Tweet

The Pia Lord Show-Warren Buffett Principle #4

Guest post by: Pia Lord

Article Overview: Does Warren Buffett remain true to his 13 owner related business principles as Berkshire Hathaway looms larger and more powerful in capital accumulation and allocation? Or has Warren Buffett indulged his own wishes and fantasies in his latest Railway Company purchase. Pia Lord reviews the Owner Related Principle # 4 found in the Berkshire Hathaway Annual Report 2008.

The Pia Lord Show-Warren Buffett Principle #4



Berkshire Hathaway in Principle #4 strives to own a diversified group of businesses that generate cash and have an above average return on capital. Their second preference is to have the insurance subsidiaries purchase marketable shares of stock of similar businesses or parts thereof. Furthermore, the price and availability of businesses and the need for insurance capital determine any given year’s capital allocation.

Now clearly this particular goal is unique to companies with large amounts of cash and little or no debt on the books. Although many people purchase stocks to buy into successful companies, few make the size of purchase which would constitute a majority stake in a company.

So lets take a closer look at Mr. Buffett’s statement for his Principle # 4. Consider first that Mr Buffett says that Berkshire Hathaway wants to own businesses that generate cash. In terms of owning companies, Berkshire Hathaway has 10 Insurance Businesses and 67 Non-Insurance Businesses. The insurance businesses range from consumer offerings, re-insurance, liability insurance for commercial enterprises and more. The 67 non-insurance businesses cover a wide spectrum from jet airplane share-ownership and airplane training technology to chocolate, world book, furniture, jewelry, ice cream, underwear, shoes, water systems, vacuum cleaners, energy companies, financial services and more. All in all the total number of employees in 2008 amounted to 28,188 for the insurance businesses and 246,083 for the non-insurance businesses. These companies have varying years of ups and downs in generating cash for Berkshire Hathaway holding company. The excess cash that these companies “throw off” goes to Berkshire Hathaway for Warren Buffett and Charlie Munger to invest. “Throw off’’ is a term that Warren Buffet uses in the 2008 annual report. I assume that he means that each of the companies that generate excess cash over and above their expenses or some profitability level goes to Berkshire Hathaway corporate.

Then he mentions the terms parts of businesses that generate ‘above average returns on capital”. By this I believe Mr. Buffett means purchasing shares in other companies that do well, as identified by him, on an annual basis overtime. Looking at the Berkshire line up for 2008, Berkshire Hathaway owns more than 64 % of the Marmon Company stock which in this year, is about the largest percent ownership of a stock holding that is on BH books. Now in 2010, his purchase of Burlington Northern Santa Fe is most likely his biggest purchase of an entire company.

Surprisingly enough though, this purchase does seem to run counter to Warren Buffett’s interest in acquiring debt free businesses. Since in this acquisition, a significant level of debt was acquired.

It seems that Warren Buffett is catering to some boyhood fantasies in making this sweepingly grand purchase of the railroad. Even Moody’s stock rating did trim Berkshire Hathaway stock to a AA- rating from a AAA.

Perhaps though this purchase is something that Berkshire Hathaway can handle though with no apparent afterthought. After all, what should they care about Moody’s rating, they barely blink an eye. Since Berkshire Hathaway has so many billions sitting in premiums from its insurance companies. They subsequently invest these and enjoy the income from these.

Related Articles
  Lesson #3: Enjoy The Process
  Investor\'s Insight: How Buffett Created an Empire
  Warren Buffett Owner Principle # 3
  Lesson #2: Keep Your Wits About You
  Lesson #4: Make People Your Priority
  Berkshire Hathaway's 2006 Chairman's Letter
  Lesson #1: Be Honest With Yourself
  Lesson #5: Stick To Your Guns
  Investment Whiz Kid: Buffett Amasses a Fortune
  The Oracle of Omaha: Warren Buffett is Born
  Warren Buffett and his Effect on the Stock Market!
  LEADERS NEVER EFFORT TO LOSE IT……
  Common Pitfalls in Buying a Business - Buyer Overpays
  Warren Buffett and the Longterm Principles of Investment
  YOU GET WHAT YOU GIVE-Warren Buffet Business Principle # 10
  Entrepreneurs, Investors Alert For Berkshire Investment Opportunity
  Sanctity of Life, God and Religion
  Joyce Hall Quotes
  What do I need to know when I am buying a Business?
  Honesty is Still the Best Policy

Article Tags: annual report, berkshire hathaway, business education show, business principles, capital accumulation, fantasies, pia, principle, railway company, warren buffett
Referred by: http://jaykubassek.com



Related Forum Posts
Re: Just a simple comparison & contrast of our truths in crisis. - I I totally agree you have to be extremely grateful. I am extremely grateful because I have all my body parts complete, look all the people that don't. Look at all those soldiers that honoring their country go to war get killed. Believing in their cause not only now but threw out history that never left no children. We all must be Thankful for those that helped our loved ones the old ancestors that were so wise in been abundant and fruitful that left us a body to live in. Man and how blessed are we can you imagine how many people never had children or couldn’t and we are the lucky descendants of the ones that could. Come on now bless be the Lord Almighty King and Lord of heaven. By just existing you should be humbled and eternally meek for such success. A sacred quote from a very wise woman If that is not enough, look at all the sperms that fought for your place and you’re the winner. I wish I could have reached that Billionaire with this or any person thinking that it is a great shame and people should mourn and be sensitive to that evil that won and prevent it from happening again. A person in that position or any alive would have influence allot more people before going. But unfortunately you do not know what you have until you don’t have it. That’s why it is wise to be close to your creator the founder while you can.
Re: Quote of the Day - "The best way to pursue happiness is to h - This is the bible quotes that nailed it on the head. You are rewarded for helping others "because you know that the Lord will reward each one for whatever good they do, whether they are slave or free." New International Version (NIV)
Re: Blog sells for up to $15 million - Okay. I'm in. How do we, as EvanCarmichael.com members, work together as a group to start a business blog with some niche focus that we can all contribute [u:yn1bfylm]quality[/u:yn1bfylm] content to (like the quality of the $15 million blog) to eventually attract the interest of a $15 million buyer? We can then sell it and split the limelight and the proceeds! ;-] Forgive me, Evan, if you already have such a blog started on your site! The Mastermind Principle. Can we put it into practice? GT :-]
Re: Blog sells for up to $15 million - [quote="GT Bulmer":23fizvat]Okay. I'm in. How do we, as EvanCarmichael.com members, work together as a group to start a business blog with some niche focus that we can all contribute [u:23fizvat]quality[/u:23fizvat] content to (like the quality of the $15 million blog) to eventually attract the interest of a $15 million buyer? We can then sell it and split the limelight and the proceeds! ;-] Forgive me, Evan, if you already have such a blog started on your site! The Mastermind Principle. Can we put it into practice? GT :-][/quote:23fizvat] GT, I am game. Let set up a committte to get the blog rolling. But which niche are we writing about?
How about discussing Costco's biz model?? And CEO - Here's a recent article that covers both.............. Costco: The 'anti-Wal-Mart' The warehouse-club retailer 'has figured out the big, simple things': Hold down expenses and prices, treat employees well, make discount shopping fashionable and keep shareholders happy. By Barron's "Membership has its privileges." That slogan belongs to American Express, but it might better apply to Costco Wholesale, the leading warehouse-club operator in the U.S., whose determination to deliver value and innovative products to its 23 million members has made it one of the country's top retailers. Costco (COST, news, msgs) has succeeded by flouting industry norms. The big-box retailer charges customers a base yearly fee, now $50, to shop in its sprawling stores, which offer quality goods at low markups. Consequently, its margins are among the slimmest in retailing. The privileges also extend to employees, who are paid well and enjoy generous health-care benefits. This formula has generated fierce loyalty among both shoppers and workers while rewarding long-term investors. Costco shares, which traded Thursday around $58, are up from a split-adjusted price of $1.67 when the company went public in 1985. True, they no longer are dirt-cheap, but in view of the company's superior management and opportunities for growth, neither are they rich. Small businesses are big customers at Costco, but the company also has managed to make discount shopping fashionable for affluent Americans by offering fine wines, books and big-screen televisions at low prices, and staples such as paper towels and razor blades in bulk. By offering one-time specials like discounted Prada bags or Callaway golf clubs at individual outlets, Costco has created what it calls a "treasure-hunt" atmosphere in its stores. Not the Wal-Mart way Costco is among a handful of retailers that has flourished despite Wal-Mart Stores' (WMT, news, msgs) onslaught; Wal-Mart's more downscale Sam's Club chain runs second to Costco. With its strong labor relations, low employee turnover and liberal benefits, Costco has been called the "anti-Wal-Mart." Its approach has paid dividends because Costco, based in Issaquah, Wash., hasn't encountered the same community resistance as Wal-Mart when it has sought to open stores. "Retailing isn't rocket science. Costco has figured out the big, simple things and executed with total fanaticism," says Charles Munger, a Costco director for the past 10 years. The outspoken Munger, 82, is better known as Warren Buffett's longtime partner at Berkshire Hathaway (BRK.A, news, msgs), where he serves as vice chairman.Crucial to the chain's success is CEO Jim Sinegal, who co-founded Costco in 1983 with Jeff Brotman, the company's chairman. "Jim would be on any intelligent list of the top 10 retailers of the past century," Munger says. Sinegal, 70, also is one of the biggest bargains among big-company CEOs: In an era of seven- and eight-figure pay packages for CEOs, Sinegal earned a salary of $350,000 in Costco's latest fiscal year, which ended in August. He garnered other compensation of about $100,000. What's more, Sinegal got no bonus last year, after the company determined that it had failed to measure properly the appropriate date for certain option grants from 1996 to 2002, although no evidence of fraud or falsification of records was found. "Jim wouldn't let the board give him a bonus. His view was that the option glitch happened on his watch," Munger says. "How many people behave like that? No wonder everyone loves him." Unlike Buffett, who draws a salary of just $100,000 as the CEO of Berkshire, Sinegal isn't a billionaire. He owns Costco stock worth about $135 million and has options on 1.2 million shares. Sinegal's compensation and demeanor offer a welcome contrast to former Home Depot (HD, news, msgs) CEO Robert Nardelli, who alienated employees with his autocratic style and whose gargantuan exit package of $210 million didn't sit well with shareholders. Video: Behind the scenes at Costco None of this has been lost on the investment community. At nearly $58, Costco trades for 22 times fiscal 2007 projected earnings of $2.58 a share. It has one of the highest price-earnings ratios among major retailers. Target (TGT, news, msgs) shares, at nearly $63, trade for 17 times estimated 2007 earnings, while Wal-Mart, at $48, commands 15 times projected 2007 profits. Though some retailing analysts deem Costco shares expensive, the company seems to qualify under one of Buffett's investment dictums. Buffett has said he'd rather buy a good business at fair price than a fair business at a good price. Berkshire owned 5 million Costco shares at the end of September. Growth and more growth This is a genuine growth story. Earnings per share have increased at a 12% annualized rate in the past five years. Neil Currie, a retailing analyst at UBS Securities, believes the company is capable of generating 13% growth in earnings per share in the next few years and an even higher rate if it gets more aggressive in repurchasing shares. The bullish Currie carries a 12-month price target of $66. With large annual buybacks, Costco could earn more than $4 a share in fiscal 2010, Currie estimates. That could support a stock price of $80. The company plans to open 36 to 40 stores in the current fiscal year and about 35 annually in subsequent years. The store base totaled 474 on Dec. 31, including 371 in the United States. Costco says domestic and international markets ultimately can support more than 1,000 stores. Outside the U.S. and Canada, the most promising markets are likely Mexico, the United Kingdom and Japan. Costco's merchandise sales in its most recent fiscal year rose 14% to $59 billion, while membership fees generated $1.2 billion in revenue. This year, sales are expected to rise more than 10%, reflecting lower prices for gasoline. Sales at stores open at least year, a key gauge of retailing success, were up a healthy 8% in fiscal 2006. Could the company be a candidate for a leveraged buyout? Costco does possess some of the key characteristics that private-equity players seek. It has a strong balance sheet, a predictable cash flow and a durable franchise. Its market value is a hefty $26 billion, but LBOs of that size are doable these days. Costco bought back $1.5 billion of stock in its latest fiscal year and $400 million in the quarter that ended Nov. 30. But it has resisted a large debt-financed buyback like the one under way at Home Depot, and to date it hasn't sought to raise funds through the sale of its real estate. The company takes pride in its impressive financial condition. "Have we gotten to the point in America that balance-sheet strength is a negative?" Munger asks.Currie argues that Costco could keep LBO operators at bay by launching a more aggressive buyback program and taking on a moderate level of debt. "The best way for Costco to protect its independence is to have a high multiple on its stock," the analyst says, adding that an augmented buyback would help achieve that goal. He believes Costco comfortably can repurchase $2 billion or more of stock annually. The dividend yield on the stock is a low 0.9%. Most income from members' fees Its cooperativelike operation makes the retailer's business model unusual. In its latest fiscal year, Costco generated pretax income of $1.75 billion, about 70% of which came from membership fees. An additional $125 million was kicked in by the interest income on the company's cash. Costco earned just $400 million from its stores, for a retailing operating margin of less than 1%. The low margin is intentional and reflects the company's commitment to low prices. As a matter of corporate policy, Costco refuses to mark up any product by more than 15% above its cost. When the company signed a new contract in 2005 with a supplier for Brooks Bros.-style men's cotton and button-down shirts, and got a significant price reduction for a massive two-year order, it immediately cut the price of the shirts to $12.99 from $17.99, notes Richard Galanti, Costco's chief financial officer. Other retailers might have phased in the reduction and captured added profit, but that's not the Costco way. The shirts now cost $14.99 because they are made with better-quality cotton. One attraction in the eyes of a potential buyer would be the opportunity to lift margins. Costco leads Sam's Club in most financial measurements, including total sales, sales per store, sales per square foot of retail space and sales per employee. But Sam's operating profit margin of 3.5% tops Costco's 2.8%. Some complaints on Wall Street If Costco were to raise its margins to Sam's level, it would translate into an additional 65 cents a share of net income -- a large amount relative to the current-year consensus estimate of $2.60 a share. Sinegal has talked in the past about lifting Costco's margins to 4%, but little progress has been made. This has led to some criticism on Wall Street. An analyst report in December, after Costco reported its fiscal-first-quarter profits, was entitled "Still No Margin." Galanti says management has no interest in going private. "The public model has worked for us. We have no plans to change," he says. Video: Behind the scenes at Costco Many Costco shareholders are also happy with the current situation. "Costco refuses to be undersold and thinks so long term that the company will not even remotely degrade the value it gives customers, even if it would fuel a healthy increase in margins and earnings and very few customers would notice," says Ken Charles Feinberg, a co-manager of the Davis New York Venture Fund (NYVTX) and Selected American Shares (SLADX), both run by Davis Selected Advisors. "That's how a great management builds a great business franchise that's built to last." The Davis funds are Costco's largest shareholder, with a 12% stake. Feinberg says that Costco's effective valuation is lower than its stated price-earnings ratio because of the company's conservative approach to depreciation. He recently calculated that Costco trades for about 16 times his projection of calendar "owner earnings." This profit measure adds to operating earnings depreciation expense in excess of what is needed to maintain the existing store base. Feinberg believes Costco is a "compelling bargain" for long-term investors. Sinegal doesn't talk much to Wall Street and wasn't available to speak with Barron's. Even at 70, he maintains a grueling schedule. He aims to visit each Costco store twice a year and is about 70% successful in that goal, Galanti says. This means he's on the road 40 to 45 weeks a year. Costco executives jokingly refer to Sinegal's weekly travels as a "death march" because he usually begins each day at 7 a.m. and finishes at 10 p.m. Dressed in sneakers, khaki pants and Costco's now-$14.99 button-down shirts, Sinegal asks store managers what's selling, what's not and how Costco prices compare with the competition. He has no set plans to retire, although he has talked casually about holding the job for five more years. Because he hasn't set a retirement date, there is no heir apparent. But Costco has a strong group of managers who share Sinegal's passion and vision. Unlike most CEOs, Sinegal has no severance or golden parachute in his contract, which runs less than a page. He insists on one-year contracts, believing the Costco board should have the opportunity to evaluate him annually to determine if he's still up to the job. Sinegal's view is that the restrained terms of his contract send an important message to employees. In the view of Berkshire's Munger, one of Costco's great strengths is that its two founders, Sinegal and Brotman, are still active. Brotman, 64, focuses on real estate. "There is no better site acquisitor in the retailing industry," Munger says. "I'd like to see Jeff get more credit. He deserves it." Costco has chosen to focus on more affluent coastal markets; California alone is home to 30% of its stores. Finding sites for new outlets in densely populated areas is one of Brotman's specialties. The company features products that offer its members large cost savings over what they would pay at traditional retailers. The chain carries just 10% of the items in a typical supermarket, which might stock 40,000 products.The formula works. Costco sold 1.5 million TVs last year and has successfully built what it calls ancillary businesses such as prescription drugs and eyeglasses, filling 26 million prescriptions in 2006. Hungry Costco members bought 63 million hot-dog-and-soda combinations last year at in-store snack bars -- priced at only $1.50 and with free soda refills. The dogs are even kosher. Costco's customer-focused strategy is apparent in its 87% membership-renewal rate. The retailer allows returns on nearly all items at any time, with no questions asked; computers are the lone exception. It doesn't even need to see receipts. This liberal policy has proved costly in the past year because the company is seeing returns of an unusually large number of big-screen TVs. Analysts suspect that many members are taking advantage of the sharp drop in TV prices to return models bought in the past 12 months so they can buy new ones at lower cost. Costco said it is evaluating its TV-return policy but emphasizes that no change will be retroactive and that it still plans to maintain the industry's most generous return policy on electronics. Low turnover among employees Workers get a relatively good deal at Costco -- a point of emphasis for the company, which contends it's also a matter of good business. Despite fewer stores, Costco's sales are about 50% above those of Sam's Clubs, and sales per employee are about $500,000 a year versus $340,000 at the Wal-Mart unit, UBS' Currie calculates. Sinegal was asked in a recent Bloomberg TV interview about the company's health-care benefits. Costco provides health insurance to its 93,000 domestic employees and pays 90% of the cost, which runs about $6,000 annually per employee. Video: Behind the scenes at Costco "We're 100% committed to maintaining this program," Sinegal said. "It works for us, and our people count on it. We think they're entitled to that security." Costco has one of the lowest turnover rates in retailing. Among employees who have been with the company for at least a year, just 6% leave annually. That may be because store employees such as cashiers can earn more than $40,000 a year after only four years on the job. Costco shares aren't a bargain at current levels, but patient investors could be rewarded because the company is an industry leader with top-notch management, a loyal customer base and solid growth prospects in the U.S. and abroad. In Street-speak, Costco may be "under-earning," meaning its profit margins are lower than they need to be. Management is loath to tinker with a successful formula, but margins probably have only one way to go: up. In time, the shares are likely to follow. This article was reported and written by Andrew Bary for Barron's


Share this article with your friends. Fund someone's dream.

Leave a comment below or share on the left and you'll help support entrepreneurs in Africa through our partnership with Kiva. Over $50,000 raised and counting - Please keep sharing! Learn more.

Newsletter

Get advice & tips from famous business
owners, new articles by entrepreneur
experts, my latest website updates, &
special sneak peaks at what's to come!

Name:
Email:

Popular Articles

Web Design in 30 Minutes - Can this be Right?

Four Secrets to Earning Income as an Author

••••••>SEO Tip Of The Day: HTML Validation

Suggestions

Email us your ideas on how to make our
website more valuable! Thank you Sharon
from Toronto Salsa Lessons / Classes for
your suggestions to make the newsletter
look like the website and profile younger
entrepreneurs like Jennifer Lopez.