Fin 4201/ New opportunities, Timeless Principles.

Fin 4201/ Beyond Buffett Buffett does not invest in the technology companies or international companies or small (public) companies because they are outside his circle of competence; his tenets can be applied to investing in any company, any industry, any market.

Fin 4201/ Application in other areas Technology companies Small companies International stocks

Fin 4201/ What are the problems? Less certainty Solution Higher margin of safety Buy less (as a percentage of your wealth) Hagstrom sees?

Fin 4201/ How do the big 12 fit? Small-Tech-Int’l Simple/understandable? Consistent operating history? Favorable long-term prospects? Rational management? Candid management? Resist herding?

Fin 4201/ How do the big 12 fit? (The sequel) Focus on ROE, not EPS? Calculate “owner earnings” High profit margins? A dollar retained → A dollar market value? Determine value of business Can purchase at discount?

Fin 4201/ Bill Miller – Technology stocks CEO Legg Mason Funds and Manager of Value Trust Profiled as one of the five heroes of value investing. Adapted Buffettology to investing in the New Economy stocks (Recall Level 3)

Fin 4201/ The Sales Pitch At the end of 2003, Value Trust became the only fund to have outperformed the S&P 500 each of the past 13 calendar years. Keep in mind that past performance is no guarantee of future results. “I am confident the bear market is over and that the probabilities favor much better results than we experienced in the past five years…Whether…provisional beliefs turn out to be true, please be assured that no one will work harder or care more about your money than the Value Trust team.”– Bill Miller, Portfolio Manager April 19, 2004

Fin 4201/8001 9

10

Fin 4201/ Value stocks Low Market-to-book ratio. Market Price / Book Value Low Price-to-Earnings ratio. Market Price / EPS

Fin 4201/ Miller’s argument This line of thinking is flawed because value does not depend on market price, it depends on the future cash flows. The trick is value the future cash flows rationally and buy them at a big discount.

Fin 4201/ What is different about tech co.’s Uncertainty. High M/B and PE ratios. Do sensitivity analysis. Keep higher margin of safety. Invest a lower percentage of your wealth. So did we get them all?

Fin 4201/ What is similar about tech? high profit margins, high returns on capital, the ability to reinvest the profits back into a fast-growing company, and management that acts in the interests of shareholders.

Fin 4201/ The Franchise Factors “Yes, people are still buying Coca-Cola and Gillette razor blades, and using their American Express Card, but they are also using America Online, and Microsoft software, and buying Dell computers – and that’s ubiquitous.”

Fin 4201/ The Franchise Factors for Tech Network effect “Everybody I know is on AOL…” Positive feedback Lock-in VHS technology and Computer Keyboard. Increasing returns Low capital expenditure is needed to increase sales.

Fin 4201/ Case Study: AOL and the Buffett Tenets Simple and understandable? Yes. Consistent Operating history? No, new. Favorable long-term prospects? Yes.

Fin 4201/ Rational management? Yes. Institutional Imperative? Yes. Candid management? Yes and No.

Fin 4201/ ROE? High profit margins? Yes.

Fin 4201/ What is the value? In 1996, Bill Miller calculated it to be $7.5 billion as compared to the market price of $4 billion. Discount? His average cost is $1.75 as compared to a market price (after a steep fall) is around $17.

Fin 4201/ AOL and the Technology Franchise Factors. Network effect - Positive feedback Lock-in: flat rate. Increasing returns.

Fin 4201/ Smaller and Mid-Cap Stocks Why Buffett does not invest? Too small for his big pool of funds. Market impact Lack of liquidity Will invest if can buy “whole” business

Fin 4201/ Wally Weitz Wallace R. Weitz & Company (Estd. 1983) Mid-cap funds Weitz Value Fund Weitz Partners Fund Small-cap fund Weitz Hickory Fund

Fin 4201/ Similarities with Buffett Both operate from Omaha, Nebraska. Weitz tries to determine what a rational buyer would pay if that buyer had the opportunity to purchase 100 percent…. Does the company have some special market niche, or a franchise value?

Fin 4201/ Like Buffett, he sticks with businesses he can understand. Seeks businesses that generate excess cash and have honest managers. Low turnover – 20 to 30 percent per year.

Fin 4201/ Small-Cap Companies - Problems Until they have gained substantial market share, they are potentially greater economic risks. Low liquidity Require low turnover.

Fin 4201/ Advantages They tend to be less complex, less bureaucratic. Their managers are often more accessible. Less covered

Fin 4201/ International Stocks - Challenges They may have different accounting standards. There is a risk that the currency will decline relative to the dollar.

Fin 4201/ It is more difficult to interview management. Political, social and economic turmoil can ruin companies and swallow the expected gains. Why hasn’t WB done much Int’l

Fin 4201/ Mason Hawkins, Southeastern Asset Mgt. Longleaf Partners funds. Concentrate on cash and not the accounting figures. Only buy if it is selling for less than 60 cents for a dollar. Shareholder oriented “good” managers Non-diversified investments.

Fin 4201/ Hedge the currency risk, add the cost of hedging at the valuation stage. Travel to collect the information.

Fin 4201/ Essential To Look For – Anywhere, Any Time “Good businesses that generate great economies run by smart managers available at cheap prices.”