A reader of my blog, asked me this question:
“Hi Geoff,
I have actually given this 15% return a lot of thoughts recently. I gathered from various sources, including Buffett's BRK letters, that Buffett always aims for adequate return of 15%. But I am still not sure how to put it into practice.
Let’s take JNJ as an example. If I remember correctly, Buffett bought more JNJ mid last year when the price was around $58. And let me use the most favourable figures from GuruFocus for the sake of this discussion. (In actual analysis, we would of course use the least favourable figures to give us the margin of safety.) JNJ's 2009 FCF is $5.20 per share. Assuming JNJ's earning is growing at 12% p.a., 2010 forecast FCF will be $6.24. So, Buffett's initially FCF yield is 6.24/58 = 10.7%. That's a big step below the 15% hurdle he sets for himself.
So, where did Buffett see the 15% return from JNJ?”
Short Answer: Johnson & Johnson (JNJ, Financial) grows and Berkshire Hathaway (BRK.B, Financial) uses leverage.
Long answer…
It used to be that Buffett wanted to start with a 15% return and have that return grow from there.
See Alice Schroeder’s video and my article about Warren Buffett’s 1959 investment in Mid-Continent Tab Card Company.
Growth
But it's become very difficult for Buffett to get that. If he bought around a 10% free cash flow yield and JNJ was growing faster than the yield on 30-year government bonds, then he probably said that growth was worth something. Think about the preferred stocks the same way. He bought a 10% preferred. How can you make 15% on preferred stocks that pay 10%? Well, both GE & Goldman Sachs gave him warrants. So he had a 10% coupon plus an equity kicker.
That’s a lot like getting 10% today in Johnson & Johnson plus a growth kicker.
Basically, Buffett wants 15% - that's true. But when Buffett buys stocks today we can't be completely sure it's because he sees a 15% return in the future. We can, however, be sure it's the best thing he sees right now – for Berkshire. Obviously there are many better stocks smaller than JNJ but he can't put billions of dollars into them.
I'm not sure Warren Buffett really targets 15% unleveraged returns anymore.
He did in his partnership days. And in the early days at Berkshire. But Berkshire Hathaway is a much, much bigger company than it used to be. The number of stocks he can choose from – the number he can put billions of dollars into – is very small.
And the biggest big cap stocks are a lot less likely to be priced way too cheap.
Every stock study I’ve seen has shown that the world’s biggest stocks are usually the world’s worst stocks in the sense that they tend not to be priced low enough to give you a good initial return on your investment and they tend not to be able to grow fast enough to make a small initial return a big future return down the road.
When bought individually, big stocks may be safe in the sense they’re unlikely go belly up. But, as a basket, they’re simply the worst aisle in the store to do your stock shopping.
But that aisle – the supersized stock aisle – is the place Warren Buffett is stuck doing all his stock shopping these days. So, he’s lowered his expectations:
“The aversion to equities that Charlie and I exhibit today is far from congenital. We love owning common stocks – if they can be purchased at attractive prices. In my 61 years of investing, 50 or so years have offered that kind of opportunity. There will be years like that again. Unless, however, we see a very high probability of at least 10% pre-tax returns (which translate to 6½-7% after corporate tax), we will sit on the sidelines. With short-term money returning less than 1% after-tax, sitting it out is no fun. But occasionally successful investing requires inactivity.”
(2002 Letter to Shareholders)
So, more recently, Warren Buffett said he won't buy a stock unless he sees a very high probability of 10% annual returns.
I assume Buffett means if you buy the stock today and just hold it forever it has a high probability of returning 10% a year. Buffett isn’t a stock flipper. And Berkshire can’t flip billion dollar positions anyway – the media publicizes Berkshire’s reported holdings. So, it’s not even that easy for Berkshire to get into a position without the pricing going against them. Getting into and out of a position would be really tough. And really counterproductive. Because Berkshire has to invest so much capital – with more and more cash pouring in every day – Buffett’s best bet is to buy something he can hold forever. If Buffett finds something he likes with a very high probability of returning 10% a year forever – he’s going to buy it.
I think that's really where JNJ appealed to Buffett. The return on the stock itself looked like it would be 10% or better. And it looked like he could buy Johnson & Johnson for keeps.
Buffett could put a lot of money into it. And he could leave that money there.
And with Berkshire's use of float, Buffett was effectively leveraging up that high probability 10% to a much better than 15% return on equity for Berkshire's shareholders. And this would all be possible because JNJ was only paying maybe 4% out in a dividend. So, 6% of the 10% return was tax deferred (shareholders don't pay taxes on the earnings their investments retain) and the 4% dividend is the only part taxed.
When you look at Johnson & Johnson as a high-probability 10% return on investment with 6% of that return being tax deferred and the whole 10% return being able to be leveraged – an investment in Johnson & Johnson starts to make a lot of sense for Berkshire’s shareholders.
Buffett thought JNJ was attractive because he thinks it has a very good chance of returning 10% from now on and he can keep his money in it without having to reinvest it elsewhere or pay a lot in taxes. When combined with Berkshire's leverage from insurance float, the result will easily be more than a 15% return on equity for Berkshire’s shareholders – especially if JNJ grows from here.
Leverage
Just looking at Berkshire’s balance sheet from its latest quarterly report, I see $363.98 billion in total assets (including intangibles), $154.60 billion in total equity (including intangibles), and $49.20 billion in intangibles. That means Berkshire has $105.40 billion in tangible equity out of a total balance sheet size of $363.98 billion.
That means total assets are 3.45 times tangible equity. So, the company’s return on its total assets – including intangibles – is going to translate into a return on its tangible book value of 3.45% for each 1% return on assets (including goodwill).
If we exclude goodwill, we’d still have a ratio of just under 3 to 1. This is the leverage ratio that matters most in assessing the returns you can expect as a Berkshire shareholder if you buy Berkshire shares at their tangible book value.
If Buffett gets a 10% return on his Johnson & Johnson (JNJ, Financial) stock, the return on tangible shareholder’s equity will be higher, because of this leverage ratio.
Banks that can’t earn 2% on assets somehow earn 15% on equity. How do they do it?
Leverage.
Same with insurance companies.
You don’t want to know how leveraged a life insurer has to be to earn a decent return on its equity. A life insurer is a pebble of equity that’s trying to balance a mountain of assets.
Because of this leverage, if Berkshire can just find stocks – and businesses – that return 10% a year forever, the Berkshire’s shareholder will do fine as long as they don’t buy the stock at prices too far above tangible book value.
If Berkshire can invest in tangible assets – like JNJ – that return 10% a year and Berkshire can make those investments using 3 times leverage, Berkshire can return 15% a year to its shareholders as long as they pay no more than 2 times tangible book value for the stock (10% * 3 = 30%; 30% / 15% = 2).
It isn’t necessary for Buffett to actually find stocks that return 15% a year to provide a 15% a year increase in Berkshire’s intrinsic value.
Now, you might think this invalidates Warren Buffett ’s record. Since obviously lots of people can make 20% a year if they’re leveraged 3 to 1.
Is that all Warren Buffett is doing?
No.
Actually, Berkshire’s stock investments have been about as good on an unleveraged basis as its overall gain in book value. There have been studies of Berkshire’s stock portfolio. And basically they show that Berkshire’s equity portfolio has been the company’s strongest performer.
When Warren Buffett is doing the investing, a stock portfolio becomes a very high return on capital business.
Unfortunately, Berkshire’s stock portfolio is the hardest place to put new money to work. This is especially true as Berkshire increased in size.
Size
The Buffett record is that he basically made 50% a year running something the size of an individual investor’s stock portfolio. See my article Warren Buffett: How to Make 50% a Year in Micro Caps for details. Then Buffett made 30% a year running something the size of a fund manager’s stock portfolio (his partnership). And, finally, Buffett made 20% a year running something the size of a large insurance company’s stock portfolio (Berkshire Hathaway).
Clearly, Warren Buffett ’s unleveraged – or close to unleveraged – returns have declined as the size of his portfolio grew. He made 50% on a small portfolio, 30% on a medium portfolio, and 20% on a large portfolio.
Buffett’s been totally open about this:
“If we were working with $25 million – so we could sort of look at the whole universe of stocks – I would guess that you could find 15 or 20 out of three or four thousand that you would find that were A) selling for substantially less than they’re worth, and B) that the intrinsic value of the business was going to grow at a compound rate which was very satisfactory. You don’t want to buy a dollar bill that’s sitting for 50 cents, and it demands positive capital, and it’s going to be a dollar bill ten years from now. You want a dollar bill that’s going to compound at 12%...And, you want to be around some competent people. Just the same thing as if you went in and bought a Ford dealership in South Bend. The same exact thought processes goes through you mind if some friend called you tonight and said “I’d like you to go into the Ford dealership” or whatever, is exactly the kind of thought as goes through mind about all the other businesses that are in Standard and Poor’s. When I was 20, I went through Moody’s and Standard and Poor’s page by page – twice – because that is it, that’s the universe. The universe is much smaller now, unfortunately.”
Today, Buffett has – let’s call it – 500 stocks to choose from. Well, if he thinks you could find 15 or 20 good stocks in a universe of 3,000 to 4,000 stocks, that means the kind of stock Warren Buffett is looking for is a 1 in 200 rarity.
So, we’d expect there to be 2 or 3 stocks worth buying in Warren Buffett ’s universe of 500 stocks.
And that’s assuming the 500 largest stocks are as efficiently priced as the 3,500 next largest. That’s not what most studies show. And that’s not what Warren Buffett thinks. He found the most mispriced stocks were the smallest stocks he invested in back in the 1950s.
So, in reality, it’s likely that there are – at any one time – fewer than 2 good stocks for Warren Buffett to buy if by good stocks we mean stocks selling for substantial less than they’re worth and compounding at a very satisfactory rate.
So Buffett’s choices are really, really limited. He just isn’t going to find investments that have a high probability of returning 15% a year – unleveraged – in his ideal size range of multi-billion dollar investments.
It’s not that Warren Buffett’s lost his touch. It’s not that he can’t find these sure bets. It’s that they aren’t there anymore. The world of big, big stocks is a world without stocks that offer very high probabilities of very high returns.
Some may offer good risk-adjusted returns. But Buffett isn’t looking for something that pays 100% if it succeeds, costs 100% if it loses, and has a 70% chance of success.
Warren Buffett starts his investment process the same way he always did. He first weeds out the stocks with a risk of catastrophic loss. If there’s a chance of ending up with nothing, he doesn’t make that bet.
After all, Buffett only invested in Goldman Sachs when he thought the government would soon step in and he was guaranteed a 10% dividend ahead of the common shareholders. He didn’t go out and buy Goldman Sachs common stock himself.
Because Buffett is so picky about his investments, Berkshire’s stock portfolio is a place where he can earn good long-term returns. But it’s also a place where he can’t put much money to work. Buffett’s standards are just too high. They’re aren’t many multi-billion dollar stocks that meet his standards of both price and quality.
As a Berkshire shareholder, here’s what you need to know.
Berkshire Hathaway will almost always be able to get the best unleveraged returns in its stock portfolio. However, it will almost always be most difficult to invest new money in the stock portfolio. The reason for both the high returns and the difficulty in putting new money to work is Warren Buffett’s very high standards when it comes to picking stocks.
The truth is that Berkshire Hathaway couldn’t buy all of Johnson & Johnson for the price it paid for its small part of Johnson & Johnson. You get prices on small pieces of a company in the stock market that you can’t get on the whole thing.
Warren Buffett would never have been able to buy 100% of The Washington Post (WPO, Financial) on the terms he bought 10% of it for in the stock market. Buffett would have never been able to buy 100% of Walt Disney (DIS, Financial) on the terms he bought 5% of it for in the stock market.
I want to reprint Buffett’s explanation of both purchases here, because it’s so important to understanding why the stock market offers better returns than you can get buying private businesses – without using leverage. And Buffett explains it so well using two companies everybody knows:
We bought 5% of the Walt Disney Company in 1966. It cost us $4 million dollars. $80 million bucks was the valuation of the whole thing. 300 and some acres in Anaheim. The Pirate’s ride had just been put in. It cost $17 million bucks. The whole company was selling for $80 million. Mary Poppins had just come out. Mary Poppins made about $30 million that year, and seven years later you’re going to show it to kids the same age. It’s like having an oil well where all the oil seeps back in....in 1966 they had 220 pictures of one sort or another. They wrote them all down to zero – there were no residual values placed on the value of any Disney picture up through the ‘60s. So (you got all of this) for $80 million bucks, and you got Walt Disney to work for you. It was incredible. You didn’t have to be a genius to know that the Walt Disney company was worth more than $80 million. $17 million for the Pirate’s Ride. It’s unbelievable. But there it was. And the reason was, 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.’ I don’t care if the earnings are down like that. You know you’ve still got Mary Poppins to throw out in seven more years…I mean there’s no better system than to have something where, essentially, you get a new crop every seven years and you get to charge more each time…I went out to see Walt Disney (he’d never heard of me; I was 35 years old). We sat down and he told me the whole plan for the company – he couldn’t have been a nicer guy. It was a joke. If he’d privately gone to some huge venture capitalist, or some major American corporation, if he’d been a private company, and said ‘I want you to buy into this’...they would have bought in based on a valuation of $300 or $400 million dollars. The very fact that it was just sitting there in the market every day convinced (people that $80 million was an appropriate valuation). Essentially, they ignored it because it was so familiar. But that happens periodically on Wall Street.
And now the Washington Post:
In ‘74 you could have bought the Washington Post when the whole company was valued at $80 million. Now at that time the company was debt free, it owned the Washington Post newspaper, it owned Newsweek, it owned the CBS stations in Washington D.C. and Jacksonville, Florida, the ABC station in Miami, the CBS station in Hartford/New Haven, a half interest in 800,000 acres of timberland in Canada, plus a 200,000-ton-a-year mill up there, a third of the International Herald Tribune, and probably some other things I forgot. If you asked any one of thousands of investment analysts or media specialists about how much those properties were worth, they would have said, if they added them up, they would have come up with $400, $500, $600 million…That is not a complicated story. We bought in 1974, from not more than 10 sellers, what was then 9% of the Washington Post Company, based on that valuation. And they were people like Scudder Stevens, and bank trust departments. And if you asked any of the people selling us the stock what the business was worth, they would have come up with an answer of $400 million…It isn’t that hard to evaluate the Washington Post. You can look and see what newspapers and television stations sell for. If your fix is $400 and it’s selling for $390, so what?...If your range is $300 to $500 and it’s selling for $80 you don’t need to be more accurate than that.
Buffett’s point is that from time-to-time pieces of businesses sell at lower prices than entire businesses sell for in negotiated transactions. As a result of these lower prices, you can get a higher initial return on your investment buying a publicly traded stock than a privately shopped business. Berkshire Hathaway can’t get a 15% initial return on private businesses, because that would mean the owner was selling the company for between 4 and 5 times pre-tax earnings (1/0.15 = 6.67; 6.67 * (1-0.35) = 4.33x).
If you look really, really hard in the stock market – I mean stock after stock day after day – you’ll occasionally find perfectly decent businesses that are being quoted at less than 5 times pre-tax earnings. If that company’s board called Goldman Sachs and said: “Put out the for sale sign” – the bidding isn’t going to start at 5 times pre-tax earnings. Not for a control buyer. But for you, the individual investor, that’s today’s price.
Sometimes. Not often. But sometimes.
And it’s crazy. And it happened in 1930 and it’s going to happen in 2030.
And that’s why the business of buying stocks is a very high return business. Because it’s a business where occasionally you get offered perfectly decent merchandise at crazy, close-out prices.
At first, people think Warren Buffett ’s investment approach is real simple. Then they learn his whole history. His years under Ben Graham. What he did with his own money. How he bought REITS and junk bonds in 2000. How he bought toll bridges and water companies and banks and insurers and now railroads. When people hear all that – when they learn about the cigar butts and Long-Term capital management and so on and so on – they think: “wow, Warren Buffett’s approach is real complicated.”
But it’s not.
If you look at all these things, the special deals on the preferred stocks, the negotiated transactions where he bought family businesses, the buying of Fruit of the Loom out of bankruptcy, or J&J stock today, or Coca-Cola (KO, Financial) 20 years ago, or the Washington Post more than 30 years ago…
It all came down to one thing. He thought he was getting a steal. He thought the other guy was willing to sell something to him for less than it was worth.
It’s that simple.
Buffett thought the combination of a 10% coupon from General Electric (GE, Financial) or Goldman Sachs with some long-term stock options thrown in is worth way more than he paid. He thought the price he paid for his piece of The Washington Post or Western Insurance or whatever was way, way less than the pro-rate price the business would sell for in a negotiated transaction.
Just like Buffett thought Long-Term Capital’s positions were worth more than what he was bidding for them.
My point is just that you don’t need to make predictions of the future, or discounted cash flow calculations, or any of that to understand Warren Buffett ’s thinking.
Buffett is very simple. And very demanding.
When Buffett buys Johnson & Johnson at a 10% initial return on his investment, he knows he’s using leverage and he knows he’s paying less than the thing is worth. If he buys an asset at a discount to the value it would have if shopped around – and he does it with leverage – he’s going to get that 15% return he wants.
Finally, I need to say that the presence of insurance float doesn’t invalidate Buffett’s record.
He made 50% a year on his unleveraged investments in companies like Western Insurance and GEICO and all that. He made 30% a year on his – basically – unleveraged investment partnership. And he made 20% a year on his unleveraged stock portfolio at Berkshire.
So, we’re really talking about two separate questions.
If you’re a Berkshire shareholder, the question is really what the returns to you will look like after leverage has amped up Buffett’s own returns on a stock like Johnson & Johnson or a wholly owned company like Burlington Northern.
For a Buffett watcher, you need to look at the unleveraged return he’s getting. To me, it looks like Buffett’s not getting much better than a 10% initial return in Johnson & Johnson plus the possibility of a growing equity coupon in future years. So, those are the questions to look at for an investor considering Johnson & Johnson.
For an investor considering Berkshire, there are 3 questions to consider:
1. What will Berkshire’s – unleveraged – investments/assets return?
2. How much leverage will Berkshire use?
3. What is the price-to-tangible book ratio you’re buying in at.
I’ll give an example.
It’s not the best estimate or anything like that. It’s just an example to show you how the leverage Buffett uses and the price-to-tangible book value ratio you buy the stock at determines the return you get on your investment in Berkshire Hathaway.
Hypothetically, let’s say…
I expect Berkshire will earn 8% a year on its tangible assets. I also expect Berkshire will leverage its tangible assets 3 to 1. That means Berkshire will earn 24% on its tangible book value. I am buying Berkshire stock at 1.95 times tangible book value today. Therefore, my return on my investment in Berkshire Hathaway stock will be 12.3% a year.
That’s leverage.
And that’s what you need to think about when you decide between directly buying the stocks Warren Buffett buys or indirectly buying those stocks through Berkshire Hathaway.
Do you want an unleveraged – say – 10% return on Johnson & Johnson or do you want a leveraged – say – 15.4% return on your investment in Berkshire’s investment in Johnson & Johnson?
At a 3 to 1 tangible leverage ratio and a stock price that’s 1.95 times tangible book value, a stock that returns 10% if you buy it yourself will actually return 15% if you buy it through Berkshire.
But, obviously, when you buy Berkshire you also get everything Berkshire already owns too. And maybe you don’t want those things. Maybe you’d rather just make an unleveraged investment in Johnson & Johnson yourself.
It’s your choice.
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Also check out: “Hi Geoff,
I have actually given this 15% return a lot of thoughts recently. I gathered from various sources, including Buffett's BRK letters, that Buffett always aims for adequate return of 15%. But I am still not sure how to put it into practice.
Let’s take JNJ as an example. If I remember correctly, Buffett bought more JNJ mid last year when the price was around $58. And let me use the most favourable figures from GuruFocus for the sake of this discussion. (In actual analysis, we would of course use the least favourable figures to give us the margin of safety.) JNJ's 2009 FCF is $5.20 per share. Assuming JNJ's earning is growing at 12% p.a., 2010 forecast FCF will be $6.24. So, Buffett's initially FCF yield is 6.24/58 = 10.7%. That's a big step below the 15% hurdle he sets for himself.
So, where did Buffett see the 15% return from JNJ?”
Short Answer: Johnson & Johnson (JNJ, Financial) grows and Berkshire Hathaway (BRK.B, Financial) uses leverage.
Long answer…
It used to be that Buffett wanted to start with a 15% return and have that return grow from there.
See Alice Schroeder’s video and my article about Warren Buffett’s 1959 investment in Mid-Continent Tab Card Company.
Growth
But it's become very difficult for Buffett to get that. If he bought around a 10% free cash flow yield and JNJ was growing faster than the yield on 30-year government bonds, then he probably said that growth was worth something. Think about the preferred stocks the same way. He bought a 10% preferred. How can you make 15% on preferred stocks that pay 10%? Well, both GE & Goldman Sachs gave him warrants. So he had a 10% coupon plus an equity kicker.
That’s a lot like getting 10% today in Johnson & Johnson plus a growth kicker.
Basically, Buffett wants 15% - that's true. But when Buffett buys stocks today we can't be completely sure it's because he sees a 15% return in the future. We can, however, be sure it's the best thing he sees right now – for Berkshire. Obviously there are many better stocks smaller than JNJ but he can't put billions of dollars into them.
I'm not sure Warren Buffett really targets 15% unleveraged returns anymore.
He did in his partnership days. And in the early days at Berkshire. But Berkshire Hathaway is a much, much bigger company than it used to be. The number of stocks he can choose from – the number he can put billions of dollars into – is very small.
And the biggest big cap stocks are a lot less likely to be priced way too cheap.
Every stock study I’ve seen has shown that the world’s biggest stocks are usually the world’s worst stocks in the sense that they tend not to be priced low enough to give you a good initial return on your investment and they tend not to be able to grow fast enough to make a small initial return a big future return down the road.
When bought individually, big stocks may be safe in the sense they’re unlikely go belly up. But, as a basket, they’re simply the worst aisle in the store to do your stock shopping.
But that aisle – the supersized stock aisle – is the place Warren Buffett is stuck doing all his stock shopping these days. So, he’s lowered his expectations:
“The aversion to equities that Charlie and I exhibit today is far from congenital. We love owning common stocks – if they can be purchased at attractive prices. In my 61 years of investing, 50 or so years have offered that kind of opportunity. There will be years like that again. Unless, however, we see a very high probability of at least 10% pre-tax returns (which translate to 6½-7% after corporate tax), we will sit on the sidelines. With short-term money returning less than 1% after-tax, sitting it out is no fun. But occasionally successful investing requires inactivity.”
(2002 Letter to Shareholders)
So, more recently, Warren Buffett said he won't buy a stock unless he sees a very high probability of 10% annual returns.
I assume Buffett means if you buy the stock today and just hold it forever it has a high probability of returning 10% a year. Buffett isn’t a stock flipper. And Berkshire can’t flip billion dollar positions anyway – the media publicizes Berkshire’s reported holdings. So, it’s not even that easy for Berkshire to get into a position without the pricing going against them. Getting into and out of a position would be really tough. And really counterproductive. Because Berkshire has to invest so much capital – with more and more cash pouring in every day – Buffett’s best bet is to buy something he can hold forever. If Buffett finds something he likes with a very high probability of returning 10% a year forever – he’s going to buy it.
I think that's really where JNJ appealed to Buffett. The return on the stock itself looked like it would be 10% or better. And it looked like he could buy Johnson & Johnson for keeps.
Buffett could put a lot of money into it. And he could leave that money there.
And with Berkshire's use of float, Buffett was effectively leveraging up that high probability 10% to a much better than 15% return on equity for Berkshire's shareholders. And this would all be possible because JNJ was only paying maybe 4% out in a dividend. So, 6% of the 10% return was tax deferred (shareholders don't pay taxes on the earnings their investments retain) and the 4% dividend is the only part taxed.
When you look at Johnson & Johnson as a high-probability 10% return on investment with 6% of that return being tax deferred and the whole 10% return being able to be leveraged – an investment in Johnson & Johnson starts to make a lot of sense for Berkshire’s shareholders.
Buffett thought JNJ was attractive because he thinks it has a very good chance of returning 10% from now on and he can keep his money in it without having to reinvest it elsewhere or pay a lot in taxes. When combined with Berkshire's leverage from insurance float, the result will easily be more than a 15% return on equity for Berkshire’s shareholders – especially if JNJ grows from here.
Leverage
Just looking at Berkshire’s balance sheet from its latest quarterly report, I see $363.98 billion in total assets (including intangibles), $154.60 billion in total equity (including intangibles), and $49.20 billion in intangibles. That means Berkshire has $105.40 billion in tangible equity out of a total balance sheet size of $363.98 billion.
That means total assets are 3.45 times tangible equity. So, the company’s return on its total assets – including intangibles – is going to translate into a return on its tangible book value of 3.45% for each 1% return on assets (including goodwill).
If we exclude goodwill, we’d still have a ratio of just under 3 to 1. This is the leverage ratio that matters most in assessing the returns you can expect as a Berkshire shareholder if you buy Berkshire shares at their tangible book value.
If Buffett gets a 10% return on his Johnson & Johnson (JNJ, Financial) stock, the return on tangible shareholder’s equity will be higher, because of this leverage ratio.
Banks that can’t earn 2% on assets somehow earn 15% on equity. How do they do it?
Leverage.
Same with insurance companies.
You don’t want to know how leveraged a life insurer has to be to earn a decent return on its equity. A life insurer is a pebble of equity that’s trying to balance a mountain of assets.
Because of this leverage, if Berkshire can just find stocks – and businesses – that return 10% a year forever, the Berkshire’s shareholder will do fine as long as they don’t buy the stock at prices too far above tangible book value.
If Berkshire can invest in tangible assets – like JNJ – that return 10% a year and Berkshire can make those investments using 3 times leverage, Berkshire can return 15% a year to its shareholders as long as they pay no more than 2 times tangible book value for the stock (10% * 3 = 30%; 30% / 15% = 2).
It isn’t necessary for Buffett to actually find stocks that return 15% a year to provide a 15% a year increase in Berkshire’s intrinsic value.
Now, you might think this invalidates Warren Buffett ’s record. Since obviously lots of people can make 20% a year if they’re leveraged 3 to 1.
Is that all Warren Buffett is doing?
No.
Actually, Berkshire’s stock investments have been about as good on an unleveraged basis as its overall gain in book value. There have been studies of Berkshire’s stock portfolio. And basically they show that Berkshire’s equity portfolio has been the company’s strongest performer.
When Warren Buffett is doing the investing, a stock portfolio becomes a very high return on capital business.
Unfortunately, Berkshire’s stock portfolio is the hardest place to put new money to work. This is especially true as Berkshire increased in size.
Size
The Buffett record is that he basically made 50% a year running something the size of an individual investor’s stock portfolio. See my article Warren Buffett: How to Make 50% a Year in Micro Caps for details. Then Buffett made 30% a year running something the size of a fund manager’s stock portfolio (his partnership). And, finally, Buffett made 20% a year running something the size of a large insurance company’s stock portfolio (Berkshire Hathaway).
Clearly, Warren Buffett ’s unleveraged – or close to unleveraged – returns have declined as the size of his portfolio grew. He made 50% on a small portfolio, 30% on a medium portfolio, and 20% on a large portfolio.
Buffett’s been totally open about this:
“If we were working with $25 million – so we could sort of look at the whole universe of stocks – I would guess that you could find 15 or 20 out of three or four thousand that you would find that were A) selling for substantially less than they’re worth, and B) that the intrinsic value of the business was going to grow at a compound rate which was very satisfactory. You don’t want to buy a dollar bill that’s sitting for 50 cents, and it demands positive capital, and it’s going to be a dollar bill ten years from now. You want a dollar bill that’s going to compound at 12%...And, you want to be around some competent people. Just the same thing as if you went in and bought a Ford dealership in South Bend. The same exact thought processes goes through you mind if some friend called you tonight and said “I’d like you to go into the Ford dealership” or whatever, is exactly the kind of thought as goes through mind about all the other businesses that are in Standard and Poor’s. When I was 20, I went through Moody’s and Standard and Poor’s page by page – twice – because that is it, that’s the universe. The universe is much smaller now, unfortunately.”
Today, Buffett has – let’s call it – 500 stocks to choose from. Well, if he thinks you could find 15 or 20 good stocks in a universe of 3,000 to 4,000 stocks, that means the kind of stock Warren Buffett is looking for is a 1 in 200 rarity.
So, we’d expect there to be 2 or 3 stocks worth buying in Warren Buffett ’s universe of 500 stocks.
And that’s assuming the 500 largest stocks are as efficiently priced as the 3,500 next largest. That’s not what most studies show. And that’s not what Warren Buffett thinks. He found the most mispriced stocks were the smallest stocks he invested in back in the 1950s.
So, in reality, it’s likely that there are – at any one time – fewer than 2 good stocks for Warren Buffett to buy if by good stocks we mean stocks selling for substantial less than they’re worth and compounding at a very satisfactory rate.
So Buffett’s choices are really, really limited. He just isn’t going to find investments that have a high probability of returning 15% a year – unleveraged – in his ideal size range of multi-billion dollar investments.
It’s not that Warren Buffett’s lost his touch. It’s not that he can’t find these sure bets. It’s that they aren’t there anymore. The world of big, big stocks is a world without stocks that offer very high probabilities of very high returns.
Some may offer good risk-adjusted returns. But Buffett isn’t looking for something that pays 100% if it succeeds, costs 100% if it loses, and has a 70% chance of success.
Warren Buffett starts his investment process the same way he always did. He first weeds out the stocks with a risk of catastrophic loss. If there’s a chance of ending up with nothing, he doesn’t make that bet.
After all, Buffett only invested in Goldman Sachs when he thought the government would soon step in and he was guaranteed a 10% dividend ahead of the common shareholders. He didn’t go out and buy Goldman Sachs common stock himself.
Because Buffett is so picky about his investments, Berkshire’s stock portfolio is a place where he can earn good long-term returns. But it’s also a place where he can’t put much money to work. Buffett’s standards are just too high. They’re aren’t many multi-billion dollar stocks that meet his standards of both price and quality.
As a Berkshire shareholder, here’s what you need to know.
Berkshire Hathaway will almost always be able to get the best unleveraged returns in its stock portfolio. However, it will almost always be most difficult to invest new money in the stock portfolio. The reason for both the high returns and the difficulty in putting new money to work is Warren Buffett’s very high standards when it comes to picking stocks.
The truth is that Berkshire Hathaway couldn’t buy all of Johnson & Johnson for the price it paid for its small part of Johnson & Johnson. You get prices on small pieces of a company in the stock market that you can’t get on the whole thing.
Warren Buffett would never have been able to buy 100% of The Washington Post (WPO, Financial) on the terms he bought 10% of it for in the stock market. Buffett would have never been able to buy 100% of Walt Disney (DIS, Financial) on the terms he bought 5% of it for in the stock market.
I want to reprint Buffett’s explanation of both purchases here, because it’s so important to understanding why the stock market offers better returns than you can get buying private businesses – without using leverage. And Buffett explains it so well using two companies everybody knows:
We bought 5% of the Walt Disney Company in 1966. It cost us $4 million dollars. $80 million bucks was the valuation of the whole thing. 300 and some acres in Anaheim. The Pirate’s ride had just been put in. It cost $17 million bucks. The whole company was selling for $80 million. Mary Poppins had just come out. Mary Poppins made about $30 million that year, and seven years later you’re going to show it to kids the same age. It’s like having an oil well where all the oil seeps back in....in 1966 they had 220 pictures of one sort or another. They wrote them all down to zero – there were no residual values placed on the value of any Disney picture up through the ‘60s. So (you got all of this) for $80 million bucks, and you got Walt Disney to work for you. It was incredible. You didn’t have to be a genius to know that the Walt Disney company was worth more than $80 million. $17 million for the Pirate’s Ride. It’s unbelievable. But there it was. And the reason was, 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.’ I don’t care if the earnings are down like that. You know you’ve still got Mary Poppins to throw out in seven more years…I mean there’s no better system than to have something where, essentially, you get a new crop every seven years and you get to charge more each time…I went out to see Walt Disney (he’d never heard of me; I was 35 years old). We sat down and he told me the whole plan for the company – he couldn’t have been a nicer guy. It was a joke. If he’d privately gone to some huge venture capitalist, or some major American corporation, if he’d been a private company, and said ‘I want you to buy into this’...they would have bought in based on a valuation of $300 or $400 million dollars. The very fact that it was just sitting there in the market every day convinced (people that $80 million was an appropriate valuation). Essentially, they ignored it because it was so familiar. But that happens periodically on Wall Street.
And now the Washington Post:
In ‘74 you could have bought the Washington Post when the whole company was valued at $80 million. Now at that time the company was debt free, it owned the Washington Post newspaper, it owned Newsweek, it owned the CBS stations in Washington D.C. and Jacksonville, Florida, the ABC station in Miami, the CBS station in Hartford/New Haven, a half interest in 800,000 acres of timberland in Canada, plus a 200,000-ton-a-year mill up there, a third of the International Herald Tribune, and probably some other things I forgot. If you asked any one of thousands of investment analysts or media specialists about how much those properties were worth, they would have said, if they added them up, they would have come up with $400, $500, $600 million…That is not a complicated story. We bought in 1974, from not more than 10 sellers, what was then 9% of the Washington Post Company, based on that valuation. And they were people like Scudder Stevens, and bank trust departments. And if you asked any of the people selling us the stock what the business was worth, they would have come up with an answer of $400 million…It isn’t that hard to evaluate the Washington Post. You can look and see what newspapers and television stations sell for. If your fix is $400 and it’s selling for $390, so what?...If your range is $300 to $500 and it’s selling for $80 you don’t need to be more accurate than that.
Buffett’s point is that from time-to-time pieces of businesses sell at lower prices than entire businesses sell for in negotiated transactions. As a result of these lower prices, you can get a higher initial return on your investment buying a publicly traded stock than a privately shopped business. Berkshire Hathaway can’t get a 15% initial return on private businesses, because that would mean the owner was selling the company for between 4 and 5 times pre-tax earnings (1/0.15 = 6.67; 6.67 * (1-0.35) = 4.33x).
If you look really, really hard in the stock market – I mean stock after stock day after day – you’ll occasionally find perfectly decent businesses that are being quoted at less than 5 times pre-tax earnings. If that company’s board called Goldman Sachs and said: “Put out the for sale sign” – the bidding isn’t going to start at 5 times pre-tax earnings. Not for a control buyer. But for you, the individual investor, that’s today’s price.
Sometimes. Not often. But sometimes.
And it’s crazy. And it happened in 1930 and it’s going to happen in 2030.
And that’s why the business of buying stocks is a very high return business. Because it’s a business where occasionally you get offered perfectly decent merchandise at crazy, close-out prices.
At first, people think Warren Buffett ’s investment approach is real simple. Then they learn his whole history. His years under Ben Graham. What he did with his own money. How he bought REITS and junk bonds in 2000. How he bought toll bridges and water companies and banks and insurers and now railroads. When people hear all that – when they learn about the cigar butts and Long-Term capital management and so on and so on – they think: “wow, Warren Buffett’s approach is real complicated.”
But it’s not.
If you look at all these things, the special deals on the preferred stocks, the negotiated transactions where he bought family businesses, the buying of Fruit of the Loom out of bankruptcy, or J&J stock today, or Coca-Cola (KO, Financial) 20 years ago, or the Washington Post more than 30 years ago…
It all came down to one thing. He thought he was getting a steal. He thought the other guy was willing to sell something to him for less than it was worth.
It’s that simple.
Buffett thought the combination of a 10% coupon from General Electric (GE, Financial) or Goldman Sachs with some long-term stock options thrown in is worth way more than he paid. He thought the price he paid for his piece of The Washington Post or Western Insurance or whatever was way, way less than the pro-rate price the business would sell for in a negotiated transaction.
Just like Buffett thought Long-Term Capital’s positions were worth more than what he was bidding for them.
My point is just that you don’t need to make predictions of the future, or discounted cash flow calculations, or any of that to understand Warren Buffett ’s thinking.
Buffett is very simple. And very demanding.
When Buffett buys Johnson & Johnson at a 10% initial return on his investment, he knows he’s using leverage and he knows he’s paying less than the thing is worth. If he buys an asset at a discount to the value it would have if shopped around – and he does it with leverage – he’s going to get that 15% return he wants.
Finally, I need to say that the presence of insurance float doesn’t invalidate Buffett’s record.
He made 50% a year on his unleveraged investments in companies like Western Insurance and GEICO and all that. He made 30% a year on his – basically – unleveraged investment partnership. And he made 20% a year on his unleveraged stock portfolio at Berkshire.
So, we’re really talking about two separate questions.
If you’re a Berkshire shareholder, the question is really what the returns to you will look like after leverage has amped up Buffett’s own returns on a stock like Johnson & Johnson or a wholly owned company like Burlington Northern.
For a Buffett watcher, you need to look at the unleveraged return he’s getting. To me, it looks like Buffett’s not getting much better than a 10% initial return in Johnson & Johnson plus the possibility of a growing equity coupon in future years. So, those are the questions to look at for an investor considering Johnson & Johnson.
For an investor considering Berkshire, there are 3 questions to consider:
1. What will Berkshire’s – unleveraged – investments/assets return?
2. How much leverage will Berkshire use?
3. What is the price-to-tangible book ratio you’re buying in at.
I’ll give an example.
It’s not the best estimate or anything like that. It’s just an example to show you how the leverage Buffett uses and the price-to-tangible book value ratio you buy the stock at determines the return you get on your investment in Berkshire Hathaway.
Hypothetically, let’s say…
I expect Berkshire will earn 8% a year on its tangible assets. I also expect Berkshire will leverage its tangible assets 3 to 1. That means Berkshire will earn 24% on its tangible book value. I am buying Berkshire stock at 1.95 times tangible book value today. Therefore, my return on my investment in Berkshire Hathaway stock will be 12.3% a year.
That’s leverage.
And that’s what you need to think about when you decide between directly buying the stocks Warren Buffett buys or indirectly buying those stocks through Berkshire Hathaway.
Do you want an unleveraged – say – 10% return on Johnson & Johnson or do you want a leveraged – say – 15.4% return on your investment in Berkshire’s investment in Johnson & Johnson?
At a 3 to 1 tangible leverage ratio and a stock price that’s 1.95 times tangible book value, a stock that returns 10% if you buy it yourself will actually return 15% if you buy it through Berkshire.
But, obviously, when you buy Berkshire you also get everything Berkshire already owns too. And maybe you don’t want those things. Maybe you’d rather just make an unleveraged investment in Johnson & Johnson yourself.
It’s your choice.
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