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For Wednesday, July 1st, 2020
Yesterday, I was re-reading the book “Capital Allocation” (The Financials of a New England Textile Mill: 1955-1985) by Jacob McDonough, when I decided to write this post about capital re-allocation. And I want to stress the “re” part here, because it was a key to Buffett’s success. In fact, it was THE early key to Buffett’s success. So, let’s talk about what I mean when I say capital RE-allocation.
There are two kinds of stocks out there. There are a lot more than two. But, these two stand out for value investors as holding tremendous promise. For example, Andrew and I are on a road trip visiting companies, managements, locations, etc. right now. And a few of the best potential ideas fall into these two kinds of stocks. Sometimes we see a company with a lot of runway, a management that knows what it takes to grow the business, etc. The company is producing good earnings now and has someplace it can put the earnings it retains. That’s one group of stocks. This is the group Buffett is famous for: American Express, Washington Post, Coke, etc. However, this is not how he got rich. Or, it’s not the whole explanation for how he got rich. That brings us to the other kind of stocks. Therese are often the opposite of the compounders in all respects. They are cheaper. In fact, their assets are often so great versus their market price that they aren’t just trading at a discount to book value – they’re clearly trading at a big discount to liquidation value. Andrew and I have seen the locations of a few of these companies, what assets they own, etc. You read the balance sheet. You go look at the acreage. And there is no doubt that they are trading at half or even sometimes a fifth of what the business could probably be sold for. Here, I don’t mean the business in its entirety. I mean selling the assets off piece-by-piece to different buyers. Carving up the company and leaving nothing left. No jobs for management. No legacy. Just cash distributions to the shareholders. Those are the two extreme kinds of public companies out there. Or, at least, the two kinds of extremes that are really promising. A market price way below fair market value of the assets is promising. And a business that just keeps creating more and more value over time is promising. There are lots of mediocre business out there, overpriced stocks without assets, etc. But, we can assume Buffett could eliminate those stocks from his universe of potential investments almost instantly. That left him with these two choices: cheap, overcapitalized stocks with assets you could liquidate or growing compounders.
Which did he pick?
A lot of investors who know a bit about Buffett think he used to pick the asset stocks in the 1950s and early 1960s. Then, sometime around the 1960s, he started transitioning into a few of the great businesses. With his Berkshire purchase in the mid-1960s being seen as the end of his asset phase. And his purchases of a bunch of great compounder stocks – like the Washington Post – about 10 years later (roughly mid-1970s) marking the transition into the compounder focused investor we all know today. If that was an accurate record of history, it’d make the period covered by “Capital Allocation” particularly interesting. It starts BEFORE Buffett buys Berkshire (1955) and ends AFTER Buffett had supposedly become a growth stock investor focused on the compounders and no longer interested in the asset plays (1985).
The investments covered in the book “Capital Allocation” are even more interesting than that though. They’re more interesting, because Buffett did not abandon asset investing for growth investing. He did both at the same time. And this is what really, really juiced his returns in his first 20 years at Berkshire. See, when I say Andrew and I are visiting some locations where the assets are so clearly worth more than the market value – you should be asking than why not buy the stock?
Well, management could do dumb things with the assets. The business could deteriorate etc. A lot of investors would stop here. Buffett would always go further though and ask: “Okay. But, what if this capital was put to better use. What if the company stopped trying to re-invest in the existing business”. For a passive investor, this can be hard. In two of the cases I’m thinking of here on this trip, there are takeover defenses and dual share classes and entrenched management and so on that would present a problem for anyone trying to improve capital allocation at the company.
That’s clearly the reason why you can find a stock trading at 50% or even 20% of what the assets would fetch in an orderly liquidation. This is especially true in cases where cumulatively over the last decade or so a company hasn’t lost money. It makes sense to avoid a melting ice cube even if the ice cube is now worth $2 and you only have to pay $1 for it. It makes a lot less sense to turn down paying $1 for a $2 ice cube that’s likely to be worth $2.10 in another year and $2.20 the year after that and so on. These stocks do sometimes exist (even today). But, they don’t exist as good takeover targets or even good activist targets. Investors are quick to pounce on any of these situations they can shake up. So, the ones you find left are the ones where there are strong takeover defenses and a management determined never to leave.
Buffett was managing a fair amount of money by the time he was thinking about retiring from his fund. So, he could buy up control of some companies – though it might often take a few years – if the company was small enough and he was determined enough. Berkshire was small enough. And Buffett became determined enough. He was not at first though.
I think the only reason Buffett really chose Berkshire instead of other net-nets available at the time is because Berkshire was allocating capital differently. This part of the story does get told. But, I don’t think it gets stressed enough. Berkshire’s capital allocation BEFORE Buffett got involved with the company was already highly unusual for any public company at that time. And I think it’s the signal that originally interested him. So, what was Berkshire doing?
Berkshire was shrinking its business voluntarily. It was closing its least profitable plants and selling off inventory and so on. This was producing more cash flow than reported earnings. Reported earnings were basically nil for the half decade or so before Buffett bought in. Cash flow was very strongly positive though. And, more than that, it wasn’t being plowed back into the textile business. Nor was it being piled up on the balance sheet. Berkshire had some sort of plan. And that plan didn’t involve a ton of textiles. It wasn’t a very sustainable plan. But, it also was a lot more rational than the capital allocation done at many companies – either then or now.
Berkshire was paying a dividend it couldn’t afford to pay (at least not based on earnings of the recent past). And it was buying back a ton of stock. It’s hard to overstate how unusual this was in the 1960s. Net-nets today don’t buy back stock. They conserve cash. Compounders with no place to put their free cash flow might be regular buyers of their own stock in the 2000s. But, they weren’t in the 1960s. It didn’t matter if you were U.S. Steel or IBM – you didn’t spend vast amount of your own earnings reducing your shares outstanding. Berkshire was doing a few impressive things at once with this buy back.
One, it was diverting cash away from textiles. If the money wasn’t spent on buybacks today – there was a risk it could one day in the future be put into textiles through acquisitions, plant upgrades, even just additional inventory. These buybacks were a safety valve. Remember, the ROIC of the textile business was very, very close to nil at this time. Bank accounts had much better returns. So, any money diverted from textiles even just to sit “idle” would add value over time.
Two, it was spending this cash on something that could return a lot more than you might think. Berkshire consistently traded below tangible book value. The company was not buying any meaningful amounts of stock above book value. It was often buying at much, much lower prices than book. This meant that the same shareholders – who chose not to sell – were owning more and more of the textile business. Tangible book value per share actually grew over time while the company reported flat earnings to even some losses at times. The buybacks were offsetting this.
Three, Buffett had a way out of the stock. If you bought in and it went up 50%, it’s likely that – at some point – Berkshire would’ve offered to buy his shares (and everyone else’s). I’m not talking about greenmail or something here. Berkshire was doing regular tenders for stock. So, any investor could’ve done what I’m describing here – even a small-time individual investor. However, it’s true that anyone who became one of Berkshire’s larger shareholders might have some unusual opportunities here, because: 1) Management might want you to get out of the stock to make them feel more secure, 2) You’d be a big source of shares even if they didn’t care about your votes, but did just want to buy in a lot of stock over time, and 3) There might be more of a “market” for you leaving the stock than entering.
Number three is often a problem in overlooked stock. But, if management would want to buy back your stake from you – and be more determined to do that the bigger your stake got – then, obviously, you wouldn’t need to worry as much about selling in the open market.
In other words, while Buffett has said buying Berkshire was a mistake – it may be that NOT SELLING Berkshire was the bigger mistake. This was actually a net-net lined up well to buy, hold till it rose 50% or 100%, and then get out of. If it didn’t rise, you keep nibbling in the open market all the time and getting a bigger and bigger stake. If it does rise, you sell out in the open market – or, in the next tender from the company.
Buffett nearly did. But, he got annoyed with an offer from management that was slightly less than he’d been promised in person. So, he held on to his shares. And he started aggressively buying more till he took over the company
This is where the capital RE-allocation part gets interesting. Was it a mistake to buy Berkshire? Maybe not. Was it a mistake to NOT SELL? Yes. But, then, once controlling it – should Buffett have stuck with it?
Berkshire actually had a lot of capital. And Buffett did some interesting things immediately. They slashed expenses which briefly led to about a 2-year strong (by Berkshire standards) inflow of cash from the textile business. This combined with some other liquidations of excess capital in the business produced cash that was stuck in bonds for a while. Berkshire then bought an insurer – National Indemnity.
Buffett’s thinking about the purchase price of that insurer was very, very interesting and very, very correct. But, it’s a way I’ve seen almost no one ever think in a situation like this.
So, Berkshire paid let’s say 1.25 times tangible book value. However, once Buffett controlled the insurer, he’d able to invest the “float” basically how he would have invested anyway. This point is somewhat arguable with some insurers. But, not dramatically so. Even in cases where a buyer would be highly restricted regulatorily, the allocation by asset class can still be really similar. I mean, I’ve seen investment firms with allocations of 60% stocks and 40% bonds that could buy an entire insurer and then keep that same allocation of 60% stocks and 40% bonds inside that insurer without worrying regulators – yet, they don’t. Because they never think the way Buffett did.
Buffett figures if you’re paying – I’m changing the numbers here but keeping ratios roughly similar to make this easier on your eyes – $12.5 million for an insurer with $10 million in tangible net worth and all their assets in stocks, then you’re really only paying $2.5 million.
Well, the $10 million of common stock portfolio you get from buying the insurer (and this is $10 million NET of leverage, the actual portfolio could be bigger on a gross basis) is really just a swap of sorts. I mean, you were holding stocks or bonds before you bought the insurer. And, the insurer – being an insurer – basically just holds stock or bonds itself. So, it is only the excess over the tangible value of the stock that you’re paying in cash and risking. That’s the change part of the equation you are betting on.
How sure was Buffett that paying 25% more for an insurer than its portfolio would be worth in liquidation was a good bet?
To figure that out, he needed to estimate what float would cost (that is, what the combined ratio would be) an dhow fast it’d grow. In the case of National Indemnity, it turned out the cost would be “pretty good” and the growth in float would be very high for a very long time. So, the premium was totally justified.
What I just described is important. Buffett slashed costs to free up several million that otherwise would’ve been in stuff like textile inventory. He then parked that cash in bonds till he could find an acquisition he wanted to do. Then he bought an insurer. But, he did it in a way where the premium he paid over their investment portfolio was small.
So, what Buffett did is basically spend a couple million buying an insurer instead of starting it up. The rest he did wasn’t exactly spending. It was actually shifting capital already on the books – in the forms of assets of the textile business – into common stocks, bonds, etc.
Now, because a lot of this went into common stocks Buffett himself chose – the investment results were amazing.
A meaningful improvement in returns at Berkshire could’ve been achieved by ANY investor doing this. No skill was required to raise returns from an ROA of 0-1% and no use of leverage in the textile business to an ROA (on the stock/bond portfolio) of 5-6% and 2-3 times leverage in the insurance business. Just buying some pretty average stocks, bonds, etc. and writing premiums at the normal levels allowed by regulators and practiced in the industry really could have improved the average earning power of a company like Berkshire by 5-10 times if you simply liquidated textiles as quickly as you could in an orderly way and bought insurers at about book value.
Now, National Indemnity was a much better than average insurer. However, Buffett also paid more for National Indemnity than the price-to-book ratio at which investors could buy many different publicly traded insurers. He paid a premium. He paid that premium both for control (getting investment control in the hands of Buffett fully justified the premium in this case) and for getting a better underwriting operation in National Indemnity than it was possible to buy or build at a much lower cost.
This capital RE-allocation appears again and again in the early days of Berkshire. You buy something like Blue Chip Stamps and then you allocate that to See’s. Or, you buy into an S&L and then – over time – you basically get out of the core parts of what an S&L business really is (mortgages and such).
Over and over, you see Buffett using both sides of the value investing playbook. You buy into something that is overcapitalized and cheap. So, you pay $1 in the market for $2 or even $5 of tangible book value. But then, you don’t stop there. You figure out how to free up that capital and put it into something better. Buffett doesn’t just buy cheap stocks with a lot of inventory, receivables, land, etc. He buys – or bought, he stopped this decades ago – stocks that are cheap relative to their inventory, receivables, land, etc. and then he figures out how he can swap out of those businesses and into things like the compounders.
In fact, some of the things he bought using capital freed up and re-deployed at Berkshire in those early days were: American Express and Disney.
So, in effect, he was able to swap things like textile inventory for things like Amex and Disney. That’s capital re-allocation.
The return comes partially form the “leverage” of buying $1 of assets for 40 cents. And then it comes from replacing the one bad dollar with one good dollar.
Without buying these assets cheap though – that is, without buying Berkshire below book or buying National Indemnity with the potential for it to have the float to control a lot more assets, these returns couldn’t be achieved.
If you take one dollar in cash and put it into the a stock – your return will be as good as that stock. But, if you take one dollar in cash and buy two dollars in book value and liquidate it to buy an insurer that has two dollars in investments for every one dollar in equity and so on, we are now talking about you turning $1 of cash into $4 of investments. And it’s not through borrowing that others can’t do. It’s through ignoring the walls between capital allocation ideas. Capital is capital. And Buffett saw the potential to shift any sort of low returning capital into some other higher returning form. Buying at a low price-to-book alone isn’t what he did. Nor did he just buy the compounder outright. He bought poor-returning capital at a discount and turned it into high returning capital.