The Investing Digest (29/1/2023)
Interesting investing resources from a week in the fintwit pits
Kicking things off this week, I’d like to address the following question posed by reader SM, about last week’s Issue:
A sensational point, and I’m not just referring to the positive feedback. Firstly, some house keeping. The Moody’s spin was completed 30th of September, 2000. The top in quality-growth valuations had topped sometime before then. The below chart of Coca Cola ($KO) illustrates that the shares traded down over 50% top to bottom, and just shy of that by the time of spin.
The historical information is a touch difficult to divine - but i’ll do my best with the information at my disposal (if you happen to have better information than me, I’d be grateful if you would share it). It appears that Coca Cola traded somewhere between 30-35x LTM EPS at the end of September 2000. Undoubtedly, a full price by anyone’s reckoning.
As SM correctly mentions, betting on a multiple re-rate to a 2% earnings yield in even the best businesses is unrealistic, and an unhappy surprise to the long-term shareholder in any event. The academic literature is replete with data suggesting that expensive shares tend to under-perform in the long term. If you don’t accept that, you’ve found your way onto the wrong blog.
A tangent if you’ll allow me. The academic literature broadly agrees on two points. Cheap shares (pick your metric) outperform, and expensive shares under-perform over the long-term. These studies, however, track shares as a population. Any concentrated investor is making a decision to identify investment opportunities ground-up. While I appreciate the timeless nature of quantitative value, I don’t worship at its alter.
So Coca Cola experienced a 100% change in it’s LTM multiple over Buffett’s then 12 year ownership period. While I won’t wax-philosophic about what the correct multiple is, some facts and history are in order.
Firstly, facts. As stated in the Issue, over this 12 year period EPS grew at about 15% per year, and dividends were paid during that time. Even if you divorce the multiple expansion from the quoted value of the stock, the financial performance of the business was very strong. An excellent result would have occurred even if generally observed equity multiples had remained the same. The most important driver of long-term returns is EPS/FCFPS growth and capital allocation.
History next. The Coca Cola Roberto Goizueta had taken control of in 1981, and even the company Buffett purchased shares in, in 1988, was not exactly the same business that existed in 2000. During this 19 year period, Coca Cola, through a number of steps, renegotiated pricing contracts with it’s bottlers, and dramatically overhauled operations. The financial profile of the company, from end to end, had changed in a very positive way. How much multiple expansion should that be worth? I’ll let you, dear reader, answer that.
Incidentally, Moody’s has experienced a similar amount of margin expansion (currently 38x LTM EPS) over the period of its sole listing. What is a seemingly perpetual bond with a yearly 10% hike in it’s coupon worth? I’ll take a stab at this one:
It’s worth a great deal.
While I’ve been trying to banish the ChatGPT-hype from my mind, sometimes developments are so interesting that even the most committed Luddite can’t resist. See the below post by semi-legendary Australian finblogger find the moat (@findthemoat):
The news that BuzzFeed is actually going to replace a number of journalists with ‘a generally available API’ is incredible. We’re looking into the (imminent) future here - a world where content gets commoditized quickly. Unfortunately, my crystal ball is hazy today so I can’t share with you who wins out of this. In a world where content is created en masse - value may accrue to the systems that can find the good stuff, quickly.
The share price reaction to the news was equally stunning:
Speaking of find the moat - he reemerged this week after a 6 year hiatus. That’s taking ‘patience tempered with pretty decisive conduct’ to an entirely new level. I’ll make that this week’s mantra while we’re at it.
The blog post was about Australian cloud-based accounting software company Xero ($XRO). This is a company I have followed for sometime due to the immense economic goodwill it’s sitting on in it’s core Australia-New Zealand market. Under the right circumstances I could see myself owning the name - ideally they would halt the unfortunate practice of lighting shareholder capital on fire beforehand.
I went to Church again this week - but it was more bible study than sermon.
Late last year, Substack writer Investment Management Insights, released a summary of a conversation between Michael Mauboussin and Berkshire Hathaway’s Todd Combs at the yearly Graham & Dodd Annual Breakfast. For the value investing fraternity, it really doesn’t get much better than this.
For the uninitiated, Combs is one of two money managers running an independent pool of capital at Berkshire Hathaway aside from Buffett himself. At my last reckoning, each of these gentleman is responsible for about $10B worth of assets. Combs is remunerated in an interesting way. An annual salary of $1M, and a split of the profits above the performance of the S&P 500, with a claw-back in the event of under-performance. While both money managers started off strongly in their early tenures at Berkshire, my understanding is that the results until present day have been about average.
I don’t envy their task - outperforming the broad-based indexes with 11-figures under management is no easy feat. It might even be impossible. A look at the smaller Berkshire positions, prompts many questions:
The participation in private market (now public market) investments like Snowflake ($SNOW) has stretched what many have understood to be ‘value’. Snowflake began it’s listing as a publicly traded company on the spritely multiple of 140x LTM sales.
In any event, Combs is now also CEO of GEICO. As is fairly well understood, GEICO has been facing a deterioration in it’s competitive position vis-a-vis Progressive. The later has spent a decade or more investing heavily in telematics, giving it a cache of data that allows it to more efficiently price insurance. Apparently such investments at GEICO were poo-poo’d by both Buffett and Munger. Alas, no one bats .1000.
A few insightful quotes for your reading pleasure:
The two posed the following question as a means of valuation: if you take a business, what is your level of confidence in predicting what it looks like in five years?
Predictability and durability, so good so far…
Combs recalled the first question Charlie Munger ever asked him was what percentage of S&P 500 businesses would be a “better business” in five years. Combs believed that it was less than 5% of S&P businesses, whereas Munger stated that it was less than 2%…
When Combs started at Berkshire, they had a 7/10 confidence on the businesses outlook for the next five years. The nature of the world is that things are constantly changing, and Todd says they are right on maybe 1/10 predictions.
These are quite interesting observations, but not that helpful for the smaller investor. If the number of domains that are predictable are less than before and presumably getting smaller, it’s a happenstance that calls for concentration - or speculation. This is also generally observable across Berkshire’s portfolio of businesses, both public and wholly-owned. A large portion of $BRK’s value is in a handful of public equities, a railroad, and a collection of insurance companies.
Michael asked if there are traditional measures that Combs/Berkshire look at to indicate good business performance? And how does Combs/Berkshire assess that quantitatively? Combs explained how one question is constantly asked, usually daily, and that is if the moat is wider or narrower on any of their businesses.
98% of what Buffett and Combs discuss is qualitative. If something is 30x earnings you can calculate what it will have to do to get to run rate earnings. The worst business grows and needs infinite capital with declining returns. The best business grows exponentially with no capital.
I resonate with the last part on a spiritual level. There are very few companies like this, even fewer in the S&P 500, and almost none that Buffett doesn’t own already.
Now for the real gems:
Warren asks “How many names in the S&P are going to be 15x earnings in the next 12 months? How many are going to earn more in five years (using a 90% confidence interval), and how many will compound at 7% (using a 50% confidence interval)?” In this exercise, you are solving for cyclicality, compounding, and initial price. Combs said that this rubric was used to find Apple, since at the time the same 3-5 names kept coming up.
Businesses are run by people, and Buffett says he likes taking the cash flow and removing it from managers and investing it himself. There’s a known adage, when looking to buy a business: look to buy a business a dummy can run, because eventually a dummy will run it.
There’s a bunch of discourse after this, which is much less interesting. I’ll leave it your good self to dig out the less obvious wisdom. Although as a quick aside, the discussion of M&A was excellent.
That’s it for this week, make sure to subscribe to keep up with the blog. See you next week.
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Another great article, thanks for writing it. It's a good way for me to start my week off. I saw on Twitter that you were considering stopping these, I hope that doesn't happen.