Guru Speak: Buffett Partnership Letters (1957 to1970) - Key Takeaways and Learnings - Part III

In continuation of reading the Buffet Partnership Letters, here is the 3rd part in the series. You can read the previous posts here:
Part I
Part II

On being contrarion and doing your due diligence:

You will not be right simply because a large number of people momentarily agree with you. You will not be right simply because important people agree with you. In many quarters the simultaneous occurrence of the two above factors is enough to make a course of action meet the test of conservatism.  You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.

The hallmark of value investing. Buy cheap!

This is the cornerstone of our investment philosophy: “Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results. The better sales will be the frosting on the cake.”

On the kind of management he likes.

On Harry Bottle who took over as President of Dempster Mills once Buffet bought controlling stake - "Harry had never thought of running an implement company six days before he took over. He is mobile, hardworking and carries out policies once they are set. He likes to get paid well for doing well, and I like dealing with someone who is not trying to figure how to get the fixtures in the executive washroom gold-plated."

Market fluctuations and how it really does not matter much.

I think you can be quite sure that over the next ten years, there are going to be a few years when the general market is plus 20% or 25% a few when it is minus on the same order, and a majority when it is in between. I haven’t any notion as to the sequence in which these will occur, nor do I think it is of any great importance for the long-term investor. 

When to walk away if you do not understand the transaction. Ignore tips.

Early in 1962 I heard rumors regarding a sellout to Union Oil of California. I never act on such information, but in this case it was correct and substantially more money would have been made if we had gone in at the rumor stage rather than the announced stage. However, that's somebody else's business, not mine.

Guru Speak: Buffett Partnership Letters (1957 to1970) - Key Takeaways and Learnings - Part II

In the second part on Buffett's letters, the focus is on the types of stocks he buys. My comments are marked in blue in brackets. You can read the first part here.

Our Method of Operation

Our avenues of investment break down into three categories. These categories have different behavior characteristics, and the way our money is divided among them will have an important effect on our results, relative to the Dow in any given year. The actual percentage division among categories is to some degree planned, but to a great extent, accidental, based upon availability factors.  

The first section consists of generally undervalued securities (hereinafter called "generals") where we have nothing to say about corporate policies and no timetable as to when the undervaluation may correct itself. Over the years, this has been our largest category of investment, and more money has been made here than in either of the other categories. We usually have fairly large positions (5% to 10% of our total assets) in each of five or six generals, with smaller positions in another ten or fifteen. (provides a glimpse of Buffett's portfolio sizing thoughts.)

Sometimes these work out very fast; many times they take years. It is difficult at the time of purchase to know any specific reason why they should appreciate in price. However, because of this lack of glamour or anything pending which might create immediate favorable market action, they are available at very cheap prices. A lot of value can be obtained for the price paid. This substantial excess of value creates a comfortable margin of safety in each transaction. This individual margin of safety, coupled with a diversity of commitments creates a most attractive package of safety and appreciation potential. (His cigar-butt approach - legacy from Ben Graham). Over the years our timing of purchases has been considerably better than our timing of sales. We do not go into these generals with the idea of getting the last nickel, but are usually quite content selling out at some intermediate level between our purchase price and what we regard as fair value to a private owner.

The generals tend to behave market-wise very much in sympathy with the Dow. Just because something is cheap does not mean it is not going to go down. During abrupt downward movements in the market, this segment may very well go down percentage-wise just as much as the Dow. Over a period of years, I believe the generals will outperform the Dow, and during sharply advancing years like 1961, this is the section of our portfolio that turns in the best results. It is, of course, also the most vulnerable in a declining market.

Our second category consists of “work-outs.” (mainly arbitrage operations) These are securities whose financial results depend on corporate action rather than supply and demand factors created by buyers and sellers of securities. In other words, they are securities with a timetable where we can predict, within reasonable error limits, when we will get how much and what might upset the applecart. Corporate events such as mergers, liquidations, reorganizations, spin-offs, etc., lead to work-outs.

This category will produce reasonably stable earnings from year to year, to a large extent irrespective of the course of the Dow. Obviously, if we operate throughout a year with a large portion of our portfolio in work-outs, we will look extremely good if it turns out to be a declining year for the Dow or quite bad if it is a strongly advancing year. Over the years, work-outs have provided our second largest category. At any given time, we may be in ten to fifteen of these; some just beginning and others in the late stage of their development. I believe in using borrowed money to offset a portion of our work-out portfolio since there is a high degree of safety in this category in terms of both eventual results and intermediate market behavior. (Interesting thought process. Buffett defends using leverage when the results are predictable) Results, excluding the benefits derived from the use of borrowed money, usually fall in the 10% to 20% range. My self-imposed limit regarding borrowing is 25% of partnership net worth. Oftentimes we owe no money and when we do borrow, it is only as an offset against work-outs.

The final category is "control" situations where we either control the company or take a very large position and attempt to influence policies of the company. (Again extremely interesting and instructive. As an investor Buffett thinks in terms of buying out complete companies and be able to influence management. Very few investors, including UHNIs think on those lines) Such operations should definitely be measured on the basis of several years. In a given year, they may produce nothing as it is usually to our advantage to have the stock be stagnant market-wise for a long period while we are acquiring it. These situations, too, have relatively little in common with the behavior of the Dow. Sometimes, of course, we buy into a general with the thought in mind that it might develop into a control situation. If the price remains low enough for a long period, this might very well happen. If it moves up before we have a substantial percentage of the company's stock, we sell at higher levels and complete a successful general operation.

Reputation & Integrity - Critical succes factors

Rajat Gupta sentencing has yet again reminded me of the importance of ethics and integrity above all else in life and career. He has provided an excellent instance of vicarious learning. 

A few thoughts on this episode...

"I have lost my reputation that I have built over a lifetime. Implications (of the verdict) to all aspects of my life — personal, professional and financial — are profound" - Rajat Gupta, in court before he was sentenced to 2 years in prison for insider trading.

 "It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you'll do things differently." - Warren Buffett

"History shows that where ethics and economics come in conflict, victory is always with economics. Vested interests have never been known to have willingly divested themselves unless there was sufficient force to compel them." - B. R. Ambedkar

 

Guru Speak: Warren Buffett's Interview on Oct 24, 2012

2012-10-24 Warren Buffett Squawk Box Transcript

Buffet Partnership Letters (1957 to1970) - Key Takeaways and Learnings - Part I

Reading Warren Buffet is always fascinating and instructive. So, yesterday I started re-reading the Buffet Partnership Letters that he wrote between 1957 to1970 with the express desire to brush up on some of his wisdom when he was in his "formative" years as an investor. Also, another factor I want to understand is how his thought process changed over the years, so I am planning to read all his letters till date sequentially. So, expect a few more posts on this topic in the future.
 
I start off from 1957 onwards.

On his investment philosophy:

Obviously during any acquisition period, our primary interest is to have the stock do nothing or decline rather than advance. Therefore, at any given time, a fair proportion of our portfolio may be in the sterile stage. This policy, while requiring patience, should maximize long term profits.

I would consider a year in which we declined 15% and the (Dow Jones) Average 30% to be much superior to a year when both we and the Average advanced 20%. Over a period of time there are going to be good and bad years; there is nothing to be gained by getting enthused or depressed about the sequence in which they occur. The important thing is to be beating par; a four on a par three hole is not as good as a five on a par five hole and it is unrealistic to assume we are not going to have our share of both par three's and par five's.

On the exuberant market levels:

During the past year almost any reason has been seized upon to justify “Investing” in the market. There are undoubtedly more mercurially-tempered people in the stock market now than for a good many years and the duration of their stay will be limited to how long they think profits can be made quickly and
effortlessly. While it is impossible to determine how long they will continue to add numbers to their ranks and thereby stimulate rising prices, I believe it is valid to say that the longer their visit, the greater the reaction from it.

Most of you know I have been very apprehensive about general stock market levels for several years. To date, this caution has been unnecessary. By previous standards, the present level of "blue chip" security prices contains a substantial speculative component with a corresponding risk of loss. Perhaps other standards of valuation are evolving which will permanently replace the old standard. I don't think so. I may very well be wrong; however, I would rather sustain the penalties resulting from over-conservatism than face the consequences of error, perhaps with permanent capital loss, resulting from the adoption of a "New Era" philosophy where trees really do grow to the sky.

Guru Speak: Charlie Munger - Speech at Harvard-Westlake School

Charlie Munger is my guru and a person who I have infinite respect for. Anything he says is worth its weight in gold. His thoughts are not only on investing but on life as well.Munger Talk at Harvard-Westlake

Stock Idea: CEBBCO

CEBBCO looks to be a good medium-term (2-3 years) growth story. Details below.

1	Describe the business in a few sentences. What does the company do? Who are its primary customers?
	CEBBCO is a commercial vehicle “body-builder”!! It is the largest player in the Fully Built Vehicles and manufactures Fully Built Vehicles, Wagons, EMU’s, Refurbishment and Components for Railways, Structurals for Electrostatic Precipitators (ESP) and Boilers for power plants. Tata Motors makes up for 53% of its revenues. Other than Tata Motors, Ashok Leyland, Eicher Motors, Man Force Motors, Indian Railways, Defence Factory Jabalpur, L&T and BHEL are major clients.
2	Is the sector that the company is in growing? i.e. Is there a headwind or a tailwind present?
	1. Projected FBV industry growth from about Rs 1100 cr in 2011-12 to Rs 8000 cr by 2016-17 - a 6.5x growth. 2. The stated policy of the OEM’s is to convert to 100% FBV by 2017. 3. Bank finance for truck bodies and quality assurance from the OEMs are key demand triggers for truck buyers to shift towards FBVs from buying truck chassis. 4. Within medium and heavy CVs, heavier truck sales are gaining momentum which should also aid a shift towards FBVs since OEM-fitted FBVs are better designed. 5. The Government, in an effort to encourage FBV sales, has placed a 2% excise duty differential for buyers who buy FBV as against chassis.
3	What is the current market share of the company? Can the market share be increased?
	CEBBCO has about 30%-35% of the organized market. CEBBCO is one of the preferred vendors for most of the OEMs and is looking to increase market share to 40%. Beyond that it will be very difficult. The business does not seem to have any sustainable competitive advantage (moat) and has low entry barriers. Number of companies in the unorganized sector is fairly large.
4	Who are the primary competitors? Why is this company a better investment than them?
	Competition from the organized segment remains limited and includes players like multinational Hyva and local player Utkal.
5	What is the owners’ and managements’ stake in the company?
	Management own 55% of the stock.
6	Are management's salaries too high?
	Father-son duo together earn 2.1 cr on a PAT of 40.8 cr implying 5.25%. This seems to be on the higher side, especially considering that they own 43% of the stock between the two of them.

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1	How much debt is there in the balance sheet? Is it increasing, decreasing or remaining constant?
	D/E is 0.43. Debt has gone up along with equity and reserves.
2	Is the debt level normal for the sector the company is operating in (i.e. how much is the debt-equity ratio of its nearest competitors)?
	Debt level is not excessive so not much of a concern here.
3	How much cash is there on the BS? What is the cash per share?
	Cash & Investments are negligible.
4	Is the Networth rising over the years?
	Networth has increased significantly. From 50.17 cr in 2008 to 258.09 cr in 2012.
7	Has the company increased its sale, net profit, operating margins and net margins over the years?
	Compounded Sales Growth 5 Years: 34.01% 3 Years: 22.05% 1 Year:   116% Compounded Profit Growth 5 Years: 18.01% 3 Years: -1.54% 1 Year: 617%
8	Has the company increased it RoE, RoCE, (RoA for financial companies) over the years or atleast maintained it? How does it compare to its competitors?
	FY12 FY11 FY10 RoCE (%) 17.91 6.27 29.33 RoNW(%) 15.80 2.62 28.52 FY11 was a difficult year with multiple problems. The company has a checkered history of PAT growth.
10	Is the company operating cashflow positive? Is the operating – investment cashflow positive? Is the company net free cashflow positive? Is the Operating cash flow higher than earnings per share?
	Net Cashflow (Operating – Investing) is constantly negative for the last 3 years.
11	Does the company pay tax, dividends every year?
	The company has been a regular tax player. It will be paying its maiden dividend this year.
12	Is the Free Cash Flow per share higher than dividends paid?
	Company is negative cash flow for the last 3 years
13	Is the business capital intensive?
	RoA is close to 46% thus it is not very capital intensive.

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1	What is the expected valuation?
	I am expecting a EPS growth of 30%+ for the next 2-3 years. With that an EPS of 12-13 is possible by FY14. A PE ratio of 15 can drive the price to 180.
2	Is the PE ratio below 15? Is the PEG above 1.0?
	PE is currently 10.52 (CMP=100)
3	Why do you think the stock is under priced? Is there an expectation to double the investment in 2-3 year timeframe? If not, why bother?
	Growth is expected to be very strong in the next 3-4 years.

Disclosure: I am interested in CEBBCO and my views are likely to be biased. Please do your own due diligence before investing.

Guru Speak: Bruce Berkowitz on WealthTrack

The legendary fund manager of the Fairholme Funds on his contrarion picks. 

Stock Update: JK Lakshmi Cement

In my previous post on the company, here is what I had said, 

The management has announced an equity share buyback up to an amount of Rs 97.5cr at a maximum price of  Rs 70 per share. Assuming  that entire buyback happens at  the price range of Rs 65-70,  the paid-up equity will  reduce by somewhere around 7-8%. Currently, the stock is available at a P/B of 0.7 and EV/ton of $54 both of which are at a discount to its peers.

The stock has moved up sharply in the last few weeks,from a low of 40 in the end of Dec'11 to its current price of nearly 62. The stock is still available at a reasonably cheap price and can move up significantly from here in the next 1 year. I would not be surprised if I see a triple digit price in the next 6 months.

Well, the stock has indeed touched triple digits, CMP is Rs 118 today. The quarterly results are to be announced on Oct 20th. Results are expected to be good for this quarter and also they is an expectation of demand pickup in the coming quarters. 

Cautious investors can book partial profits. Adventurous investors can continue to hold. Bumps along the way but it should be rewarding to hold on for another year or so, in my opinion.

Disclosure: I am invested in JK Lakshmi Cement. Please take my views as biased. Consult with your financial adviser before investing.