Now with the S&P back up to near highs, many are calling out Buffett and saying he’s lost his touch. “Maybe he’s too old now” and “maybe he doesn’t care anymore now that he’s approaching 90 and loaded” or “maybe the oracle has lost his touch”.
I don’t really think that’s the case and think the negative sentiment creates an opportunity in Berkshire Hathaway stock. People who argue that Buffett is too old and “lost it” could have easily argued the same thing when he was 65 going on 70, 75 going to 80… Buffett has that itch that can’t be scratched.
I do think some of his methods are too old fashioned. I can’t actually confirm this is true, but he has said he won’t participate in auctions. What board would actually be able to justify selling to him without a second bid? Especially when times are good and they are a good business.
I’m taking Berkshire Hathaway’s current market cap and subtracting the market values of his equity holdings (note, I pulled this from Bloomberg, so it may not be 100% accurate). I then subtracted the cash to arrive at the value the market is ascribing to the “core Berkshire Hathaway” business.
I say core, but in reality there are so many subsidiaries within Berkshire Hathaway. You have GEICO, Berkshire Hathaway Energy, BNSF, Precision Castparts, just to name a few well known ones. If interested, I highly recommend perusing the list of subsidiaries on Wikipedia. I bet there are quite a few you didn’t realize he owned.
At the end of the day, you’re being asked to pay <8x earnings for the collection of businesses that Warren has acquired AND you have free upside from the cash if it is ever deployed.
Frankly, the real upside in the stock may be 5-10 years away when Berkshire Hathaway is broken up and people realize the sum of the parts is worth more than the whole.
Either way, look at the impact of Berkshire going out and deploying cash. Earnings could likely go up 30% from where they currently are and even deploying the cash at a worse multiple than where Berkshire trades today (i.e. dilutive), you’re still paying <9x earnings.
Unfortunately, if you want to read a 10-K to get better at investing or understanding how companies work, you can’t just read a 10-K in a vacuum. You must put the knowledge and information you glean into context.
If you were moving to a new city and needed to purchase a home, would you look at one home and determine you had enough information? Probably not. You’d probably want information on that home as well as several others and weigh the pros and cons of each (how are the schools, how much room am I getting for the price & is it a good trade off, do I need to pay city taxes, etc.).
Same is true for investing in companies. I want to read about this company, understand how it works, determine if I think it is good or not, and then go read about its competition. Is the competition even better? Maybe the customer is actually the better business or its supplier.
As you can probably tell, this creates a web of information you need to understand, but can be worth it in the end.
Also in the context of not reading a 10-K, I almost never open up a 10-K without opening up the company’s latest investor presentation (typically on their investor relations site), and then also typically plan on reading the latest earnings calls as I get more interested.
Ok – let’s dive into what I do when I first open a 10-K.
“How does this business actually make money” – Read the Business Overview Section and Understand How that Flows Through to the Income Statement
Nowadays, there are links upfront in a 10-K that can help you jump to the sections you want. First thing I do is click on the Business Overview section.
From there, I jump ahead to where the company has the opportunity to describe what it does.
I can’t tell you how much I respect companies that really take the time to help investors understand what they do. Sometimes companies leave it ambiguous which is super frustrating. Especially when covering small caps and I also look at private companies, the amount of times I’ve heard investors think an a company does one thing, when in reality they do not actually understand how they make money, is alarming.
As a quick aside, I once had a company describe themselves like this: “[Company’s] performance resins and surface overlays are ubiquitous in products used in residential and commercial applications and are increasingly displacing traditional building material through value-adding attributes. [Company] is a highly profitable, vertically integrated provider of these products.
Very hard to even determine what they were doing. Turned out, they would saturate paper with a formaldehyde-based resin and sell it into various building products. That’s the importance of diligence.
I have to commend Fastenal on how well they describe their business in 7 sentences. It gives some history, what customers they target, how many branches they have, and what their general strategy is.
So right off the bat, I can generally tell how Fastenal makes money. They sell fasteners. Their business description actually continues on for several pages, which I’ll let you read as opposed to pasting here. It’s a good read.
But as soon as I read this description, I start to have questions pop into my head. I’m trying to understand the value chain. Do manufacture themselves or buy from suppliers? What industries do they target? How do they differentiate themselves? The reason why I ask these is because the answers will start to tell me things about the business.
If they manufacture themselves, it’s probably a unique offering that they can charge a higher margin for, but it will be more capital intensive (need machines, plants as well as branches). If they just buy from China and sell in the US, maybe others can do the same so I’d expect their margins to be lower, but not much capital is really needed.
Turns out, Fastenal mostly buys from third-party suppliers, but as you’ll see later, its margins are surprisingly high. Fastenal is a rare company where it actually provides some detail on this. As I said in my competitive strategy series, looking just at the numbers doesn’t tell the whole story. We need to understand why a company may have high margins or not and if that is OK.
To understand a business and get better at investing, you have to know how a business works. If the above snippet doesn’t make a ton of sense to you, then you need to map it out.
Here is a quick snapshot of what I typically do. I first just try to make a made-up model of the company. I just say, “Hey, I understand selling fasteners, widgets, what-have-you, means buying fasteners in inventory and selling them for a profit. Let’s assume I sell 100k fasteners for $5 – how does that look here for Fastenal?” Note, these numbers are made-up, but the margins are about what Fastenal has.
Hopefully from the notes above, you can see I’ve also made attempts on how the cost structure of the business works. Is this a highly variable cost business or not? I would say it is highly variable. If my sales go down, I’m not just going to keep buying fasteners and keep paying bonuses to sales staff (I’m going to incentivize them to get sales up).
Contrast that to an automotive company like Ford or GM. They typically have unionized workforce, so I’m not sure how many people they can actually cut in a downturn. They also have huge manufacturing plants that are hard to just turn off and turn back on without expenses associated with it. Contrast that to Fastenal, whose branches are very basic stores with shelves. That’s one reason why automotive companies and airlines go bankrupt so often. They are highly competitive, highly cyclical, highly fixed cost businesses – demand going down hurts the bottom line a lot more.
I digress. Back to Fastenal.
Let’s now see an impact of what happens with more fasteners being sold – what impact does that have on the bottom line (using EBITDA here for now)?
As you can see, a 4% increase in fastener sales actually leads to a ~7% increase in EBITDA. The main reason is that, while COGS went up by a similar amount to sales, SG&A stayed relatively flat. This is important to understand because you may say, “Ok Fastenal is a mature business. Maybe it should only grow with growth in industrial production, manufacturing, or GDP in the long term. Well if that is 2-3% growth, earnings probably will grow at a faster clip than that, which is important for valuation.
This is a simplistic example and view (for example, more detailed models will have store branches modeled out, how many fasteners each branch sells, what the sales impact and cost impact will be of adding a new branch) but hopefully shows in more detail of how I examine a business and how it makes money.
“Show me the money!” or, uh, Free Cash Flow – Examine the Cash Flow Statement; Understand Drivers
First, the income statement doesn’t capture everything. Net income does not equal free cash flow that we use to value a business. It may capture depreciation which can be used as a proxy for capex in a mature business, but for a fast growing business, capex will likely exceed depreciation. The income statement doesn’t capture the working capital investment needed to grow the business. It also doesn’t tell us where the free cash flow is going (M&A, dividends, share buybacks, debt paydown, just sitting on the balance sheet?).
I also focus on the cash flow statement next because frankly I am trying to find good businesses. If after examining the business overview and parts of the income statement, I see that the cash flow statement is a mess, I may or may not decide whether or not it’s worth my time. Sometimes I like to dig into a messy cash flow statement because people who do simple stock screens will miss opportunities. Other times I’ll decide it’s best to drive on.
To find the cash flow statement, I typically search the document for “Operating activities” which will allow me to jump to “Cash Flow from Operating Activities” part of the cash flow statement. If you don’t know, free cash flow = cash flow from ops minus capital expenditures. This is typically the cash leftover to the business that it can use for other discretionary items.
So I do some quick math and try to determine FCF for Fastenal.
They generated around $600MM of FCF last year, which was a nice jump from $500MM the year before despite what clearly was a big increase in capex. You probably want to figure out why to see if it is sustainably higher. Very quickly, I can see that net income increased (+$39MM), depreciation & amortization increased slightly (+$11MM) which is non-cash so added back, and I have to do some math, but I can see changes in working capital also benefited them in that it looks like they didn’t need to invest as much there, as you can see the increases in inventory and accounts receivable are down a lot Y/Y (total W/C benefit +$141MM Y/Y).
After figuring this out, you need to understand why these occurred. Does the company say anything in its earnings calls about this? Investor presentations? Why is capex up so much? New branches? Is that what drove net income higher? But if they opened new branches, why didn’t working capital increase? Is it a new type of branch that doesn’t require as much of an upfront investment?
After figuring out FCF and whether the past few years look sustainable, I take a look at where the cash is going. It looks like from above Fastenal paid down some debt (as payments are larger than issuance of debt) and paid a big dividend, which has been consistent in size.
However, one red flag I immediately see is that 2019’s dividend is nearly identical to 2018’s FCF… do they have enough FCF to cover the dividend? Yet ANOTHER reason why focusing on net income and payout ratios that are thrown around never makes much sense to me.
Anyway, looking at the cash flow statement provides a lot of clues as to how good the business is. Frankly, I only really need to Income Statement and Cash Flow statement to get an idea if the business generates a good return on capital.
Management’s Discussion & Analysis
This section of the 10-K is when management teams can really explain what drove business results over the past few years. Look at how much detail Fastenal provides in just one section. This doesn’t even really get into cost of goods or operating expenses.
This section really should help an investor with the detective work needed to understand the business. It certainly helps me model companies and think about drivers for the future.
Obviously, there are many more things to study when evaluating an investment, but wanted to share my starting point for how I read a 10-K.
Many know the history behind McDonald’s, but if you don’t I highly recommend the movie The Founder. It details how McDonald’s started as a simple restaurant business, but Ray Kroc took it over to expand the business and eventually takes it over. It also gets into the groundwork for McDonald’s strategy it would use for decades to come.
McDonald’s is not in the restaurant business, per se, it is in the real estate business.
As a reminder, this Competitive Strategy series I am doing is trying to unravel why some businesses do better than others, even in highly competitive industries. This post will be brief and mainly focus on this real estate point – to me, it is a truly differentiated strategic decision from McDonald’s.
Why Does McDonald’s Own or Lease the Real Estate?
Typically, McDonald’s will own or lease a restaurant site and lease or sublease it to a franchisee. McDonald’s return on that real estate investment is derived from a fixed % of sales as rent payment from the franchisee. McDonald’s also earns a royalty fee, but the bulk of earnings is actually tied to this “rent” payment.
As you can imagine, this is a unique relationship between franchiser and franchisee.
Here is a comparison of gross PP&E on a group of restaurants balance sheets compared to the number of locations they have. The only names that come even close are Chipotle, which has no franchisees so isn’t really comparable, and Starbucks, which also is mostly company-operated stores.
Think about if you were a landlord and received rent plus a fixed percent of the tenant’s sales. You want the tenant to do well and may even kick in funds to help them (if you think the returns will be favorable to you).
This is the case with McDonald’s. When a restaurant unit needs to be remodeled or needs new capital investment, McDonald’s will typically share some of the expense, which helps relieve some of the burden on the franchisee, while also allowing the company to cycle through new looks and new menu items. This keeps McDonald’s menu relatively fresh and restaurants looking up-to-date.
McDonald’s also does not allow passive investors. This aligns incentives for the store owner to maximize sales and profits (because that is how they derive most of their income) which in turn boosts McDonald’s profits.
As a result, McDonald’s has posted a powerful financial track record over the past couple decades. As shown below, its same-store sales results are pretty impressive when you think about how mature McDonald’s is as a business.
But doesn’t this make McDonald’s more capital intensive?
Here is a chart of capex as a % of sales for each of the players:
But that actually doesn’t hinder the company much. Look at its return on assets compared to peers. It actually stacks up quite well, which is surprising when you think about how much more in assets the company has.
What could be the driver of that? Profitability. McDonald’s is just much more profitable than most of its peers. Part of this is scale (can leverage corporate fixed costs well with the number of branches), but also part of it is the way the company has established its fees.
NVR stock has absolutely crushed the competition. The company is a homebuilder, which isn’t a very good business, but has a differentiated strategy than its peers. Below is a chart comparing NVR to other builders.
This may surprise some people, but investing in NVR in the 1990s would have outperformed buying Microsoft!
Note, the starting point differs a bit from the chart above, but you get the idea. $10,00 invested in NVR stock would be worth $2.8MM today compared to only $1.1MM in Microsoft stock.
Quick overview of the homebuilding industry
Homebuilding is pretty simple — essentially acquire land and subcontract most parts of the building process out.
Therefore, if you had the capital and time, you could probably enter the industry. That’s probably why most homebuilders do not create much value for shareholders in the long run. There are several other reasons as well.
Trusting them to be good asset managers. Homebuilders want to acquire cheap land, so they acquire in areas outside of where they currently operate – going where they think the growth will be. This land is typically “raw” and needs to be zoned & entitled, roads paved and sewer installed, etc. Now, builders typically let a land developer handle this, but enter into a contract to purchase that land when it is developed. By the time the land is developed and the builder is prepping to build homes, they are praying that demand will hold in or has moved in their direction, otherwise the investment in the “raw land” may not be fruitful.
In homebuilding,you are rebuilding the factory each year. Builders are constantly acquiring lots for growth. Think about it. What other business are you constantly selling your asset base down? In manufacturing, typically your factory creates products that you sell, but at the end of the year you still have the factor. In farming, I sell the fruits of my labor, but I still have the land for next year.
I liken homebuilding to oil & gas – if I drill one well, it will produce cash but for me to keep my earnings power constant, I’ll need to reinvest that cash into other wells. Typically this means they are burning cash in the good times, as demand looks good in the future so they continue to acquire future inventory. In bad times, the builders need to generate cash, but do so at the worst time. They have illiquid assets that need to move quickly to generate liquidity so they have to take a haircut.
As you can probably tell, I think homebuilding is a bad business. But as I said when I launched this series, you can have a bad industry, but a great company. Oftentimes investors will write-off sectors and leave gems out like NVR stock.
Summing up NVR in one picture: The company takes very limited land risk.
So for an initial deposit, NVR keeps flexibility of whether or not it will buy the lot. This helps it keep flexibility in a downturn so that its not still acquiring things that may be bad investments or it can divert capital elsewhere when needed (in fact, NVR is the only builder right now that can confidently buy stock on the cheap due to its flexible model and strong balance sheet). This also means it keeps very little land on the balance sheet compared to peers because it doesn’t own it.
This is very different than the rest of the industry:
Let’s compare how the cash flows then look for a traditional builder. Pay attention to working capital, which is mostly inventory movements (may need to click on picture to see better):
As you can see, Lennar generated cash in the financial crises, but it came from liquidating inventory. It then needed to replenish as the market came back. It was forced to sell when you’d want to be a buyer and forced to buy when you’d want to be a seller.
Let’s compare that to NVR’s cash flows. It too sold down inventory, but as a % of earnings, it was much lower and emerged much stronger. It also didn’t need to impair large portions of its book like Lennar did.
NVR Builds Only After the Home is Sold. NVR does not typically take ownership of a lot until it has pre-sold a home and the buyer has qualified for their mortgage and then it begins construction on the unit. This also reduces risk that the company spends capital today for no reason.
NVR ships pre-cut materials to the job site at specified requirements. This speeds up the building process for quick & efficient assembly. The company is one of the few builders to maintain manufacturing facilities for framing products as well as windows & cabinets. This type of vertical integration helps control costs and provide efficiency.
Maintains leading market share on a local level. I shudder whenever a homebuilder acquires another where it doesn’t currently build. Think about it – what benefit does the transaction bring? Yes, it brings lots in a new region. Some would say diversity is good. But M&A is typically done at 1x book value or above. So how does that create value? You won’t get any purchasing scale or scale on labor used unless you expand your market locally. It’d be much better to buy a player where you already operate. Lower competition plus gain regional scale.
NVR’s strategy is to gain leading market share where it operates and growth areas stem from places its operated before. NVR has a dominant 20%+ share in its core markets — much higher than peers’ typical share of 7-10% when they have a leading position.
Combining the last two points translates into similar margins to peers. NVR did about 35% of the sales that Lennar did in 2019. Yet compare their financials. NVR is lower GMs (which is a byproduct of their business model), but also much more efficient with SG&A, as discussed. This leads to comparable margins to peers.
Land is the most capital intensive part of the business, so they (i) are earning similar margins as peers but also (ii) turning inventory much faster than peers. This translates into much higher ROEs… higher ROE in the long-run helps NVR stock outperform peers.
Breaking this out – look at NVR’s historical ROE!
Why doesn’t everyone operate this way?
Not all geographic areas offer options like the ones NVR uses, so it may inhibit NVR in the long-term. But also many builders in other areas simply don’t have this option.
In times of growth, NVR’s top line will typically lag peers as its business model acts as a governor. Through cycle though, we can clearly see the benefits
Gross margins, in the good times, can also be better because you are selling low cost inventory into higher prices
NVR’s sales and earnings aren’t the largest, but its differentiated strategy aimed at limiting risk has obviously helped in a cyclical industry. As you can see by NVR stock, slow and steady wins the race.
Saudi Arabia and Russia are in a price war — increasing the supply of crude oil at a time when we are seeing an unprecedented collapse in demand due to the coronavirus (COVID-19). Exxon has gotten crushed this year, down 45% YTD with a 9% dividend yield. They’ve consistently paid, and grown, the dividend over the past 37 years. Exxon’s dividend offers a juicy proposition for a company that is rated investment grade and at a time when the 10 yr treasury yield is <70bps.
But let’s do some quick math to see if the dividend is covered, first by looking at 2019 figures. As shown below, Exxon did $1.5BN in FCF.
This is not good. The Exxon dividend cost $14.6BN in 2019.
One thing we could do is look at what bare-bones capex is. In other words, what did the company spend in 2015/2016 when the oil outlook was also bleak? Cutting capex down to those levels would help preserve cash:
So now we have ~$10.5BN of FCF, but that still doesn’t cover the Exxon dividend. The other problem is that cutting capex is not what the company wants / intends to do. As stated in their March 5, 2020 investor day, they will actually be spending more than 2019:
Even so, cutting capex back doesn’t help. And the bigger problem is that oil was roughly 100%-200% higher in 2019 than it is right now.
What other ways could the Exxon dividend be maintained?
They could sell assets, but what price would they get in a time like this?
They could issue a bond to help cover it – but do you want an increase its debt load? Is jeopardizing the company for the dividend worth it?
I think its a matter of when, not if. Besides, I personally don’t think the oil industry is dead – there must be good long-term investment opportunities out there for them now that so many players are distressed.