If people asked these two questions, most of the losses caused by my examples above would not have happened.
Of course this happened in the late 90s too with the internet; many companies coming out with names ending in ".com". The early 90s saw biotech stocks boom on the promise of biotechnology. The Japan bubble was partly based on the limited supply of land in the tiny island nation, and those 'hidden' assets the Tokyo Stock Exchange-listed companies owned.
Oftentimes, the 'story' or 'theme' will prove to be correct. But the accuracy, or correctness of the story does not often lead to good investment results. In the 1800s, British investors rushed to buy into hundreds of railway companies starting up in the U.S. The story was that railways across America will change the country. It did. But how many of those British investors made money? Of the hundreds of railway companies that were started, only a few were left by 1900.
The same happened with automobiles early this century. Autos was the future. It will change the country. Every household will own their own car at some point etc... Sure, it was a big thing. But there too, many automobile companies were started. How many survived? As far as I know, only GM, Ford and Chrysler survived and the rest went under.
This is the same story that we repeated back in the early 1980s. Computers will change the world! But out of the hot computer stocks back in the early 1980s, how many are still around today? Disk drive makers?
The internet bubble. The story was that the internet will change the world. Yes, it did change the world. Those prediction came true, pretty much as people expected. But how many people made money by buying internet stocks back in 1999/2000? How many picked the winners, and were smart enough to get out at the top? Not many.
A similar thing may be happening in natural resource and commodity stocks. China's growth is deemed inevitable, and that means more demand for just about everything.
Another 'theme' these days is green energy, solar and things like that.
I think these predictions will come true, about the growth of China and the increase in use of renewable energy sources.
But as usual, I am highly skeptical of people's ability to pick the winners.
This doesn't mean, of course, that people shouldn't invest in the area. It's just that it is a hard game to play, to invest in themes/stories as I showed above with historical examples.
One great example of green energy is Pacific Ethanol. Pacific Ethanol was a great story. They were a pure play on ethanol, which was a bio-fuel to help reduce our dependence on imported crude oil. The government supported this industry with incentives. The stock price soared to $300 or so (actually more like $40 or so since there was a recent 1:7 reverse split).
Corn was cheap and abundant in the U.S., and crude oil was expensive. What's not to like about turning cheap, abundant corn into something you can put into your gas tank? And it burns cleaner than gasoline too, and the government is offering incentives. This is a layup. How can you lose money? It kills two birds with one stone (reduce dependence on foreign oil and help the environment at the same time!)
And then on top of that, you had Bill Gates' investment company owning a large stake. This is the richest and smartest guy in the world with an investment in Pacific Ethanol.
What a really great story. If I was a retail broker pushing stocks, this would have been an easy one to sell for sure. What's not to like? How can you not understand it?
So what happened? From a high of $300 or so (I'm just eyeballing the chart on Yahoo Finance; ticker symbol is PEIX), it is now trading at $0.38. That's not a typo. It is trading for less than one dollar. And they didn't even make subprime loans or buy CDO squareds! (see chart here)
Another one is Ballard Power Sources. Check out this chart. This too is an alternative energy play. For as long as I have been in the business, Ballard has occasionally been promoted as the answer to the country's energy problem. They develop and manufacture batteries, and will presumably be suppying many of the batteries that will go into the future electric cars.
I have been hearing this story over and over for many years, particularly when oil prices go up and people start talking about electric cars.
Nobody really knows who will dominate the electric vehicle battery market. Nissan, Toyota and many other companies are putting a lot of money into R&D to develop a good battery that would work well in an electric car.
Here too, I think the 'prediction' will come true. Some day, most of our cars, buses and maybe trucks will run on electricity. But who will profit from that? That's a very different and very difficult question to answer.
My guess is that the winners will be a complete surprise.
So what matters, then?
At the end of the day, all investments come right back to the two simple questions:
1. Is it a good business?
2. Is it priced reasonably?
If the answer to the above two is yes, then it's a good buy and if the answer is no for either one of them, then it's not a good buy.
If someone can find a good business with a good story, that is great too. But the above two questions should come before the story or theme.
If people asked these two questions, most of the losses caused by my examples above would not have happened.
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