Investment Process – Grey Owl Capital Management, LLC

One Question for Messrs Buffett and Munger

Tomorrow, Saturday May 2nd, 2015, Warren Buffett and Charlie Munger will hold court over a crowd of 40k+. As they do every year, they will spend several hours answering questions about the current and future workings of Berkshire Hathaway. Three journalists and three investment analysts will ask the questions.

If we were given the opportunity to ask a question, we would focus on Berkshire Hathaway Energy -BHE – (formerly MidAmerican Energy) and the threat to traditional utility businesses from distributed generation (DG).

During 2014, BHE provided 9% of Berkshire’s revenue and 11% of pre-tax operating earnings. In the most recent annual letter, Mr. Buffett refers to BHE as one of the “Powerhouse Five” collection of Berkshire’s largest non-insurance businesses. He goes on to write, “a century hence, BNSF and Berkshire Hathaway Energy will still be playing vital roles in our economy.” Later, he adds that BHE has “recession-resistant earnings, which result from these companies offering an essential service on an exclusive basis.”

Their conviction is very high. We wonder if both Messrs Buffett and Munger are underestimating the potential threat from distributed generation (i.e. power generated at the individual household level using solar technology). Is it possible that the developments in Hawaii described in detail in a recent NYTimes article are just the beginning?

BHE has invested $15B in renewable energy generation capabilities and is the largest generator of renewable energy in the US. In addition BHE’s largest subsidiaries are in geographies with no immediate threat (the ratio of sunlight to traditional generation fuel cost is favorable). Yet, solar is not a typical fuel source. It is a technology that behaves according to Moore’s Law – every year it is twice as efficient and half the price as the previous year.

So, if we had the floor for a minute in Omaha tomorrow, here is what we would ask: “Messrs Buffet and Munger, what if technology made it so BHE was no longer the exclusive provider of power in its covered geographies? Doesn’t solar offer the possibility that the distribution component of the regulated utility industry shrinks significantly in size? BHE uses solar as a fuel source, but that alone can’t neutralize the threat. Solar has the potential to be much more than a substitute for coal or gas in the old utility regime. Centralized power generation isn’t necessarily ideal. In the past it was just the only practical option. Today, decentralized power generation is just as practical in a few locations (e.g. Hawaii), but it is becoming so in more and more geographies by the year. The efficiency of solar is increasing and the cost decreasing at a rate commensurate with Moore’s Law – and it should, as solar panels are similar in structure to computer chips. As this trend continues, individual solar power generation will become practical in more and more locations. And so, how can you be so confident in BHE’s ability to earn a “good” return long into the future? Is it possible that solar may be to the utility industry what the internet was to the newspaper business?”

We remain long $BRK, confident in the overall business mix, the broad diversification, and the “moat” that accrues from the structure Mr. Buffett has developed over the last 50 years. We are also optimistic that BHE managers can adjust the business to new realities over time. Still, we would like to hear some additional details on how they think about the distributed generation threat.

Long $BRK.

The Time to Prepare for Today’s Volatile Markets Was Long Ago

The S&P 500 peaked this year on May 2^nd at 1371 (intraday). The current selloff began on July 7^th just slightly lower at 1356 (again, intraday). From the close on July 7^th through today’s close (August 8^th), the S&P 500 (as measured by the SPDR S&P 500 ETF)(1) was down 17.20% on a total return basis to 1119.

While the media has recently been filled with stories fomenting panic (about the European debt crisis, the recent US debt-ceiling political argument, and now S&P’s lowering of the US’s credit rating) and suggesting all sorts of portfolio strategies, the time to prepare for increased volatility and lower equity prices was long ago. These crises did not appear out of thin air and are not really crises in and of themselves. Rather, they are symptoms of underlying issues that have been building for some time, in plain sight. The Fed was trying to trick investors with zero percent interest rates into ignoring the problems, but eventually that had to give.

We have long been advocating portfolios built primarily around higher quality investments and reserving some cash or “dry powder” for a time when securities would likely sell at better values. Our rationale was based on the following:

Broad equity market valuations were and are too high. We discussed a basic methodology for valuing broad markets in detail in our fourth quarter 2009 letter when the S&P 500 was also in the mid-1100s.
Developed market sovereign debt has reached unsustainable levels relative to GDP which will likely lead to increased volatility and inflation (though deflation is a potential too). We discussed the issues of sovereign risk in our first quarter 2010 letter.
The US economy has been supported by fiscal and monetary stimulus and will atrophy when the steroids are eventually removed. Our first quarter 2011 letter tells this story in pictures.

While the last month is merely a short battle in a long war, we are pleased that our typical equity (or “risk”) account’s losses were limited to 10.65%(2) during this period; only 62% of the S&P 500’s 17.20% loss. An important element to increasing long-term compounded growth is to minimize drawdowns. Our equity portfolios have behaved as designed.

1. The SPDR S&P 500 ETF (“SPY ETF”) is used for comparing performance on a relative basis. There are significant differences between the SPY ETF and our accounts, which do not invest in all or necessarily any of the securities that comprise the SPY ETF.

2. This is an intra-month estimate reflective of one account invested in our model and is not representative of all clients. While clients were invested in the same securities, this performance does not reflect a composite return.The return presented is net of all adviser fees and includes the reinvestment of dividends and income. Clients may also incur other transactions costs such as brokerage commissions, custodial costs, and other expenses. For the most recent performance, please visit www.greyowlcapital.com or call us at 703-459-9400.

THE RETURN SHOWN REPRESENTS PAST PERFORMANCE AND IS NO GUARANTEE OF FUTURE RESULTS. NO CURRENT OR PROSPECTIVE CLIENT SHOULD ASSUME THAT FUTURE PERFORMANCE RESULTS WILL BE PROFITABLE OR EQUAL THE PERFORMANCE PRESENTED HEREIN.

We’ll Buy a “Poor” Capital Allocator Like Microsoft Anytime

Microsoft (MSFT) is as out of favor as out of favor can get. Apple adds “i” to the word “Cloud,” talks about it at a developer conference, and Steve Jobs is on the front page of the Financial Times. Microsoft releases the fastest selling operating system of all time (Windows 7) and then the fastest selling consumer device in history (the Kinect) and newspaper editors and investors alike just yawn. Microsoft can’t innovate, Steve Ballmer inherited a great company but hasn’t really done anything to move it forward, and he allocates capital poorly with dumb acquisitions (Skype) and silly R&D projects (Kin One and Kin Two).

Despite this, or perhaps because of it, we think Microsoft is a spectacular investment opportunity. We have owned Microsoft for several years, trading around the position multiple times. Today it is one of our largest positions. We articulated our thesis at length in a recent quarterly letter. In this brief post, we want to take a look at the claim that Mr. Ballmer has been a poor allocator of capital.

Last week, David Einhorn presented his investment thesis for Microsoft at the Ira Sohn Conference. He was bullish on the stock. He said it is very cheap on both an absolute basis and relative to the market and yet the business is outperforming the average S&P 500 company by a wide margin. Mr. Einhorn believes Microsoft is cheap for a reason. He argued that the number of poor capital allocation decisions on the part of Steve Ballmer has overwhelmed the superior operating performance and good decisions that have been made.

It seems clear that Steve Ballmer IS an “overhang” on the stock as Mr. Einhorn phrased it. The stock would likely appreciate if he was to move on. However, the question of whether Mr. Ballmer truly is a poor capital allocator seems less obvious to us. Remember, it isn’t his fault that the market irrationally bid the stock up to a PE of 70 right when he took over as CEO. So, you can’t judge him on stock performance alone. In addition, we think that the sheer size of Microsoft can cause confusion. Skype may or may not turn out to be a good acquisition. If it is a mistake, the $8.5B price would seem to make it a big one. But, it is only 4.5 months of free cash flow to Microsoft. What has Mr. Ballmer done with the rest of Microsoft’s cash?

From a base of $10.5B in 2000, Microsoft grew free cash flow (i.e. operating cash flow less capital expenses) to $22B in 2010. This is a CAGR (compound annual growth rate) of 7.7%. The total free cash flow generated over this ten year period was $155B. During that same period, Microsoft returned to shareholders $142B in cash via dividends and stock buybacks. In other words, Microsoft returned 92% of all the cash they generated to shareholders!

Let’s now use this information to perform a brief thought exercise. Today, you can purchase Microsoft stock for $24/share or you can buy the entire company for $203B. Imagine you were to buy the entire company today. Next, imagine that Microsoft were to grow free cash flow at the same rate for the next ten years that it did for the previous ten years. This means the firm would generate $360B in free cash flow over the next ten years. Given the firm’s historical need to retain very little capital, further imagine that 92% of all cash generated was returned to shareholders. Let’s assume it is all in the form of share buybacks so we don’t need to worry about taxes. At this point you would have received 1.6x your money back AND you would still own the entire business that is Microsoft: whatever it is that becomes of a cloud development platform (Azure), software as a service (Office 365 and Dynamic CRM), home entertainment (XBox, Kinect, XBox Live), etc., etc. Hmm… maybe Mr. Ballmer has presided over some innovation.

If those are the available investment dynamics, one could certainly do much worse. Perhaps that is exactly Mr. Einhorn’s point. If you buy Microsoft today, you likely get the above investment dynamics. You also get a free call option on Mr. Ballmer’s departure.

The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this blog will come to pass. Investing in the stock market involves the potential for gains and the risk of losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.

A complete list of recommendations by Grey Owl Capital Management, LLC may be obtained by contacting the adviser at 1-888-473-9695.

Claims of the “Death of Stock Picking” Are a Good Sign for Value Investors

A recent Wall Street Journal article highlights the macro-driven nature of today’s stock market. In it, long-time value investors lament the current environment where stocks appear to trade in unison based on unemployment data or European bank stress test results. If stocks are driven by macro factors instead of individual company fundamentals, stock pickers can’t get an edge. Market strategist James Bianco of Bianco Research asserts “stock picking is a dead art form.” Macro hedge-funds are opening at a rate equivalent to that of traditional stock funds and the big asset management firms are even launching macro mutual funds.

We think stock-picking is very much alive. In fact, we recently wrote a 20-page investment guide that details a bottom-up approach for today’s environment. Call us contrarian, but we couldn’t think of a better sign than this article that fundamentally-driven, bottom-up stock-picking is likely to make a comeback sooner rather than later. Didn’t the commodity bubble burst right around the time that the asset management firms were rolling out a new commodity fund or ETF every week? Moreover, didn’t “the death of equities” cover stories in the early 1980s signal the start of a 20+ year bull market for stocks?

The Wall Street Journal article presents data that shows the correlation of stocks in the S&P 500 between 2000 and 2006 was 27% – quite a bit of disparity indicating undervalued stocks could appreciate and overvalued stocks could depreciate as opposed to trading up or down in unison. The article also points out that correlation spiked to 80% during the credit crisis and again more recently during the European sovereign debt scare. As these issues petered out, correlations never dipped below 40% and today hover around the mid 60s. However, the article does not point out the length of time over which the correlations were measured – days, weeks, months?

The time period over which the correlation is measured is critical. “Time arbitrage” has proven to be a very effective investment strategy. Who cares if individual stocks are correlated over days and weeks when your investment horizon is years? Glenn Tongue (one of the Ts in T2 Partners along with Whitney Tilson) highlights this fact in a recent appearance on Yahoo! Finance. Like us, the partners at T2 believe buy-and-hold stock picking is far from dead. Mr. Tongue also makes a critical point about matching the duration of the investment strategy and the investors. This is why we work very hard to ensure our investors understand our process before they become clients.

Don’t misunderstand our view. We agree the data shows a significant increase in correlation between individual stocks (and we witness this as we watch the market and our individual names on a daily basis). We also agree that the macro backdrop driving the market will remain for some time. The over-leveraged PIIGS, US federal and local governments, and the US consumer will likely take years to adjust to sustainable levels. In addition, the massive government intervention in fiscal and monetary policy does not appear to be subsiding with Bernanke and company preparing for QE2’s maiden cruise. (We have discussed these issues at length in several of our recent quarterly letters.) The market will certainly react to macro factors over short time periods, but that doesn’t mean significantly undervalued stocks or significantly overvalued stocks won’t gravitate toward fair value over a longer period of time.

In our recently published investment guide titled How to Prosper in Volatile and Range-Bound Markets we detail the strategy we are employing to deal with the current environment. We believe a concentrated portfolio will be more likely to outperform – a few deeply discounted names that are returning capital to investors (via share repurchases or dividends) and that also have a catalyst can outperform even if the majority of the market moves in unison. In addition, the flexibility of corporations to deal with macro shocks (be they slower growth, inflation, government regulation) means equities have a better chance of outperforming government bonds, currencies, or commodities (areas macro funds are more likely to play in). Finally, we think valuation-based timing will be more important than it has been for traditional stock pickers. While Japan’s macro-driven market now trades at close to a quarter of its peak value 20 years ago the market experienced four rallies and five sell-offs of greater than 30% over that period. That type of volatility creates terrific opportunities for value investors to increase exposure as the macro shock of the day creates fear and to pare exposure as the fear fades away.

For a more detailed overview of our approach, you can download our full 20-page investment guide here: www.greyowlcapital.com

On Buffett’s Berkshire Primer

This past Saturday, Warren Buffett released Berkshire Hathaway’s 2009 annual report and his annual letter to Berkshire shareholders.* The last Friday in February has become like Christmas Eve for value investors the world over. A night of tossing and turning is followed by a mad rush to the computer to download the latest version at 8am on Saturday morning. And then, maybe 30 minutes later, melancholy as we all realize that Mr. Buffett won’t write to us again for 365 days. As admirers of Mr. Buffett, frequent shareholders, and practitioners of the “value” approach to investing, you could count us among the sleep deprived on February 27^th.

Given Berkshire’s recent (and massive) acquisition of Burlington Northern Santa Fe, Mr. Buffett chose to make this year’s letter a primer on the various Berkshire business lines, as well as his value-oriented approach to investing. Here are a few thoughts on areas we found particularly interesting:

Berkshire’s stated book value was $84,487 / share (page 3). Investments totaled $59,034mm with a cost basis of $34,646. If one were to mark these investment to market and then subtract 20% for capital gains taxes (estimate of federal and state), Berkshire’s book value is just over $97,000 / share. As of the close on March 2, 2010, the stock traded at $121,740 or 1.26x “adjusted” book value.
Mr. Buffett has always shunned excessive leverage and talked about its many risks. He often admits that during good times the company’s equity might underperform more leveraged entities. “Sleeping well at night” is the reason he usually provides for this strategy. True enough, but 2008 demonstrated that over a full cycle, low leverage entities such as Berkshire can outperform because they are able to provide liquidity precisely when no one else can and in doing so receive outsized compensation. As he writes on page 4 of the letter, “When the financial system went into cardiac arrest in September 2008, Berkshire was a supplier of liquidity and capital to the system, not a supplicant. At the very peak of the crisis, we poured $15.5 billion into a business world that could otherwise look only to the federal government for help.”
The 17^th century philosopher Frederic Bastiat spoke of “what is seen and what is not seen” in regards to the unintended consequences of laws on the economic sphere. Mr. Buffett recognizes similar risks in over handed management and thus promotes an organizational approach at Berkshire that is as laissez-faire as the political approach recommended by Bastiat. On page 5, Mr. Buffett states, “We would rather suffer the visible costs of a few bad decisions than incur the many invisible costs that come from decisions made too slowly – or not at all – because of a stifling bureaucracy.”
In the Insurance section beginning on page 6, Mr. Buffett states the two critical aspects of the insurance business: 1) fairly unique in business, insurance operates on a “collect-now, pay-later model” and thus requires “negative” working capital – called “float” and 2) because enough people have recognized how favorable these economics are, the insurance industry as a whole operates at an underwriting loss. Berkshire offers shareholders a unique proposition: the firm has demonstrated an ability to invest the “float” in a very profitable way AND because of the superior managers and compensation structure the Berkshire insurance companies operate under, the firm has consistently operated at an underwriting profit.
In the Utilities section, which begins on page 8, Mr. Buffett provides insight into why Berkshire is now willing to own such capital-intensive business when in the past they avoided them. Two explanations are given: 1) today, Berkshire is so big that Mr. Buffett has no choice but to look at opportunities he would have passed on before and 2) given the regulated nature of utilities, Mr. Buffett seems to believe that he is trading some investment upside for greater certainty. This makes sense to us. Other investors and financial writers (including Whitney Tilson) have articulated a third possibility: because Berkshire pays a “negative” rate on its borrowings (i.e. “float”) investments that would be unprofitable for others can be profitable for them.
The housing market makes its way into the letter on page 12 in the Finance and Financial Products section. Given the lowest-in-fifty-years 2009 housing start number, Mr. Buffett believes that “within a year or so residential housing problems should largely be behind us.” While he is correct in stating that 2009’s 554k starts is well below the 1.2mm annual housing formation number, we think his optimism might be a bit premature. The recession has probably lowered the annual housing formation number and published inventory numbers are too low when bank “real estate owned” is considered.
Mr. Buffett then discusses the structural problems at Clayton Homes that are a result of the government’s housing finance policy. The government artificially lowers the interest rate for conventional mortgages. Therefore, when financing is considered, a traditional home can be cheaper than the manufactured houses sold by Clayton. Mr. Buffett doesn’t say this but this is another example of Bastiat’s “not seen.” It also reminds us that in the current climate, government interference must be a part of the investment calculus.
Berkshire is unlikely to experience the damaging impact of “group think.” In describing Berkshire’s derivative contracts, Mr. Buffett (on pages 15 and 16) assures shareholders that these contracts neither expose Berkshire to extreme leverage nor to counterparty risk. “If Berkshire ever gets in trouble, it will be my fault. It will not be because of misjudgments made by a Risk Committee or Chief Risk Officer.”
Mr. Buffett concludes the financial section with a well-deserved excoriation of financial company CEOs and directors. However, regarding his defense of investors against the “bail-out” claim, we offer one final quibble with Mr. Buffett. He states, “Collectively, they [shareholders of the largest financial institutions] have lost more than $500 billion in just the four largest financial fiascos of the last two years. To say these owners have been “bailed-out” is to make a mockery of the term.” If he is using the term “owners” very explicitly, then, with the exception of Bear Stearns shareholders, perhaps he is correct. However, he leaves out the fact that bond holders of these same insolvent institutions, who knowingly assumed the risk of capital loss, were in fact bailed out to the tune of hundreds of billions of dollars and made whole by taxpayers.

That wraps up the highlights as we see them. However, the whole letter is well worth reading and it is available here: http://www.berkshirehathaway.com/letters/2009ltr.pdf

*This discussion should not be construed as a recommendation to buy or sell Berkshire Hathaway.

The Deeper the Slump, the Stronger the Recovery?

In September, (seemingly perma) bear Jim Grant announced his bullish turn in the Wall Street Journal. He summarized the core of his argument by quoting Michael T. Darda, chief economist of MKM Partners. We repeat the quote here: “The most important determinant of the strength of an economic recovery is the depth of the downturn that preceded it. There are no exceptions to this rule, including the 1929-1939 period.”

Mr. Grant continues by pointing out that inhospitable government action does not provide a reasonable argument against a snap-back, as the mid-30s showed four years of close to 10% annual expansion despite Roosevelt’s anti-business activities. In addition, the combination of government fiscal and monetary stimulus this go-around is 19.5% of GDP compared to the average recessionary government response that has measured just 2.9% of GDP.

Mr. Grant finds himself in good company. Close to the market trough in April 2009, Ben Inker of GMO published a piece titled “Valuing Equities in an Economic Crisis.” The crux of this piece is that it is relatively easy to value a broad index given the long-term stability of the economy. The US economy has always gotten back to its long-term growth trend following recessions, including the Great Depression. Mr. Inker points out that the 1929 25% fall in real GDP “was a fall in demand relative to potential GDP, not a fall in the economy’s productive capacity, and so the economy eventually got back onto its previous growth trend as if the Depression had never happened.”

These arguments certainly have merit. Not only do they come from some of the investment world’s preeminent thinkers, they also make logical sense. However, from an investment process standpoint they highlight a common analytic error: focusing on experience versus exposure. (This is the same analytic error that led people to believe that because country-wide housing prices had never fallen on an annual basis, they never would.)

Which leads us to ask the question, what is our exposure if we follow this line of thinking? Most importantly, these analyses focus on the US economy. (Mr. Inker does make reference to the rebound of Japan and Germany post WWII, but not much detail is provided and like the US period cited, these were 20th Century industrialized economies.) Interestingly, Samuel Brittan wrote a piece a couple of weeks ago in the Financial Times saying “Goodbye to the pre-crisis trend line” citing an IMF analysis that included a much broader swath of global recessions. Mr. Brittan points out that this analysis tells a far different story from Mr. Grant’s and Mr. Inker’s: “much of the loss of output in a severe recession is permanent and that the economy never gets back to its old trend line.”

In conclusion, while Mr. Grant and Mr. Inker may be proven correct and the US may experience an extraordinarily powerful recovery to match the recent downturn, making a binary investment decision based on that hypothesis does not take into account one’s exposure. (If looking beyond the US, it does not even appear to take into consideration experience.) With total US debt still at very high levels and anemic fixed private investment (to name just two systemic issues), betting on a strong economic recovery based solely on the depth of the slump does not appear to us to provide a necessary “margin of safety.”