Buffett & Munger on Cost of Capital: Don’t listen to what they say but look at what they do

After bashing David Einhorn for his Consol Energy WACC assumption last week, by chance I read at the very good 25iq blog an article on how Buffett and Munger publicly speak about those things.

Indirectly, this is clearly a slap in my face because even the headline already says it all:


Why and how do Munger and Buffett “discount the future cash flows” at the 30-year U.S. Treasury Rate?

The post summarizes what Charlie and Warren have said over the years with regard to cost of capital and discounting. I try to summarize it as follows:

  • They seem to use the same discount rate for every investment, the 30 year Treasury rate
  • in a second step they then require a “margin of safety” against the price at offer
  • they estimate cash flows conservatively
  • Somehow Buffet seems to have a 10% hurdle nevertheless
  • Buffett compares potential new investment for instance with adding more to Wells Fargo

So if Buffett doesn’t use more elaborated methods why should any one else ? Was I wrong to beat up David Einhorn because he used a pretty low rate for Consol Energy ? Add to this Mungers famous quote “I’ve never heard an intelligent cost of capital discussion” and we seem to waste a lot of time here, right ?

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Book review: “Mister Swatch -Nicolas Hayek and the secret of his success”


This is basically part 4 and a half of my “watch series”. The founder of Swatch Group, Nicolas Hayek who died in 2010 was such an interesting character so I thought it made sense to read this biography.

The biography is unauthorized, Hayek was against it. The author is one of the most well-known Swiss Journalists. I actually read the German version because it was 10 EUR cheaper as hardcover than the English version.

Hayek was born in Lebanon into the “affluent middle class”. He went to Switzerland because he fell in love with a Swiss Aupair girl. His parents would not let marry him because of”low status” of the girl, so he left and went to Switzerland.
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Dear David Einhorn: Why are your interns doing all the cost of capital estimates (Consol Energy) ?

Just to be clear: I have nothing personally against David Einhorn. I am just wondering how he comes up with his underlying valuation assumptions these days.

I already had issues with funding cost assumptions at AerCap as well as his return assumptions for SunEdison.

Now I came across his latest pitch for Consol Energy this week. This is the slide which explains the value of the coal business:

Without going into the other details, the question here is of course: How the hell did he come up with a WACC (Weighted Average Cost of Capital) of 8,4% ?

The WACC is supposed to be the blended total cost of capital of a company, including both, debt and equity. For Consol Energy however the obvious problem is the following: Their bonds are trading at a level of 12-15% p.a. Even if we us an after-tax figure of maybe 8-10%, even the after-tax cost of debt is higher than the assumed WACC.

As the cost of equity has to be higher than senior debt (it is more risky), there is no way in ending up with a WACC of 8,4%. Maybe some of my readers can help me out if I am missing here something, but I am pretty sure that 8,4% is not the right number for Consol’s cost of capital. He uses the same WACC later for the shale gas part of the company, so it is certainly not a typo:

On his website he then explains how they (or his intern) came up with the WACC (slide “A-1”):

consol wacc

The real joke however is to be found a little bit below:

consol 2

Edit: Now that I know that it was meant as a joke it reads somehow different ;-)


So he somehow believes that his WACC is actually conservative.

Let’s look at some “real world” data. This is the overview of Consol’s currently outstanding bonds:

consol bon ex

The average yield based on outstanding amount of Consol’s bonds is 14,5%, a full 11% (or 1.100 basis points) higher than in Einhorn’s calculation. As I have said above, the cost of equity has to be higher than the cost of debt as thee is no protection to the downside. So if we use Einhorn’s quity risk premium of around 6%, we would get cost of equity of around 20,5%.

Based on Einhorn’s weighting, we would get a WACC of (20,5%*0,75) + (15,5%*0,65*0,25)= 17,73%, roughly speaking double the charge that Einhorn uses. You might say this is conservative but in effect it is just realistic and based on current market prices.

Even at issuance, Consol’s cheapest bond had a 5,875% coupon, far above the assumed 3,5%, so it is not even a question of current market dislocation.

Either Einhorn assumes implicitly that cost of capital goes down dramatically or he has some “secret” that I don’t know. If I look at Einhorn’s last pitches, especially AerCap, SunEdison and Consol, there seems to be a common theme: He is always pitching capital-intensive companies with significant debt where he assumes pretty low cost of capital in order to show upside.

So what he seems to do these days is effectively betting on low funding costs which, at least for SunEdison and Consol didn’t work out at all.

In my opinion, this has nothing to do with value investing. Value investing requires to make really conservative assumptions to make sure that the downside is well protected as first priority. For those leveraged, capital-intensive businesses however, the risk that you will get seriously diluted as shareholder in those cases is significant, there is no margin of safety. On the other hand I somehow admire his Chupza. Standing in front of a lot of people who paid significant fees to hear the “Hedge Fund honchos” speak and pitching such a weak case with unrealistic assumptions is brave.

Of course a stock like Consol can always go up significantly after dropping -75% year to date, but the underlying analysis is really flawed. I would actually like to ask him if he really believes in those assumptions or if he just didn’t pay any attention to the details. This would be really interesting.

Maybe a final word on this: I am always criticising David Einhorn on his assumptions. Which is easy because he actually is very transparent about them. Many other Hedge Fund managers just tell nice stories. I am pretty sure that in many cases the assumptions behind those cases are not much better.

Movado (MOV) – Is Fossil’s little cousin worth an investment ?

Movado is the second US-based company specializing in watches (see my previous posts on Fossil part 1 and part 2). The company has a quite interesting history. Cuban Refugee Gerry Grinberg founded the company in the 1960ties basically as a Swiss Watch importer. Later on they actually acquired the rights to the Movado brand with the iconic Museum Watch.

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Some links

Market Folly with notes on all pitches from the “Invest for Kids” conference

You still believe that Operating Cash Flows are a better indicator than earnings ? Well, maybe not at Valeant.

Whole Foods is having a pretty hard time right now, maybe it’s worth having a closer look into ?

Wexboy likes Finish company Saga Furs

A rare glimpse into Baupost Group, especially they way the look at cash (H/T Valueinvestingworld)

Carl Icahn tells his story (8 minute video)

Adjusted EBITDA conquers the world or at least the S&P 500…..

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