Seeking Wisdom

by Peter Bevelin

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  themselves in three years. And after 20 years of doing it, somehow you've earned a return of only about 4% per annum. That's the textile business.

  And it isn't that the machines weren't better. It's just that the savings didn't go to you. The cost reductions came through all right. But the benefit of the cost reductions didn't go to the guy who bought the equipment.

  Warren Buffett tells us about the illusionary benefits:

  Many of our competitors ... were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide. Viewed individually, each company's capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational.

  Whenever we install a policy, take an action or evaluate statements, we must trace the consequences. When doing so, we must remember four key things:

  Pay attention to the whole system. Direct and indirect effects,

  Consequences have implications or more consequences, some which may be unwanted. We can't estimate all possible consequences but there is at least one unwanted consequence we should look our for,

  Consider the effects offeedback, time, scale, repetition, critical thresholds and limits,

  Different alternatives have different consequences in terms of costs and benefits. Estimate the net effects over time and how desirable these are compared to what we want to achieve.

  We can't get something/or nothing.

  Take the issue on alternative energy sources. Some relevant headlines when thinking about alternatives: Energy used versus usable energy produced (considering the entire production process)? Infrastructure requirements? Scalable? Transport and storage? Costs (considering subsidies)? Who pays? Environmental benefits and costs? Sustainability? Consequences over time? Degree of difficulty in properly evaluating all the factors involved? Consequences of being wrong?

  Judge an action by its net consequences over time considering the whole system. Follow up changes in individual variables by determining how the rest of the system will respond over time. Reducing risk in one area may increase it in

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  another. Changes in one variable may change the entire system. One change may cause another change causing another, etc. This includes considering short and long-term consequences since there may be a long time between an action and its full effects.

  Marcus Tullius Cicero said: "Extreme justice is extreme injustice." Some systems should be made deliberately a little unfair if they carry better consequences for us all. Charles Munger tells us about the Navy model - a rule with net benefits:

  If you're a captain in the Navy and you've been up for 24 hours straight and have to go to sleep and you turn the ship over to a competent first mate in tough conditions and he takes the ship aground - clearly through no fault of yours - they don't court martial you, but your naval career is over.

  Napoleon said he liked luckier generals - he wasn't into supporting losers. Well, the Navy likes luckier captains.

  You can say, "That's too tough. That's not law school. That's not due process." Well, the Navy model is better in its context than would be the law school model. The Navy model really forces people to pay attention when conditions are tough - because they know that there's no excuse. Very simply, if your ship goes aground, your career is over.

  "It doesn't matter whether it was your fault or not. Nobody's interested in your fault. It's just a rule that we happen to have - for the good of all, all effects considered."

  I like some rules like that - I think that the civilization works better with some of these no-fault rules. But that stuff tends to be anathema around law schools. "It's not due process. You're not really searching for justice."

  Well, I am searching for justice when I argue for the Navy rule - for the justice of fewer ships going aground. Considering the net benefit, I don't care if one captain has some unfairness in his life. After all, it's not like he's being court marshalled. He just has to look for a new line of work. And he keeps vested pension rights and so on. So it's not like it's the end of the world.

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  - EIGHT -

  QUANTIFICATION

  To talk sense, is to talk in quantities. It is no use saying that the nation is large,

  - How large? It is no use saying that radium is scarce, - How scarce?

  -Alfred North Whitehead (from The Aims of Education)

  Most aspects of our life depend on our ability to quantify and understand patterns and relationships, proportions, or magnitudes. What does math do? It helps us develop consequences, and evaluate when things make sense. And math is stable. Two plus two is four was true 1 million years ago and will be true 1 million years from today.

  When we translate something into numbers we can make comparisons. How can we evaluate if a decision is intelligent or not if we can't measure it against a relevant and important yardstick?

  Some things can't be measured exactly, so estimating a range is the next best alternative.

  "It is better to be roughly right than precisely wrong," said J.M. Keynes. Don't overweigh what can be counted and underweigh what cannot. Beware of false concreteness - often we believe that data based on figures with lots of decimal places are more accurate than words alone. Charles Munger says:

  You've got a complex system, and it spews out a lot of wonderful numbers that enable you to measure some factors. But there are other factors that are terribly important and there's no precise numbering you can put to these factors. You know they're important but you don't have the numbers. Well, practically everybody overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and doesn't mix in the hard-to-measure stuff that may be more important.

  Let's illustrate the importance of quantification with examples from the world of business and investing.

  How much capital is needed to produce a dollar of cash flow?

  Does return on invested capital make a difference? Assume two businesses - X

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  and Y - generate the same cash earnings of $10 million and "perpetual" growth of 5%. The difference lies in how much capital they use to produce these earnings. X needs $100 million and Y $40 million. This means that their return on invested capital is 10% respective 25%. This also means that they differ in the free cash flow (after reinvesting) or distributable cash they generate. X generates

  $5 million and Y $8 million. Return on invested capital makes a difference in value.

  Business X

  Business Y

  Invested capital

  100

  40

  Free cash flow

  10

  10

  Reinvested capital

  -5

  -2

  Return on reinvested capital

  10%

  25%

  Available cash flow for distribution

  5

  8

  Value at 10% discount rate

  100 (5/(0.1-0.05))

  160

  Warren Buffett describes what businesses are best to own:

  Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite - that is, consistently employ ever-greater amounts of capital at very low rates of return.

  Should higher earnings automatically impress us?

  Warren Buffett gives an example from one of Berkshire's subsidiaries:

  While an increase in earnings from $8 million to $72 million sounds terrific - and usually is -you should not automatically assume that to be the case. You must first make sure that earnings were not depressed in the base year. If they were instead substantial in relation to capital employed, an even more important point must be examined: how much additional capital was required to p
roduce the additional earnings?

  We need to understand what is behind the numbers. Warren Buffett says that, "return on beginning equity capital" is "the most appropriate measure of single year managerial performance. Informed use of that yardstick, however, requires, an understanding of many factors, including accounting policies, historical carrying values of assets, financial leverage, and industry conditions."

  We can't expect to get a higher return on investment over time than the

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  underlying business produces on its invested capital over time. Charles Munger says:

  Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result.

  Few companies can manage, over a ten to twenty-year period, to keep earning high returns on 20% or more on invested capital while reinvesting all or most of their earnings. Changes in the competitive arena, buyer habits, and the environment will make that almost a certainty.

  Warren Buffett reveals the limits of earnings growth and how lofty predictions lead to dumb behavior:

  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 avery 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.

  He continues:

  Finally, be suspICtous of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don't advance smoothly (except, of course, in the offering books of investment bankers).

  Charlie and I not only don't know today what our businesses will earn next year - we don't even know what they will earn next quarter. We are suspicious of those CEOs who regularly claim they do know the future - and we become downright incredulous if they consistently reach their declared targets. Managers that always promise to "make the numbers" will at some point be tempted to make up the numbers.

  Suddenly demand goes down and price competition rises.

  How does a change in growth rate change business value? Business value is a function of the amount and timing of future cash flows. If cash flows decreases and/or appears further off in the future, business value declines.

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  Warren Buffett illustrates how valuations must change when growth expectations are revised:

  A few years ago the conventional wisdom held that a newspaper, television or magazine property would forever increase its earnings at 6% or so annually and would do so without the employment of additional capital for the reason that depreciation charges would roughly match capital expenditures and working capital requirements would be minor. Therefore, reported earnings (before amortization of intangibles) were also freely distributable earnings, which meant that ownership of a media property could be construed as akin to owning a perpetual annuity set to grow at 6% a year. Say, next, that a discount rate of 10% was used to determine the present value of that earnings stream. One could then calculate that it was appropriate to pay a whopping $25 million for a property with current after-tax earnings of $1 million (1/0.1-0.06).

  Now change the assumption and posit that the $1 million represents "normal earning power" and that earnings will bob around this figure cyclically. A "bob-around" pattern is indeed the lot of most businesses, whose income stream grows only if their owners are willing to commit more capital (usually in the form of retained earnings). Under our revised assumption, $1 million of earnings, discounted by the same 10%, translates to a

  $10 million valuation. Thus a seemingly modest shift in assumptions reduce the property's valuation to 10 times after-tax earnings.

  Do we pay the same price for a business financed with debt as for a business with no debt?

  Assume Mary is interested in buying a furniture store. The business is stable with no growth, free cash flow of 15 and financed with 75 in equity. A price of 100 (15/0.15) will give her a 15% return. Does debt make a difference? Yes, the seller could then make extra money by leveraging the business before selling it.If the seller refinances the business with 50 in debt (and the business can borrow at 6% interest) and withdraws 50 as a dividend, income after interest would be 12 (15-3). If Mary then buys the store for 80 (12/0.15) the seller would have made an extra 30 (50+80-

  100) without any change in the underlying operations of the business.

  Instead Mary should assume she acquires a debt-free business and adjust for 50 of debt and pay 50 (15/0.15-50). She should also correct (add to the price) for excess cash - cash or cash assets that aren't needed to conduct the business.

  This is the same type of reasoning as when we buy a house. If we for example

  buy a house for $500,000 and put in $200,000 of our own saved money and mortgage the rest or $300,000, the price of the house is still $500,000.

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  "The synergies we expected from the merger never materialized They were mere illusions. "

  Don't forget to quantify consequences when making acquisitions. Take the profit & loss statement and balance sheet of the acquiring company and the target company. Calculate what happens with volume, prices, cost, and invested capital when the companies combine, considering consequences and behavioral changes of employees, suppliers, customers, and competition. How does business value change? Be realistic. Studies show that most mergers fail to generate value for the acquiring company's owners. The main reason is that the buyer paid too much for synergies that weren't real.

  "Of one thing, however, be certain," says Warren Buffett, "If a CEO is enthused about a particularly foolish acquisition, both his internal staff and his outside advisors will come up with whatever projections are needed to justify his stance. Only in fairy tales are emperors told they are naked."

  john reads the paper. A company announced a $10 million contract and its market capitalization jumped $1 billion.

  Does this make sense? If we assume the contract generates a 15% profit margin,

  the implied market value increase is $1.5 million. And even a high-margin project can be a loser if it requires a lot of capital and human resources.

  If present value is the same for different businesses, does the timing of the dividend matter?

  Assume there are 2 different businesses -X and Y -with the following forecasted dividends. After year 5 the two companies close down.

  Year

  1

  2

  3

  4

  5

  Dividends from X

  10

  10

  10

  10

  10

  Dividends from Y

  0

  0

  0

  0

  61

  All cash generated by X is each year distributed to its owners. The free cash flow generated by Y is reinvested and not paid out until after the five year period. Assuming we want a 10% return, the present value of X's respective Y's dividends are the same or about 38. But this assumes that we can reinvest our dividends from X at 10% so that we have 61 after 5 years. It also assumes that Y can reinvest their cash flow at rates that cause the dividend to be 61 after 5 years. But in both cases the future may turn out different than expected. The business environment may change and competition increase making the dividends from X and Y come

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  out differently from what we expect. The more our calculation depends on cash flows far out in the future, the more opportunities there are for unwanted events, and the more uncertain our expected return.

  Do the
math!

  We can do a simple exercise to test our possible return from investing in a company and if its market valuation makes sense. Just think about the math implicit.

  Below are some examples where we have ignored dividends and options (in reality we need to properly account for options and make sure that the company's accounting reflects reality and the true operational performance.) Think of a stock as part of a business and remember that small changes in assumptions can dramatically change value.

  John is thinking of buying 1,000 shares of stock in a public ice cream manufacturer with a market value of $1 billion and no debt or off-balance sheet obligations. How should John reason?

  What is my estimated annual rate of return?

  John projects the future value, and then compares that value with the present market value of $1 billion. What is his implied annual rate of return? Will the price paid give him an adequate return?