QUALIPORT
Buffett 2000: Valuation, Insurance and Common Stocks

By Maynard Paton (TMFMayn)
March 12, 2001

Carburton Street, London -- On Saturday, Warren Buffett published his latest Shareholders' Letter. As usual, it's a very informative and educational read. There were three topics within Buffett's missive that I've covered recently for the Qualiport and wish to expand upon today, as I feel they're the most relevant for the ordinary investor. For those wanting a deeper analysis of Buffett and the performance of Berkshire Hathaway (NYSE: BRK.A), the Berkshire Hathaway message board over at the US Fool is awash with in-depth comment and insight.

Common Yardsticks

On the subject of valuation, Buffett emphasised that the discounted cash flow (DCF) formula was the method he used to evaluate stocks and businesses. Buffett also dismissed shorthand valuation methods:

"Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years."

This comes as a slight embarrassment to me, and perhaps to Whitney Tilson, given that I used one of Whitney's features from the US Fool to declare in this Qualiport article:

"it appears Buffett isn't the big fan of DCF that his Letters imply".

No matter.

Regardless of what Buffett says about "common yardsticks" and DCFs, my own experience supports the use of shorthand valuation measures. It's not that the mathematics involved in a DCF model is difficult, nor the determining of the values to plug into the calculation that tricky. Instead, I'm a firm believer in "obvious and immediate" value. An attractive valuation has to hit you in the face, rather than be hidden through a DCF or similar. Simply, the longer the forecasting timescale, or the more obscure the valuation method, the greater the chance of justifying a valuation which, in time, just won't prove to be all that attractive. 

To repeat my thoughts on valuation from the earlier article about Buffett and DCFs:

"Imagine finding a company that you feel can double its profits in five years (equating to 15% annual earnings growth) without recourse to acquisition, operates without debt and has 20% margins, and generates plenty of cash too. In general, the company looks to be an above-average business, and so, all things being equal, should be valued with an above-average rating."

"However, if that company was valued on a P/E of just 10, way below average, and offered a dividend yield of 5%  too, then its "value" characteristics should be obvious. You wouldn't need to construct a DCF to conclude that the company was undervalued. The shorthand measures instantly tell you there was some margin of safety factored into the current share price."

Insurance

Buffett also touched upon the insurance business. Shareholders of former Qualiport company Independent Insurance (LSE: IIG) may rue this comment:

"A caution is appropriate here: Because loss costs must be estimated, insurers have enormous latitude in figuring their underwriting results, and that makes it very difficult for investors to calculate a company's true cost of float. Errors of estimation, usually innocent but sometimes not, can be huge. The consequences of these miscalculations flow directly into earnings. An experienced observer can usually detect large-scale errors in reserving, but the general public can typically do no more than accept what's presented... Both the income statements and balance sheets of insurers can be minefields."

"At Berkshire, we strive to be both consistent and conservative in our reserving. But we will make mistakes. And we warn you that there is nothing symmetrical about surprises in the insurance business: They almost always are unpleasant."

Indeed, there was an unpleasant surprise from Independent last week, as the insurer reported its annual results. The reassessment of all Independent's liability business led to the company announcing the purchase of unexpectedly large reinsurance protection.  The cost of this additional cover will severely dent medium-term profits.

Looking back at the Independent sell report (triggered after Independent had warned over increased costs relating to its London Market subscription business), one of the three question marks I raised at the time now looks quite prescient:

* Increasingly prudent reserving policies:  The recent [London Market] developments could (or perhaps, should) inspire a more cautious view towards the reserving of future liability claims. Will the company revert back to its historical underwriting achievements after the introduction of a more conservative accounting approach?

While Independent may become some sort of crisis play in the future, there remain far too many corporate uncertainties for the discerning private investor. A definite investment minefield. Buffett may wax lyrical about how he has generated fantastic returns from the insurance industry. But in my opinion, and with the ordinary UK investor in mind, the sector should be left to short-term players only.

Common Stocks

And finally, a quick word concerning Buffett's common stock investments:

Company               Value ($m)


American Express         8,329
Coca Cola               12,188
Gillette                 3,468
Washington Post          1,066
Wells Fargo              3,067
Others                   9,501

Total                   37,619

There are three points to note.

* Big bold bets are best: Buffett's has only five major constituents in his common stock portfolio, the largest of which represents 32% of its total value. This concentration is consistent with his portfolios of years gone by.

* Great long-term businesses are rarely attractively valued: It's now been five years since Buffett topped up on one of his "core" common stock investments. At the moment, Buffett says there are "no bargains" among his current holdings.

* Don't fall in love with your stocks: After 12 years of holding Freddie Mac (NYSE: FRE), Buffett dumped "nearly all" of this particular holding in 2000. And following on from the calculations presented in this feature, Buffett's average holding period (since 1977) for his common stock investments has edged up from 4.58 years to just 4.72 years.

More: Learning from history: Buffett the short-term investor | Buffett: Making Fortune Tellers Look Good | Big Bold Bets are Best: Forget about diversification | Buffett Scores Grade D: Last year's report card