On the Level
Buffett, Compound Rates of Return and Winning in a Post-Bubble Market
By
Brett D. Fromson
Chief Markets Writer
3/15/01 7:08 PM ET
URL: http://www.thestreet.com/p/comment/onthelevel/1347206.html
Some years ago -- don't ask how many-- I had the opportunity to sit down one-on-one with Warren Buffett in Omaha and talk investing for a few hours.
Buffett perched on a large couch in his cluttered and dark office (he keeps the blinds down). The phone never rang. There was not a computer in sight. We talked about his mentor Benjamin Graham and about the evolution of Buffett's investing approach. It was the kind of moment that fundamentally alters how one thinks about investing.
He made many observations, most witty and all wise. The one that stands out in my mind right now is this: A key to winning big money in the market over time is not losing big in any one year. (This approach does not work for everyone -- super investor Robert Wilson, for example, often had big down years and still made a ton -- albeit not as much as Buffett. Wilson, however, is the exception that proves the rule.)
The Sage of Omaha's observation seems apt today given how many people have suffered devastating losses in the past year. For example, the CEO of one medium-size manufacturing company tells me that at his company, the average 401(k) account of employees was down 35% last year! Unless you're a Bob Wilson, that kind of down year -- unless it comes near the end of you investing life -- pretty much dashes any hopes you may have of achieving an average annual compound rate of return north of 15%. (If you can get 15% a year, you double your money every five years.)
Even small losses can keep an investor from leaping over the 15% hurdle. Take one professional investor I know. Over the past 10 years, he earned a 13% average annual return. Why? In year eight, he lost 15%. If he had simply been flat in that year, he would have achieved 15% a year for the entire period.
Buffett is a wonderful example of the power of consistently positive returns. Since 1965, Berkshire Hathaway(BRK^A:NYSE) has never had a year in which book value per share declined. In contrast, the S&P 500 stock index, including dividends, has had eight years in which it fell, and the bulk of those declines took place in the early years. This explains in large part why the S&P generated an 11.8% average annual gain from 1965 to 2000, whereas Berkshire's book value gained a far superior 23.6% a year. The S&P's overall gain was a healthy 5,383% for the period, but in large part because Berkshire didn't have any losing years, its cumulative gain was an astounding 207,821%!
Of course, to beat the S&P like that, you also need to outperform the index in the up years. Buffett did that as well. Berkshire's book value increased more than the S&P in all but four years during the period. As he says in this year's letter to shareholders, "A small annual advantage in [Berkshire's] favor can, if sustained, produce an anything-but-small long-term advantage."
OK, so how can you think about achieving consistent long-term returns a la Warren? First, use 15% as you target, not 23.6%. Remember that when Buffett was buying the likes of American Express(AXP:NYSE), Coca-Cola(KO:NYSE), Gillette(G:), Washington Post (WPO:NYSE) and Wells Fargo (WFC:) they were far, far more reasonably priced than stocks are today.
Second, remember that your investing fate is tied to the underlying cash earnings of the companies you own. You can achieve superior returns only if you own superior companies. To quote once more from Buffett's 2001 letter, "Examine the record of, say, the 200 highest-earning companies from 1970 or 1980 and tabulate how many have increased per-share earnings by 15% annually since those dates. You will find that only a handful have. I would wager you a very significant sum that fewer than 10 of the 200 most profitable companies in 2000 will attain 15% annual growth in earnings-per-share over the next 20 years." You do not want to bet against Buffett on this. The point is that 15% will be a more difficult bogey to beat than you may think.
How might you get 15% going forward? You could do worse than simply buying Berkshire, but, hey, let's diversify a bit. Berkshire is not the only good stock in the market.
Nor is Buffett the only good value investor around. OK, he's the best, but there are others. One really good one is Bill Nygren, partner and portfolio manager at Harris Associates, the investment company that runs the Oakmark family of mutual funds. (For the record, Harris oversees about $14 billion, of which $7 billion is mutual fund money, $3.5 billion high net worth and another $3.5 billion pension fund/institutional money.)
Nygren looks for high-quality companies selling at no more than 60% of their "intrinsic value" as calculated by the analysts at Harris. What's intrinsic value? Essentially, the price Nygren and associates estimate a buyer would pay for the entire company. They don't want to pay more than 60% of that number.
To get at intrinsic value, Nygren relies heavily on recent cash acquisitions in the industry the company is part of. (If you're looking at a technology or high-growth company, be wary of comparable valuations based on stock purchases where the buyers use inflated shares to do deals. They can fool you into paying too much. Remember, unlike the Ciscos(CSCO:Nasdaq) of the world, you are investing your cash in these companies. At the moment, of course, there are fewer such overpriced deals.)
For instance, in the newspaper industry, which Nygren has long subscribed to as an investment, companies are typically bought on price multiples of cash flow -- the dreaded earnings before interest, depreciation and amortization, or EBITDA. Historically, buyers have paid 11 to 12 times EBITDA. Nygren wants to be a buyer when cash flow multiples are much lower. That is the "discount" he looks for.
Of course, to get that discount requires you to step up and buy when others are turned off by short-term disappointment. If Nygren thinks the bad news is temporary, he "normalizes" a company's cash flow and earnings per share to see if the stock price has been unduly penalized. That simply means he looks at a company's annual report, sees the normal fluctuations and then estimates an average earnings and cash flow number for the next three to five years based on company reports, Wall Street reports and his firm's own analysis. (Most of this can be done by a well-educated sixth-grader.)
The final piece of his analysis is to make sure that a company's management has its financial self-interest allied with that of shareholders. In his view, most CEOs have a few key decisions to make each year -- critical strategic decisions like buying another company or selling their own company. Nygren wants the CEO to approach such decisions as an owner, not just as a highly paid employee.
Here is how Nygren evaluates one newspaper company -- Knight-Ridder (KRI:NYSE) -- that Harris has bought in various accounts. (Harris has been a buyer of the company ever since Tony Ridder took over as CEO six years ago and they added to their position at both the beginning and the end of the fourth quarter of 2000.)
Knight-Ridder will generate about $900 million of EBITDA this year. It has about 93 million shares outstanding. So, the company offers $9 to $10 of cash flow a share. Put the 11 to 12 times cash flow multiple on that, and you get about $110 a share. Then knock off the debt, which is about $5 a share, and you get an intrinsic value for Knight-Ridder of between $100 and $110 a share.
The stock closed Thursday at $56.03. Why so cheap? Because of the current advertising slowdown and rise in newsprint prices. Those two variables will undoubtedly reverse. They always have. That's why Nygren thinks $56 a share is cheap for a stock with an intrinsic value of $100 to $110.
So do I. This is the kind of stock that can help you compound your money at a superior rate without risking major losses in any one year. That's how to win in this post-bubble market.
Brett Fromson writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He invites you to send your feedback to bfromson@thestreet.com. TheStreet.com has a revenue-sharing relationship with Amazon.com under which it receives a portion of the revenue from Amazon purchases by customers directed there from TheStreet.com.
