BNI

In April of 2000, we first stepped to the plate and bought Berkshire Hathaway (BRK) and made it one of our larger holdings, where it has remained until last month, when we sold half our position. After a few romantic days alone with the 2009 Berkshire Hathaway Annual Report, and several emails to people we know in the insurance world to confirm for the 32nd time in 20 years what we know and don’t know about insurance accounting, we admit to mixed feelings about both the half we sold and the half we retained. As anyone with even modest investing experience can honestly attest, sometimes it just ain’t easy. What follows is our thought process. In a nutshell, our decision to sell half our position in Berkshire was predicated on a variety of factors, which we will attempt to thoroughly list below. The key driver of our decision is that the stock is at best fairly valued at $83ish per share for the “the little guy” on any number of measures including a sum of the parts basis; a price-to-book value for the whole Omaha enchilada; and a reasonable assessment of normalized “look-through” earnings. There are those who suggest that BRK is still 20% undervalued, but we believe this work contains several flaws, which include discounting Berkshire cash flows at unusually low cost of capital hurdles (Buffett premium, see below), double counting a material percentage of the operating businesses (the majority of which are housed within the insurance companies, not the holding company), and some very fancy assumptions in the valuation of float or the free money that can be generated by the insurance companies and invested profitably. Additionally, some analysis tends to value all Berkshire earnings streams as equal, which is a huge question mark when you consider the current and historical differences between the multiples accorded to financial vs. industrial companies.

In a previous post back in September, ValueExpectations.com provided an analysis of the main holdings from Berkshire Hathaway and how each company was viewed according to The Applied Finance Group’s (AFG’s) valuation model and Economic margin methodology. The 29 top holdings of Berkshire were divided into 3 buckets (Attractive, Fairly Valued and Unattractive) based on how each company ranked according to key AFG criteria including valuation. Thus far each bucket of companies has performed just as expected.

The Applied Finance Group (AFG) has a disciplined approach for identifying companies that are expected to outperform and underperform the market by using proprietary metrics and measurements that have been tested and proven through time. Because AFG’s research is fundamentally derived, AFG’s quantitative analysis spans across growth and value stocks, all sectors, industries, and market caps with over 20,000 covered securities globally.

When searching for Large-Cap ideas, AFG’s Buy/Sell list is a good starting place as it has proven to create a significant spread in performance between companies that come up on AFG’s buy list and those on the sell list. Further focusing on companies based on AFG’s proprietary screening criteria (Economic Margin, valuation, quality of earnings, and management’s ability to create shareholder wealth) will save investors time in their research process. The result is a target group of stocks that can help you outperform as well as identify potential torpedoes to avoid in your portfolios.

Below is a list of attractive companies in the S&P 500 from each major AFG sector (excluding financials). It serves as a focus list of companies for investors to begin with as they meet AFG’s criteria to be an attractive opportunity. They are more likely to outperform their sector peers and the S&P 500, the benchmark that AFG’s clients most often compare themselves with.

Investment Rank within Sector Ticker Name Sector  Opportunity Valuation Signal EM Change Signal  Attractive Large Caps - S&P 500 (NYSE:FCX) FREEPORT-MCMORAN C & G Basic Material Attractive Attractive Positive (NYSE:BMS)  BEMIS CO INC Basic Material Attractive Attractive Positive (NYSE:WAT)  WATERS CORP Capital Goods Attractive Attractive Positive (NYSE:DO) DIAMOND OFFSHRE DRILLING Capital Goods Attractive Attractive Positive (NYSE:OI) OWENS ILLINOIS INC Consumer Durable Attractive Attractive Positive (NYSE:WHR) WHIRLPOOL CORP Consumer Durable Attractive Attractive Positive (NYSE:LO)  LORILLARD INC Consumer Non Durable Attractive Attractive Positive (NYSE:CL)  COLGATE-PALMOLIVE CO Consumer Non Durable Attractive Attractive Positive (NYSE:KSS) KOHL'S CORP Consumer Services Attractive Attractive Positive (NYSE:WAG)  WALGREEN CO Consumer Services Attractive Attractive Positive (NYSE:NEM) NEWMONT MINING CORP Energy and Extraction Attractive Attractive Positive (NYSE:MUR)  MURPHY OIL CORP Energy and Extraction Attractive Attractive Positive (NYSE:PFE) PFIZER INC Health Attractive Attractive Positive (NYSE:WPI) WATSON PHARMACEUTICALS Health Attractive Attractive Positive (NYSE:VZ) VERIZON COMMUNICATIONS Technology Attractive Attractive Positive (NASDAQ:ORCL)  ORACLE CORP Technology Attractive Attractive Positive (NYSE:UNP)  UNION PACIFIC CORP Transportation Attractive Attractive Positive (NYSE:BNI)  BURLINGTON NTH SANTA FE Transportation Attractive Attractive Positive (NYSE:PEG) PUBLIC SVC ENTPRS GROUP Utilities Attractive Attractive Positive (NYSE:AEP)  AMERICAN ELECTRIC POWER Utilities Attractive Attractive Positive

Source: EconomicMargin.com

AFG's Valuation Metric – Measures the percent to target (deviation between a stock’s current trading price and its AFG current default target price). To derive the intrinsic value of a firm, AFG uses its proprietary Valuation Model (modified discounted cash flow model).

Economic Margin - A corporate performance measurement that addresses the gaps in GAAP, eliminating distortions caused by accounting policies to measure what a company is truly earning above or below their cost of capital.

Management Quality – Assesses management’s ability to make wealth creating decisions.

+View our List of Value Expectations Recommended Articles

AFG Recommendation Performance
9/1998 – 5/2009
Annualized Returns

Source: AFGView client databases from 9/1998 – 5/2009
Universe size: 4,000 to 5,500 firms

Question: Why Buffet Is The Wizard of Omaha? Answer: (NYSE:BNI) Analysis of Berkshire Hathaway's (NYSE:BRK.A) acquisition of Burlington Northern Santa Fe Corporation (NYSE:BNI) Value Expectations is often critical of silly corporate acquisitions, where bidders overpay to add growth or strategic opportunities. While those terms sound nice, the bottom line is that firms need to be able to justify the value of said growth or strategic opportunities with future cash flows. More often than not, firms bank on unreasonable growth or profit expectations to justify a deal. For recent examples, see our analysis of Kraft/Cadbury or Dell/Perot:

The Oracle of Omaha Warren Buffett is generally viewed as the most respected and successful investor in history, and many of our value-oriented readers follow the movements and purchases of Buffett rather closely and for good reason. Berkshire Hathaway, a conglomerate holding company, which Buffett built from a textile company into a major corporation, has averaged a 20.3% compounded annual gain in per-share book value from 1965-2008. There is no doubt about the success Buffett has achieved over the years, and there has even been a recent study done that shows an investor could have earned over 14% returns a year had they purchased each Buffett stock, a month after his investment company disclosed ownership.

We thought it would be an interesting story to show how Buffett’s holdings would rank according to The Applied Finance Group’s (AFG’s) valuation model and Economic Margin Methodology. The companies we believe look the most attractive and that investors should pay the most attention to when searching for long investment opportunities are the companies that have both an attractive default AFG valuation and are expected to improve their Economic Margins at a greater rate than their sector peers.

AFG's track record of identifying winners and losers has proven that companies AFG identifies as undervalued are more likely to outperform, than those AFG ranks as overvalued, and the same holds true for companies with expected improvements in EMs vs. expected declines. The Economic Margin methodology adjusts for common distortions in GAAP accounting practices and helps investors to understand the true economic profitability a company earns above its cost of capital. By understanding the true economic profitability a company earns and by gaining a firm grasp on the expectations embedded in security prices, investors can come to a more refined intrinsic value for a company and thus put themselves in a better position to outperform.

Below is a list of Berkshire Hathaway’s current holdings (excluding Financials) ranked by valuation attractiveness, and followed by expected change in economic margins.

Rank within Sector Ticker Name Sector Valuation Signal EM Change Signal Berkshire Hathaway's Holdings (ex. Financials) (NYSE:SNY) SANOFI-AVENTIS ADS Health Attractive Positive (NYSE:WMT) WAL-MART STORES INC Consumer Services Attractive Positive (NYSE:UNP) UNION PACIFIC CORP Transportation Attractive Positive (NYSE:BNI)  BURLINGTON NTH SANTA FE Transportation Attractive Positive (NYSE:GSK) GLAXOSMITHKLINE PLC Health Attractive Positive (NYSE:BDX)  BECTON, DICKINSON & CO Health Attractive Positive (NYSE:NLC) NALCO HOLDING CO Basic Material Attractive Positive (NYSE:NRG)  NRG ENERGY INC Utilities Attractive Negative (NYSE:COP)  CONOCOPHILLIPS Energy and Extraction Attractive Negative (NYSE:NSC) NORFOLK SOUTHERN CORP Transportation Attractive Negative (NYSE:JNJ) JOHNSON & JOHNSON Health Attractive Negative (NYSE:PG) PROCTER & GAMBLE CO THE Consumer Non Durable Attractive Negative (NYSE:LOW)  LOWE'S COMPANIES INC Consumer Services Attractive Negative (NYSE:KFT) KRAFT FOODS INC CL A Consumer Non Durable Fairly Valued Positive (NYSE:KO) COCA-COLA CO Consumer Non Durable Fairly Valued Negative (NASDAQ:COST) COSTCO WHOLESALE CORP Consumer Services Fairly Valued Negative (NYSE:HD)  HOME DEPOT INC Consumer Services Fairly Valued Negative (NYSE:NKE)  NIKE INC CL B Consumer Non Durable Fairly Valued Negative (NYSE:CEG) CONSTELLATION ENERGY GRP Utilities Unattractive Positive (NYSE:WPO)  WASHINGTON POST CO Consumer Services Unattractive Positive (NYSE:IRM) IRON MOUNTAIN INC Consumer Services Unattractive Positive (NYSE:USG)  USG CORP Capital Goods Unattractive Positive (NYSE:KMX)  CARMAX INC Consumer Services Unattractive Positive (NYSE:GE) GENERAL ELECTRIC CO Capital Goods Unattractive Negative (NYSE:UPS)  UNITED PARCEL SERVICE B Transportation Unattractive Negative (NYSE:ETN)  EATON CORP Capital Goods Unattractive Negative (NYSE:IR) INGERSOLL-RAND PLC Capital Goods Unattractive Negative (NYSE:IR) WABCO HOLDINGS INC Consumer Durable Unattractive Negative (NYSE:GCI) GANNETT CO INC Consumer Services Unattractive Negative

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With Berkshire Hathaway’s annual meeting just behind us, we thought it would be interesting to provide an analysis of the Oracle of Omaha’s companies (ex. Financials) to give you a better idea of their valuation attractiveness. The companies that rank highest on valuation should be more likely to outperform going forward and could represent an attractive investment opportunity.

Year to date Mr. Buffet’s portfolio has delivered an average return of 5.18% compared to the 12.93% delivered by the S&P 500 Index (as of May 8, 2009). In the future we will measure the performance of each of the three groups of stocks we now label as Attractive, Fairly Valued, and Unattractive, in order to see what type of spreads are achieved between them.

 

Berkshire Hathaway's Holdings (ex. Financials) Ranked By Valuation Attractiveness

If you want to learn more about AFG's Valuation methodology, click here.

In March, Jim Jubak of MSN Money released a list of stocks that he believed should be stocks that you should pay attention to in the upcoming months/quarters as potentially attractive investment opportunities. ValueExpectations.com set out to answer the question, which stocks on Jim’s watch list look attractive according to AFG’s valuation model and should be on your watch list?

Provided in the table below are Jubak’s watch list companies and how they fare from a valuation perspective using The Applied Finance Group’s Value Score variable which ranks the valuation attractiveness of each company based on the discrepancy between the company’s current trading price and AFG’s target price.

 

Jubak's Watch List Companies (Ranked by Valuation Attractiveness)

 

Valuation Model – Using AFG’s modified discounted cash flow model to measure the intrinsic value of a firm compared to its peers.

AFG's Value Score - A score which represents the ranked percent to target (deviation between stock’s current trading price and AFG’s current default target price) or attractiveness (upside) relative to the universe. A Value Score of 100 is the most undervalued and 0 is the most overvalued company in the universe.

In our April Market Review we released a series of graphs representing the valuation attractiveness of each sector relative to its historical norms and to the entire AFG universe. Below is a graph representing the Transportation sector which is attractively priced when you compare against its historical trading ranges (red line) and when comparing against the overall AFG Universe (represented by the value of 1). Listed are 4 companies in the Transportation sector that look attractive from a valuation standpoint along with their implied sales expectations. Also listed below the graph is an explanation of AFG’s Relative Valuation Chart.

Transportation Sector Relative Valuation Chart

Relative Valuation Chart -This graph shows the Percent to Target Current (Valuation Attractiveness) for a universe relative to the overall market. Values greater than 1 indicate the universe is more undervalued than the market, while values less than 1 indicate the opposite. The red line identifies the historical median value to provide a basis to understand valuation levels relative to historic norms. This example illustrates that the median Transportation company is undervalued relative to the market currently and has been trading at a discount to its historic relative valuation, indicating a potentially attractive opportunity.

 

Transportation Companies With Attractive Valuations (S&P 500)

 

*AFG’s Value Expectation allows us to understand the imbedded Sales Growth, EBITDA Margins, and Asset Turnovers a company has to deliver in the future to justify its current trading price. In theory and in normal circumstances, if the imbedded future performance is very conservative relative to the company’s historical performance, the stock is regarded as undervalued. The table displays the implied future sales growth of companies assuming their EBITDA margins and Asset turnovers stay at the 5 year median levels.

By using The Applied Finance Group’s (AFG's) Risk Analysis, we have identified the top and bottom two firms in each sector (excluding the Financial sector) according to an overall risk score based on 9 variables (see more detail below). In addition to the risk analysis variables we also added another layer of analysis by evaluating the companies’ Earnings Quality (based on the concept of Accruals) and Altman Z-Score (identifies firms that are at risk of going bankrupt in the next 2 years).

Applied Finance Group’s Risk Analysis is designed to systematically calculate a stock’s risk score based on fundamental relationships between the Quarterly Income Statements and Balance Sheets. The template measures 9 factors to determine Risk: Changes in A/R, Changes in Inventories, Cash Flow vs. Operating Cash Flow, Fixed Payments vs. Pre-Tax Cash Flow, Leverage, Intangibles, Write-offs, Management Quality, and Valuation. Companies with lower scores have less risk. Companies in the Financial Sector were excluded due to their differences in financial statement structure.
 

 

Here is a list of the variables that are taken into account within this risk analysis:

1. Receivables to Sales - Delta – takes the difference in the median A/R to Sales ratio over the last 4 quarters vs. median 4 quarters before that.

2. Inventories to Sales - Delta – takes the difference in the median Inventories to Sales ratio over the last 4 quarters vs. median 4 quarters before that.

3. AFG’s Cash Flow-Oper. vs. Operating Cash Flow - AFG's Cash Flow-Oper. for a company is net cash that is generated by the continuing and discontinuing operations of the firm. We compare it to the company's Operating Cash Flow to assess its ability to pay its debt.

4. Fixed Payments vs. Pre-tax Payments Cash Flow – This ratio assesses the company’s ability to cover long-term obligations. If the fixed pmts are greater than 50% of the pre-tax payments cash flow, there is chance that this company may not be able to meet its obligations. Obligations less than 30% of cash flow are considered safe.

5. Leverage – Book leverage and Market leverage are analyzed to give us information about the company’s leverage position. Best score is given to the companies with Book Leverage lower than 60%, and negative score to these with Book Leverage higher than 60% and Market Leverage greater than 0.9*Book Leverage.

6. Intangibles as a Percentage of Total Assets – With this score we try to filter through and reward the companies that have grown organically, rather than through acquisitions. Our research has shown that on average companies tend to overpay for acquisitions and thus are rarely a profitable investment. Companies with Intangibles less than 20% of Total Assets get the best score.

7. Write-offs – Shows the number of years with significant write-offs over the last 5 years.

8. Management Quality – Measures a company’s EM+1 and LFY Asset Growth and there is empirical evidence that companies with positive EMs that are able to grow their business tend to outperform companies with negative EMs who continue to invest into unprofitable business.

 

9. Value Score – Measures a company’s attractiveness from valuation perspective.

Most/Least Risky Firms By Sector S&P 500 (excluding financials)

If you are a professional investor and would like to learn more about this analysis as well as other useful valuation tools click here for a free trial subscription to The Applied Finance Group's research.

Recently Berkshire Hathaway released a letter to its shareholders, which outlined last year’s activities and provided insights on their outlook going forward with an overview of the company's major holdings.  Below is a list of Berkshire's major holdings (excluding Financials) and ValueExpectations.com’s recommendations for these companies.

We will revisit this later in the year to see how ValueExpectations.com's recommendations fared.

 

Applied Finance Group's quantitative process is centered on their proprietary Economic Margin Framework. The core of AFG’s quantitative process starts with evaluating a company's corporate performance and the expected improvement on a relative basis, assessing the valuation attractiveness of the company, and determining if a firm is following a wealth creating or wealth destroying strategy.

A brief description of those variables is below:

Economic Margin - A corporate performance measurement that addresses the gaps in GAAP, eliminating distortions caused by accounting policies to measure what a company is truly earning above or below their cost of capital.
Valuation Model – Using AFG’s modified discounted cash flow model to measure the intrinsic value of a firm compared to it's peers.
Management Quality – Assess management’s ability to make wealth creating decisions.