Saturday, November 14, 2009

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.


Frank said...

Hi Brian, welcome back.
After i understand buffett thesis on WFC and looking at WFC latest investor presentation, (the PTPP earning is right on dot as what buffett estimated) I am taking some profit on AXP, COP, USB and put all my money adding on my WFC holding already.
Should have listened to you earlier on WFC :-)

Berkshire said...

Hi Frank,

Good move. You may like to retain some AXP stake. I think AXP is still fairly cheap. Between USB and WFC, WFC is by far the cheaper buy based on PTPP. Moreover, with the recent secondary stock offering, it takes away some concern on the thin capital ratio WFC has.

Did you read about how Citi blames all others on how they botched their secondary offering? That is a classic example of an atrocious firm who blames all others except looking at themselves.

Penny Stock Blog said...

I would like to comment about warren buffetts holding company berkshire hathaway investing in BYD auto company. This does not seem like the sort of company that warren buffett generally invests in warren generally invests in fairly solid safe companies.