Someone who reads my blog, asked me this question:
“What do you think is the significance of the Buffett blurb on the Washington Post? To me, it doesn't take great insight to realize there were bargains in 1974. Its just another example of Buffett's tenet that you should be greedy when others are scared. I don't think you can get a lot of valuation insight from it. I think the blurb on (Disney) is similar. Your thoughts?”
I totally disagree.
I agree these were very simple bargains. But I don't agree they were just stories about being greedy when others are fearful. They were stories about thinking like a businessman.
Those stories – about his investments in Walt Disney, The Washington Post, and Western Insurance – are the key to understanding how Warren Buffett invests.
Here’s what Buffett is doing in those stories.
Buffett is contrasting thinking like you’re buying a stock and thinking like you're becoming a junior partner in a private business. His point in both the Disney and Washington Post stories was that these institutional investors didn't want to own the publicly traded stock. But, if this had been a private company and they had been offered a – totally unmarketable 30% block in the company – they would have happily bought in at prices higher than the public stock traded. But because they were publicly traded – there was actually a liquidity discount being applied to these companies.
Which is bonkers.
A quoted property should never be less valuable just because it’s quoted. If you don’t like the quote – if it’s giving you ulcers – just close your eyes. Eyelids are the only body part that’s absolutely essential to value investing.
I’ve talked with people who told me: “I knw the company’s worth more than I sold it for, but…”
- The stock just went up without any news
- It’s already a double for me, so I sold half my position and now it’s a free ride
- I don’t want to be greedy
- I just don’t want to own an (insert industry here) stock right now
- It got to be too big a part of my portfolio
And none of the quotes I gave you right there are from traders. Those aren’t growth investors talking. Those are things hardline Graham and Dodd value investors told me.
The institutional investors who were selling Washington Post stock to Warren Buffett didn’t disagree about the value of the company. They disagreed about what it meant to own a stock. They disagreed about whether when you think something is going to keep going down in price for 3 months or 3 years you should sell it and try to buy it back later. They disagreed about their ability and willingness to stick their fingers in their ears and hum when Mr. Market named a price they didn’t like.
That's classic Ben Graham.
Ben Graham didn't buy net/nets because you could liquidate them. Ben Graham bought net/nets because they were marketable stakes in public companies that were selling at a discount to non-marketable stakes in private businesses.
A net/net is just a private value acid test. Basically, Graham was saying since historically profitable private businesses don’t sell for less than their current assets minus their total liabilities, historically profitable public businesses – stocks – shouldn’t trade for less than their current asset minus their total liabilities either. After all, a stake in a public business should be worth more than a stake in a private business – since a stake in a public business comes with an option to either buy or sell at some price every day.
An option has some positive value. And a stake in a private business has some positive value. So a stake in a public business – which is really just a stake in a private business with an option attached – should sell for at least as much as a stake in a private business.
In other words, if you always just value public companies like private companies, you will get the same returns private investors get plus you’ll get the option of marketability thrown in.
All you have to do to be successful in public markets is to be a good private investor and be able to ignore the option of marketability except when it’s mispriced in your favor.
That’s what Ben Graham taught Warren Buffett.
Here’s a good example of Graham – the teacher – in action:
“A&P shares were introduced to trading on the New York Stock Curb in 1929 and sold as high as 494. By 1932 they had declined to 104, although the company’s earnings were nearly as large in that generally catastrophic year as previously…In the business recession and bear market of 1938 the shares fell to a new low of 36. That price was extraordinary. It meant that the preferred and common were together selling for $126 million, although the company had just reported that it held $85 million in cash alone and a working capital (or net current assets) of $134 million. A&P was the largest retail enterprise in America, if not the world, with an uninterrupted record of large earnings for many years. Yet in 1938 this outstanding business was considered in Wall Street to be worth less than its current assets alone – which means less as a going concern than if it were liquidated.”
Stop right there.
Graham just said that America’s biggest retailer was worth more dead than alive. It’s hard for folks reading this now to understand just how important a company A&P was in 1938. But if you had used Phil Fisher’s scuttlebutt approach back then, you would have heard only good things. If you had asked my Grandma or Grandpa – 60 years later – about A&P, they’d remember it. And they’d muse about how the waves of history could erode something as great as A&P – like they were talking about the dismantling of the British Empire or something.
In 1938, A&P was a sexy company. It just wasn’t a sexy stock.
If you read Ben Graham’s A&P quote and then you read Warren Buffett’s quotes about The Washington Post, Disney, and Western Insurance – you realize what Buffett’s stories are really about.
These are Mr. Market stories.
They're about how if you just think like a business owner – if you really imagine Mr. Market walking into your office and pitching you the whole business at that price – that's how you make money in the stock market.
If you just buy public companies at discounts to their private values, you'll make money when Mr. Market has a mood swing. You don't have to judge his mood. Eventually, a marketable stake in a public business will sell for at least as much as a non-marketable stake in a private business. If you like the terms of a private deal, you shouldn't care that you have to endure the indignity of getting absurd quotes thrown at you on the stock day after day. Let Mr. Market taunt you. You don’t have to trust his price. You’re still entitled to your own appraisal.
You don't mark your house to market every month. A restaurant owner doesn't sell off 10% of his establishment every time he gets antsy, just because he needs a quote. That's how stock traders think. Not how business owners think.
When Warren Buffett tells students about The Washington Post or Disney, he’s saying that publicly traded shares are priced both as pieces of paper with prices that wiggle around from day to day and as companies. If you just think about them as companies, you will win in the end. Remember, the Washington Post's stock did go down. The institutional investors who sold to Buffett were right. Over the next 3 years, the stock went down. Over the next 10 years, the stock was up 30% annualized. Buffett was wrong about the stock but right about the company.
Traders call that being wrong. Investors call that being right.
Those stories Buffett told college students about Disney and the Washington Post are very significant. They offer real insight into the way Buffett actually thinks through an investment. And it’s not the way analysts do it. And it’s not the way most authors think Buffett does it.
Warren Buffett’s approach is totally different from how most people model the way he thinks through an investment. Buffett doesn't make 10-year projections or do discounted cash flow calculations. In those stories he told college students, he didn't talk about future numbers at all. He just appraised the properties. He included the earnings only in the sense that some properties get their value from their earnings power.
But he looked at them as businesses. He looked at what he was getting today as the owner of that business. He worked in a way very similar to Mario Gabelli or Joel Greenblatt –You Can Be a Stock Market Genius not The Little Book That Beats the Market – in that he valued the business as if it was one of many houses on the same street. Buffett did an appraisal. Not a projection.
Remember, the Warren Buffett who bought Coca-Cola (KO) in 1989 is the same Warren Buffett who was heavily into REITS in 2000. He’s the same Warren Buffett who bought junk bonds. He's the same Warren Buffett who bought banks and insurers. The idea that he's doing some sort of 10-year earnings projection with a discounted cash flow calculation – that doesn’t even seem practical.
Buffett works like an appraiser.
Now, Buffett only buys businesses he likes. He doesn’t want to buy a house in a crummy neighborhood. He doesn’t want to buy a house with a river running through the back yard. He wants high returns on capital, a moat, good management, and a simple – preferably recurring – business.
But once he’s in the right neighborhood in terms of checking all those boxes – once the house has the good schools, and the pool, and whatever – he just appraises the damn thing.
Here’s an example from Warren Buffett’s1959 letter to partners:
"Last year I referred to our largest holding which comprised 10% to 20% of the assets of the...partnership...the Commonwealth Trust Co. of Union City, New Jersey. At the time we started to purchase the stock, it had an intrinsic value of $125 per share computed on a conservative basis. However, for good reasons, it paid no cash dividend at all despite earnings of about $10 per share, which was largely responsible for a depressed price of about $50 per share. So here we had a very well managed bank with substantial earning power selling at a large discount from intrinsic value. Management was friendly to us as new stockholders and risk of any ultimate loss seemed minimal.
Commonwealth was 25.5% owned by a larger bank (Commonwealth had assets of about $50 million - about half the size of the First National or U.S. National in Omaha), which had desired a merger for many years. Such a merger was prevented for personal reasons, but there was evidence that this situation would not continue indefinitely. Thus we had a combination of (1) Very strong defensive characteristics; (2) Good solid value building up at a satisfactory pace and; (3) Evidence to the effect that eventually this value would be unlocked although it might be one year or ten years. If the latter were true, the value would presumably have been built up to a considerably larger figure, say, $250 per share...
Over a period of a year or so, we were successful in obtaining 12% of the bank at a price averaging $51 per share...Commonwealth had only about 300 stockholders and probably averaged two trades or so per month...Late in the year we were successful in finding a special situation where we could become the largest holders at an attractive price, so we sold out block of Commonwealth, obtaining $80 per share although the quote market was about 20% lower at the time."
That sounds more like what people think of when they think of Mario Gabelli or Joel Greenblatt or Marty Whitman. Buffett is comparing one bank to other banks. Banks he and his partners know. He's thinking a bank like this should trade around 12.5 times earnings (or maybe some book value multiple), but it doesn't because of the lack of a dividend, which is important to investors. So the stock isn’t trading at the right price relative to the company’s value. The problem here is that investors pick their bank stocks on the basis of dividend yield – and this bank doesn’t have one – so there’s a mismatch between the stock’s value and the company’s value.
A control buyer probably wants to own this. The value should continue to compound over the years – hints of Marty Whitman here - and it's got defensive characteristics.
Buffett doesn’t do any projections.
His only projection in that whole story is an extremely vague statement that the bank will likely double its intrinsic value per share over 10 years. But remember, Commonwealth wasn't paying dividends, and it was already earning $10 per share. So, over the next 10 years it would have increased its intrinsic value per share from $125 to $225 just from retained earnings. And 8% growth over 10 years in a bank that doesn't pay dividends isn't hard to predict. In fact, I'd say all Buffett is doing is saying that banks compound over the years with the economy so it's not like you can have a bank retain earnings and keep the same low intrinsic value for 10 years. This isn't some tract of unimproved land in Montana or some bond or something. At the very least, the stock’s going to grow its coupon and compound its value the same way a savings account does.
Reading those 3 discussions - Disney, Washington Post, and Commonwealth - along with things like Western Insurance gives a better impression of the similarity between Buffett and Graham. Buffett was just thinking like a business owner.
Both Graham-Newman and Buffett's partnership did control investments. They took a large stake in a business and held it for a while. If you think the way Buffett and Graham did about picking stocks, it’s natural to also make control investments. And when you make control investments, it’s natural to think of your other investments more in terms of appraisal value than market value.
I’m really looking forward to Alice Schroeder’s next book about the way Warren Buffett invests. Because I feel stuff like the Buffettology books have reinforced the idea of Buffett as a discounted cash flow calculating growth investor who’s just a bit stingy on price.
The way Buffett actually thinks through an investment is both less conventional - and in a sense - simpler than what analysts do and what authors think Buffett does.
I want to make clear that what Graham was talking about with A&P and what Buffett was talking about with The Washington Post, Disney, Western Insurance, and Commonwealth is a rare occurrence.
Markets are not perfectly efficient. Big stocks like A&P get badly mispriced in the Great Depression. Although most of us forgot the 1938 recession, it was very scary for those living through it. They didn’t know the depression was almost over. Investors were having flashbacks. It was a scary time. And A&P had gone public just before the crash. It was terrible timing.
The Washington Post also went public at a bad time for stocks. And it got worse from there.
Disney had a huge hit in Mary Poppins. It couldn’t repeat the same performance next year. Everyone on Wall Street knew earnings would be down. Warren Buffett didn’t care.
Obviously, Western Insurance and Commonwealth were obscure stocks. And Commonwealth wasn’t paying a dividend, which was very weird for a bank stock.
The stock market – like the racetrack – doesn’t price every pony perfectly. It gets a lot of them roughly right. But there are some races where it clearly misprices things. You don’t need to know the future to see the mispricing. Any expert appraisal of companies like A&P, The Washington Post, Disney, Western, and Commonwealth would have shown the stock market was not valuing the company correctly.
In each case, the reason was a mismatch between what investors were willing to pay for a publicly traded stock and what investors would have been willing to pay for a privately owned business. Pain came with owning those stocks. You had to see the quotes. You didn’t have the luxury of looking at the balance sheet and income statement just once a year.
Here’s a current example of this phenomenon: George Risk Industries (RSKIA).
I own this stock.
And I was recently talking to another blogger who I thought owned the stock. It turned out he sold it at some point.
George Risk trades at $6.50 a share right now.
When I told him I figured George Risk was worth at least $10 a share, he asked if I thought it deserved a premium valuation. And I said:
“I don't think I value George Risk's business at a premium. Their 14-year average nominal EBIT is $2,911,786 and they have 5,054,668 shares - so that's an EBIT of $0.58 a share. They have $4.56 a share in cash and investments. So, a valuation of $10 a share is $10.00-$4.56 = $5.44. And $5.44/$0.58 = 9.38 times EBIT. So that's just under 15 times after-tax income if we take the last 14 years as the right number.
I think the business - excluding cash - is worth about $6 a share and I think the investment portfolio is worth $4.50 a share. So, the stock is probably worth $10.50.
I think we differ more on the nature of the management/ownership situation at George Risk. You talk about poor capital allocation - but I don't see that. They just don't allocate the capital. It's not poor. Poor capital allocation would be if they issued shares or made acquisitions. They just pile up the cash. That's value deferment not value destruction. Something like Fair Isaac (FICO) from 1999-2007 is bad capital allocation. They effectively sold off close to 40% of their original business by doing a merger of equals. That destroyed value. Also, I don't think the Risk family overpays themselves. I think they just know how to run this business and don't know anything about allocating capital or running a public company. That's pretty common. It's just they've been so successful in earning so much on capital that they have retained this incredible pile of cash that does nothing.
George Risk looked like a Ben Graham stock to me. It looked like National Presto.
This used to be pretty common. I collect Moody's Manuals. If you flip through companies - even names you'd recognize like General Electric - from the 1910s or so they all kept investments on hand. There were no corporate raiders or activists. This is just what you have to deal with in these sorts of companies. But I see it as being the junior partner in a family firm where the family may be irrationally conservative or whatever. But I don't see them as destroying value. And I calculated what would happen if they did nothing for 10 years and I figured if I got stuck in the stock for 10 years, I'd survive. I'd do as well as if I held bonds or something. That's the downside, they do nothing.”
Now, you can love George Risk or you can hate George Risk. That isn’t the point. The point is that I said it was worth at least $10 a share. The guy I was talking to – a blogger who follows microcaps closely – figured it was worth at least $8 a share. This is a stock that was trading at $4.50 a share earlier this year. And hundreds of thousands of shares traded at prices like that – so we’re talking about something like a half a million dollar investment opportunity at the very least. Totally unsuitable for fund managers. Totally suitable for mild mannered bloggers and sundry individual investors.
The point isn’t whether George Risk is a good investment or not. Obviously, I think it is. I own it. The point is that it’s been written about by several different value investors. I have no problem admitting I didn’t find George Risk. Ravi Nagarajan found this stock for me.
Ravi – the author of Rational Walk – first wrote about George Risk in January 2010. I don’t remember reading this article when it was first published. I doubt I would have forgotten it if I had read it. Then, Ravi wrote about the company again in July 2010. I read that post and decided I absolutely had to buy the stock.
A similar thing happened when I found an old guest post about Solitron Devices over at Greenbackd.
That makes it sound like I’m easily impressed. Actually, the opposite is true. I must have read thousands of blog posts in 2010. George Risk and Solitron kind of stuck out since the stocks were trading for less than net cash and the businesses were both historically profitable. In other words, you bought the investments and got the business for free.
That’s unusual. Even in micro cap land, those two stocks jumped out in a way almost nothing else did.
And that’s what we’re talking about when we talk about inefficient markets. We don’t mean the stock market is mispricing 10,000 stocks a day. We mean the market is getting some a little right and some a little wrong.
Very, very occasionally – I can’t emphasize enough how super rare this is – you get something like George Risk or Solitron Devices or Commonwealth or Western or Disney or The Washington Post or A&P.
And if you’ve spent your whole adult life searching for these kinds of things – like Graham and Buffett and, yes, even me – you can’t help but look at them and say that doesn’t look right. That can’t be right. The market is mispricing this thing. And it’s obvious. And I’m going to make money on it.
And you kind of sit there and wonder how in a world with other people picking stocks this could happen. But there it is. And you put in the order. And it gets filled. And you’re thinking: who the heck is selling this thing? I literally can’t imagine who would sell this business at this price, and then…
It hits you.
It’s not a business.
It’s a stock. They’re selling you a stock. And then you understand why it’s mispriced.
They don’t want to own this stock at this particular moment.
And that’s the game. That’s investing.
It's taking advantage of folks like that. It's taking advantage of Mr. Market.
That’s what Graham taught Buffett. And that’s what Buffett was teaching those college students when he told those stories about Disney and The Washington Post.
He was just saying you look at a stock as a piece of a private company, you value it, you check the price, and if Mr. Market gives you an absurd quote, you take advantage of him.
Why do public companies sometimes sell for less than private companies?
1. In the case of A&P: “First, because there were threats of special taxes on chain stores; second, because net profits had fallen off in the previous year; third, because the general market was depressed.”
2. In the case of Disney: “In 1966 people said, ‘Well, Mary Poppins is terrific this year, but they’re not going to have another Mary Poppins next year, so the earnings will be down.’”
3. In the case of George Risk, it’s hard to trade and it’s family controlled.
Well, a private business is impossible to trade – and unless you’re the majority owner – you don’t get any say in how its run either. No one’s implying there should be some huge premium on George Risk because you can trade it. Some people are just saying maybe it shouldn’t sell for less than the price you could liquidate it for considering it’s a consistently profitable, high return on capital business.
But, in 2010, there were times when George Risk was selling at less than the price you could liquidate if for. And in 1938, there were times when A&P was selling for less than the price you could liquidate it for.
That’s kind of weird. Since both companies had competitors and customers who would tell you those companies were actually pretty good at what they do.
Markets are mostly efficient. But then they should be. If reasonably intelligent people get together in a room with real money on the line, they should be pretty good at handicapping any situation. They should be pretty good at finding patterns and making sense of the game. Humans are wired for that.
That’s not the weird part. The weird part is that there are sometimes things like A&P and Disney and George Risk and The Washington Post where people don’t disagree about the quality of the company. People don’t really disagree about the value. I mean, sure, they disagree – but they disagree at much higher prices than where the stock trades.
What’s weird is that sometimes people know what a business is worth, they like the business just fine, and yet they refuse to buy the stock. They even sell the stock.
That’s the real lesson Warren Buffett was trying to teach:
“No one would have argued about the value of American Express. They just didn’t want to own it for a while. That’s why you’re buying periodically. They didn’t want to own the Washington Post in ‘74. All you’ve got to do is find one, two or three businesses like that in a lifetime, load up when you do, and not do anything in between.”