Opinion: Warren Buffett will soon tell us what he really thinks about stocks, investing and the coronavirus pandemic -- by Lawrence Cunningham

I would like to summarise what I thought was important while reading the article,  Opinion: Warren Buffett will soon tell us what he really thinks about stocks, investing and the coronavirus pandemic.

Summary:

Φ First, Buffett has been as vocal during this crisis as he has been in others — and his tune has not changed.  For instance, on February 24, as the pandemic gathered lethal force, Buffett sat for an interview with Becky Quick of CNBC. He called the pandemic “scary stuff,” but said it does not alter his long-term outlook or approach — disciplined fundamental business analysis remains vital.

Φ Buffett drew comparisons to the U.S. stock market crash on October 19, 1987 and the credit market panic of September 15, 2008 — from both of which the world eventually recovered.

† 1987 October 19, Black Money:  is the name commonly attached to a sudden, severe, and largely unexpected stock market crash that struck the global financial market system. In the United States, the Dow Jones Industrial Average fell exactly 508 points, accompanied by crashes in the futures and options markets.

†2008 September 15, Global Financial Crisis: The filing for Chapter 11 bankruptcy protection by Lehman Brothers on September 15, 2008 remains the largest bankruptcy filing in U.S. history, with Lehman holding over US$600 billion in assets.

The bank and financial services firm had become so deeply involved in mortgage origination that it had effectively become a real estate hedge fund disguised as an investment bank. At the height of the subprime mortgage crisis, it was exceptionally vulnerable to any downturn in real estate values.

The bankruptcy triggered a one-day drop in the Dow Jones Industrial Average of 4.5%, at the time, the largest decline since the September 11, 2001 attacks.

Φ In the first of those, Buffett said he had never before seen people more “fearful, economically;” that “the economy is going to be getting worse for a while;” and that frozen credit markets were “sucking blood” from the U.S. economy. Things were no better six months later, when Buffett said the economy had “fallen off a cliff” and a turnaround would take time — but that five years later normalcy would return.

Φ In this current crisis, just as in the 2008-09, it is not only impossible to predict daily market volatility, it is impossible to predict how long it will last.

Φ Berkshire’s survival includes maintaining abundant liquidity, meaning Buffett will not allocate all capital to acquisitions or other investments. That is why Berkshire is also actively adding to its already-large cash position: in early April issuing $1.8 billion of yen-denominated bonds and, following an issuance of a €1 billion European debt offering in February.

Φ One unique difference between the crisis now and in 2008-09: Berkshire is just as frozen as every other company in a paralyzed global economy. As Buffett explained on CNBC recently, the construction industry has been stalled — hurting the carpeting business at Berkshire’s Shaw Industries unit and insulation sales at Johns Manville —and retail has been largely closed, hitting Berkshire’s businesses from Dairy Queen to See’s Candies.  Yet again stressing the long-term over the short term, Buffett said: “There’s always trouble coming.  The real question is where are those businesses going to be in five or 10 years.”

Φ “A major catastrophe that will dwarf hurricanes Katrina and Michael will occur — perhaps tomorrow, perhaps many decades from now. “The Big One” may come from a traditional source, such as wind or earthquake, or it may be a total surprise involving, say, a cyberattack having disastrous consequences beyond anything insurers now contemplate.”

Strategy| Guides to Net-Net (Cigarbutt) Investing

This article: Your Essential Guide to Net Net Stocks I found that it's interesting to know the investing strategy of net-net (cigarbutt) that Benjamin Graham advocated and practised. This author has done a great job to share with the readers as to the essential guide to net net stocks. After reading, I would like to highlight the key points of the articles that were shared.

Excerpts

Here's what you can expect in this essential net net stock guide:

1. What Exactly Is a Net Net Stock?

Essentially a net net stock is a low Price to Book stock but where the “B” in the P/B ratio has been stripped of all long-term assets. That's about the easiest way to explain the concept.

Why strip away long term assets?

Stripping away long term assets turns book value into what net net stock investors call net current asset value (NCAV). By focusing only on the NCAV of the company, a net net stock investor is calculating a highly conservative estimate of the company’s liquidation value.

2. Why Are Net Net Stocks So Cheap?

Companies with Market Caps below their NCAV are often very troubled – they’re facing large business problems that investors just don’t think the company can come back from. Sometimes these problems reach to the core of the business, such as a major industry disruption that has all but killed a company’s only product.

It's not uncommon to find companies that have seen their revenue decimated by as much as 90%, and their earnings turn to large losses. If you see a company devastated this way, the last thing you want to do is buy stock in the company. In fact, if a typical investor owns shares in the company, he's very likely to want to dump the investment.

That reaction is understandable. In situations like that, investors have little hope that the company will survive, especially if the firm has debt to pay off. But, not all distressed situations are created equally. Some distressed firms are stuffed with current assets and have little in the way of debt or liabilities. It's these companies that astute value investors swarm in to buy.

The key fact to remember is that Graham's net net stock strategy is focused on assets, not earnings, and specifically current assets. Many firms that have quickly eroding operations still have current assets that remain resilient. If the stock is priced low enough relative to the firm's net current assets, it may constitute a net net stock and be an outstanding buy candidate. In the end, it doesn’t matter if the company continues operations or not since there are a number of ways that the investment can turn out really well.

3. Four Common Ways to Win Big

I want to point out right here that Graham favoured net nets that had positive earnings and were paying a dividend. Having said that, the evidence from academic and industry white papers show that positive earnings aren't really important when it comes to buying net nets and dividends can actually reduce returns. This is partly due to how investors tend to profit by buying net nets.

I’ve found that there are four common ways value investors make money from net net stocks: 

[1] liquidation, 
[2] 3rd party buyout, 
[3] price spike due to good news, and 
[4] recovery in operations.

Obviously, if the company doesn’t have a hope of continuing its business then liquidation is a real possibility. Since net net stocks are purchased so cheap, though, liquidations can ultimately mean a quick cash windfall. In these situations, the company distributes the cash received for the assets directly to shareholders. In a full liquidation scenario, the firm will have to cover its liabilities before distributing anything to shareholders.

A firm can also partly liquidate, selling the assets associated with a money-losing division and then distributing that cash to shareholders. Ironically, while Graham's strategy is based on liquidation value, firms rarely liquidate.

6. Narrow Focus Vs. Broad Focus in NCAV Investing

The discussion above should make one thing fairly clear: investors should really take a broad focus rather than a narrow focus on their investing when it comes to net net stocks.

Investors have to make two mental shifts before they start investing in net net stocks. Focusing on the Balance Sheet over the Income Statement is the first shift, and adopting a broad view of investing is the second.

A narrow focus refers to performance over a short time horizon or focusing on the success or failure of individual stocks. Most value investors focus a lot of attention on what an individual company will do going forward and focus far less attention on how their portfolio is constructed. They end up putting a lot of time and effort into conducting in depth research on individual stocks in an attempt to forecast the future.

Net net stock investors, on the other hand, focus on a few telling characteristics of a company and almost totally ignore qualitative research. This is because net net stock investors know that they are using a mechanical investment strategy and that the success of their portfolio depends on the statistical return characteristics of net nets in general. Net nets as a group have yielded roughly 15% over the market return since the 1930s so, as long as they have selected their net net stocks intelligently, they should see a very similar return on average over their lifetime.

Taking a broad perspective and leveraging the returns associated with net net stocks in general takes a good amount of diversification. How much? The more the better. If you're randomly selecting net net stocks then, according to my university statistics professor, 30 stocks is when your portfolio would start to approximate the population of net net stocks. Graham bought 100s of net nets, but I'm after the highest possible returns.

That means that whenever I buy net nets, I try to buy the highest quality picks. These are stocks that have growing NCAV, growing earnings, no debt, tiny Market Caps, are trading at 50% of NCAV or less, and have PEs of 10x or less. These sort of stocks are as rare as they are profitable. If I can find enough of these companies, then I'd be comfortable holding ten stocks. The further away from this ideal that the stocks available get, the more diversification I demand. I recommend that Net Net Hunter members buy 10 to 20 net net stocks, and never buy average quality net nets. Doing so should drastically increase the returns achieved and help prevent investors from buying into frauds.

Knowledge| Steel Industry

At a Glance:

1. Iron (about 98% of the iron mined each year to manufacture steel) is vital to the global economy as it's a key ingredient in making steel.

2.  In 2018, about 51% of the steel produced went into buildings and bridges, with another 12% used to make automobiles.

3. Overall, iron typically ranks as the third biggest commodities market by dollar value behind oil and gold.

1) Oil

2) Gold

3) Iron

4. The steel industry uses pig iron to manufacture steel.

5. Steel is vital for building the infrastructure needed to support economic growth. Both governments and the private sector use it to construct transportation networks such as:

1) bridges

2) tunnels

3) railways

4) transport-related facilities like gas stations, train terminals, ports, and airports

6. Steel is also vital to the energy industry. Oil and gas companies, for example, use lots of it to drill new wells and for pipelines to move hydrocarbons from production regions to end-users.

7. The renewable energy industry also uses lots of steel.

8. Iron ore is a commodity, its price tends to be highly sensitive to changes in supply and demand. If the global economy slows down or mining companies produce more iron than the steel sector needs, the price of iron ore can plummet. The decline in price will have a direct impact on the profitability of iron ore producers and their stock prices.

Source: <https://www.fool.com/investing/2019/12/14/how-to-invest-in-iron-stocks.aspx>

Investing Philosophy| Pricing Power

Buffett's Testimony

Bondi: Okay. What kind of due diligence did you and your staff do when you first purchased Dun and Bradstreet in 1999 and then again in 2000?

Buffett: Yes. There is no staff. I make all the investment decisions, and I do all my own analysis. And basically, it was an evaluation of both Dun and Bradstreet and Moody’s, but of the economics of their business. And I never met with anybody.

Dun and Bradstreet had a very good business, and Moody’s had an even better business. And basically, the single-most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you’ve got a terrible business. I’ve been in both, and I know the difference.

Bondi: Now, you’ve described the importance of quality management in your investing decisions and I know your mentor, Benjamin Graham – I happen to have read his book as well – has described the importance of management.

What attracted you to the management of Moody’s when you made your initial investments?

Buffett: I knew nothing about the management of Moody’s. I’ve also said many times in reports and elsewhere that when a management with reputation for brilliance gets hooked up with a business with a reputation for bad economics, it’s the reputation of the business that remains intact.

“If you’ve got a good enough business, if you have a monopoly newspaper, if you have a network television station (I’m talking of the past) you know, your idiot nephew could run it. And if you’ve got a really good business, it doesn’t make any difference.”

Bondi: What about any board members? Have you pressed for the election of any board member to Moody’s –

Buffett: No, no –

Bondi: – board?

Buffett: – I have no interest in it.

Bondi: And we’ve talked about just verbal communications. Have you sent any letters or submitted any memos or ideas for strategy decisions at Moody’s?

Buffett: No.

Bondi: In –

Buffett: If I thought they needed me, I wouldn’t have bought the stock.

Financial Ratio| Return on Invested Capital (ROIC)

Regarding the financial ratio, ROIC, I think this article is quite knowledgeable and informative to share with the readers to improve the related knowledge altogether.

Extract

The best long-term investments tend to be companies that can reinvest over and over again at high rates of return.  Those high rates of return attract competitors so you must also understand barriers-to-entry.  But first study how to calculate incremental returns on capital or marginal returns on invested capital (“MROIC”).   

Φ One quick and dirty way is to look at the amount of capital the business has added over a period of time, and compare that to the amount of incremental growth of earnings. Last year Walmart earned $14.7 billion of net income on roughly $125 billion debt and equity capital, or just under 12% return on capital. Not bad, but what we really want to know if we are going to buy Walmart is: 

a) how much of their earnings will they retain and reinvest in the business going forward? and 

b) what will the return on that reinvested capital be?Φ 10 years ago in fiscal 2006, Walmart earned $11.2 billion on roughly $83 billion of capital, or around 13.5%. But in the subsequent 10 years, they invested roughly $42 billion of additional debt and equity capital ($125b invested in 2016 and $83b invested in 2006), and using that incremental $42 billion they were able to grow earnings by about $3.5 billion (earnings grew from $11.2 billion in 2006 to around $14.7 billion in 2016). So in the past 10 years, Walmart has seen a rather mediocre return on the capital that it has invested during that time (roughly 8%).

Φ We can also look at the last 10 years and see that Walmart has retained roughly 35% of its earnings to reinvest back in the business (the balance has been primarily used for buybacks and dividends).

Φ As I’ve mentioned before, a company will see its intrinsic value will compound at a rate that roughly equals the product of its ROIC and its reinvestment rate. So if Walmart can retain 35% of its capital and reinvest that capital at an 8% return, we’d expect a modest growth of intrinsic value of around 3% per year (35% x 8% = 2.8% per year).

Φ This is a really rough measure, and this back of the envelope method works okay with a large, mature company like Walmart.

Φ But what you really want to know is what will the business retain going forward and what will the return be on the capital it retains and reinvests? Of course, there are different ways to measure returns (you might use operating income, net income, free cash flow, etc…) and there are many ways to measure the capital that is employed. 

QL Resources| Is it undervalued? How to justify its valuation.

From The Edge's article: Earnings growth anticipation heats up at QL Resources, I would like to highlight the following points to ponder:

1. Its present share price has already surpassed the 12-month consensus target price of RM 7.52 (based on Bloomberg data). It implied that the market growth rate was an approximately 21% and the analysts had the same consensus that QL Resources could continue to grow the businesses by double-digit year-on-year (y-o-y).

2. If QL Resources can register double-digit y-o-y profit growth of 15% to 20%...it'll be enough to justify its valuation. If assuming the growth of 15% and 20% respectively, it derives the calculated price of RM 5.69 (PE 38.50, PEG 2.57) and RM 7.16 (PE 48.50, PEG 2.43) respectively. 

3. Some investors are buying the stock on the possibility that QL would spin off the subsidiary that houses its Family Mart franchise business for listing. It's the market expectation.

4. QL Resources has been deemed as sustainable staple-based food and generally recession-proof. It's the market perception.

5. AffinHwang Capital expects Family Mart to post its maiden earnings contribution to QL:

FY20: Estimated pretax earnings of RM 24 million

FY21: Estimated pretax earnings of RM 42 million

FY22: Estimated pretax earnings of RM 77 million

For your information, QL's subsidiary, Maxincome Resources Sdn. Bhd. [199601010973 (383322-D)] which runs the Family Mart convenience business. As at 31st March 2018, it registered an operating loss of RM 7,111,561 on the back of  its revenue of RM 75,158,046 (source: CTOS). On 28th August 2018, it had opened 59 outlets if deriving from this, its revenue would be RM 1.274 million per store.

6. AffinHwang Capital puts a 'buy' call with a higher target price of RM 9.30 (from RM 8.50 previously). According to AffinHwang Capital's target price of RM 9.30, it implies a market growth rate of an approximately 27% (PE 62.50, PEG 2.31 but the industry PE 24.90). Does it make sense?

In conclusion, I have nothing to add...

Whether HeveaBoard Berhad is operated by candid and competent management?

Recently, HeveaBoard Bhd's 2Q19 financial result just released and recalled me something related to 1Q19 quarterly result as I did put some comments on KLSE i3 (Search Genghis Hoe if you're interested to know what I commented). 

When reading the Notes to Financial Statements of the respective quarterly reports, I sensed that the management weren't be frank with the problems that they faced and also looking for excuses on the poor financial performance:

Figure 1.0: 2Q16 Quarterly Result

Figure 2.0: 3Q16 Quarterly Result

Figure 3.0: 1Q19 Quarterly Result

Figure 4.0: 2Q19 Quarterly Result

From the above Figure 1.0 to 4.0, it's obvious that the management provided the similar reason while the financial results' release didn't meet the expectations -- why it had a major shutdown for preventive maintenance, couldn't it be avoided during the operation? I'm not sure that whether the management did highlight the 'cyclical factors' during the AGM or any interview before. Would the preventive maintenance be one of the  major business risks?

To recall, let's refer to the past 5-year Financial Highlights to assess whether the management is candid to face the issues and competent to resolve it.

From the past 5-year revenue, it's obvious that revenue FY2018 was plunged by RM 96.58 million (down by 17.74%) and net assets were squeezed by RM 16.69 million (down by 3.65%) as compared to the previous financial year. In hindsight, the management might be aware that its core business operations would be impacted by inherent risks, therefore proposed to venture into King Oyster mushroom cultivation by giving the reason that those residual wastes could be utilised to cultivate the mushroom, in order to create extra income stream in future.

"We select our marketable securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can easily understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at an attractive price."