BERKSHIRE HATHAWAY’S TOBACCO HISTORY PART III
Previously, we examined Warren Buffett and Bill Ruane’s RJR stock investments in the early 1980s. [LINK] [LINK]. The stock was deeply undervalued when they started buying it. But the question remains - How does Warren Buffett decide a potential investment is undervalued?
In 2018, Value Investing World had an interesting article on his analysis method. [LINK] It is not what I expected - unlike a typical security analyst.
FORECASTING THE FUTURE – THE ANALYSTS’ STOCK-IN-TRADE
Almost every analyst begins by trying to predict the future with “Where-we-are-now” as the starting point. This is what I have always done. Isn’t the objective to estimate what the company will look like in the future? Analysts project the company’s sales, earnings, cash flow, balance sheet and other financial information that we deem important, even critical. Then we look at the future cash flows that the company will produce over the next 10 or 20 years and discount that back to see what the return will be based on the price we pay. It looks so neat and precise. But “precision” is not “accuracy.” The more data I pile into my model, the more comfortable I am with the output. But more data do not make my assumptions are better. It is easy to be lulled into believing that I really can tell what is going to happen. Even though I also know that when the future unfolds, it rarely looks anything like my model. Having only a superficial knowledge of the industry being analyzed certainly compounds the problem and makes it difficult to answer the important question – what can go wrong?
THE BUFFETT WAY
Warren Buffett uses a completely different approach. First, he immerses himself in the operating details of the industry and the company whose stock he is considering as a buy. As the article explains, he knows so much about business. He has a wealth of accumulated knowledge from years of reading. Few other analysts have this. He homes in on one or two factors that will decide the success of the investment. And then he looks backward – not forward – at all the historical data, quarter by quarter for every single detail on the company and its competitors. Then his analysis is usually several pages with little hen scratches with all this information that he studies.
The first question he asks, and answers, is, “What can go badly wrong?” If the answer to that question does not raise a red flag, He then asks a second question, “Will this investment give me a 15% return now?” If so, he becomes an investor.
This all sounds so simple – but the genius of Buffett is that he has insights from years of study to answer these questions. He never does a forecast or a spreadsheet because they are irrelevant if he has the first two questions right. If it makes 15% now, the future will take care of itself.
“He is not greedy. He has said for decades, “I want a 15% day-one return on my investment, and then it compounds from there. Ta-da! That is all he has ever wanted, and he is happy with that. Nothing fancy about it. He is a very simple guy. He doesn’t do any DCF models.”
ANOTHER LOOK AT THE RJR DEALS
Once we understand his thought process, his two investments in RJR make great sense.
In 1980, Buffett could see that RJR’s price reflected a modest multiple for the tobacco business. Once he peeled away some reasonable value for the foods, shipping, and oil businesses, he was buying the tobacco business that would instantly return him 100% now, not 15%. Even if he had overestimated the value of the other businesses, he was getting a tremendous margin of safety. The general expectation for tobacco was that it would continue to churn out an ROE of about 19% a year.
He didn’t want the company to reinvest its cash flow for him. He could do a much better job investing the money than RJR management. Over the next four years his investment rose in value, and he was happy with his profit. He did not want the risk the RJR would make another large acquisition and dilute its tobacco earnings. So, he sold.
The RJR PIK bond investment lent itself even better to his simple approach. He asked what could go wrong? The answer was bankruptcy, about the worst outcome imaginable. But once the new owner, KKR, infused $1.7 billion in the RJR balance sheet, the bankruptcy cloud went away for Buffett. Now he could buy the bond with an instant return of 15%, his “hurdle rate.” And in short order, RJR called the bonds, and Buffet realized a 30 % return.
He wisely recognized the folly of junk bonds. I did not. My partner and I bought the bonds while bankruptcy was still a risk. We made a bigger return than Buffett. But it never occurred to me to ask, “What could go wrong?” In situations like this my approach would end in disaster probably half the time. Warren Buffett, examining the same opportunities would probably have a disaster about 4% of the time. And that is why Warren Buffett is worth billions and I am not.
In another post, we will examine in some detail the investments that RJR made and judge them by the Warren Buffett approach to see what he might have thought about them.