10,000 Hours of Practice

Many investors are impressed by Warren Buffett's ability to make an investment decision in 5 minutes. In a recent town hall meeting at Columbia University, a student asked which particular information does Buffett looks at to make an investment decision in 5 minutes. Buffett answered: "Well, it is basically 50 years of preparation and 5 minutes of investment decision."

And his answer struck me and brought me back to a chapter that I read in the book Outliers by Malcolm Gladwell. In the book lies the ingredients for success. One of the ingredients is clocking 10,000 hours of practice just to attain a skill such that it functions as how your arms and legs do for you.

When we look at outliers like Bill Gates, Tiger Woods, or Roger Federer, it is so easy to assume they had it easy because they are cruising their way through competition and life. But the question is how did they get to where they are. All of them, in fact, devoted more than 10,000 hours of practice just to get the correct stroke, or basics, perfect. How many of us have the will and patience to do the same thing over and over again just to get a single subject perfect? And yet we envy them and think they had it easy, though it is undoubtable they have the innate talent for what they do. So even for the best in class need to put in tons of time and effort to get it right. How about the rest of us, the ordinary folks? All the more we should put in more time to get it right, even we can never get to the level of the outliers, but at least, we would end up in the top 10 or 20 percentile - to get an advantage over the others who don't devote time and effort who have the same innate capability.

Take for example, Berkshire's investment in the Coca Cola Co in 1988. Buffett has been a Cola drinker all his life - though he was a Pepsi drinker earlier in his life. He had been evaluating Coke all his life ever since he started buying 6-pack cans of coke and broke it up to sell for a dime each. For 50 years, he did not own a share of Coke - a period where he knows hell lots about what is tipping the advantage towards Coke's economic future. For instance, the advent of refrigeration caused a surge in Coke's sales volume in the 1960s. Beginning 1980s, with the opening up and growth of the Asian economies, Coke is bound to have a bigger share of the beverage market (international sales made up more than 50% of its operating profit today). It was only in 1988 that a sudden down shift in Coke's share price that Berkshire made a huge investment in Coke without much further evaluation because he knew all the factors that drove Coke's business and profit at the back of his hand with 50 years of knowledge. So that is basically the effect of "50 years of preparation and 5 minutes of investing decision."

Lack of patience is well evidenced when a young shareholder asked Charlie Munger how to follow in his footsteps to becoming rich. Munger responded: "We get these questions a lot from the enterprising young. It's a very intelligent question. You look at some old guy who's rich and you ask, 'How can I become like you, except faster?' Spend each day trying to be a little wiser than you were when you woke up. Discharge your duties faithfully and well. Step by step you get ahead, but not necessarily in fast spurts. But you build discipline by preparing for fast spurts. Slug it out one inch at a time, day by day, at the end of the day - if you live long enough - most people get what they deserve."

In short, success is about continuous learning even after you get it right. The more you know, the less time you need to make a decision because you would have known most, if not all of the unnecessary information you would have looked at when you started and eliminate those from the decision process. Again, Munger pointed out that 10% of freight carries 90% of the weight. So to get to the level of making a decision in 5 minutes, we need to know which are the 10% of the freight and to arrive there, we need patience, and continuous practice and learning. In Munger's terms, building a latticework of mental models. So when someone tells you a short cut, there's no short cut. If it sounds too easy and good, it is most likely too good to be true.

Steve Jobs: How to live before you die

Daily Journal Corp. - A Goog Buy?

Daily Journal Corp (Stock code DJCO) seems to be selling very cheaply whether valued by itself or compared to other print businesses. What I find that really interests me is not the core print business but rather the equity portfolio which is on the books.

DJCO is an obscure and extremely small-cap stock. But behind it lies a one of the best investment managers as its largest owner and director - Mr. Charlie T. Munger. DJCO's core business is news prints and publications and are sold to more niche markets, like targeting in the area of law.

Some numbers at a glance. Market cap is $85 to $86 million. Earnings was about $8 million for the year ended Sep 2009. Free cash flow is about the same as reported earnings. Current assets = $72.5m, total liabilities = $31.1m. Of the $72.5m in current assets, $62.1m is cash, treasuries and marketable securities. And out of $62.1m, $54.1 is marketable securities ($47.9m is stock and rest is bonds).

The company, after deducting all liabilities and assuming all noncurrent assets of $10.15m is worthless, the net assets is still worth $41.4m ($72.5m - $31.1m). In other words, at the current market cap, the core business of the company is valued at less than 6 times its earnings ($85m - $41.4m / $8m profit).

As mentioned, what is interesting is the stock portfolio worth $47.9m as at end Sep 2009. The whole of 2008, DJCO actually did not own any stocks, most were invested in Treasuries worth of about $20m. During the period Jan 2009 to Mar 2009, DJCO sold the treasuries and bought mostly into stocks and some into bonds. The cost of stocks were $15.5m and bonds $4.9m. In a period of 6 months, the value has more than doubled from $20.4m to $54.1m. I don't think they achieved this due to luck but rather most likely due to the foresight of Mr. Munger that he recognized that the market is totally irrational at the time. For example, banks, even Wells Fargo, were selling for ONE time its pretax preprovision for credit losses income. That is how ridiculous it was in early Mar 2009.

However, DJCO does not disclose the stock they hold. But whatever they hold, I am highly certain it will be worth many times more the longer they hold to it. On top, investors get a rather cheap print business that is still holding out fine, though maybe a slowing and dying business in time to come.

Buffett Personal Wealth and Wells Fargo

Too Big To Fail is surely the best investigative business book since Barbarian at the Gates or The Smartest Guy in the Room. Andrew Sorkin gave many new details and juicy insights into the events leading up to and during the crisis last Fall. One of which was the implied personal fortune of Warren Buffett.

On page 508, Buffett quoted, "I will be willing to personally buy $100 million of stock in this public offering (a Buffett's idea which subsequently led to the eventual PPIP)," which, he explained, "constitutes about 20 percent of my net worth outside of my Berkshire holdings." We can infer that he has a personal fortune of $500 million outside of his fortune in Berkshire.

And during last fall, his by-now famous co-op, Buy America: I am, revealed Buffett bought stocks for his personal account. One of which is Wells Fargo. He owns a personal stake of 2,240,000 shares which he most likely accumulated at a cost of about $56 to $60 million last fall. This constitutes about 12% of his personal fortune.

Disclosure: I own Wells Fargo.

A review of my current and past holdings

This is the first time I'm reviewing the decisions I made for my investments - both current and past holdings. There're mistakes I made (like I should have sat rather than to jump) and things I learnt (eg., investments are like gardening, some flowers take a longer time to bloom than others).

• Wells Fargo (current holding)

Banking sector, generally, in the States were selling at historical lows early this March. Wells Fargo hit a low of $7.8 - in effect, the whole company was available for $33 billion (based on the outstanding shares at that time). Wells potentially earns $40 billion in pre-tax pre-provision earnings. That priced the whole company at less than 1 time its earnings before tax and provision for credit losses.

Now, banking stocks have recovered somewhat - about 3 times from the sector's lows in March 09. Wells is selling at over $27. Even with the recovery, the sector is still selling at a low valuation historically. Wells, for one, is valued among the lowest of the banking stocks available. At $27, it is priced at no more than 3.2 times of pretax preprovision income. With every passing week, it's another week towards hitting the bottom, which means recovery. When the economy turns and earnings normalize, assuming Wells earns $40 billion in pretax preprovision, and 30% of it is catered for credit losses, and after a tax of 35%, it leaves roughly $18 billion available to shareholders. That translates to about $3.8 per share and if a multiple of 12 is applied, the stock can sell for $45.

Why is Wells priced so low? Probably because of the uncertainty on the extent of credit losses from the Wachovia's loan portfolio. The other worry is the rising rate of Wells Fargo's nonperforming loans. At this time, the market is likely to be a couple of quarters away from seeing a peak in nonperforming loans. Once nonperforming loans peak, banks, including Wells Fargo, will need to provide less for credit losses. If we look at Wells Fargo earnings before tax and credit losses - $40 billion - this equates to 5% of its loan portfolio. In order for Wells Fargo to sustain a loss, its nonperforming loan would have to hit 5% of its total loan portfolio. End of 3Q09, nonperforming loans stand at $21B (2.63% of the loan portfolio). So nonperforming loans would have to about double before eating into shareholder's equity.

What are the risks? If nonperforming loans continue to grow at a faster pace than in the past for the next few quarters, then Wells may have to raise capital which in turns dilute shareholders. However, if nonperforming loans grow at a much slower pace than in the last few quarters before peaking, the likelihood is the share price would shoot up quite dramatically.

• American Express (current holding)

A much misunderstood stock early this year when it was priced at less than $20, bottoming out at about $9. Amex, unlike Visa or Mastercard, offers credit to its customer rather than just offering a system for payment. However, interest income from its lending operation only accounts for less than 15% of total revenue. Majority of Amex's revenue comes from discount revenue - slightly more than 50%.

In recent years, Amex may have over-expanded credit businesses to less than desired customers, leading to an increase in loans. When the economy tanked last year, so did Amex share price because investors became worried of the credit losses Amex may face.

All told, Amex pretax preprovision earnings is about $8.5 to $9.5 billion, which means it covers more than 10% of its total loans and accounts receivable ($78 billion at end of 2008).

At the low sub-$10 a share, the company was priced at less than $12 billion (1.36 times its pretax prevision earnings). Amex is now $40 a share or $47.5B (5.57 times its pretax prevision earnings).

In normal times, Amex is priced 7 to 8 times its pretax preprovision earnings. So if this holds in the future, the upside is another 34% or more.

• Kraft Food (current holding)

This is a simpler investment to analyze. At $27, Kraft is selling for less than 14 times its earning power (EPS of estimated $1.97 for Y2009). Moreover, Kraft aims for a 7 to 9% growth in EPS yearly, and for a 15% operating income margin (compared to 12% in the past).

Kraft pays a dividend of $1.16 (4.4% yield). With operating cash flow of over $4 billion a year, and after lessing out dividend of $1.7 billion and capital expenditure of $1.2 billion, it leaves net cash of over $1 billion in the company's coffer.

Moreover, Kraft has lagged the stock market in 2009. With the Dow Jones gaining 17% so far this year, Kraft is about flat. Chances are Kraft would outperform the general index some time in the future, especially with the potential positives that the management has set Kraft up for.

• Berkshire Hathaway (current holding)

Berkshire has been a laggard this year. But all good deals are happening to Berkshire. Many people believed that Berkshire always get better deals because of who they are. But the truth is many couldn't get deals like Berkshire because they did not have the lending capacity or cash like Berkshire had during the time of crisis. When all others are pulling back, Berkshire was the only one that was willing to lend to credit-worthy companies and then of course, with lesser lenders, Berkshire was able to dictate for better terms.

The past year alone, Berkshire had extended over $22 billion in various types of investment securities to 10 different companies - Goldman Sachs, Wrigley, Dow Chemical, GE, USG, Swiss Reinsurance, Harley Davidson, Sealed Air, Tiffany, and Vulcan Materials. All securities came with a basic 8.5% to 15% yield. Some of the securities come with warrants, like Goldman Sachs, which is now in the money by over $2.5B just for the warrants alone. Swiss Reinsurance is another which can be converted some time in the future, which if it is today, it is in the money by over $2B (for a principal of $3.3B).

This month, Berkshire did their biggest investment to date, acquiring Burlington Northern Santa Fe at a valuation of $34B. However, it is by no means cheap. It was bought at an earnings multiple of 17 to 18 based on 2008 earnings. But Buffett called it an "all-in" bet on the future of America's economy. If America does well in the future, Burlington will do likewise. It is invested with a very long term view of 10, 20 or 50 years. By then, Warren wouldn't be around but he is positioning Berkshire for the future which he has been building Berkshire towards this end both in terms of culture, and the mix of businesses.

That is a very brief overview of Berkshire. Now to the details of Berkshire's value. Based on Berkshire's 3Q09 shareholder's equity, the share price is valued at less than 1.3 times its book value. A ratio that has not been seen since probably for a decade or more. But simply to base an investment decision on this ratio is an easy way out, probably not sufficient for an investor to understand the value of Berkshire.

Berkshire, primarily, can be broken down into 4 major categories of business - insurance; manufacturing, services & retailing; utilities & energy and; financial & financial products.

The headline net earning on the income statement can swing wildly from year to year or quarter to quarter because of the impact of the put option derivatives underwritten on 4 major global indexes (S&P 500, FTSE 100, Euro Stoxx 50 & Nikkei 225). So in order to understand the normal earnings, the gain/loss from such derivatives should be excluded.

The ultimate gains or losses on these contracts will not be known for many years but it is important to understand the mechanics of it because derivatives that are written without discipline are "weapons of mass destruction." The notional value of these equity put options is $37.1 billion. The first contract comes due Jun 2018. Any losses will only be paid on the due date. Meanwhile the value of these contracts are mark to market and any losses will be recorded as a liability. As of 3Q09, the liability recorded for these contracts was $8.1B. Meanwhile, Berkshire received a premium of $4.9B, which they have invested. These two items - the liability and the premium - means Berkshire had so far reported a mark-to-market loss of $3.2B (compared to a mark-to-market loss of $5.1B at end 2008, showing how volatile marking to market gain or losses can be).

To illustrate how Berkshire can lose on these contracts, say, Berkshire had sold a $37.1B (the notional value) 15 year put option on the S&P 500 index when that index is at 1300. If the value of S&P 500 is at 1170 - down 10% - on the day of the maturity (15 years later), Berkshire would pay $3.71B. For Berkshire to lose $37.1B, S&P 500 would have to go to zero. In the meantime, Berkshire had been paid $4.9B as premium to write the put contract and free for Berkshire to invest. As you can see, even if the index is 10% less than the day the contract was written (which is 15 years later), Berkshire would still not have lost a dime, in fact, a gain of $1.19B, not including any other gain Berkshire had realized from the $4.9B they had put to work.

The derivatives subject is a bit of a diversion. Now, let's get back to valuing the 4 different categories of Berkshire's main business, excluding impact of derivatives.

Insurance operations:

In Y2008, insurance earned $5.3B, of which $1.8B comes for underwriting gain and $3.5B from investment income. Valuing the insurance business would depends on which approach you use. There're a few.

• If you apply a straight 15 times multiple to its earnings, you get a valuation of about $80 billion.
• If you based it on its net worth (or book value), the insurance book value is probably about $75 billion and applying a 1.5 times book value, you get a valuation of about $113B.
• Another way is to value underwriting and investment income separately. Underwriting gain does not really gets its earnings from the book value or investment assets, though the capacity or amount that can be underwritten depends on the net worth or equity in the business. So if you apply a multiple of 12 to the $1.8B in underwriting gain, you get a value of $22B. Then since investment income is derived directly from investment assets, we can simply just based the value of the investment income side on the net book value which is roughly about $75B and if you apply a 1.5 times to the book value, it is worth $113B. In total, the insurance business is worth about $135B.

Depending on which valuation method, the insurance business is worth between $80B to $135B.

Manufacturing, Service & retailing:

This motley collection of businesses earned $2.3B in 2008. The various businesses in this group can be as different as night and day from each other. For simplicity sake, we will apply a multiple of 15 to its earnings which give a value of $34B.

Utilities & energy:

In 2008, this sector earned about $1.2B after one-off items. By applying a multiple of 15, it is worth up to $18B, of which Berkshire owns 87.4% (diluted) interest. So Berkshire's interest in MidAmerican is about $15.7B.

Financial & financial products

This sector earned roughly about half a billion in 2008. By applying a factor of 10 to the earnings, it is worth in the range of $5B, more or less.

Conclusion: Berkshire, when we add up the individual valuations, it is worth between $135B to $190B (difference lies in how you value the insurance business).

This is getting too long. I will try to write more on some other investments that I still hold or had held in the past.

Berkshire Hathaway's 15 Biggest Stock Holdings - Slideshows - CNBC.com

Berkshire Hathaway's 15 Biggest Stock Holdings - Slideshows - CNBC.com

Food for thoughts on investing in undervalued companies

Again, I had a rather long break. And I'm back. One of the cornerstone to successful investing is to buy undervalued businesses. But is it enough? I'd argue it ain't. One other aspect is to have good management that really thinks and acts in the right manner on the behalf of the shareholders, whom the management ultimately have a fiduciary responsibility to.

Sometime in July 09, IMS Health was selling at $12 - click here for more details in a previous post. At $12, the whole company was selling for $2.2 billion. A value that substantially undervalues the company in relation to its future earnings potential. This week, a consortium led by TPG offered $4 billion (or $22 a share) to buy out IMS. The offer was accepted by IMS management. David Carlucci, IMS Chairman and CEO, said: "This transaction enables our shareholders to realize substantial value from their investment in IMS with an immediate cash premium." But is it really so?

Yes, it is but with a caveat. It only offer substantial immediate value for those shareholders who had bought at $12 or so during the period in July but not for the other shareholders. In effect, the management had sold out on the majority of its shareholders. During the period between Oct 08 to before the offer, its share was traded in the range of about $10 to $18 (mostly at $12). Only shareholders who had invested during this period had benefitted but not fully - substantial value is left on the table.

Prior to Oct 08, its share traded at above $22. At that price, it too was undervalued in relation to what a full price would be. At $22, the whole company sells for $4B, with a free cash flow of over $350 million. The company is holding up well through the crisis and business prospects appear sound, though revenue had declined. Expanding global pharmaceuticals market, as expected by IMS, to grow at a compound rate of 4 to 7% to about $1 trillion in 2013. So what value, if any, does TPG and its partner bring to the table. Indeed, much value is left behind.

In my view, the management had failed in its fiduciary responsibility to its shareholders. Even for investor who bought at $12, they may have less cause for celebration because the management failed to do their best to get a full value of what the company is really worth. One reason the management is eager to sell could be because of the generous slice of equity in the deal they can get.

So in essence, even if an investor manage to find an undervalued company (imagine you had bought IMS at $22 which is an undervalued price), they may not get rewarded because of a mediocre management.

On the other hand, it is always better to invest in a company that is not only undervalued, but comes with a decent management (think of Berkshire, YUM Brands, Amex, Wells Fargo) who takes care and thinks for their shareholders whom they represent. However, if an opportunity comes where a company is undervalued but its management is mediocre, it's best to buy only at a substantially undervalued price, for IMS case, it did be at $12 or so, not $22 - though both prices are undervalued. Any value investor who had bought before Oct 08 at $22 would perhaps rethink about the whole concept of buying into a company that is run by people who do not think for the people they represent.