Book Reviews, Value Investing

Book Review of Even Buffett Isn’t Perfect

Book review of “Even Buffett Isn’t Perfect: What You Can — and Can’t — Learn from the World’s Greatest Investor” by Vahan Janjigian.

This book has a catchy title. From the title, I initially thought the whole book is dedicated to analysing the mistakes made by Buffett, but it turns out that it is more like 95% of it devoted to what Buffett did right (which most devoted value investing followers would already know by heart), and only 5% on where Buffett went wrong.

One good thing about this book is that it is an easy read, you can finish the book in say an hour. Another good thing about the book is its section on expensing of stock options. It clearly writes down exactly my thoughts on why I don’t think stock options should be expensed on issuance.

Some key points:

  1. Diversification
    • Berkshire’s portfolio is still concentrated despite its size. As of Dec 2006, more than half of its stock holdings are in just 4 companies: Coca-Cola, American Express, Wells Fargo, and Proctor & Gamble.
  2. Asset allocation
    • Even though studies show that asset allocation is more important than security selection, that is more so for short-term returns (e.g. Brinson, Hood, and Beebower’s research conclude that > 90% of variation in quarterly returns over time was explained by asset allocation). If  you are investing for the very long-term (e.g. 30 years), stocks beat other asset classes.
  3. Discounted Cash Flows
    • The book wrote that Buffett uses the risk-free rate to discount projected cash flows, and Buffett believes he does not need to account for risk in the discount rate since he consciously avoids stocks that he considers too risk. From my own reading of past writings of Buffett however, he did acknowledge that he doesn’t just use the risk-free rate, and he apparently does account for risk in the discounting.
  4. Momentum Strategies
    • Narasimhan Jegadeesh and Sheridan Titman conducted a study on momentum strategies and found that investors can generate considerable profits by shorting stocks that had done poorly over the prior 6 months and buying stocks that had been doing well during that same period. This works best for investment horizons of about 12 months.
    • Narasimhan Jegadeesh, Louis Chan, and Josef Lakonishok in a later study found that stocks that did well in the momentum strategy were the ones with the highest (yes highest) P/B ratios and were also the ones with the largest Standardized Unexpected Earnings (SUE). SUE is the difference between a company’s actual earnings per share and the consensus estimate divided by the standard deviation of all the analysts’ estimates.
    • Momentum investing works only on average, and does not work in every single instance. Those who implemented momentum strategies in the late 1990s incurred big losses when they fell out of favour, but they can make profits during the dot-com sell off.
  5. Purchase Prices
    • Forest River was speculated by RV Business to have been bought for more than $800M, just over 0.5 P/S.
    • Iscar Metalworking was estimated to have been bought at 3.6x P/S and 11x P/E.
    • PacifiCorp was bought by Berkshire’s MidAmerican Energy unit for 1.25x P/B. PacificCorp reported ROE of 9.7% for the fiscal year ended March 2006.
    • Russell Corp (sporting goods) was bought by Berkshire’s Fruit of the Loom unit in August 2006 for $600M, which is less than 0.5 P/S. Berkshire assumed about $600M of additional debt.
  6. Mistakes
    • Salomon
      • Salomon traders rigged the U.S. Treasury bond auctions with full knowledge of Salomon’s management.
    • General Re
      • Bought at end of 1998 for $22B, increased Berkshire’s average float from $7B to $23B.
      • Made underwriting losses, raised its rates, causing premiums earned to fall from 2000 to 2006.
      • Had pretax underwriting loss of $1.9B due to September 11, 2001, this increased its cost of float.
      • Buffett gave 3 learning points:
        1. Accept only risks you can properly evaluate
        2. Make sure the risks you accept are not  correlated with one another so that no single event threatens solvency
        3. No matter how profitable, don’t do business with bad people
      • Buffett admitted that he was wrong when he thought General Re was practicing proper underwriting discipline and that reserve policies were conservative.
      • Unwound and shut down General Re Securities, a unit that was engaged in derivatives trading.
    • NetJets
      • Because of shortages of aircraft, NetJets was forced to rely on expensive charter services to meet its contractual obligations. Planes must often be flown empty to pick up a customer (deadhead flights).
      • Had two competitiors Flexjet (owned by Bombardier) and Flight Options (owned by Raytheon) which were more concerned in creating buzz for their planes than making profits.
    • Pier 1 Imports
      • Total store count had increased from 763 to 1074 from fiscal 1998 to 2003.
      • Got killed by specialty retailers (Bed Bath & Beyond, Williams-Sonoma, Restoration Hardware, Pottery Barn, Cost Plus) and megadiscounters (WalMart, Target, Costco).
  7. Expensing Stock Options
    1. Companies must estimate how much options are worth when they are granted (e.g. using Black-Scholes), and expense the full amount on the income statement as the options vest.
    2. If the options are exercised and the company issued Treasury stock (stock that was authorized but not yet issued), the company received money from the employee and didn’t lose any money.
    3. If the options are exercised and the company purchased the shares from the open market, then the company would incur a real cash outflow equal to the market value of the shares minus what the company received from the employee.
    4. If the options are never exercised, there is no net effect to the company.
    5. Hence the true cost of the options depend on whether the options are exercised, when they are exercised, how the company chooses to meet its obligations, and potentially what the share price is at time of exercise. By expenses options early on, the expense can overstate / understate the true cost of the options. When the stock price falls, the true cost is less than what was originally expensed. When the stock price rises, the true cost can be much greater. You run into this problem because the rules require companies to expense options at issuance.
    6. My own view is that if the company always issues Treasury stock, then essentially the company is making money (from what the employee pays) and the shareholders are losing money because of dilution. By requiring the expensing of options at the company accounts, it essentially means that the accounts will show the company to be losing money. This results in the accounts not showing what I believe to be a ‘true and fair’ view. I think what should be done instead is for companies to be required to have a section in their quarterly and annual reports which shows the impact to the company for each of the methods the company can choose to meet its obligations for outstanding stock options, including a sensitivity analysis if the stock price moves up/down by 5, 10, 15, 20%.
    7. Buffett opined that executives should not be allowed to sell the shares immediately after acquiring them through exercising options because they would have lost the incentive to think and act like owners.
    8. One of the problem Buffett highlighted is also that with a fixed exercise price, executives might be rewarded simply for being on the job during a bull market. The book highlighted that Buffett does not oppose a floating exercise price.
  8. Taxation
    1. Liberals argue that those who make more money should pay a greater proportion of their income in tax (i.e. progressive tax rates).
    2. Conservatives argue that if income tax rates are flat, those who make more will pay more. Progressive tax rates reduce the incentive to work hard and be productive, and discourage investment. This slows economic growth, results in fewer jobs being created, and generates less revenue for the government.
    3. Liberals argue it is right for the government to take wealth from those who have substantial estates soon after they pass on.
    4. Conservatives object and point out that wealth is what is left over after taxes have been paid, so it would be wrong to tax that wealth over and over again. This encourages wastefulness and spendthrift behaviors and punishes hard work and frugality.


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