Same to you Joe. Happy Holidays!

Value Rules!

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happy x-mas !

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Kala Christouyenna?

I didn’t expect a wish in greek while reading about stocks on Christmas day…..

Greetings from Athens/Greece Joe.

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Happy Christmas and New Year brother of mine!

What a great website – keep the perspective coming. It is changing my brain and plans.

Manny Grimaldi

Louisville, KY

UNITED STATES OF AMERICA

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Hey Joe,

I hope you are having a nice holiday season.

I wasn’t sure where to post this, so I suppose this is as good a place as any. Why do you think Buffett purchased Kraft even though it does not show an upward trend in owner earnings (similar to CPB which you mentioned in another post) and has a mediocre ROE? Also, why is it that some companies seem to have a moat (ex. brand name with KFT and CPB) but their earnings don’t increase? (In contrast to KFT, a very similar company, GIS shows an upward trend in earnings, perhaps suggesting that a moat is present). Is there simply a problem with management?

On a related thought, why didn’t Buffett buy GIS, which-to my inexperienced eye-seems to be a better purchase due to its increase in earnings and high ROE? Thank you very much for your excellent website/thoughts.

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Hope everyone is having a good Christmas and has a better 2009. I just got back in town from my own personal holiday travel Odyssey, which I won’t bore you with, except to say it had a happy ending.

A lot of what happened in 2008 had been obvious to me for a long time. That’s the problem right there, the phrase “for a long time”, makes this awareness almost useless. I was able to shield myself somewhat, but like many value investors, I jumped in too early on a few issues. Although I always found myself to be more cautious and even negative than most, I was not negative enough and got optimistic too soon. I did manage to avoid the biggest traps, such as financial and home builder stocks, as well as anything with any sizable debt. Still, I find little comfort in knowing I’ve done a little better than most as down is down, regardless of how the other guy is doing.

The good news is that I still like all but one of my stocks and like them for the long term. Almost all pay some kind of dividend and one pays a hefty one, so that helps. I expect 2009 to be almost as challenging as 2008 has been, but I’m still optimistic and feel pretty secure in the knowledge that I’m truly investing, with the appropriate time ranges and not trading like so many other “investors”.

Once again, happy holidays to all and thanks to Joe for this wonderful site and to all who contribute to the conversation here.

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Joe, as always, you and FWallStreet (which is you) are the best. Happy holidays to you and the Ponzio ladies. Stay warm in Chicago.

Niel, the Kraft purchase is pure Buffett — a la Philip Fisher, Benjamin Graham, John Burr Williams, and Charlie Munger (the four greatest influences on Buffett).

Kraft is the ultimate hedge against an uncertain economy, with predictable results and compounded returns. It is not (and will never be) the darling of Wall Street, because, as you note, growth is absent. Not only is ROE flat, ROA is flat, as well … and so is owner’s earnings. When owner’s earnings contribute to owner wealth to the tune of $5 trillion per annum and discounted cash flows indicate the company is fairly valued, it becomes an attractive investment. In other words, it has all the sexiness of a CD reliably paying $5 trillion.

So, why is it consistent with Graham (the father value investing) and Fisher (the father of growth investing) at the same time? Well, in the case of Graham, it has abundant reliability. Recall that Graham lost his shirt in the crash of 1929 and, thereafter, sought to purchase demonstrably cheap stocks (net-nets). While Kraft is not a net-net stock, it has what Graham valued in stability. Beyond working on Wall Street, Graham taught investing at Columbia University (where Buffett met him). Buffett wanted to learn from Graham after reading Graham’s “Security Analysis.” While there is much in that seminal text on valuing companies, the first half is devoted to valuing bonds, and, thereafter, taking many of the same concepts and applying them to stocks. Kraft is as much bond as stock, which means that Buffett can identify its intrinsic value with reasonable assurance … even in today’s mercurial market.

The connection to Fisher is more nuanced. Fisher favored growth stocks to the point of paying a premium for them because of their CAGR (compounded annual growth rate). In other words, Fisher was less interested in securing Graham’s margin of safety as he was interested in pursuing the miracle of compounding. While Kraft isn’t growing a rates Fisher would find attractive, it is compounding (or, more accurately, contributing to owner wealth at rates sufficient for the owner to generate a compounded return).

John Burr Williams, as a Ph.D. candidate at Harvard, wrote his dissertation on the time value of money — creating discounted cash flow analysis. Using Joe’s DCF spreadsheet, KFT is worth $26.66 and is selling for $26.64 (roughly fair value). Interestingly, the stock has $17.23 in accumulated equity of $26.401 trillion … adding an addition $5 trillion in owner’s earnings per year. So, the investor is paying $9.41 ($26.64 minus $17.23) to earn a $3.26 ($5 trillion divided by 3.8 million shares), for a investor-realized return on investment of 34.69 percent.

The Charlie Munger side is the willingness to pay a fair price for an excellent company (a la Coke).

That, at least, is my take on the KFT purchase. I should note that the company is rebounding, as well. Last year, it posted an Altman Z-score of 2.19 — now 3.43. Note, as well, that the stock declined just 20 percent off its highs versus the S&Ps decline in excess of 40 percent since September of this year. So, the stock is stable, the company is stable, and the return on investment is attractive. It is pure Buffett … wish I had seen it when he did (didn’t buy then), but, now that you’ve brought it to my attention, it is time to dive into the financials more thoroughly.

Robert

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Awesome Post Robert! I couldnt have summarized it any better!

Also, remind yourself that, Kraft’s commodity costs have risen so much that profits havent been able to match organic growth. On the other hand, their ability to offset costs with price increases due to their moat is truly valuable! However, in the short-term the effects mean stagnant “growth” but still holds great promiss over the long-term. This is where Wallstreet’s pessimism on the stock’s prospects gets fudged over by Wall-street (including panic about commodity prices).

You mentionned that the growth rate wasn’t significant. That is true yet its not comparing apples to apples in some sense because the future is more important than the past.

Here are some developments which WILL(or did) affect the outcome:

- The organization was part of a larger company pre-2001. Thus, operations have suffered during re-organization). Kraft managed to keep stable earnings during this whole process.

- There’s a new CEO/chairman who has over 20 years of experience and has held various positions in kraft. She is very much a maverick in her own right (Buffet’s ideal candidate, which might be something he likes.

-There has been re-structuring of operations for the past 3 years for, Kraft is updating its business model and they have created more reliable and distinguishable business units. The point being that they will re-wire Kraft for Growth.

-Kraft has bumped dividends TREMENDOUSLY within the last few years. Management certainly showed intelligence IMO for acknowledging that investors would be MUCH better served in the meanwhile if earnings were re-distributed. (current yield at 4.31%)

-Finally, check out their 14DEF , you will see that Kraft’s management eat their own cookings:

1) CEO (12X salary in stocks) 2) Rewards for lower level managers based on individual units

3) Top-managers compensation changes:

-awards based on ORGANIC GROWTH (revenue,freecashflow,operating margin)

To conclude, lets not forget that Growth depends on THE FUTURE!

Happy Holidays!

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Hey Robert and Amrit,

I agree with both of your qualitative thoughts about KFT, and I think the restructuring was a key factor in Buffett’s decision to buy KFT since, like Amrit says, growth depends on the future (and Kraft’s CROIC of 5% should improve due to the restructuring). As for the quantitative analysis of KFT, I end up with an estimate of a 15% return (purchase around $27) if we assume 10% growth (using DCF analysis and 25% Margin of Safety). I end up a return of about 13% for GIS if we dial growth back from 19.2% (median) to 10% (like Kraft) if you purchase around current prices of $58. At the time of Buffett’s purchase however, I believe, the differential in projected return/price would be greater (since GIS earnings were less but KFT’s were approx. the same), so KFT may have looked substantially more attractive.

However, I don’t believe you can subtract the equity value from your purchase though when calculating the investor realized return on investment. It would make sense to me to subtract cash and cash equivalents from your purchase price; however, the accumulated equity you refer to is responsible for generating owner earnings. Therefore, it seems like “double counting” if you both subtract the equity (as if the assets are sold and proceeds are distributed to shareholders) and count the earnings (which are dependent on the assets). (Although, I think that you could, I suppose, assume the company liquidates at some point in time (say 10 to 20 years from now) as Pabrai does.)

Thoughts?

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Amit, thanks for the insights. As mentioned, I’m still early in my analysis of KFT, and they are most helpful.

Niel, much to consider from your response, as well. Let me address the double counting issue and leave some of the rest to germinate.

The way I looked at it last evening was to figure that the investor is breaking even on that portion of the cost attributable to equity. In other words, you are immediately getting a dollars worth of company for a dollar invested, up to the limit of accumulated shareholder’s equity. This means, it is an even exchange on day one, even though it is not an even exchange when taking into account the time value of money. I’ll return to this foregone capital in just a second, but, setting that aside temporarily, the return on investment for the owner’s earnings portion then takes on a more significant role, and it is that portion of your investment that renders a 34 or 35 percent return in year one. What this does is it teases out the return on owner’s earnings.

Now to the double counting of shareholder’s equity and the foregone return on capital tied up in the dollar-for-dollar exchange. You are absolutely correct, but I see it from a marginally different perspective and suspect Buffett does, as well. Personally, I view it as an opportunity cost, where the tied-up funds should be viewed in light of their alternative uses (not something mentioned in my previous comment, in an effort to keep things simple). This is where Buffett’s frequent comparison to the risk free cost of capital (RFCC) comes into play — where RFCC is normally considered the yield on the 10 year treasury –, and it is why I suspect Buffett might agree with my perspective on this. If you subtract out the RFCC return on that portion of the investment matching shareholder’s equity per share you avoid double counting … sort of. Even then, it is necessary to take into account the tax benefits of investing in the 10 year bond (i.e., the opportunity cost). That, however, still falls marginally short of parity, if you believe you can consistently and reliably achieve returns exceeding the RFCC. Assuming you can not (most delude themselves into believing they can), you would subtract the RFCC yield times shareholder’s equity per share, and then apply the tax benefit. In the case of KFT, that reduces the return from 35 percent to 31 percent or so. Even at that rate, the return is attractive and the double counting represents a marginal effect (which is why I chose to “keep it simple.”)

That small effect is a function of the low interest paid on the RFCC, however. If RFCC were higher, the adjustment would be larger. This raises an interesting question concerning use of RFCC — namely, whether employment of a buffer is justified. RFCC represents the rate today. Tomorrow it will be a little higher or lower. Next year, the difference may be more substantial. As buy and hold investors (waiting for the market come its senses and make us rich), should we apply a buffer to the RFCC yield if expecting to wait three to five years for intrinsic value to be realized? It seems to me that arguments can be made on both sides of this question, and I am not wedded to either. I suspect Buffett would argue that this is not rocket science (i.e., the laws of physics are not at play, so precise calculations represent a delusional exercise), and, therefore, it is better to leave this moderate measure of uncertainty to Graham’s abundant-margin-of-safety requirement.

Amit, you indicate the stock is undervalued by 13 percent using DCF and provide the criteria. For mine calculations, I used zero percent growth in the first decade, 5 percent in the second decade, discount at 15 percent, and apply a required 50 percent margin of safety. The most significant difference in our calculations is the margin of safety, and you can argue in support of either rate. Given Kraft’s established brand (moat), 25 percent seems reasonable. That appears to be the rate Buffett used when valuing JNJ (another established company with a strong moat) [See Joe's assessment of Buffett's logic on JNJ]. Kraft, however, is a new spin-off, and we lack a full decade’s worth of data. Moreover, these are, indeed, Black-Swan days in the broader market. For both reasons, I’ve chosen to apply the larger margin of safety. In fact, I’ve entirely eliminated DCF from consideration in most of my investing, given today’s uncertainties surrounding free cash flow growth rates and the question of whether the US economy will experience its own “lost decade.”

As for the question of whether and how to consider dividend yields, these strike me as uncertain as free cash flow growth rates in the current economy, and, besides, not taking them into account just adds to the margin of safety. This doesn’t mean they are insignificant, however. Instead, they simply represent proceeds that are deployable at the company’s discretion (either sent to shareholders or plowed back into the company’s coffers to catalyze further growth or to keep creditors happy). Regardless of their use, they serve to benefit the investor. In fact, when dividends are not paid, I incur no taxes (which serve to lower the effective utility of the dividends paid).

Finally, the CROIC rate is the one disconcerting aspect of KFT. They need to get that up in order to provide a buffer in a suspect market. The general rule of thumb is to demand a 13 percent CROIC. At 5 percent, another leg down in the market could prove problematic. Recall that the crash of ‘29 was in fact several successive crashes. This is the problem with global crashes (versus a normal recession or a single-country crash). This (CROIC) is something Joe has written about several times (and with greater clarity than any other educator on the web). That 13 percent and the use of rolling median of three-year and five-year free-cash-flow medians in the use of DCF, however, assumes what amounts to a normal distribution in the prior data (10 years if using Morningstar.com). In other words, it assumes the presence of a boom and bust in the prior decade; serving as the basis on which to derive a notional growth rate — from which to subsequently adjust downward (see Joe’s comments concerning the magnetic pull of weighted average cost of capital or the cost of production on, both, CROIC and FCF.) All of this is reasonable, but it doesn’t assume a 100-year flood — where the market retracts by as much as 80 percent. That is why the 15 percent discount rate, the 50 percent margin of safety, the use of medians in estimating FCF growth, and the downward adjustment Joe advocates are so important … and, even then, it may not be enough to accommodate that exceedingly rare 80 percent decline … but it will limit the downside risk significantly.

Now, you may argue that market crashes are so rare as to be ignorable in every year but this one … or 2001 or 1987 or the whole of the 1970s or … you get the point. Because ours is now an international market (post-WTO), the interconnectedness of the markets and the added complexity of the system increases the risk and frequency of “outlier” events — making the Gaussian tails fatter. This is Taleb’s argument in “The Black Swan,” and it is important because it runs counter to what we have all been taught (namely, that an international market is a diversified market and diversification reduces risk). And this further supports using a 50 percent margin of safety versus a 25 percent MOS — regardless of the company’s strong history and admirable character.

Thanks,

Robert

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Hey Rob, thanks for the feedback

btw I believe your assumption of 50% MOS is a smart idea! Looking back, I do realize the Mr. Graham had became much more conservative in his assumptions post 1929. He definately wasn’t wrong for doing that as time proved later on. Kraft is a recent spin-off (unproven somewhat).

In my view, it is more speculation than “sound investment operation promissing safety of principal” because the price paid at 27$ is highly dependent on considerable growth (from the restructuring “promiss”). But all investment is anyways so I can be absolutely wrong…

My DCF valuation is simple as follows:

if we project from a FCF of 2 billion dollars(historically has been higher than this in past 5 yrs)

growth of 12% 15% disc, 25% MOS = Price 2 pay = $26.85 (no share-bb/dilution)

The discount rate and the MOS should shield your principle somewhat as long as kraft grows …say 5-6% at least. (im just guessing here).

If you don’t have comfort in your premise(which will be based on qualita/quantita factors)

then there’s no way you would waste your time because you outta be “sure” they will grow AT LEAST half of the growth rate your using. (an aproximation).

If someone invests in Kraft at say 25$, he’s banking that the company will grow more than 0-5% in the long-term (or say at least 6%) or ELSE it would be a mistake to be investing in the first place. But there’s also the opportunity that owner earnings does grow at say 9-12% in the long-term.

Not saying he’s right at all, but Buffet must be seeing “through the past numbers” and based on the qualitative factors, his wisdom allows him to set forth a confidence on an approximate but useful price range to buy. I don’t see Buffet making it to see his investment fructify(unfortunately) but he sure has alot more to lose now than he ever did by speculating on the future of a spin-off: his reputation for picking excellent opportunities would be scrutinized after his passing.

Just my 2 cents… Happy Holidays guys… New year is coming, celebrate!

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On your last point of this post: you don’t have to own stocks.

As you scan the headlines in the near future about various endowments, pensions, and foundations losing their shirts in 2008 and cutting their 2009 operating budgets, return and reflect on this point. Notice in these articles the equity allocations and think on Joe’s point. It is one of most misunderstood axioms of investing that risk-return is linear or even parametric. Nonsense! It’s a shell game of: find the leverage.

There’s an interesting article published by the hedge fund group Bridgewater Associates. It is written by their founder Ray Dalio titled “Engineering Targeted Returns and Risks” at http://www.bwater.com/Upl... I think that in the last Forbes 400 Dalio was in the top 50 or so. Maybe the top 20.

Some of it may draw a “Ha-rumph” from the crowd regarding financial engineering and the use of leverage as a boondoggle. However, the interesting points are related to Dalio’s discussion of “The Optimal Beta Portfolio” on page 2. I quote: “Since the risk-adjusted returns of asset classes are broadly similar (and not reliably known), and since their expected returns are greater than that, of cash, the expected return and risks of these asset classes can be made similar and adjusted to deliver returns closer to your target by using leverage or leverage-like techniques.” Essentially, what this means is that when you strip out the implied leverage of “riskier” asset classes like equities, private equity, and real estate the returns are similar for all asset classes. Thus an extreme overweight to equities just exposes you to greater equity asset class volatility.

I’ll leave it to you to decide the applicability of this article, but it does play to the point that you don’t just have to own stocks nor should you. This does not mean, however, that if you are a great analyst and can pick stocks (particularly uncorrelated workouts) that you shouldn’t be 100% allocated to stocks.

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Hello Mr. Crawford,

I’m new to this website and don’t know Kraft Foods (KFT) at all, but I’m really wondering about your math….

“Interestingly, the stock has $17.23 in accumulated equity of $26.401 trillion … adding an addition $5 trillion in owner’s earnings per year. So, the investor is paying $9.41 ($26.64 minus $17.23) to earn a $3.26 ($5 trillion divided by 3.8 million shares), for a investor-realized return on investment of 34.69 percent.”

I am unaware of any other definition for “trillion” except the US 1,000,000,000,000 or 10^12, and the UK 1,000,000,000,000,000,000 or 10^18. I’m believe you mean billion, with a “b”, and not the UK 10^12, but the US 10^9. KFT has a current market cap of $39.08B, that’s $39,080,000,000.

By the way, $3.26 is not $5 trillion divided by 3.8 million shares.

$5 x 10^12 /( 3.8 x 10^6 ) = 1.3 x 10^6, that is, not $3.26, but $1.3 million.

Even if you do mean *B*illion, it is still $1300. This is a long way off.

After this you’ve lost me completely. I can’t even guess what you are trying to say.

Thank you in advance for your re-edit.

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Adam,

First, please call me Robert.

Second, the errors you note are correct. Allow me to provide what I believe are the accurate numbers (which I invite you to check).

Price/Shr $26.60

- ShE/Shr $17.23

Premium Paid $9.37

RFCC Adjustment $10.55

at 12.6%

OE/Shr $2.50

Adj OE Yield 23.73%

The intent is to recognize that accumulate shareholder’s equity lacks the uncertainty associated with a wager on future cash flows. In other words, the shareholder’s equity per share portion of the share price amounts to a dollar paid for a dollar earned. The remainder is the premium the investor is paying for future earnings (net of the cost of funds tied up in purchasing the shareholder’s equity). This allows the investor to look at yield for owner’s earnings in comparison to the premium, but it requires that the opportunity cost with purchasing shareholder’s equity be accounted for. So, the premium would be increased by the investor’s required return (or, alternatively, shareholder’s equity should be reduced accordingly), before calculating the owner’s earnings yield on the premium. Even at 23.73 percent, among the universe of investment candidates Buffett can consider, this return is attractive.

Robert

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Hey Neil,

I havent investigated General Mills(GIS) in-depth at all but simply by spotting 4.5 billion of cash spent on sharebuybacks at those high prices (last 4 years) makes me wonder if management is having a party or what…

they’ve retired aprox 30 mill shares oustanding in that time frame.

Someone correct me if I’m wrong

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I have just joined this blog and wish all a better 2009 than 2008. I was thinking about the “what” and “when” mentioned in your message. Being educated in an engineering/science field I love to using cross-training in my thoughts. Having said that Bridges are built to last for a period of time prior to being replaced or (or repaired) they may collapse. The “what” is predictable; the “when” is not. Failure happens and when you least expect it.

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Joe,

“I tried to change my last name to Enroni”

Frigging hilarious…all the best in 2009.

-Crip

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Joe,

Another great post! Thanks for the last year’s wonderful posts and ideas, can’t wait for the next one =)

Anyways, it turns out the Mr. Market awoke in a rather dismal mood these past few days, and I have been waiting to invest a bit (still in college, just thought to try), so I thought of starting to buy soon.

You posted a link to some site that gives you really good FCF data, 5-7 years back I think, but I can’t seem to find that link now, someone care to help me with this one?

Thanks upfront,

Ziv.

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I believe the link you are looking for is http://www.morningstar.com It has the 10-year FCF for companies found under the Financial Statements section after getting a quote for a stock. Hope this helps.

-William

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thanks a lot William,

Just what I was looking for.

Cheers =)

Ziv.

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Cool rational thinking…I like it.

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