Ankie Wong Benny Cheng Christine Wai Chris Tam Jacky Chan Veronica Chang
1155008805 1155006903 1002549534 1005140000 1155006899 1155008802 1
In this case study, we attempt to study an investment Guru, Mr. Warren E. Buffett, through (1) evaluating his 2 major investments - acquisition of PacifiCorp. in 2005 and the ‘Big Four’ (2) investigation and critical analysis of his 8 major investment philosophies and other important ideas such as intrinsic value, valuation of stocks and time value of money. I. Acquisition of PacifiCorp.. On May 24, 2005, it was announced that MidAmercian Energy Holdings Company, a subsidiary of Berkshire Hathaway, would acquire a private energy company, PacifiCorp., whose parent,
Scottish Power, is a listed energy company PacifiCorp.. Berkshire has utilized $5.1 billion in cash, which will be paid after 1 year, together with further liabilities to complete the acquisition. The market responded very positively on the same day. As illustrated in figure 1, Berkshire’s stock price has been increased by 2.4%, which PacifiCorp.’s parent, Scottish Power’s by 6.28% and S&P 500 closed up 0.02%.
We believe there are 4 possible reasons for such a response: a) Psychological factor- The general public believed Buffett is an investment guru rather than rationally studying market information of the acquisition. b) Higher Return on Equity (ROE) ratio of Scottish Power (PacifiCorp.) than Berkshire (7.5% vs. 5.7%) c) Outperformed stock price of Scottish Power (PacifiCorp.) than the market while Berkshire was underperformed. 2
d) More diversified investment portfolio of Berkshire after the acquisition was expected to provide more stable returns. Before the acquisition, Berkshire did not have significant investment in energy sector. Using Intrinsic Value concept to evaluate the acquisition The positive market response had provided Berkshire a gain of $2.55 billion in market equity value.
We can hence apply the intrinsic value concept and evaluate if Buffett paid higher or lower than the market price for PacifiCorp.. Buffett defines intrinsic value as ‘discounted value of the cash that can be taken out of business during its remaining life.’ He actually paid $4.67 billion for PaciCorp. (i.e. his intrinsic value of PacifiCorp. before the announcement) It is calculated by discounting the $5.1 billion cash paid for 1 year at a discount rate of 9.315%.
And the rate is obtained by using capital asset pricing model (CAPM). It was given that yield on the 30-year US Treasury bond (i.e. risk free return rate) on the announcement day was 5.76%, Berkshire’s beta was 0.75 and annual average total return on all large stocks from 1965 to the end of 2004 (i.e. market return) was 10.5%.
Therefore, market price of PacifiCorp. was $7.65 billion (which comprised of the $5.1 billion cash & $2.55 billion gain) at closing of May 24, 2005. However, Buffet was actually paying lower. His intrinsic value was only $7.31 billion (which comprised of the discounted value of $4.67 billion and $2.55 billion gain) Another way – Using Financial Multiples Besides looking into the intrinsic value implied by the response from the market, we can also 3 use the financial multiples (i.e. Price to Earnings and Book Values) of other companies in the same industry to estimate the possible value of PacifiCorp..
5 Comparable Regulated Energy Firms were selected to benchmark the value of PacifiCorp., namely Alliant Energy Corp, Cinergy Corp. NSTAR, SCANA Corp and Wisconsin Energy Corp. a) Price to Earnings By using the net income and shares outstanding provided, we can obtain the earnings per share of these 5 firms. With earnings per share, we can estimate the possible range of price to earnings of the utilities industry. Table 1 shows how it works and the results told the range will be from 11.28 to 20.33.
Hence, we can estimate the stock price of PacifiCorp. to be ranged from $9.1 to $16.4 and the corresponding estimated value range will be $2.84 billion to $5.12 billion. (Detailed calculation can be referred to Table 2) b) Book Value From the Value Line Investment Survey and Standard & Poor’s data provided, the market value of PacifiCorp. is derived by using median and mean multiples of the comparable energy firms.
The result shows that the value of PacifiCorp. is ranged from $5.68 billion to $5.90 billion. Is Buffett paying too much? We have already found Buffett actually paid $4.67 billion for PacifiCorp.. Hence, the results obtained from the financial multiples - earnings per share and book value above seem to 4
conclude in 2 different directions. From perspective of price to earnings, he was paying at a mid-high side of it. However when we look at the book value, he paid over 20% less than the amount PacifiCorp. should worth. II. The ‘Big Four’
Besides PacifiCorp., Warren Buffett acquired many large companies; some of those acquisitions have been named as “Big Four” in Berkshire Hathaway; namely American Express, Wells Fargo and Gillette together with Coca-Cola. With multiple transactions between May 1988 and October 2003, it shows application of his stock pick up criteria for the holding period 12.5 years in ‘Big Four’.
These criteria are mainly (1)simplicity and consistency of companies’ operation history (2) attractiveness of long term prospects (3) quality of management’s firm’s capacity in order to create value. The success was shown by their outstanding performance over the benchmark. Table 3 shows their holding period return and annualized returns. III. Buffett’s Investment Philosophy
Buffett shows his successful acquisitions many times and concluded that it is contributed by his 8 investment philosophies. In the following, we will assess them & show our position to each of them. 1) Economic Reality; not accounting reality Buffett does not believe in conventional accounting which reveals very little about true economic performance. Accounting is backward looking and contains conservative figures 5
that past records could not have any indication of the future. Instead, Buffett uses ‘Value Investment’ to search for company with high intrinsic value; this can be done by economic reality which is at the level of the business itself, but not affected by other external factors like the market and economy. Hence, focusing on economic instead of accounting reality is the key rule of Buffett in investment selection process. We can also apply this in reality.
For example, one of the listed company in HK stock market, Nine Dragon Papers Holding Limited (Stock number: 2689) has a very poor accounting reality but its stock price still went up because it gives investors confidence for its value creating ability. 2) The cost of lost opportunity When considering investment opportunities, Buffett picks one of the choices and only compare it against next best opportunity, named as cost of lost opportunity. He is assertive and determinative with only either /or decisions framed out from his plans.
He pointed out that comparison of an investment against other returns available in the market was an important benchmark of performance. 3) Value Creation: Time is money As mentioned from the first philosophy, Buffett viewed intrinsic value as the key to assess if the company is worth to invest; whether it can create value and true economic performance. Intrinsic value is present value discounted from future cash flows; and he 6
thinks it is the only logical way to evaluate the relative attractiveness of investment and business. Even there is a concern on how to figure out accurate discount rate and future expected cash flows, we could not deny that book value on account statement is meaningless in relation to future potential growth.
Standing on his viewpoint, business is cost and benefits analysis. We should focus on the future growth but not the amount of investment outlay we put. 4) Measure performance by gain in intrinsic value, not accounting profit To sum up more specifically, Buffett thinks long term economic goal is to maximize average annual rate of gain in intrinsic values with per-share basis.
It is not difficult to find a company with increasing and more capital base enhancement in total sales and net income. However, if measured by size, a greatly enlarged capital base will distort the overall performance measurement. On the other hand, we should not say accounting profit is useless. Operation and management are usually positively related with the fact that management aims at maximizing shareholders’ benefits; incentive scheme is one of the examples that can be used to determine the quality and performance of management.
At the same time, accounting profit is still useful when there is high volatility in dividend and uncertainty of future incomes; hence, we could not be short-sighted that only calculate accurate and precise intrinsic value. We think intrinsic value is a key pillar but accounting profit can also reflect the quality of 7 account managers 5) Risk & Discount Rates Conventional academic and practitioners usually think risk and return are positively related- more risk implies higher return.
Hence, when getting intrinsic value of any kind of investment, the discount rate we use is risk free rate (US treasury bond yield) plus a risk premium; that is risk of cash flows applied in capital asset pricing model (CAPM). However, Buffett pointed out his practice by ‘putting a heavy weight on certainty’; with focus on companies with predictable and stable earnings. Risk means ‘the possibility of loss or injury’ instead of relative volatility of stocks.
He thus only uses risk free rate to discount and get intrinsic value of the investments. We believe it is not a true picture of real cases in the world. Risk implies uncertainty meaning something out of our expectation. No matter how hard and powerful Buffett is, it’s still difficult to get perfect information with certainty. There are still risks which cannot be completely avoided and predicted, such as natural disasters, wars and political events.
One of the typical examples is stock markets in the whole world slumped when New Zealand and Japan had earthquakes last year. Besides, no matter how updated the information Buffett gets in the financial market, he’s still not a fortuneteller who knows what will happen in the market. As mentioned, discount rate is calculated by the risk of future cash flows. To conclude, we cannot ignore existence of risk and should not use risk 8
free rate to get intrinsic value which the return of investment will be overvalued. 6) Diversification Buffett declined conventional thinking that investors better keep a broad portfolio of stocks in order to spread away company-specific risk. He commented that ‘Asset allocation is for people who don't know what they're doing.’ Diversification is protection against ignorance only; besides, it does not have significant uses.
We think it is partly correct with assumption of perfect market information. If our market is efficient and investors get perfect information, it is worth for us to wait for a so-called ‘exceptional company’ with potential growth and this kind of investment can help us to offset time cost we wait for. However, the true picture is that market information is not perfect; and this is applied to all investors, including Buffett himself. To be frank, Berkshire itself is truly a massively diversified company with several subsidiaries and holdings covering different industries from apparel to energy sectors.
7) Investing behavior should be driven by information, analysis & self-discipline; not by emotion or ‘hunch’ Buffett has one renowned speech, ‘we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful’. He does not try to ‘time the market’ but keeps a strategy of patience; long term and valuable investing. Awareness and information are pillars of rational investing, stock market does not exist, what we are 9
investing is the businesses instead of the stocks. It states a right scenario that rational investors should invest based on systematic and objective analysis; with rational behaviors, they will tend to buy low and sell high, focus on long term values but not short term fluctuations. Those who invest by emotions or gut feelings will be easily affected by others and they tend to be followers in the stock market and usually buy high and sell low; thus losing further business opportunity and growth potential of investment. 8) Alignment of agents & owners Buffett stated that he is ‘a better businessman because I am an investor. And I am a better investor because I am a businessman’.
Aligning of agents and owners is the best motivation of management and managerial policies will not be filled at shareholder expense. By the way, alignment can help to bring out management’s net worth which is reflected by company shares. We agree with this philosophy as everyone is selfish and loyal to one’s own interest. If aligned one’s interest to the company interest, management will utilize all possible tools and solutions to maximize shareholders’ interests.
To encourage better performance from management, many incentive programs are implemented to motivate their performance. To conclude, we found the study is very useful to our understanding and application of financial concepts in the real world. For example, when we invest in the stock market, the 10 intrinsic value calculation and comparing with the peers companies will be useful to evaluate the worthiness of the stocks. Besides, his investment philosophies also provide us a comprehensive guideline for different types of business investments in the real world.