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 ?
Well, as a starter, this is one important sentence from Buffett quoted in the post:
We try to deal with things about which we are quite certain. You can’t compensate for risk by using a high discount rate
So yes, if you don’t invest in anything more risky than Coca Cola, then a standard low discount rate makes sense. I will most likely not pay off to spend a lot of time analyzing if Coke’s beta is 0,95 or 0,97.
However if your investment universe is wider, then using just one discount rate can really be dangerous. A classic example for this are for instance the Global P/E comparison charts which always tell you that Russia looks cheap at a P/E of 6. Unfortunately, with a 15% local risk free rate, using a standard 10% hurdle would make even a Russian Government bond look good at least on paper. So how can we solve the issue if one wants to invest across a wider risk spectrum than just blue chip stocks ?
I guess Buffett and Munger sometimes over-simplify what they are doing, especially when they are answering one question after the other in their annual meeting. One hint that Buffet thinks more differentiated about his “true” cost of capital can be found for instance in Berkshire’s 2007 annual report where he comments on his 1993 acquisition of Dexter Shoe:
Finally, I made an even worse mistake when I said “yes” to Dexter, a shoe business I bought in 1993 for $433 million in Berkshire stock (25,203 shares of A). What I had assessed as durable competitive advantage vanished within a few years. But that’s just the beginning: By using Berkshire stock, I compounded this error hugely. That move made the cost to Berkshire shareholders not $400 million, but rather $3.5 billion. In essence, I gave away 1.6% of a wonderful business – one now valued at $220 billion – to buy a worthless business.
So he clearly is aware that the cost of issuing new Berkshire shares is really high. Buffett again used own stock to acquire Burlington Northern with some new Berkshire Stock in 2009:
Buffett, who has long preferred all-cash deals, is paying $100 per share in cash and stock for the 77.4 percent of BNSF shares that Berkshire does not already own.
I am pretty sure that Buffett didn’t discount Burlington’s cash flows with the 30 year treasury rate but thought very hard on how much shares he wants to put into the deal following the Dexter Shoe experience 25 years ago. I think 2009 was also one of the years where Buffett was to a certain extent capital constrained. He saw so much good deals that their return seemed to have outweighed the high cost of his own stockthat he actually did the Burlington deal and offering own stocks.
If I would have a chance to ask Buffett a question I would ask him how he determined how much Berkshire stocks to use in the offer. He must have done some “cost of capital” calculaton back then.
Another hint that Buffett’s investment apporach is much more sophisticated can be easily found a year earlier, when in the height of the financial crisis, he took a stake in Goldman Sachs:
Fabled investor Warren Buffett took advantage of the turmoil in the markets last week to make a shrewd $5 billion investment in the beleaguered but best-run major Wall Street securities firm, Goldman Sachs.
Mr. Buffett’s Berkshire Hathaway, which owns companies in a variety of industries from insurance to candy making, is purchasing $5 billion of preferred stock with a juicy 10% dividend yield. Berkshire also is getting warrants to buy $5 billion of Goldman common stock at $115 a share, $10 below Goldman’s share price when the deal was announced last Tuesday.
This was clearly a more risky deal than normal for Buffett and clearly he demanded more than 10%. The 10% on the Coupon were only the starter, the “juicy part” was getting multi-year,in-the-money warrants for free. Without calculating the values, the warrants will easily have added 5-10% p.a.on top of the preferred coupon, so all in all Buffett required Goldman to pay somewhere between 15-20% p.a. for this deal.
I am pretty sure that Buffett didn’t project cash flows for GS and never tried to estimate the appropriate WACC or so. Nevertheless he seems to have a pretty good idea what he needs to earn on more risky transactions. This is how he explained the transactions in his 2008 annual report:
On the plus side last year, we made purchases totaling $14.5 billion in fixed-income securities issued by Wrigley, Goldman Sachs and General Electric. We very much like these commitments, which carry high current yields that, in themselves, make the investments more than satisfactory. But in each of these three purchases, we also acquired a substantial equity participation as a bonus. To fund these large purchases, I had to sell portions of some holdings that I would have preferred to keep (primarily Johnson & Johnson, Procter & Gamble and ConocoPhillips).
It is also obvious that in times where opportunities are plenty, he is selling existing holding which he deems less attractive than the new investments. Again, his “buy and hold forever” mantra clearly sometime gets overruled by opportunity.
Interestingly, on the same page we find this paragraph which I have actually not noticed before:
I made some other already-recognizable errors as well. They were smaller, but unfortunately not that small. During 2008, I spent $244 million for shares of two Irish banks that appeared cheap to me. At yearend we wrote these holdings down to market: $27 million, for an 89% loss. Since then, the two stocks have declined even further. The tennis crowd would call my mistakes “unforced errors.”
This is another example of Buffett sometimes doing exactly the opposite of what he is saying. For him this 244 mn were a mini gambling position and he lost. In public he will aways argue for concentrating positions and play it safe. He can obviously do whatever he wants but it is also an example not to put everything he or Charlie says as a carved in stone commandment for any value investor.
What you can learn from Buffett with regard to Cost of Capital
Despite Warren being a genius and owning his own multi billion company, I think there is still a lot to learn from him. In my opinion, those are the most important lessons for investors:
1. Do have a rough idea what you need to earn for a given risk profile. For more risky deals, require a higher return
2. Use common sense to determine required returns. For instance the return for a stock has to be higher than the yield of a bond of the same company
3. Try to compare every new potential investment with your old ones. If the old ones look better, then add to the existing ones
4. If the new investment is better than the old ones, it is OK to sell some of the old ones if you don’t have enough cash for the new opportunity
5. Make sure to compare apples with apples, it’s easier if you do only investments with similar amount of risk.
6. Make sure your overall risk profile of stocks matches your own risk appetite as well as those of your investors
7. Keep it simple