The Inevitables 2

by Cole Smead, Smead Capital Management

As we watched this year’s Berkshire Hathaway Annual Meeting, one thing struck us. There was sheer enthusiasm around the annual shareholder meeting for anything tech-oriented. Yes, it was disclosed that Berkshire had taken a position in Amazon that Friday, but it goes deeper.

Our CIO Bill Smead, (Dad where I come from), was speaking at a conference for value investors that Thursday and Friday in Omaha. This was a conference primarily made up of stock pickers as well as some asset allocators. The overwhelming sentiment from the group was a tone of enthusiasm, not for thinking about how to practice ignorance avoidance or other Buffett and Munger disciplines. There was enthusiasm for trying to figure out how to make big-cap technology stocks fit into their discipline. The Amazon announcement was just icing on the cake going into the shareholder meeting that Saturday.

This is not the first time that excitement has pervaded the thoughts of Berkshire Hathaway shareholders or Buffett and Munger. It was just the second time that we’ve witnessed, going back 25 years.

In the 1996 Berkshire Hathaway shareholder letter, Buffett wrote:

Companies such as Coca-Cola and Gillette might well be labeled “The Inevitables” Forecasters may differ a bit in their predictions of exactly how much soft drink or shaving-equipment business these companies will be doing in ten or twenty years. Nor is our talk of inevitability meant to play down the vital work that these companies must continue to carry out, in such areas as manufacturing, distribution, packaging and product innovation. In the end, however, no sensible observer – not even these companies’ most vigorous competitors, assuming they are assessing the matter honestly – questions that Coke and Gillette will dominate their fields worldwide for an investment lifetime. Indeed, their dominance will probably strengthen. Both companies have significantly expanded their already huge shares of market during the past ten years, and all signs point to their repeating that performance in the next decade.

If you go look at the transcript of the 1996 shareholder meeting, Tim Medley from Jackson, Mississippi asked an incredibly important question for the shareholders:

My question is an allocation of capital one. You’ve indicated that one thing you like in companies is a willingness on the part of management to repurchase its own shares. I wonder if you would talk for a minute about your own frame of reference on repurchases when it appears that the current price of the stock is rich in relation to its intrinsic value. And some have said that, with the right company, ongoing repurchases of stock should be made, irrespective of the price. So, would you speak for a moment, as to how you think it pencils out when the current price of the stock is rich in relation to its intrinsic value?

Buffett replied:

Yeah. If you’re repurchasing shares above a rationally calculated intrinsic value, you are harming your shareholders, just as if you issue shares beneath that figure, you are harming your shareholders. That’s a truism. Now, the tough part of that, of course, is coming up with the intrinsic value. And, for example — a good example might be Coca-Cola.

I think a number of people might have thought Coca-Cola was repurchasing shares at a very high price, because they’ll look at book value or P/E ratios. But there’s a lot more to intrinsic value than book value and P/E ratios. And anytime anybody gives you some simplified formula for figuring it out, forget it.

You have to understand the business. The people who understood that business well, the management, have understood and been very forthright about saying so over the years, that by repurchasing their shares, they are adding to the value per share for remaining shareholders. And like I say, people who didn’t understand Coca-Cola, or who thought mechanistic methods of valuation could — should take precedence, really misjudged the value to the Coca-Cola Company of those repurchases.

This one of “The Inevitables” couldn’t be valued in a simple way, according to Buffett. Management was smart to be adding value through their repurchases. Time was going to march forward. Don’t worry about things like book value or P/E ratios. “Forget it.”

Looking at the weighing machine, however, this couldn’t have been further from the truth. The S&P 500 Index made 5.51-times your money from the beginning of May 1996 to the end of May 2019 versus 3.17-times your money on Coca-Cola, including dividends reinvested. Tim Medley from Jackson was right.

Fast forward to the 2019 Berkshire Hathaway shareholder meeting. As the place was a buzz with the excitement over what Buffett would say about its Amazon stake, the question arrived.

This question is from Ken Skarbeck in Indianapolis. He says, “With the full understanding that Warren had no input on the Amazon purchase, and that, relative to Berkshire, it’s likely a small stake, the investment still caught me off guard. I’m wondering if I should begin to think differently about Berkshire looking out, say, 20 years. Might we be seeing a shift in investment philosophy away from value-investing principles that the current management has practiced for 70 years? Amazon is a great company. Yet, it would seem its heady shares ten years into a bull market appear to conflict with being fearful when others are greedy. Considering this and other recent investments, like StoneCo, should we be preparing for change in the price-versus-value decisions that built Berkshire?”

Buffett answered saying this:

Yeah. It’s interesting that the term “value investing” came up. Because I can assure you that both managers who — and one of them bought some Amazon stock in the last quarter, which will get reported in another week or ten days — he is a value investor. The idea that value is somehow connected to book value or low price/earnings ratios or anything — as Charlie has said, all investing is value investing. I mean, you’re putting out some money now to get more later on. And you’re making a calculation as to the probabilities of getting that money and when you’ll get it and what interest rates will be in between. And all the same calculation goes into it, whether you’re buying some bank at 70 percent of book value, or you’re buying Amazon at some very high multiple of reported earnings.

We have found it keenly interesting that Buffett went right back to the same line as he did in 1996 when he said, “book value or low price/earnings ratios.” The investment world is excited over the future of technology stocks irrespective of price in many cases. All Buffett can say on it is to make fun of basic valuation metrics?

They shortly after went on to say:

CHARLIE MUNGER: And I don’t mind not having caught Amazon early. The guy is kind of a miracle worker. It’s very peculiar. I give myself a pass on that. But I feel like a horse’s ass for not identifying Google better. I think Warren feels the same way.

WARREN BUFFETT: Yeah.

CHARLIE MUNGER: We screwed up.

WARREN BUFFETT: He’s saying we blew it. (Laughter) And we did have some insights into that, because we were using them at GEICO, and we were seeing the results produced. And we saw that we were paying $10 a click, or whatever it might’ve been, for something that had a marginal cost to them of exactly zero. And we saw it was working for us. So —

CHARLIE MUNGER: We could see in our own operations how well that Google advertising was working. And we just sat there sucking our thumbs. (Laughter) So, we’re ashamed. We’re trying to atone. (Laughter) Maybe Apple was atonement. (Laughter)

We would make the case at Smead Capital Management that Warren and Charlie are saying that Google is today one of “The Inevitables.” However, this speaks to the business. As we saw earlier with Coca-Cola, price paid and value received may be another world. What if the greatest investor of all-time and his brilliant sidekick have propagated a mania in a series of businesses as they had in a prior era?

To add one more item to sins of the past, in a Bloomberg article titled “Dot-Com Extremes Returns as Trade Angst Spurs Dash to Safety Stocks,” the writer Justina Lee wrote “Europe’s quality companies are scaling a fresh relative peak. Low-volatility trades continue to boom across the globe. And U.S. defensives are the priciest versus cyclicals since 2000, according to Evercore ISI.” Investors have been hunkering down in low-volatility bunkers buying perceived safe businesses and the 10-year Treasury note. Using one of those antiquated valuation metrics, Coca-Cola currently trades at 23.8-times their 2019 earnings while the S&P 500 trades at 16.49-times today’s earnings. As Lee’s piece stated, “‘Classic defensive factors are too well bid to be defensive,’ strategists led by Inigo Fraser Jenkins wrote in a recent note.”

Even with the bid up in stocks like Coca-Cola in today’s environment, it still isn’t rectifying the price paid in 1996 versus the average stock then. It may not be a 23-year problem for investors. This may be a 30- or 40-year problem for the investors that believed it was one of “The Inevitables.”

Being one of “The Inevitables” in the minds of an investor can be a powerful belief for their perceived confidence in the company, but a damning truth as it pertains to the value received for the price they paid at the time. At a time like now, we’d rather be Tim from Jackson, Mississippi than the “smartest” people on Wall Street. Buffett atoned for his investment in Coca-Cola later saying he should have been selling it. Will other investors be as honest with themselves as the Oracle was with Coca-Cola when looking back at “The Inevitables” of today?

Warm regards,

Cole Smead, CFA

The information contained in this missive represents Smead Capital Management’s opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Cole Smead, CFA, Managing Director and Portfolio Manager, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.

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