Interesting excerpts/quotes

29May10

An interesting post from this blog:

http://compoundingmachines.wordpress.com/2009/01/19/mid-continent-tab-card-co/

On November 6 & 7, the University of Virginia hosted its first annual Value Investing Conference. From its website: “The mission of the Value Investing Conference is to annually assemble the investing public, professional investors, scholars, and students in the field of value investing for the purpose of highlighting and disseminating best practices, honoring best practitioners, and revealing new trends and developments in the field.”

One of the conference speakers was Alice Schroeder; author of the authorized biography of Warren Buffett entitled The Snowball. The video of the presentation can be found at the link below:

http://tinyurl.com/8o9xrk

During her presentation, Schroeder provided a fascinating case study of a private investment Buffett made in 1959 in a company called Mid-Continent Tab Card Company. At the risk of sounding technical, tab cards were something used in computers back in the day. At any rate, with over 50% profit margins, selling tab cards was IBM’s most profitable business in the 1950s. As a result of a settlement with the Justice Department, IBM was forced to divest of its tab card business. A couple of Buffett’s friends, Wayne Eaves and John Cleary, had started a tab card company themselves in the mid-to-late 1950s. It was an extremely profitable business. Tab cards were made on what was called a carel press. They were turning their capital over 7x per year while earning 40% net profit margins. In 1959 they were looking to grow this profitable business which required buying more carel presses.

So, in 1959 Eaves and Cleary approached Buffett to see if he had any interest in investing in the company. This is where Schroeder’s presentation gets interesting as she describes the process Buffett went through in deciding if he wanted to invest in the business and the return criteria he desired for putting up the money. I suspect the first thing that most analysts would do when presented with such an investment opportunity is to ask for management’s financial projections and then create a discounted cash flow model. According to Schroeder, Buffett did none of this. In fact, given complete access to all of Buffett’s files, she never once saw anything remotely resembling a financial model. Instead, he analyzed on a quarter-by-quarter and plant-by-plant basis, the historical profit and loss statements for both Mid-Continent and all relevant competitors. From there he acted like a horse handicapper figuring out which one or two factors would make the horse succeed or fail. In the case of Mid-Continent it was sales growth and cost advantages.  When presented to Buffett in 1959, the company had $1 million in sales, was growing at 70%+ per year and earning 36% profit margins. According to Schroeder, the ultimate decision to invest came down to the question, can I get a 15% return on $2 million of sales. The answer in his mind was yes, so Buffett invested $60,000 of his non-partnership money representing 20% of his net worth. This investment gave him 16% of the company’s stock plus some subordinated notes.

As one would expect the Mid-Continent investment turned out quite well for Buffett. Over time he put another $1 million in the company, which would later be renamed Data Documents. The company was sold in 1979 to Dictograph. Buffett held the investment for 18 years earning a 33% compounded annual return…sign me up!

What was interesting to me from this case study was that he did not seem to bother himself with projecting revenue and profits out five years, did not grind over whether to use a 10% or 12% discount rate, nor worry about which terminal multiple to use. There certainly was no investment banker’s “book.” Instead, he approached the investment wanting a 15% “equity coupon.”  From there, he had to decide for himself whether it was a cinch to get such a return while relying solely on analyzing historical profit and loss statements.

Discussion of this investment did not make it into The Snowball because it was deemed too technical for the general public. Let’s hope that Schroeder publishes a follow-up book with more stories similar to that of the Mid-Continent Tab Card Company.

Can someone explain to me what exactly would Buffet had meant by 15% returns on 2 million $ sales. Did it mean FCF/Shareholder equity (at 2 mil$ sales) of 15%? Because Buffet usually refers FCF as the “equity coupons”. How also would he have tied this up with the valuation?

Actual Valuation: If the profits of 36% on 1 million $ sales refer to accounting profits, then he has paid 3.75 0.375 million USD (Thanks Ninad for pointing out the mistake!) for a business whose last year profit was 0.36 million, was growing at 70% yoy, and had a ROE of 200-300%. The ROE can be calculated from the capital turnover * net profit margin (capital turnover is sales/equity which is given as 7x * 30-40% which is the net profit margin). The valuation seems to have been ridiculously low. I guess it will take time to understand the “Do not lose money” credo of his!

The interesting part is he still did not put an immediate buy to such an attractive business. He analyzed it in and out to figure out how it was profitable, why it was profitable and ended up paying a modest valuation for it based on very very conservative assumptions and I guess no price for growth beyond the next year.

But any idea on how he has tied up this valuation number with his requirement mentioned above and how can we apply this to our valuations.

Advertisements


2 Responses to “Interesting excerpts/quotes”

  1. 1 rohit

    i think the first step warren does (per the video) is evaluate risk of failure. when the company was first presented ..it did not have any operating history and so he gave it a pass
    1 yr later as pointed out in the vidoe ..it has an ROE of 200%+. i think warren checked if he can get an ROC of 15% on ‘his’ investment (we dont know the valuation it was sold to him). i doubt the founders gave it at book value ..but they must have given him at a valuation where he was getting more than 15% on ‘his’ investment (with a sufficient margin of safety) and on looking at the numbers he figured that probability was high it would continue
    rgds
    rohit


  1. 1 Good articles… | Dalaal-Street

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s


%d bloggers like this: